Kennon-Green & Co. Global Asset Management and Value Investing


A Real World Examination of the Limitations of the P/E Ratio

Back in 2011, I did a 20-year case study of Colgate-Palmolive.  Global events have conspired in such a way that it can now serve as a perfect illustration of a valuation conundrum: While not cheap, Colgate-Palmolive is significantly cheaper for a long-term owner than the price-to-earnings ratio alone would have you believe.  In fact, despite having what appears to be a 26.54 p/e ratio, it’s slightly undervalued to its private market value could you get your hands on the entire empire.  It’s a rare thing to be able to talk about a gem like this under conditions such as these so I’m not going to let the opportunity pass.  Dust off your powdered wigs, take out your walking cane, and travel back with me to post-Revolutionary America.

A Brief History of Colgate-Palmolive

The year is 1806.  Thomas Jefferson is in office, serving as President of the United States; the country having adopted its new constitution only 19 years prior after giving up on the Articles of Confederation.  An English chandler and soap maker named William Colgate opened shop in New York City, giving birth to the eponymous firm that bears his name and that, for many of you, graces the stock certificates you have sitting in a bank vault or electronically registered with a brokerage firm.  In 1895, it sent a dividend out to stockholders and for 120 years, it hasn’t missed a single check.  Even better, this year marked the 52nd consecutive year of dividend increases by the company, with each annual payout larger than the one that arrived prior so owners who never bought another share still saw their income grow over time.  This maker and peddler of soap, toothpaste, toothbrushes, deodorant, mouthwash, pet food, and other necessary day-to-day items survived the War of 1812, the Civil War, World War I and World War II.  It made it through the Great Depression years of 1929-1933, which was the most painful economic collapse the world had experienced in 600 years.  It kept on keeping on during the 1973-1974 stock market meltdown, largely ignored the September 11th terrorist attacks, and barely blinked in the 2008-2009 collapse as Wall Street imploded, people were losing their homes, and panic was the order of the day.  It shrugged off the inflation of the early 1980s, couldn’t be bothered with the threat of nuclear annihilation in the 1960s, and makes older blue chips like The Walt Disney Company appear as if they are barely out of diapers.


What is the secret to such profitable longevity?  How can a single firm have managed to mint money for its owners since King George III was sitting on the throne?  At the heart is the economic engine – one of the things that puts it in the top 1% of business enterprises in history.  Colgate-Palmolive buys chemicals at rock-bottom rates, formulates them according to their scientists’ discoveries, and then sells the end product under protection of trademarks, patents, and copyrights.  It has such enormous economies of scale, it can produce finished goods for less than most firms could secure the raw materials.  Its activities generate such staggering free cash flow relative to the property, plant, and equipment it takes to produce the goods, management can devote a lot of the funds to marketing and advertising, building the brand equity of its portfolio.  It is the early mover in most markets and countries, giving the corporation first-arrival advantages that entrench defenses through habit and distribution chains to the point it can’t be unseated.  (Case in point: With India rapidly modernizing, people are trying to find a way to invest in the market but Colgate set up shop there in 1937.  That’s the reason it has a seemingly unshakable hold.  Look at rural India; the towns and out-of-the-way places far from the major urban centers.  The market share figures are so shocking you’d think they were a typo if you didn’t know better: 57.4% market share of toothpaste and 42.0% market share of toothbrushes.)  It dominates licensed child toothpaste and toothbrush products, hooking kids on Colgate’s brand from the time they are still in diapers.  It serves a need that is largely immune to technological innovation.  It is a real-world didactic exercise in all of the factors Charlie Munger talks about coming together to create something exceptional; variables interacting in a way that produce an outcome that can be almost impossible to stop or derail once the boulder starts rolling down the mountain, crushing everything in its wake.

