Quarterly Commentary

January 4, 2018

To the friends and clients of the Harvey Investment Company:

The S&P 500 rose a stunning 21.83% this past twelve months, capped by a jump of 6.64% in the fourth quarter ending December 31, 2017. The other major market indexes, the Dow Jones Industrials and NASDAQ 1000, registered even greater gains for the year. The S&P 500 has grown at a compound rate of about 15% over the last five years, and at a similar rate since December 2008 when the bear market of that era was bottoming.

Fifteen percent is a convenient number. Money growing at that rate, doubles every five years, so it is easy to extrapolate moving forward. For example, if the market continues to rise at this rate for the next five years, a portfolio will be worth roughly 8 times what it was at the end 2008. And in five more years 16 times!!! Hallelujah.

How likely is it that we will be so fortunate? We haven’t much conviction as to what the next year will hold for stock market investors, but we have a viewpoint. It is not drawn from the market forecasts we receive or the views readily found in the financial press. Our opinions are shaped largely by the communications that we receive from the companies we follow closely. These are very high quality organizations led by astute management teams. Their actions are usually quite well considered based on what they see in the period ahead.

One such company is 3M. We have taken an in depth look at its stock performance since 2010. Of course, any company’s own particulars shape its history and set the stage for its future. We, nevertheless, feel that aspects of 3M’s recent past can be generalized into useful insights into the business and the stock market climate today. Certainly, the examination of 3M offers concrete expression of certain realities underpinning our view of the market today.

3M is one of America’s great companies. Its illustrious history reaches back 115 years to 1902. The Company operates five divisions which deliver products to every corner of the world. The products 3M sells will bring in more than $31 billion in revenue and $5.5 billion in net income this year. Each division generates exceptional operating margins, a function of offering very high quality products. The Company is renowned for its productive R&D and innovation.

The last 7 years have been quite rewarding for 3M shareholders. In 2010, the first full year after recovery from the 2008-9 recession, the stock traded most of the year between $80 and $90. 3M closed 2017 trading at $235.17 per share or 2.75 times the price in 2010. That represents an annualized gain on the order of 15.5% a year. In addition, over the years, 3M shareholders received dividend payments that likely averaged another 2.5% per year, bringing the total return over the period to a stellar 18% annually.

Looking at 3M from a business angle instead of through the lens of a stock market investor, a more modest performance emerges. Revenues in 2010 were on the order of $27 billion. This year, they will be approximately $31.6 billion. Earnings per share are estimated to be $9.10 per share this year, some 1.6 times the earnings from 2010. That represents annualized growth in earnings per share of 7%. But there are 15% fewer shares outstanding today than there were back in 2010, which boosted the earnings per share growth rate. Actual earnings in 2010 were $4.09 billion and will likely reach $5.6 billion this year producing a more muted annualized rate of growth of 5% since 2010. Understanding how the modest earnings growth rate turned into super stock appreciation is an instructive exercise. How did it happen?

One helper was 3M’s decision to adopt a more aggressive financial strategy than had characterized the Company for many decades. Many conservative US blue chip companies took a similar tact. The rationale was thus. As the years rolled forward from the Great Recession of 2008-9, economic recovery was anemic and continuing malaise seemed quite likely. The period’s sluggishness was accompanied by low to non-existent inflation and very low borrowing rates.

3M, like many companies, concluded, first, that the sluggishness was likely to make real business progress problematical, and, second, that it could at least help the stock price by borrowing heavily at low rates and returning the proceeds to their shareholders. This it did. Three years in a row the Company bought back more than $5 billion of their shares. It also raised the percentage of annual earnings it pays out in dividends to 50% from 35%. This year, it will pay out more than $2.8 billion in dividends versus $1.7 billion in 2013 even though there are 12% fewer shares outstanding.

The economic malaise, perhaps perversely, had a positive effect on the appetite of investors for stocks like 3M and equities in general. The coupling of subdued demand for money to finance rapid business expansion with companies’ ability to borrow cheaply to reward investors, created a uniquely favorable backdrop to attract equity investment. And the investors came, culminating with the outstanding gains this year and the remarkable compound growth stretching back nearly a decade.

How did 3M stock do so well when the earnings were growing at but a mid-single digit rate? Getting to 18% growth per year since the end of 2010 roughly breaks down this way. Earnings growth per year was 5%. repurchases bumped up per share growth by 2.25%. Dividends enhanced progress by approximately 2.5%. That gets you 10%. Not bad at all. But where did the extra 8% come from?

Investor sentiment. In 2010 3M shares were valued at 15 times earnings per share. At this year’s end, that same metric will clock in at 25 times. A dollar of 3M earnings today is being valued at a 70% greater rate than in 2010. The heightened enthusiasm of investors for 3M stock, though unaccompanied by strong business progress, accounts for 8%, or nearly half of the Company’s outstanding performance.

The confluence of factors that created 3M’s fine performance are not unique to it, but we would suggest they are unique. We do not believe they can repeat. Can we realistically expect investors to tack on another 70% increase at which of a dollar of 3M earnings is valued? Further, though we definitely do not believe the 3M has meaningfully compromised its finances, there is no doubt that when a company significantly ups its borrowing, it has to pay that down before it can repeat the impact the original leveraging produced. In short, we would suggest that a 9-10% annual growth in the value of 3M stock over the next seven years would be an excellent outcome for 3M holders. A repeat of 18% seems extremely improbable. , it is unclear to us what a rational expectation is for 3M’s stock performance is at this time. We would say the same for the market.

Warren Buffett is a man of many maxims. One is “Be fearful when others are greedy; be greedy when others are fearful.” It is a good time to remember that one.

We feel so fortunate to have the clients we do. People like you. Have a healthy and very Happy New Year.

Samuel Harvey
Samuel C. Harvey

We are pleased to offer you upon request and without charge a copy of Part 2A of our Form ADV. This disclosure document contains information about the business practices and procedures of Harvey Investment Company, LLC. Please call us at (502) 339-8270, if you would like a copy.