I’m Starting My Week by Buying More Shares of Nestlé
I put in and order on Saturday to buy a few more shares of Nestlé SA on Monday for my family’s personal accounts. I spent much of the weekend reading the company’s 125th anniversary biography and studying the original balance sheets and income statements of the firms that went into forming one of the world’s most profitable holding companies.
I still think it’s amazing that Henri Nestlé started a business in his 50’s, and in seven years, grew it to the point he sold it in the late 19th century for 1,000,000 Swiss francs; a staggering sum in those days. The new owners grew it to 10x its size in another seven years or so before it was acquired by an equally impressive company, the Anglo Swiss Condensed Milk Company. Henri never invested in the firm after he left, not even owning a single share. Instead, he took his capital and retired with his wife. They never had children, so they spent their days doing whatever it was they wanted with no financial worries . He was not motivated so much by money or business, unlike people who bought his company, as he was a way to lower the infant mortality rate, which stood at 1 out of every 5 babies. His baby formula and cereal invention was really revolutionary.
The business is still run on a decentralized basis, with individual operating companies sitting under the parent holding company in Switzerland. It’s the same model followed by Berkshire Hathaway and Johnson & Johnson so that individual businesses are managed in the most intelligent way for their own markets.
I ran some spreadsheets and to give you an idea of how staggering the company’s historical dividend growth has been – the businesses they own can raise prices almost every year to offset inflation – I thought it would help to frame it in modern terms.
Let’s take the age of the world’s most famous investor, Warren Buffett. He is 82 years old at the moment. I am 30 years old. That is a 52 year age difference. Imagine, for a moment, that Nestlé were capable of maintaining its same dividend growth rate over the next 52 years that it has in the past, through recessions and depressions, global wars, inflation, deflation; you name it.
If the firm could achieve that (and there is no guarantee it can, this is simply to illustrate how impressive past performance has been), a single share bought today for CHF 64.50 in Switzerland would pay, over the next 52 years, aggregate pre-tax cash dividends of CHF 3,500.00. In the final year, the dividend would be CHF 333.60 and, if the yield were comparable to what it is today, the share price would be CHF 10,109.18. (Assuredly, the stock would have split many, many times so the actual exchange listing would be much lower, you’d just have a ton more shares.)
The job of the investor is to discount that back to the present, factor in inflation, taxes, and other reductions in purchasing power, and compare it to the cash outlay today to determine if the bargain is a favorable one. Do it right just a few times in a lifetime and things tend to work out extraordinarily well without a lot of subsequent effort.
Of the 15,000 publicly traded businesses in the United States and the 30,000+ around the world in the more developed markets, there are probably only 100 companies that I would ever consider for inclusion on the “permanent” list; shares that are bought and held forever. These are businesses that have almost non-assailable brand equity (and even that is no guarantee – Brut cologne was once one of the most prestigious fragrances sold in the world and now, only the good stuff is sold in France; in the United States, a cheap knockoff using the name is sold at Wal-Mart for a few bucks). They have a built-in resistance to inflation. They have the ability to raise prices almost every year. They have some sort of legal protection in the form of trademarks, patents, or copyrights. They have a strong balance sheet. They enjoy very high returns on non-leveraged equity. The products never, or rarely, change. They appeal to some basic human demand and aren’t likely to go in and out of fashion. They are not likely to turn into a basic commodity (e.g., what happened to pearls at the end of the 19th century).
These are companies like Brown-Forman, Coca-Cola, PepsiCo, Hershey, Clorox, and Procter & Gamble. They are extremely rare. When you find one trading at near its intrinsic value, it’s often a much better buy than a secondary or tertiary firm selling at a substantial discount due, in part, to the leveraging effect of deferred taxes. You go back and pull the dividend record for 25 or 50 years and see that the increase over time has far exceeded the rate of inflation.
