Mail Bag – Which 5 Dividend Stocks Would You Want to Own If You Had to Put Your Entire Net Worth Into Them and Couldn’t Change for 50 Years?

Today’s mail bag questions is a great one about long-term investing in stocks.

Dear Mr. Kennon,

I know you don’t talk about individual stocks, recommend investments, or give any sort of advice – it’s all just general knowledge and you sometimes provide case studies using real companies.  I’m hoping this passes that test because I’m more interesting in the philosophy behind your answer, so here goes.

If you were forced to sell everything you own, put it in a tax-deferred or tax-free account, invest it in 5 publicly traded stocks, reinvest the dividends, and not be able to make a single change to the portfolio for the next 50 years, at which point you could break open the safe deposit box and cash in your holdings, which companies would you choose and, more importantly, why?  In this scenario, low-cost index funds are off the table – you must choose individual stocks.  You can’t change your mind once the buy order is submitted.  Let’s also assume you can add to the positions at any time by depositing fresh cash but you can’t sell.

Sincerely,

Robert

Well, Robert, you are correct; I strive not to talk about individual investments and I only speak in broad terms about general finance theory, value investing, accounting, and other matters that are important so you can do the work yourself.  When I read your question, what is sounds like you are asking is, “How would you go about choosing a portfolio of a few, key stocks that would let you sleep soundly for 50 years without thinking about the economy, wars, elections, or the price of crude oil?”.

The Eight Things I Would Look for in a Long-Term Dividend Stock

First, I would look for a handful of important things in a long-term dividend stock if I couldn’t buy when it was undervalued and then sell when it reached intrinsic value:

• Each of the companies must generate significant cash in currencies throughout the world, not relying on a single nation
• Each of the companies must consists of a collection of companies rather than a single business
• Each of the businesses should be old, established, and have an institutional dynamic that lends itself to stability, forward-looking growth and creating leaders through the company culture
• Each company should have a good historical record of returning capital to shareholders in the form of cash dividends, spin-offs, and share repurchases
• Each company should have considerable pricing power, serving as a natural hedge against inflation to protect the company’s return on equity rate when input costs are rising
• Each company should have unparalleled distribution systems
• Each company should sell products or services to which consumers are deeply, and passionately, connected
• Each company must be lasting and unlikely to fundamentally change with technology

While these characteristics don’t guarantee that the dividend stocks I choose will beat the market, they do embody the traits of companies that have generated very good long-term rates of return over the past 100+ years.  After all, you may not be able to pick the next NBA star out of a lineup, but you have a better chance of being right if you pick the guy that is 7 feet tall and athletic instead of the one who is 5’2″ and can’t walk down the hall without tripping over himself.

The Five Dividend Stocks I’d Choose

Using the criteria we have established, there aren’t a lot of companies left from which to choose.  At this point, there is some degree of personal preference.  But in my case, the list would come down to five dividend stocks:

• Johnson & Johnson (Pharmaceutical and Consumer Goods)
• The Coca-Cola Company (Beverages)
• General Electric (Conglomerate)
• Procter & Gamble (Consumer Goods)
• Nestle (Packaged Food)

In the case of the last dividend stock, Nestle, I wouldn’t buy the ADRs, or American Depository Receipts, I’d buy the actual shares of Nestle on the Zurich stock exchange in Switzerland, paid for in Swiss Francs.  I wouldn’t want to have to worry about the bank sponsoring the ADR modifying the structure or discontinuing the product so I’d just rather have the actual stock in my hand, directly, in the home country.

Your list could be different.  You might just have well chosen Kraft Foods, or Kellogg, or General Mills instead of Nestle.  You might have preferred an investment in PepsiCo over Coca-Cola.  Based upon your own experience, career, life history, and education, you are going to be more knowledgable and more comfortable with certain industries and certain companies; a geologist working in the petroleum industry is going to have a good idea about oil companies, just as a medical doctor is going to have a better inherent understanding of the various drug portfolios of the major pharmaceutical firms.

My list reflects your question: If I had my entire net worth split evenly among those stocks, all of the dividends had to be reinvested, I could only purchase additional shares of those stocks, and I couldn’t sell until 50 years had passed, I would sleep well knowing I owned them.  There may be problems from time to time but my time horizon is half a century, not month-to-month or even year-to-year.

One complication is you limited me to no index funds.  Going back throughout history, a portfolio of small capitalization stocks that have characteristics including low price-to-book ratios, low price-to-sales ratios, low price-to-earnings ratios, high returns on equity, high dividend yields, and a handful of other factors has dramatically, and geometrically, outperformed large capitalization blue chip dividend stocks once your investment time horizon expands past ten or twenty years.  But there is no possible way you could select the four winners among the thousands of small cap companies available when you started the investment plan, let alone ones that wouldn’t be bought out for cash, leaving you parked in depreciating currency for decades!  As a result, I’d take the lower, though still likely to be satisfactory, returns generated by giants that are not likely to collapse; though, in this world, nothing is certain.

The Conspicuous Absence of One of My Favorite Companies of All Time

You may notice the conspicuous absence of Berkshire Hathaway, a business that I love as much as my own companies.  Why?  That is easy.  Berkshire Hathaway is one of the greatest companies the world has ever known.  It is essentially in the business of sourcing low-cost capital and channeling it to the highest return in a decentralized management structure (a business model almost identical to Johnson & Johnson, it should be highlighted).  Long after Buffett is gone, I expect Berkshire to continue churning out cash, gushing money from every corner and, eventually, to see that cash paid out as enormous dividends (after all, at some point, there are no longer companies large enough to buy that would make a difference to the bottom line).