The by-product is a corporation that produces after-tax returns on capital bouncing between 30% and 50%.  Global population expansion and rising middle classes around the world mean more consumers.  Natural pricing power means the ability to pass on costs to consumers (it doesn’t matter if you’ve lost your job, if your favorite toothpaste is 14¢ higher, you’re going to pay it).  Geographic diversity means lower concentration risk and the ability to engage in tax arbitrage.  Over time, it sells more, raises prices, bumps the dividend, and buys back stock (there’s been a 14% net reduction in total shares outstanding over the past decade according to Value Line).  Employee interest is aligned with outside stockholders as the employee stock ownership plan holds 7.6% of the outstanding equity.

The natural consequence is tremendous wealth accumulation for owners who are patient enough to ignore stock market cycles and keep accumulating whenever the price is advantageous.  While it may not do anything for 5-7 years at a time, the economic engine can’t help but work its magic, eventually manifesting in some form.  To put into perspective how incredible it is: A single lump sum $100,000 investment back on the day I was born in the 1980s, assuming no dividend reinvestment and no further investment of any kind, would have now grown into $6,856,421, consisting of $5,595,789 in Colgate-Palmolive stock and $1,260,632 in aggregate pre-tax cash dividends received along the way.  (If you were to pass away this year, you and your spouse could use the stepped-up basis loophole to have those unrealized gains forgiven.  You could ensure you stayed below the thresholds by doing things like gifting shares through a family limited partnership and taking liquidity discounts.)  To say “not bad” for 32 years of doing nothing but sitting on your behind, spending the cash dividends as they arrived, and never saving or investing another penny, is a serious understatement.  Had you plowed those dividends back into more stock, you’d have broken the eight-figure mark.

Put simply, it is the type of business that when you go to buy, if you are wise, you plan on dying with it still in your estate.  When you acquire a stake, you don’t pay attention to the stock price from year-to-year even when we hit a 1973-1974 situation – and it will happen – where you watch your position decline by 75% or more.  You read the annual report, collect your dividends, and act as if it were a family firm, the income from which you can spend but the principal of which you can never touch as it doesn’t belong to you; you’re merely holding it in trust for heirs, who will hold it in trust for their heirs.  Of all the corporations, partnerships, and limited liability companies you study in your lifetime, 99%+ will not fall into this category.  Make note of that.  This is a Coca-Cola, Hershey, Brown Forman, or McCormick; one of about 100 business in existence that are not securities to trade but operations to acquire, taking the money off the table once it has been outlaid.  It has a degree of certainty and simplicity that cannot be present in a business like Berkshire Hathaway or Google, which require some level of on-going vigilance despite having incredible economics of their own, coupled with returns on capital that mean almost all of the cash flow can be extracted in some form or another without hurting the competitive moat or causing declines in product quality; a concept explained in this post on owner earnings or free cash flow.  It would take a monumental amount of on-going stupidity with no intervention from stockholders to destroy what has been built over the past (now approaching) quarter-of-millennium.

What happens, though, when you get the annual report and you notice the sales and earnings per share aren’t looking so hot?  Sure, all businesses go through this from time to time – McDonald’s Corporation is famous for having to revamp itself every ten or fifteen years but ultimately making its owners richer due to the breathtaking free cash flow the real-estate-company-in-drag produces – but what’s happening with Colgate-Palmolive over the last six years?  Between 2009 and 2014, you saw earnings per share of $2.19, $2.16, $2.47, $2.56, $2.38, and $2.36.  With figures like these, which are not going to cause your heart to race, why is the board of directors showering so much more dividend income on stockholders?  Over the same period, the per share annual dividends were $0.86, $1.02, $1.14, $1.22, $1.33, and $1.42.  That’s a 65% increase in annual cash income (if that doesn’t cause your pulse to quicken, ask yourself: Do you know many people who got a 65% pay increase at work?)

Why do the reported earnings figures look less than stellar while the dividend record keeps blasting upward?  If you think something is going on, you’d be right.