Most of the time, the 100 firms on my list are recognized for their quality and trade too high to get a fair deal. (I’ve never seen Hershey’s affordable once in my entire adult life.) When they are in range, though, I think the best course of action for someone who has no credit card debt, plenty of savings, and a diversified income stream, is to write a few large checks and then stick them in a bank vault for a generation or two. You check the annual report every year and, as long as things are still humming along nicely, you keep holding. Short of a catastrophic event that I cannot foresee at present, I expect to leave the Nestlé shares I’ve been buying to my grandchildren someday. In the meantime, I get to spend the cash the firm sends me every year on furniture, video games, travel, clothing, or reinvestment, depending on what I want to do at the time.
Anglo Swiss Condensed Milk Company Headquarters
And what if Nestle someday fails? I can’t imagine that happening soon, but if it did, it’s only a matter of time before the dividend rebate effect results in me having extracted my entire initial purchase price from the investment. Not that I wouldn’t be upset, but if the unthinkable happens, and I don’t see it coming, at the very least we’re only talking about house money at that point. My original principal would have long been recaptured and redeployed.
I’ll stop posting about Nestlé now. I would think many of you are not interested anymore (though if that were the case, you wouldn’t have clicked on this post in the first place, I suppose). It’s hard … if you understand international accounting standards and go through the finances yourself, you want to take out a megaphone and start yelling about finding a firm that has economics that place it in the top 1% of all businesses to have ever existed.
I’m still hoping to get over to Europe sometime in the next six months to a year, but don’t know if I can fit it into the schedule. I’d love to tour the main campus.
Update: Several years ago, I placed this post, along with thousands of others, in the private archives. The site had grown beyond the family and friends for whom it was originally intended into a thriving, niche community of like-minded people who were interested in a wide range of topics, including investing and mental models. I decided, after multiple requests, to release selected posts from those private archives if they had some sort of educational, academic, and/or entertainment value. On 05/22/2019, I released this post from the private archives. This special project, which you can follow from this page, has been interesting as I revisited my thought processes about a specific company or industry, sometimes decades later. In this case, reading about how we approached the analysis of a real-world business was helpful to many of you and the information contained herein is now so old there is no chance a reasonable person might mistake it for current market commentary.
One major change that has occurred in the years since this post was originally published: Aaron and I relocated to Newport Beach, California in order to have children through gestational surrogacy. Within a window of a couple of years around that relocation, we also sold our operating businesses and launched a fiduciary global asset management firm called Kennon-Green & Co.®, through which we manage money for other wealthy individuals and families. That means we are now financial advisors (or, rather asset managers operating under a investment advisory model as we are the ones making the capital allocation decisions rather than outsourcing those to fund managers or third-parties), which was not the case at the time this was written. Accordingly, let me reiterate something that should be perfectly clear: this post was not intended to be, and should not be construed as, investment advice. Also, for the sake of full disclosure, I’ll state outright that Aaron and I still own shares of Nestlé personally. We express no opinion as to whether or not you should buy it. Any company can do poorly or even go bankrupt. There are no guarantees Nestlé will generate a profit or make money for shareholders. We may buy or sell Nestlé for ourselves or for private clients of our firm in the future and have no obligation to update this post or any other historical writing. You should talk to your own qualified, professional advisors about what is right for your unique circumstances, goals, objectives, and risk tolerance.
Stated candidly, this post is a historical anachronism from many years ago that arose because we weren’t in the asset management business but, rather, were private investors. In the future, things like this will not be posted on my personal blog but, instead, if they are written, released through Kennon-Green & Co., including letters to the firm’s private clients.
Reader Comments (23)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Gilvus
August 5, 2013
Joshua, I have an embarrassingly elementary question: if I'm using the dividend-adjusted PEG ratio to do a quick-and-dirty valuation on Nestle, would I simply add the dividend growth rate to the EPS growth rate and dividend yield? So the breakdown:
Dividend Adjusted PEG ratio =
Numerator: (Share price ÷ Annual EPS)
÷
Denominator: (Yearly EPS growth + Annual dividend growth + Current dividend yield?)