The thing is, Berkshire Hathaway generates a tremendous amount of its capital from reinsurance float and other insurance products.  The current management is brilliant.  Even if Warren Buffett and Charlie Munger were no longer alive, as long as Ajit Jain and the other “all stars”, as Buffett puts it, were still showing up each morning, I wouldn’t worry about the place.  But reinsurance and financial products requires smart managers.  Look at AIG – a tiny, tiny office in London took down a company that had been thoughtfully built over a lifetime into one of the biggest economic powerhouses on the planet.  In the investing world, 50 years is a long time.

If the terms were different – I could sell a stock at any time – Berkshire Hathaway might have (probably would have) made the list.  I still have the AIG annual report the year before the meltdown in my office with a note scribbled on the inside cover, “The derivatives just make me too nervous; I can’t get my head around them.  I love the company, but I can’t buy it since I can’t understand it.”  That approach saved me from making an investment even though I knew the money the firm was making was very real; I couldn’t quantify the risk.  Your mail bag question stated that I couldn’t sell, even if I wanted to sell.  That changes the entire parameters of the discussion.  It is likely that Berkshire will be several CEO’s removed from Buffett by that date and his children will no longer be alive if current life expectancy is any guide.  Tying my hands so I couldn’t sell it would leave me nervous.

(At this point, you might wonder why General Electric is on the list since it is also a conglomerate.  GE is one of the first Dow components and it was originally founded by Thomas Edison in 1892.  It is a machine; an engine the produces leaders thanks to the corporate culture.  I have little doubt that General Electric will find a way to make money and then return that money to stockholders because the company has created this culture that weeds out weak performers, makes strong performers rich, and obsesses about being “the best” in everything.  I’m betting on the company’s institutional dynamics and culture.  In 50 years, GE might look nothing like it does today, but it seems reasonable to bet it will still be making money.  This is essentially a way for me to get around the no-index fund basis upon which your question was posed.  General Electric is essentially an industrial index fund posing as a single company.  It could be broken up into component parts, each of which would be very large in the respective field in which it operates.)

When Dealing with a Investment Horizon of 50 Years, Predictability Becomes Vital

This is another way of saying that there are a lot of great businesses I admire and want to own.  But I don’t know if Apple, Inc., will still be in business in 50 years because technology changes too quickly.  I don’t know if Berkshire Hathaway will still be the fortress of financial power that it is today.  I don’t know if Wal-Mart will still be the dominant retailer (after all, Sears Roebuck was untouchable and an upstart out of Arkansas crushed it in his lifetime).  But I’m fairly certain people will still be using bandaids and mouth wash, taking medication to make their lives better, drinking Coca-Cola, washing their clothes with the same detergent their mom and grandmother used, and eating their favorite cookies or foods.

The five stocks I selected are ones that I would be comfortable owning even if we experienced another world war, significant inflation, higher taxes, social unrest, global warming, or almost any other hardship.  If they lost 50% of their market value in a year, I wouldn’t lose sleep over it.  In fact, I probably would be happy because the dividend income would buy more shares as other people panicked and sold their ownership in the business.

That Doesn’t Mean I Own Those Particular Dividend Stocks Now

It would be a mistake for you to think that I advocate someone buying those particular dividend stocks now.  Think of it this way: I love Nestle.  In fact, my parents indirectly have a considerable amount of their retirement plan assets in Nestle.  But during the Great Recession a few years ago, we were buying, investing in, and trading shares of bank and financial stocks because they offered significantly more short-term (5 years or less) upside since many were trading at a fraction of their intrinsic value.  That doesn’t mean I didn’t want to own Nestle, it just meant that the opportunity cost was too high relative to the other assets that were presented to us by “Mr. Market”, to borrow the Benjamin Graham allegory.

At the same time, I might consider buying shares of Nestle for my so-called “retirement insurance plan” if the price were right because my objectives for that account are different and I want to insulate it from my active businesses and capital investment operations.  In fact, I probably will buy some in the next month or so for that portfolio.  But if Nestle were trading at 30x earnings, I wouldn’t even contemplate owning a firm that enormous on a valuation multiple like that unless the earnings per share figure came from some sort of one-off disaster or impairment charge.

The same can be said of The Coca-Cola Company.  The last time I would have even considered buying shares would have been the mid-1990′s, and then I was only a teenager.  During the back end of the dot-com bubble, Coke reached 50x earnings, or 2% earnings yield, and it basically treaded water for a decade and a half until the underlying earnings per share caught up with the stock price so that it is now attractively valued.  Had we been having this discussion in 1995, I wouldn’t have put Coke on the list.  I would have opted for a more attractively priced alternative that displayed the same characteristics.  Still, compared to the broader stock market, the Coca-Cola dividend reinvestment plan has done fairly well on a relative basis over the past decade.

Actually, strike that.  Knowing me, I would have been clever about the entire thing and figured out a way to find a mandatory convertible security that forced me into shares of Coke but only so many years in the future when the price was likely to come down, paying me dividend or interest income in the meantime.  That way, I could sort of get around your restrictions.  But most people aren’t like that.

On What Terms and at What Price

This is one of the reasons I don’t talk about individual stocks.  An appropriate investment depends not only on valuation, but on time horizon, your willingness, emotional ability, and financial ability to ride-out volatility, your tax situation, and a host of other factors that differ for virtually every person reading this response.  That is why I adore Benjamin Graham’s response to the question, “Do you like [insert investment here]?” to which he would always reply, “Oh what terms and at what price?”.

Furthermore, the question you posed is important because it sets the parameters of the discussion.  If you asked me today, I’d say it is likely that I will continue to own shares of Berkshire Hathaway 50 years from now when I am almost Warren Buffett’s age (God willing).  In several of my portfolios, Berkshire Hathaway continues to be the single largest investment position I own as far as the public securities market goes.  But the question, as stated with the choices put in front of me, was different so that isn’t on the list.

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