Currency Headwinds Are Obfuscating the Actual Underlying Earning Power and Expansion Prospects Over the Coming Quarter-Century

Colgate-Palmolive is a truly global enterprise in every sense of the phrase.  Roughly 80% of its sales originate outside of the United States but it reports its financial statements in U.S. dollars as per GAAP rules.  During periods when investors, businesses, and institutions are flocking to the dollar, driving its value up relative to other currencies, it can appear that profits and growth rates decrease, even if unit volume and/or value increased.  (I walked you through the mechanics of how currency issues can play havoc with the reported results in A Basic Overview of What Happened with the Swiss Franc and Nestle’s Share Price; something you’ll want to read if you’re not familiar with all of this.)  While not meaningless, it does have far less meaning during periods of good-paced growth than it might otherwise appear.  Ultimately, as long as the purchasing power being acquired in each country is increasing far faster than inflation, the rest is probably going to work itself out in the end.  Colgate-Palmolive’s management can take its U.S. dollars and use them to buy foreign assets on the cheap, then when the situation reverses and the dollar falls, move the foreign profits back home.  (In grossly oversimplified terms, think of an oil giant stockpiling crude when crude prices are low.  Here, a company like Colgate-Palmolive can stockpile foreign earnings by reinvesting it abroad, waiting for the perfect tax holiday and currency conversion valuation to move the wealth back home.)

Between the turmoil in Europe and the worry in China, the dollar has been on a tear lately.  Its strength has been so extreme – this year, it hit a 12 year high against the Yen and an 11 year high against the Euro – that when Colgate-Palmolive reported its earnings back at the end of April, it appeared sales grew only 4%.  That was not the whole picture.  Foreign exchange fluctuations chopped a whopping 10% off the results.  During the quarter alone, Colgate increased its global unit volume by 1.5%, and its prices by 2.5%, over last year.  The current situation is so incredible, Ian Cook, the company’s CEO, told The Wall Street Journal he expects earnings per share to decline on a dollar basis for the year.  And this is on top of the same thing happening last year.  For the full fiscal year 2014, it looks like revenues fell by 1% but this was because of a 6% foreign currency hit; volume actually grew by 3% and pricing added 2%.

As all of this was happening, Colgate-Palmolive has taken massive charges against earnings and assets over the past few years for its Venezuela operations after the socialists took over the country, began nationalizing assets, and did what all macro-level socialist dictators before them have done – destroyed the nation’s economy, leaving it in shambles.  Entire factories, currency reserves … all had to be recorded as losses on the books with hyperinflation a foregone conclusion short of some miracle.  Unless other nations follow the same path, this isn’t likely to be an on-going charge.  The expense will disappear from the financials and suddenly the firm will look more profitable.  Does Venezuela hurt?  Absolutely.  It’s a rounding error in the long-run.

The practical consequence: These factors mean the “e”, or “earnings” in the price-to-earnings ratio is not indicative of the actual earning power.  Whereas in a peak earnings trap, the p/e ratio is understated in terms of the economic engine making a stock look far cheaper than it is, in a situation like Colgate-Palmolive at the present moment, the p/e ratio is overstated, making the stock look more expensive than it is.  (This also means that the PEG ratio and dividend-adjusted PEG ratio are also overstated because not only are earnings understated, but so, too, is the growth rate rate, which has been artificially depressed).  Colgate-Palmolive, in other words, is not really trading for 26.54x earnings, or a 3.77% earnings yield.  It’s an illusion; an accounting quirk.  If the company had been headquartered in Germany, and reporting its income in Euros, the exact same operating results would have resulted in considerably more reported net income.

On some level, you probably know this instinctively.  If Colgate-Palmolive went into a country and sold more toothbrushes than it did last year, charged a higher price for those toothbrushes than it did last year, and gained a few market share percentage points on its competitors, then turned around and reported a decline in sales and earnings from that country due to a change in the relationship to the U.S. dollar, it’s not comparable nor equal to something like a decline in revenue generated by a hotel you own in your hometown following a competitor building a new hotel across the street, taking absolute customers and requiring you to lower your room rates for those who did book with you.  The toothpaste and dish soap giant’s scorecard might look a little ugly but it’s not entirely relevant because it doesn’t have to convert the money back to dollars right now.