AmIDoingItRite? :/
Joshua Kennon
August 5, 2013
You wouldn't add the dividend growth rate on top of the EPS growth rate. You'd ignore it because you'd end up double counting the same growth to some degree, causing an asset to appear cheaper than it is. This is because dividends are almost always (there are a handful of rare exceptions that won't apply to 99.99% of situations) paid out of earnings, and they aren't deducted from the income statement. (Some beginners seem to think dividends are treated like an expense, which isn't true. If a company earned $25 billion and paid out $5 billion in dividends, the income statement is going to show $25 billion in profit. The cash flow statement is where you'd find the $5 billion distributed to owners.)
Imagine I owned a lemonade stand you wanted to buy. We earn $10,000 per year and earnings are projected to grow at 10%. I also have a policy of paying out half of profits as dividends, or $5,000 per year, which I expect to grow at 5% (implicitly telling you that I intend on retaining a greater proportion of earnings in future years, even though the actual payouts will be increasing in absolute dollars).
In this case, if you added the earnings growth of 10% to the dividend growth of 5%, you'd be using a 15% growth rate, which is wrong. As the owner of the entire business, your profits are going to grow 10%. That's it.
Bottom line: For the dividend adjusted PEG ratio, you use the conservatively estimated growth in diluted earnings per share. That's it. You do not factor in the dividend growth rate, only the current dividend yield.
The formula for Dividend Adjusted PEG Ratio is:
(Price ÷ Earnings Per Share)
----------divided by---------------
(Annual Earnings Per Share Growth + Dividend Yield)
There is no dividend growth rate in there. Anywhere. It's implicitly captured by the earnings growth.
Joshua Kennon
August 5, 2013
I don't think there is any such thing as an embarrassingly elementary question. I didn't know any of this stuff at one point. We call come into the world knowing exactly nothing. It's simply a matter of whether you learned it in the past or are learning it now.
To answer your question: Your formula is slightly off. You are adding the dividend growth rate on top of the growth in earnings per share, double counting a portion of the same growth.
The solution is to strip out the "annual dividend growth" rate you have in your formula. The correct calculation for Dividend Adjusted PEG Ratio is:
(Price You Are Paying ÷ Net Earnings)
----------divided by----------
(Annual Net Earnings Growth + Dividend Yield)
Anything 1.0 or less is considered a very good deal as long as your estimates weren't too optimistic. If you exceed 2.0 or more, you are probably going to get subpar results unless you've been too conservative in your estimates.
Imagine I owned a lemonade stand that earned $10,000 a year after taxes. I take $5,000 of that out in the form of a cash dividend. The projected growth is 10% per year. You want to buy the company.
You approach me and offer $100,000. In this case, you would have:
$100,000 purchase price ÷ $10,000 earnings
----------divided by----------
10 percent growth in earnings + 5 percent dividend yield
Which we could then reduce to: 10 ÷ 15
Which can be solved as: 0.667
That is a very good deal. So good, in fact, that I probably wouldn't sell my lemonade stand for $100,000. I would only begin parting with it if you offered $150,000 or more.
(This is an oversimplified example - there are no balance sheet assets to acquire, etc. but it should answer your question.)
For Nestle, you'd be looking at:
64.65 CHF ÷ 3.32 CHF
----------divided by----------
8 earnings growth estimate + 3.17 dividend yield
(Note: The 3.17% dividend yield is the pre-tax gross yield of 2.05 CHF cash dividends per share divided into the 64.65 CHF per share price, before Swiss withholding taxes to provide and apples-to-apples comparison to all other stocks because investors in the U.S. holding through taxable brokerage accounts are entitled to the same 15% rate they'd pay on domestic dividends. For the purpose of illustration, I just grabbed the 8% estimate projection from Value Line.)
This can be simplified to: 19.47 ÷ 11.17
Which can be solved as: 1.74
This is where judgment comes into the picture. Two stocks, both with a dividend adjusted PEG ratio of 1.74 are not created equally. Nestle has enormous economies of scale, diversification, brand equity, balance sheet strength, management talent, etc. It also has some built in protection against inflation due to pricing power. None of those things show up in the figure. That's why, for the long-term holdings, I'd pay a higher price for it than I would a steel mill trading at a dividend adjusted PEG of 1.0. With Nestle, I can buy it, sit on it for decades, and only check on it periodically. This ends up leading to better outcomes as the leveraging effect of deferred taxes starts to matter.
