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Here we are in October 2011 and the S&P 500 is hovering around 1220, about the same level it was back in December 1998. The stock market has rallied and crashed a couple of times since then only to wind up back at the same place it was when gas was $1.06 a gallon, the federal budget was balanced and Saving Private Ryan was in theaters.
But that doesn't mean that all stocks have gone nowhere in the last 13 years.
There are many stocks that have managed to generate solid returns for shareholders even though the overall market has been essentially flat. Here are some of the reasons why:
The stock market was overvalued by any reasonable metric back in the late 1990's. In late 1998, the S&P 500 traded at a nose-bleed 28x earnings, almost twice as high as its historical multiple. You can't blame weak profits for the poor returns since then, because they have actually doubled since 1998. But you can blame the irrational exuberance of the time for driving prices beyond their reasonable risk/return characteristics.
Often times when a stock or the entire market is in a bubble you'll hear people say "valuations don't matter for this stock because blah, blah, blah" or "this time is different". When you start hearing things like that, you better beware.
I came across an article from the year 2000 titled "Why high P/E stocks are good for you". Here are actual quotes from the article: "Here's a simple investing rule: risk pays. And that's why those risky growth stocks will always be better for your portfolio than value stocks".
And this gem: "the results of our study support our view that the higher the P/E, the better." I had to double check and make sure that wasn't from The Onion or something.
The Federal Reserve helped perpetuate the bubble too. In a paper from 2000 titled "The P/E Ratio and Stock Market Performance", Kansas City Federal Reserve Economist Pu Shen concluded the following:
"Some analysts view the current high price-earnings ratio of the stock market as a sign that the stock market may be headed for a downturn. This view receives some support from historical evidence that very high price-earnings ratios have usually been followed by poor stock market performance. When price-earnings ratios have been high, stock prices have usually grown slowly in the following decade. Moreover, at times such as the present when high price-earnings ratios have reduced the earnings yield on stocks relative to interest rates, stock prices have also tended to grow slowly in the short run.
Forecasts based on such evidence are subject to much uncertainty, however, because history may not repeat itself. Specifically, the possibility cannot be ruled out that this time will be different due to fundamental changes in the economy that will allow high price-earnings ratios to persist and thus stock prices to continue growing both in the near term and in the coming decade."
In reality, when stock prices get out of whack with earnings, you can expect several years, if not a couple decades, of poor returns. It took the Dow until 1954 to reach its 1929 levels for instance, and the S&P was at roughly the same level in 1982 as it was in 1968.
Believe it or not, some stocks actually managed to avoid the madness of the era and trade at fairly reasonable prices. Of course, these were mostly stocks in "boring" industries that didn't have ".com" after their names. But they did have profitable business models and positive free cash flow, and they managed to generate strong returns for their shareholders despite a flat market.
Caterpillar (CAT) was one of those stocks. It traded at just 11x earnings in 1998. The company has delivered solid profit growth and strong free cash flow growth over the past 13 years and shares are up around 266% (excluding dividends) over that time, crushing the overall market.
The Take Away: Valuation matters!
Investors can sometimes become overly pessimistic about the prospects for a company for many reasons. But a strong business that has maybe just hit a temporary snag can generate extraordinary returns, if it is able to right the ship.
Back in 1998 expectations were running high for a lot of things, but not for Guess? (GES). The brand had peaked in the 1980's, and revenue and profits were rapidly declining. But early in the 2000's the company revamped its image, expanded overseas, crushed expectations, and its stock has soared 358% despite a stock market that has gone nowhere.
The Take Away: Low expectations can lead to positive surprises...and huge price gains.
There have been many technological advances since 1998, but not all of them have led to profitable growth for firms. The companies that have succeeded at innovating are the ones that have banked real profits and produced positive cash flow for their owners.
Apple (AAPL) is the perfect example. The company literally created markets for itself out of thin air and generated tremendous value for its shareholders.
Apple was just beginning its renaissance back in 1998 as Steve Jobs took the helm once again and helped create products for markets that never existed before. The stock is up more than 4000% since 1998, quite a bit more than those super-awesome dot coms that never made a penny.
The Take Away: A truly innovative company can create opportunities for itself that never before existed and generate incredible returns for shareholders. But finding those rare gems is easier said than done.
Favorable Industry Trends
A rising tide lifts all boats. In other words, some companies have seen strong gains simply because of the industries they operate in. These companies have the wind at their backs and don't have to fight tooth-and-nail to steal market share in order to grow. The pie simply grows larger and everyone wins.
Of course any industry that is consistently generating strong returns will attract competitors. But industries with high barriers to entry and companies with wide moats can keep competitors at bay and their profits high.
Back in 1998, oil was trading around $12 a barrel. Today it's near $86. Surging demand from the emerging markets, high barriers to entry for potential suppliers, and lack of substitutions have led to record-profits for the oil industry. ConocoPhilips (COP) has certainly enjoyed riding this wave. Its stock is up 224% since December 1998 and its net income has soared from $450 million to over $11 billion.