It makes for an interesting contradiction.  You have a firm that, by most reasonably estimated future outcomes, should match or exceed the return on the S&P 500 over the next quarter-century but that, on the surface, appears to be too richly valued for many investors to notice.  Those who do notice are bound by institutional parameters to ignore it as the incentives are aligned to make them invest for the short-term (and anything less than 5 years is short-term).  Not that long ago, I saw one asset management group tweet something about Wal-Mart’s stock price, mocking shareholders who held with something along the lines of, “Yeah … but we get paid 3% per year in dividends to own it” and showing a 3 or 6 month chart of the price dropping.  That kind of thinking is lunacy.  Do you believe it’s a coincidence the richest family in the world, the Waltons, hold onto their shares, extracting value from the business itself rather than the stock market proper?  Look at the case study I did of Dolly Parton, a sort of female equivalent of Charlie Munger.  She bought those theme park assets back in the 1980s.  They’ve been in her portfolio for more than 30 years.  She’s held them through several severe, and protracted, recessions because she understood their long-term value.  Why should an owner of a great business behave any differently?  If you can get your hands on Colgate-Palmolive at a price that you can reasonably assert gives you an overwhelming chance at double-digit returns between now and the year 2040, what rational person would care if it goes nowhere, or even drops by 50%, over the next 60 months?  (You recall Coca-Cola, which also has these types of economics, has consistently beaten nearly every other stock over periods of 25 years or more as the underlying profitability drags the stock price and dividends along with it.  Nobody talks about the 13-year stretch in the 1960s and 1970s when it went sideways.  The rich men and women in Georgia buying it during those years, using it as a chance to accumulate more and more despite it never seeming to do anything, made obscene amounts in the 1980s and 1990s when the market suddenly woke up.  The windfall transformed cities like Atlanta; they were suddenly buying new cars and private jets.  You cannot control nor predict when the returns will materialize, you have to keep acquiring productive assets intelligently and know the odds are overwhelming they will, someday, somehow.)

I have written it probably 500 times in the history of this blog – to the point that, frankly, I get a bit tired saying it – but it needs to be repeated every chance I get because I’ve recently started seeing people talking on forums and messages boards about how they are going to try and time the market.  (Sure as clockwork, when you get around 7 years away from a major financial event, people forget and start behaving as if it never happened.  Go back and do case studies throughout time.  I think it has to do with a combination of neurology and demographic turnover as younger workers join the workforce and didn’t see, firsthand, their own capital get caught in the maelstrom.)  You cannot predict whether the stock market will be up or down tomorrow or even next year.  If you try, you are speculating, not investing.  That’s fine, just be honest about it.  From an investing standpoint, all you can do is find assets available at certain prices, on certain terms, that offer high probabilities of significant increases in after-tax, inflation-adjusted purchasing power over the long term, buying up as much as you can in a way that is intelligently diversified so you aren’t wiped out if something goes wrong or your thesis turned out to be incorrect.  That is the entirety of the game as it pertains to putting your surplus capital to work in holdings you, yourself, aren’t operating.

The Reason Colgate-Palmolive Is On My Mind

As some of you know, I had several of my relatives in shares of Kraft Foods Group, which recently completed a merger with Heinz to create The Kraft Heinz Company.  I had each retain their new stock in Kraft Heinz, even though I think it will take 3-5 years for the merger to payoff.  As they go to retire, the $2.20 regular dividend, which is being maintained, should provide a good source of passive income upon which they can live.  The special dividend that arrived due to the $16.50 per share payout funded by Berkshire Hathaway and 3G was put to work differently for each person based on their own considerations.  For several, especially within retirement accounts that won’t be touched for at least a decade, this involved buying shares of Colgate-Palmolive as it had a similar risk/return profile and low correlation with most underlying operating risks.

Over the years, when I write something like this, I’ll inevitably get messages – almost always from college students learning about this stuff – saying something along the lines of, “I don’t understand why you would do this.  Financial theory tells me that people maximize their potential returns at all time but the subtext if clearly you don’t think Colgate-Palmolive is going to necessarily do well in the next few years even though it’s a best-in-class business that will do fine or better than fine in the coming decades.  Why buy it?  If you have things you, with your experience and capabilities, know are demonstrably cheaper, what are you thinking?  Isn’t this stupid behavior?  Why not buy the more undervalued assets now then switch into Colgate-Palmolive later?”