Gilvus
August 5, 2013
Replying to Joshua Kennon
Ah. I didn't see dividend growth in the formula you provided on I4B because it's already included in earnings growth. See, rookie's mistake. I kept wondering why dividend growth wasn't a variable until you pointed out the obvious.
When you say "this is where judgment comes into the picture," do you mean experience and gut feeling, or are there formulae for risk adjustment? I'm traveling for work at the moment so I don't have Graham/Dodd's Security Analysis with me, or I'd consult that.
I've been doing DCF exercises, and the empirical formula is easy enough to crunch...but how you assign a numerical value for management's talent or lack thereof? How do you determine a reasonable premium for the intangibles, like the ones you just listed for Nestlé? This is where I always get frustrated, and I start looking at S&P's fair value calculations instead (my current broker doesn't offer Morningstar reports).
Even if you don't have the time to answer all that, thanks for your response. Always a pleasure to learn from the best 🙂
Gilvus
August 5, 2013
Replying to Gilvus
Oh man, I really botched the formatting on that one. I've committed aesthetic atrocities 🙁
Joshua Kennon
August 14, 2013
Replying to Gilvus
It's the same kind of judgment that an athlete has when he or she sees a situation and knows how to respond. It's partly past experience, partly study (watching game tapes, or in this case, reading 10Ks and case studies) ... you look at certain situations and think, "Something's not right here ..."
Think about R.C. Cola and Coca-Cola. If I offered you a stake in either firm for the same price, both of which generated $100,000 in profit per year, which would you take? On identical terms, you'd go with Coke. Why? Common sense tells you that the superior distribution network, the bigger brand power, etc. has a better chance of surviving another century than the other. Some of that shows up in the numbers, but some of it doesn't. Look at the outrage that happened when "New Coke" was introduced. People feel a powerful connection to the brand. They feel as if they, as a society, own it. It's more than just a product. That's a line of defense; a protection, that doesn't show up in the balance sheet.
I strongly believe it is an enormous mistake to think that you can quantify risk into a complex formula. It's the entire reason firms such as Long Term Capital collapsed. It cannot be done. The idea is alluring; deceptive; like a siren calling to investors since time immortal.
Gilvus
August 18, 2013
Replying to Joshua Kennon
Understood. Since I posted that question, I realized that differences in each investor's risk tolerance would outweigh a lot of the empirical factors I asked about. But your answer really solidifies it. Thanks for the response.
Dave
August 5, 2013
Replying to Joshua Kennon
I am sure you have addressed this in the past, but cant find it anywhere. Which share class of Nestle are you looking at? Or better yet which class would US investors be best served to buy?
Joshua Kennon
August 14, 2013
Replying to Dave
I'm happy buying both. I have very low commission rates, so if I have an extra $500 or $600 sitting around, I'll just pick up the ADR for my family's personal brokerage account, sometimes doing that half a dozen times in a month. If I'm making a larger block purchase, I'd go with the Swiss shares directly.
I do know the Nestle ADR program has a conversion right, so you can transfer your ADR into the underlying foreign stock but I can't remember the minimum amount required to do it.
I'm firmly of the conviction that an American investor should almost never buy the ADR within a retirement plan as the foreign dividend tax withholding is not recoverable in 99% of situations. There's no reason to accept that; just buy the Nestle in a regular account and swap in a dividend-tax free holding from the US or UK or something in the retirement plans.
So rule of thumb: No ADR in retirement; if the transaction is is the five-figures, go with the Swiss shares, if they are four figures or less, the ADR are probably going to be a better deal. If the ADR is at more than a 2% or 3% discount to the Swiss shares, I'd go with them regardless. Just personal preference. If these were for a trust fund or something after I was gone, I'd buy the Swiss shares only as I wouldn't be around to examine the fine print when Citibank made changes to the fee schedule of the ADR.
Angie
August 5, 2013
Replying to Joshua Kennon
Wow. I am sure you will make an amazing teacher. And this world needs more of that. Your patience in explaining basic stuff to us readers reminds me of the best teachers i have had so far.
