Slow Growth Hits Home


Expect tepid growth in the economy and the market in the coming years—but don’t settle for lousy returns in your stock picks”

O THE LIST OF RESOURCES IN DWINdling supply—oil, forests, clean water— add company growth. There’s reason to believe rich economies and their stock markets are entering a long, chilly phase, during which sales gains and higher share prices will prove harder to come by. In what follows, I’ll explain why and look at a handful of dividend-paying companies that seem likely to beat the odds with steady sales growth.

U.S. stocks have been lucrative for their owners over most of the past half-century. From 1960 to 2006, returns averaged 6.1 percent a year after inflation, including about 3.3 percent a year in dividends. Don’t count on more of the same, though. Conditions that produced past stock gains aren’t sustainable, says economist Bradford Cornell, a former UCLA professor who provides valuation testimony for big corporate litigants.

In a paper slated for publication in Financial Analysts , Cornell traces the link between stock returns and economic growth. He finds that gross domestic product and corporate earnings rise in tandem over long time periods, even if one briefly outperforms the other over short bursts. From 1960 to 2006, U.S. gross domestic product per person increased just 1.1 percent a year after inflation. Add 1.1 percent a year for population growth and you get overall GDP growth of just over 2 percent a year, implying that earnings would grow at the same rate. The supply of shares continually increases, though, as each crop of young companies issues new shares. Because of this dilution, earnings-per-share growth lags behind total earnings growth by about two percentage points a year over long time periods. All told, then, earnings per share over the past half-century should have grown by less than 1 percent a year after inflation, resulting in yearly share-price gains of about the same.

Instead, we got nearly 3 percent a year in price gains, as P/E ratios expanded by a third (they remain well above their historical average) and as profits bubbled up as a percentage of GDP. To Cornell, seemingly high P/E ratios don’t necessarily mean stocks are due for a plunge. It could mean that demand for stocks has shifted permanently higher, perhaps because the rise of hands-off investing through mutual funds, particularly in 401(k) accounts, has made savers more comfortable with stock market participation. But today’s investors can’t count on a further ballooning of P/E ratios or on a continuance of earnings growth outpacing GDP growth. In the future, U.S. stock gains might match meager economic growth.

Other rich economies have grown faster than the U.S. over the past half-century. Cornell reckons that’s because the devastation from World War II left them catching up. Recently, growth rates throughout the rich world have converged on the U.S. rate, and population growth is slowing. Cornell figures investors should count on yearly rich-world GDP growth of no more than 2 percent per person from here on, plus a percent for population growth. Subtract two percentage points for dilution and you’re left with a single percentage point for expected share-price gains. Even with dividends, which currently average 2 percent in the U.S., total returns might be half of what investors have come to expect. Emerging markets should grow faster than rich ones, but their supply of shares is a pittance relative to world demand for them, so share prices could stay chronically high, crimping future returns in those countries, too.

Slow growth isn’t necessarily bad for humanity. Even a stationary economy, as 19th-century philosopher John Stuart Mill wrote, “implies no stationary state of human improvement. ” But if stock returns do indeed shrink, savers will need to sock away more, find stocks that can outperform in a slow-growth economy or both. Below are five companies that pay larger- than-average dividends, have reasonable valuations and seem poised for reliable sales growth over the next decade.

Coca-Cola might seem too big to grow. Last year the average American downed more than 25 gallons of the company’s drinks. Management has a plan to double companywide sales by 2020, with most of the growth expected to come from emerging markets. The company has 3,000 products, including teas, waters and fruit juices, many of them favorites in their local markets. Mexico and Chile already drink more Coca-Cola products per person than Americans, and China and India have only begun to quench their thirst.

Emerson Electric makes industrial components. In its five fiscal years ended Sept. 30, 2008, sales increased at a compounded rate of close to 13 percent a year. Last year, though, sales plunged 16 percent, and declines continued into the current fiscal year. Management has aggressively cut costs, reduced inventories and focused the business along what it sees as economic megatrends, like urbanization, emissions control and data connectivity. From its now lower sales base, it says it can increase sales by 5 percent to 7 percent a year and operating profits more than twice as fast. More than half of sales now come from outside the U.S., and a third come from emerging economies. Emerson will have plenty of financial flexibility to pull off its rebound. Free cash flow works out to nearly 8 percent of its stock market value. The company’s recently raised dividend gives shareholders a 3.2 percent yield.

Abbott Laboratories has decent growth prospects for a giant drugmaker. Its topselling products include pills for people who can’t control their cholesterol levels through diet and stents to prop open the clogged arteries of patients who didn’t get their cholesterol under control soon enough. It has a self-injectable medicine for inflammatory conditions like arthritis and psoriasis. It recently bought its way into eye laser surgery equipment, and it makes infant formula, which is enjoying rapid sales growth in developing economies. Abbott’s 2009 sales rose an estimated 4 percent, and this year’s sales are seen rising 8 percent. Shares yield 2.9 percent, and the company has increased dividend payments for 37 straight years.

Now for a couple of smaller companies with somewhat riskier shares. Life insurance is already a creepy product, in that it uses complicated math to lay odds on when a policyholder will die, thereby pricing a bet in the house’s favor. With whole life, the bet comes wrapped in a costly investment product. Cheerfully named Life Partners Holdings takes things to a new level. As the leading market maker for what’s known as settlement transactions, it helps the insured sell their policies to strangers. Buyers get attractively priced death bets.

Sellers get immediate cash. Life Partners gets a fee for arranging the trade. Wouldn’t you know, business is booming? Sales are growing at a double-digit pace, and shares have tripled in value in three years.

Finally, PriceSmart is a warehouse club like Costco Wholesale and Sam’s Club, only it operates in Latin America and the Caribbean. The stores are slightly smaller than those in the U.S., and membership fees are lower. The chain is still small, but sales are growing nicely, and the stock offers a 2.6 percent dividend yield.

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