I’ll save you the trouble of writing and me the trouble of responding multiple times: In the real world, money is a tool.  It exists to provide utility, and as CEO of your life, your job (or, if you hire an advisor, your advisor’s job) is to assign each pile of money a responsibility; responsibilities that should be carried out with the least risk possible.  Cash, for example, should be about maintaining liquidity in an emergency with interest income being secondary to that objective, even if it means losing a bit to inflation.  Furthermore, risk is individualized; different for each person.  Take, for example, my own parents.  They are relatively young – my dad is 56 and my mom is 53 (they were married at 22 and 19, respectively) – but for various reasons having to do with gender and weight, it is highly probable my mom outlives my dad by several decades.  Those are just the numbers.  Ignoring them would be beyond irresponsible and veering into outright intellectual malpractice.  This isn’t something they allow me to talk about with them – they both freak out if I bring it up – but because I love them, and I want to protect them, it plays a role in every single allocation decision I make for them for the same reason it would if I were helping someone who smoked three packs of cigarettes a day or worked in a high-risk profession.  I have to know that the morning I wake up to find my dad gone – and, hopefully, it’s a long time away or lifestyle changes are made in the meantime that make it unnecessary to consider – my mom is going to be fine; that even a horribly inconvenient stock market crash or recession occurring at the same time isn’t going to have any influence on her standard of living or independence.

One of my projects has been slowly adding to my father’s Colgate-Palmolive collection, including shares held in his retirement account.  Even though there are other stocks I can say with absolute certainty are more attractive at the moment, I look out to, say, 20 years from now, and I can still see my mother alive at 73 years old.  I’ve never seen a 76 year old my dad’s weight.  Pull up the actuary tables, and neither will you.  I hope he’s the exception but I cannot bank on that, especially not on something as important as this.  It is a near certainty that, absent some sort of much lower probability event, my Dad’s tax-sheltered accounts are going to be merged with my mom’s upon his death; all of his assets poured over from his accounts into hers, like water moving from one bucket to another; accounts that then have to put food on my mom’s table, keep her heat on in the winter, pay for her vacations, make sure she has a new car from time to time.  That means I view them, internally, as one giant account that will someday need to be combined, making sure the allocation isn’t just fine on an account-by-account basis, but works in the big picture.

From that framework, there aren’t many companies like Colgate-Palmolive.  No matter what assumptions I use, or which variables I change, in almost all outcome forecast, when my mom is 65 years old, 70 years old, 75 years old, 80 years old … there is almost no situation in which her passive income is not significantly greater than it is today, and more than satisfactory relative to the outlay required to acquire shares.  To give you an idea of what I mean, let’s take a 25 year scenario.  At the end of that period, she’ll be 78 years old.

Imagine I had my dad buy 1 share of Colgate-Palmolive today, at $67.44 per share.  There’s a sort of two-step back of the envelope calculation we can do for blue chip stocks like this (it would never work for a firm like Apple or Intel because you cannot, with any certainty, project the two variables but it works for things like Clorox and Coke, where large market shifts haven’t happened in generations and are unlikely to happen in the future for all sorts of reasons, including barriers to entry and the nature of the underlying cash generator – you’ll change your phone many times in your life, you aren’t likely to give up your favorite beverage or bleach).  This is grossly oversimplified but it will give you a big picture view of what is happening.  It involves:

  1. Coming up with a reasonable dividend growth estimate
  2. Estimating the implied market value at the end of the period based upon a presumed dividend yield

For our $67.44 share of Colgate-Palmolive, we know that the first year, we’re collecting $1.52 in cash.  Let’s say that Colgate-Palmolive’s historical dividend growth rate over the next 25 years falls to 9% compounded and no dividends are ever reinvested.  If true, the share will generate $128.75 in cash that can be redeployed elsewhere, added to savings, or spent.  After the final period has elapsed, the dividend would be around $12.02 per share.  Assuming a comparable dividend yield (and that is where things get interesting – there are all sorts of things you have to build into that; interest rate levels, market conditions), the market value of the share would be $534.44.  Add them together and you have $663.19.  If the economic engine is intact, and these assumptions turn out to correct, this would happen even if, five minutes after you bought the stock, there were a terrorist attack, the stock market closed for six months, and the shares began trading at $20.00 each when everything got back to normal.  Sure, you’d be sitting on brutally ugly losses for years but they likely won’t matter by 2040.