Anon
August 6, 2013
Ain't nothin' wrong with talkin' 'bout Nestle!
Ron T
August 6, 2013
I obtained one of my first and most important lessons on investing from Nestle back in 2002. I had just finished reading a book by Peter Lynch and was putting his "Invest in what you know" concept into practice.
After my second trip to Target in a week, I decided to research the company that made my contact lens cleaning solution. The company was called Alcon. After reading my first 10k, I found out that the company had just went public earlier in the year and it was actually Nestle that was selling 25% of its stake in Alcon. Wait.. what??? What does strawberry nesquick and nestle crunch bars have to do with some random eye care company in Fort Worth Texas?
I was so confused. I just didn't get it. I tried desperately to find the link between food and pharmaceuticals. It took me a good week before I finally got it. I had NO idea how big Nestle was. I had NO idea how many brands they owned and how much money they generated. I finally saw beyond the ticker symbols across the screen and saw an actual company. I realized that even companies look for good investments. And at the end of the day, whether it’s on a personal or corporate level, its all about allocation of capital.
DividendGrowth
August 6, 2013
Replying to Ron T
Too bad Alcon (ACL) was taken over by Novartis (NVS). It would have been an excellent long-term pick..
Andrew
August 6, 2013
Hi Joshua!
Nestle does look fascinating. On a technical question regarding such foreign stocks - I'm assuming you are buying these in a retirement account (as these are the only stocks you will talk about!), but it looks like there is a "favorable" 15% with-holding tax on the Swiss end. As far as I can tell, as an investor you'd simply have to "eat" that, but worth it for such a great company?
Thank you for your time.
Joshua Kennon
August 6, 2013
Replying to Andrew
I buy Nestle through regular, taxable brokerage accounts for the precisely reason you mentioned. It is far more intelligent than buying it through a retirement plan.
(I do have my parents in some Nestle in a retirement program but it is a legacy position that goes back almost a decade and was bought at a price substantially lower so even with the dividend withholding tax hit, it was still a very good deal. It's small, probably less than 3% of assets if I recall correctly, so it's not a major problem and one I don't foresee rectifying given that it keeps pumping out good income to fund other positions, especially relative to initial cost.)
FratMan
August 7, 2013
What ballpark investment amount do you think signifies the moment to switch from ADRs to dealing with owning something directly on the international exchange in a home country? My hunch is an investment over $20,000 or so, but I was curious where you'd draw the line if you were the demographic of your site's typical reader.
Joshua Kennon
August 9, 2013
Replying to FratMan
First and foremost, I look to see if there is a major discount for either of the shares relative to the other. It doesn't happen often but if you can get even an extra 2% or 3% one way or the other, that's essentially free money.
Beyond that, the commissions are higher (even the cheaper discount brokers charge something like the greater of $100 or 0.75% of the transaction amount) so at the very minimum, $5,000 if you were going to hold for a long time, but $20,000 would probably get you closer to where I'd be comfortable.
Of course, if you are buying through a retirement account, the ADRs are easier here in the United States. I just used the ADR for Royal Dutch Shell and BP in one of my pension funds earlier this year.
When I pick up tiny amounts of shares - the $500 or $1,000 on random days, then treat it like it was a bill I had to unexpectedly pay as I sometime do for a technique to build up positions (like I said elsewhere, it's crazy how big it can get after 5 or 10 years of doing that), I just buy the ADR. Some ADR can be converted into the underlying shares if you want, so you'd want to check out the specifics to find out the dollar amount.
That's probably not very helpful but really, it's just a matter of what I want to buy at any given time; what looks cheapest, what is easiest. It's that basic. Now, if we were talking about some highly illiquid, smaller company, I'd skip the ADR and buy the foreign, more liquid shares directly unless the discount between the two happened to be substantial.
calegp
August 8, 2013
I've taken cnn off of my hot links and I'm looking for another news source.