The Take Away: Analyze the competitive dynamics of an industry and look for those with favorable demographics and high barriers to entry.
Although dividends have historically accounted for close to 40% of the total return of the stock market, they were not very fashionable in the late 1990's. But in this era of super low interest rates and choppy stock markets, the 'ole dividend seems to be making a bit of a comeback. Not only can you get a higher yield right now on many blue chip stocks than you could on a 10-year Treasury note, many of these companies consistently raise their dividends each year.
If you would have bought a stock in the late 1990's for its dividend, many investors would have laughed at you. But if you would have chosen a company with strong free cash flow, a solid balance sheet and a history of raising its dividend, odds are you would have beaten the market over the last 13 years.
3M (MMM) is a good example. Back in 1998 the stock was yielding a solid 4%, but many investors passed it up in hopes of significant price gains in tech stocks. But 3M kept steadily raising its dividend each year, at an average rate of 5.5%. The stock price rose at an average annual rate of 6.3%, but with dividends included the total return improves to a stellar 8.6%.
Doesn't sound like much of a difference? Well, $10,000 invested back in 1998 at 6.3% would yield $22,128 today. At 8.6% it would be $29,227, more than $7,000 more.
The Take Away: Total return matters more than price return, and dividends can make up a huge chunk of that equation.
That's Great, But...
Many of the same factors that led these stocks to outperform the market since late 1998 are still applicable today. So which stocks might generate strong returns over the next decade even if the stock market is flat?
Here are 5 choices:
Fortunately for long-term investors, valuations on the S&P 500 are much more attractive than they were in 1998. But that doesn't guarantee strong returns for the stock market over the next decade. Oracle, however, seems well-positioned to generate attractive returns over the long run.
This wide-moat IT firm has solid growth prospects, a healthy balance sheet and generates an enormous amount of free cash flow. Shares trade at a very reasonable 13x 12-month forward earnings and sport a PEG ratio of 0.9 based on a reasonable 5-year growth rate of 15%.
Fashion trends are hard to get right 100% of the time, especially with today's finicky consumers. Retailer Urban Outfitters, which also owns the Anthroplogie and Free People brands, had been knocking it out of the park over the last few years. But lately Urban's unique merchandise has failed to inspire shoppers, and the stock has taken a beating.
It's hard to believe that the story is over for this one-of-a-kind retailer though. If the company can get back on track, expect its earnings multiple of 14x to revert toward its historical median around 20x. That's more than 40% upside. The company still has many growth opportunities too, including internationally, which currently accounts for just 11% of total revenue.
Anytime your company's name becomes a verb, you know you've done something right. And Fast Company recently ranked Google #6 on its list of "most innovative companies". It's true. Google it.
The company still focuses heavily on improving its search business, with about 100 quality upgrades to its search engine each quarter. But it's not just the search business Google is working on improving. In just the last few years the company has launched dozens of various products, including its Android mobile operating system, the Google Chrome web browser, the Google+ social networking service, the Google Docs web-based office suite, and even a self-driving car.
Who knows what the company will come out with next? When you have a corporate culture centered around innovation and over $42 billion in cash, a lot of interesting things can happen. Valuation is reasonable too with shares trading around 16x forward earnings.
If there is one industry capitalizing on the collapse in U.S. residential real estate, it's the apartment industry. Homeownership rates have been steadily declining since 2007 but are still above their 30-year average of 65.9%. And with more than 25% of homes underwater, don't expect this trend to reverse anytime soon.
That means a lot of people are looking for a place to rent. This has led to a sharp drop in rental vacancy rates and a steady increase in rents. And with the pace of new construction at a trickle, the demand for apartments should outstrip supply for many years. This will likely lead to a significant rise in rents over that time.
This is great news for established apartment companies like AvalonBay, which develops and manages apartment communities in high barrier to entry markets throughout the United States. If it can execute properly, AvalonBay should have the wind at its back for the next several years and produce strong returns for its shareholders.
Since 1998, McDonald's has raised its dividend at a compound annual growth rate of 24%. Investors who bought the stock back in 1998, and have held on, now collect dividends that yield a stellar 7.5% on their original investment. The stock price is up over 130% since then too.
McDonald's currently yields a solid 3.1%, about 100 basis points more than the yield on a 10-year Treasury note. With a recession-resistant business model, growth opportunities in the emerging markets, a solid balance sheet, and exceptionally strong free cash flow, perhaps the real safe haven for investors should be the Golden Arches and not Treasuries.
With strong growth and income characteristics, expect McDonald's to deliver attractive total returns over the long haul.
The Bottom Line
Just as there were stocks that significantly outperformed the flat stock market of the past 13 years, there will be stocks that materially outperform over the next decade or so, no matter where the market goes. Just because the stock market may get stuck in ruts for years on end doesn't mean your portfolio has to.
Disclosure: The author owns shares of ORCL.
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