Thursday, October 29, 2009

The Best Trades could be the ones not entered

I often analyze individual stocks on the dividend growth blog. Some if not most of the times however, after guiding readers through the company story I end up stating that the stock is either a hold or sometimes even a sell. This irritates most investors, who see the practice of reviewing a stock which results in a negative or neutral recommendation as a waste of their time.

I definitely understand the frustration for those readers. Most investors typically want to be told what to buy, when to buy it and how much they would make when selling. This strategy always works in get rich quick books, but it seldom generates any profit in the real world. The reason why so many investors lose money on a consistent basis is because they fail to educate themselves and instead end up following gurus which don’t even trade the ideas they are pitching to their followers.

The value of a stock analysis is that it should give investors ideas about what they want to see in a stock, versus what they don’t want to see in a stock. A prime example is my analysis of Paychex (PAYX), which is overvalued relative to its competitor Automatic Data Processing (ADP). In addition to being overvalued, Paychex currently distributed most of its earnings out as dividends, which is clearly unsustainable in the long run. Thus, the relatively higher dividends yield of 4% on PAYX versus 3.3% for ADP is not enough to compensate the risk of a potential dividend cut.

Another reason why a neutral stock analysis is beneficial is that it provides investors with some insight into a company which could be temporarily overpriced. Since entry price matters to some extent, it would be unwise to pay top dollar for stocks, when there are companies with similar characteristics that are priced attractively. An investor, who does his or her homework early in the game, would be well prepared from reading the analysis to enter a position on dips, should the stock fall on general market weakness or on negative news.

The urge for constant action and the inability to wait for the best entry setups might be the difference between making money and losing money in the long run. Jesse Livermore, a famous trader from the 1920’s is known for his saying that “The big money is made by sitting, not thinking. Men who can both be right and sit tight are uncommon

I completely agree with this assertion. Investors who purchased stocks in the late 1990’s when dividend yields were at their lowest have suffered inferior returns over the past decade. Other investors who finally saw some gains in their portfolios in 2009 might have been quick to take a profit too early, thus missing out on the majority of the rally off the March 2009 lows.

Even if you purchased great stocks such as Johnson & Johnson (JNJ) or Procter & Gamble (PG) while their yields were at multi year lows, you would have seen no capital growth at best, although your dividend income would be higher than it was a decade ago.

At the end of the day what truly matters is that investors develop a sound strategy that fits their personality and go with it. The strategy should incorporate entry and exit rules, diversification and hopefully some sort of position sizing methods such as dollar cost averaging.

This blog post was included in the Carnival of Personal Finance #230 – New Site Edition

Full Disclosure: Long ADP, JNJ and PG

-Paychex (PAYX) Dividend Stock Analysis
-Automatic Data Processing (ADP) Dividend Stock Analysis
-Emotionless Dividend Investing
-Are High Dividend Stocks worth it?

4 comments:

  1. Hello...thanks for writing your excellent articles on dividend investing. I have a math question on dividend investing that I hope you can help with. How does the drop in stock price once a stock goes ex-dividend affect the return on the stock using the the dividend growth models? It seems like that price reduction would have a significant impact on the returns...how is that factored in to return calculations? Thanks.

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  2. I actually prefer articles that discuss why an investment is bad. Getting caught in the hype and the good side is too easy. Knowing what is bad and what to look for is what everyone should strive for since we come across more bad investments than the good ones.

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  3. Mike,

    I start with a basic price, and add in dividends. Sure people tell you that the price of the stock trades lower by the amount of the dividend on ex-dividend day, but if you add back the amount of the dividend then you should be fine.
    Despite the fact that stocks supposedly go lower on their ex-dividend date by the amount of the dividend, there's many stocks which have paid out in dividends much more than what they are currently selling for. It seems that simply subtracting dividends on ex-div date might not be the truest method available...

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  4. I agree with Jae Jun. I don't understand why people don't want to see examples of what NOT to buy, since there are so many more of those stocks out there. Learning how to weed out bad investments will only make a better investor out of you

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