What if the stock market collapses at the end of 25 years and the shares are yielding something like 5%?  Then, the stock market value of the share would be only $240.40 added to the $128.75 in cash dividends, turning into $369.15.  But here’s the thing: Since my mom will never sell the stock as long as the economic engine is intact, it won’t matter.  That share, besides having paid back its cost 1.9x over in the form of dividend “rebates”, would be producing $12.02 per year in cash income.  That represents a 17.82% yield-on-non-adjusted cost totally irrespective of the fact you’ve already gotten that cost back in your pocket almost twice.

Comparing a Reasonable Estimate for Colgate-Palmolive Equity Over the Next 25 Years to a Comparable Duration Fixed Income Security

Perhaps an examination of an alternative will be helpful.  Imagine I were a 45 year old dentist and had $27,508.14 in a taxable brokerage account.  That exact amount, at this exact moment, would allow me to purchase Wal-Mart Stores Inc. 5% senior non-callable debentures with a maturity date of 10/25/2040.  Between now and maturity, I would collect $31,875 in interest income.  At the end of the period, the fixed income security would mature at $25,000 with the built-in loss resulting from buying at a time when market rates were lower than the coupon rate flushing out (you know the drill, no need to rehash it here).  All said and done, I’d walk away with $56,875 by the end of 25 years.  The bond ceases to exist.


Looking at Colgate-Palmolive, in comparison, that $27,508.14 would buy me just shy of 408 shares.  Over the coming 25 years, I could expect to extract $52,530 in cash dividends (which are taxed at roughly half the rate of interest income), plus, I still own the stock.  If dividend yields are comparable, the market value of the shares would be somewhere around $218,052.  So we’re at $270,582.  Even better, I’m still collecting around $4,904 in cash dividend income per year.

Regardless of what the stock market is doing – whether the stock is valued at $100,000 or $500,000 – I’ve still extracted that $52,530 and I’m still earning roughly $4,904 in cash dividend income per year, or 17.8% of my initial outlay.  Since I plan on leaving the ownership to my kids and grandkids, those are the numbers that count.  The market price will work itself out in the long-run.  All I care about: Are sales fine?  Are earnings / free cash flow growing and attractive relative to net tangible non-leveraged capital?  Are a decent percentage of those earnings making their way out to me in the form of growing dividends?

A Few Final Thoughts on Colgate-Palmolive

This is my motivation for choosing what looks to be a lower compounding security for certain family members.  Colgate-Palmolive is a fair deal right now, all things considered.  It may not be a good investment over the next few years unless something unexpected happens (e.g., Unilever makes a buyout bid), but it certainly should be for the rest of one’s life assuming a person, or his/her family, has at least a few decades to leave it alone.  In every extended period since measurement began, it has been in the top performing S&P 500 component for good reason.  If the Kennon family turns out to be actuarially normal, I expect the shares of Colgate-Palmolive I have my father buy will someday be inherited by my mother and used to support her for years, even decades.  In turn, those shares will be left to the four kids, myself included.  I, and I’m fairly certain at least my brother, will leave our respective shares to our own children and grandchildren so that they are benefiting from my dad’s efforts even if they never met him (call me a romantic, but I like the idea of his great grandkids – my grandchildren – paying for college with the toothpaste fortune he left them).  Those shares of Colgate-Palmolive are off-limits; special in a way that almost no other stocks are.  They aren’t to be sold, but rather harvested like fruit trees in an orchard.  We leave the trees for those down the line but take the apples, pears, and plums each season to enjoy ourselves.