Front page bbc, I see this nestle article. I'm sharing just in case you haven't seen it.
http://www.bbc.co.uk/news/business-23612111
Joshua Kennon
August 9, 2013
I'm the same way - I stopped checking CNN and no longer reference it for anything, with the final nail in the coffin being the combination of the lack of NSA coverage when it was the biggest international news cycle in years, and the fact that some country overseas was burning to the ground in an uprising and the local CNN was showing fluff stories on penguins or something, while only the global version of CNN was showing the fact their government had just fallen. It's infotainment, not news. It doesn't serve a purpose.
As for Nestle, I think this lowered growth expectation is the reason people have been looking elsewhere for investments. It's what let me add to the Total SA position and some other stocks for cheap. I figure it's definitely going to happen - things will be slower, but given my time horizon, I don't care. It will be a rounding error 10, 20 years from now.
Steven
September 10, 2013
Joshua, I enjoy your blog. Had a question on Nestle. I notice in one article (circa March 2011) you were purchasing Nestle while acknowledging they were overpriced.
Do you still consider them overpriced? A fair price? Or to now be selling at a discount?
Thanks!
Steven
Joshua Kennon
September 10, 2013
Replying to Steven
I normally don't comment on individual intrinsic value calculations as any two reasonable people can come up with a figure that slightly differs based on the adjustments they make - and I absolutely do not recommend, encourage, or discourage buying the shares as I think that is a determination only a person and their qualified financial advisor can make based upon their own unique situation.
That said, and I still stand by it, Nestle has been a good teaching tool for the past few months because it is an easy to understand firm with a long track record and with which most people have some familiarity in their day-to-day lives. If it helps you run your own numbers and become a better analyst, I don't mind giving you my thoughts on the condition you do not accept them as any sort of recommendation. I specifically disavow any responsibility for what you, or anyone else, may do with my opinion as I am providing it solely for academic purposes.
Running the numbers, I think Nestle has been selling for roughly 10% to 20% under its fairly estimated intrinsic value for the past few months. With a pre-tax gross dividend yield of 3.3%, and an earnings yield that is competitive with average historical rates on long-term Treasury bonds, the ability to increase consumer prices to serve as an offset to inflation, and the somewhat recession resistant businesses it owns, I think a new owner buying today is getting a little bit more than full value for his or her money.
That said, I think that the slowing economic conditions in Europe, a huge market for Nestle, are going to lead to a fairly difficult next few years as sales struggle to grow. So I don't think it's going to be the most compelling thing in the world for most "investors" who want excitement from their holdings. I do believe the price for an owner who wants to hold for 10 to 25 years is good. In almost all scenarios I run, the probability of at least earning average rates of return seem very high; much better than the typical business.
The other major caveat I would mention is that an investor would have to understand the currency risks and considerations of holding a foreign firm. If the Swiss Franc weakens by 50% against the dollar in the short-term (currencies are notoriously volatile), and you insisted on converting your dividends back into dollars every period, you could have a situation where your dividend in Swiss Francs was increased one year, but you received less U.S. dollars as a result of the changing exchange rate. Presumably this wouldn't matter as much if you were reinvesting the money back into Nestle because the share price itself would also be influenced by this condition, or better yet, if you held the shares directly on the Swiss market, and received the dividend in Swiss Francs, you could think about the holding entirely in Swiss Francs, ignoring the dollar entirely (if the relationship were bad when you went to retire, you could always fly to Switzerland and spend your money there; though, I would be surprised if that were necessary. The Swiss passed a Constitutional amendment limiting the government's ability to spend money by tying expenses to revenue increases. I am far more optimistic on the long-term value of their purchasing power than I am the U.S. dollar).
All of this is predicated upon present known factors, of course, which could change with new information.
TL;DR: It's cheap enough I've been buying for my personal accounts outside the businesses and locking it away with the intention to hold it for many years, perhaps even decades or longer. I'm hoping the tough conditions in Europe go on for awhile so I can build a sizable position over the next few years as people get bored with it.
Steven
September 10, 2013
Replying to Joshua Kennon
Thanks for the detailed response Joshua! It's a shame anyone posting on financial matters have to post such strong disclaimers about acting upon their thoughts, but I guess that is a reflection of the litigious society we live in.
Steven
October 20, 2014
The price of Nestle is creeping down again. I'm looking forward to some more excited Joshua posts if it falls much further:)