Wednesday, February 29, 2012

Accumulating Dividend Stocks is a Long Term Process

My previous article “Does Entry Price Matter to Dividend Investors?” created a lot of discussion. To summarize, it is important to have some valuation guidelines, before purchasing a dividend stock. This is to protect the investor in the very likely event that they “fall in love” with a stock and purchase it regardless of price. After all, purchasing a stock at inflated price levels might lead to sub-par returns for several years.

The typical valuation guidelines I use include a minimum yield of 2.50% for new or existing investments, as well as a maximum of 20 times earnings I am willing to pay for a company. I would sometimes purchase shares in companies I deem to have great potential, which yield less than 2.50%. My purchase of a small position in Visa (V) is an example of this. I would never however initiate a position in or add to a position when I am paying more than 20 times earnings.

I typically accumulate my positions over long periods of time. I currently add or initiate positions in 2- 3 stocks per month. At this rate, chances are that I purchase stock in a given company about once or twice per year. In the case of companies like McDonald’s (MCD), this means that I bought stock in 2008, 2009, 2010 and 2011. As long as the stock trades at less than $105/share, I might be able to add to my position in 2012 as well. Even if the stock zooms past $105/share, I would still have exposure to it, although I might invest my new funds elsewhere. Unlike other investors however, I do not avoid buying stocks simply because they “went up”. Many investors missed the boat at McDonald’s (MCD) at $70 or $80/share, because they figured that the stock has increased too fast, and thus waited for a dip before adding to their positions. This is the type of market timing, which should be avoided. Now, If investors didn’t want to pay more than 15 times earnings, then waiting for the dip after McDonald’s increased above $75-$80/share was a perfectly reasonable excuse. The key to successful investing is having a strategy that fits your personality, and then trying to stick to it.

Many times, I would see a stock defy gravity and trade at 25 times earnings. I would wait for a dip before initiating or adding to my position. Sometimes it might take months and even years before the stock reaches an attractive valuation either because of a stock correction or because earnings increased faster than share prices. In an era of instant investment gratification, where investors can buy and sell stocks in the matter of nanoseconds, this seems like eternity. With dividend growth investing however, a big part of success comes not just by identifying the best companies and initiating a position in them, but also by holding onto them for as long as possible. If the stock I really want to purchase is overvalued, I would find another candidate for my money. There are over 200 dividend achievers in the US, which means that there are always investment opportunities out there for dividend investors.

For example, some of the recent buys I have made in my portfolio over the past month or two include:

Johnson & Johnson (JNJ) engages in the research, development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 49 years in a row. The stock trades at a P/E of 14.20 and yields 3.50%. (analysis)

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends each year since 2008, when it was spun off from Altria Group (MO). However, its dividend growth culture could be traced back to the four decades of dividend increases at the original Altria Group. The stock trades at a P/E of 17.10 and yields 3.70%. (analysis)

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised dividends for 48 years in a row. The stock trades at a P/E of 18.90 and yields 2.50%. (analysis)

PepsiCo, Inc. (PEP) engages in the manufacture, marketing, and sale of foods, snacks, and carbonated and non-carbonated beverages worldwide. The company has raised dividends for 39 years in a row. The stock trades at a P/E of 15.70 and yields 3.30%. (analysis)

Just because a stock is in overbought territory however, doesn’t mean it is a sell either. Too often I see investors disposing of their positions in otherwise fine dividend stocks, just because the price went into overbought territory. This creates taxable events for them and then they have to worry about reinvesting the proceeds in other stocks. The end result is typically similar to the scenario where they simply held on to the original stock and reinvested the distributions elsewhere.

To quote Warren Buffett, his first rule of success involves not losing money. His second rule of success involves not forgetting the first rule. The goal of dividend investing is a growing stream of income as well as capital preservation that comes with it. Investors chase overvalued stocks because they are afraid to miss the boat on future price gains and dividend increases. Unfortunately, stocks with higher valuations have a higher chance that anything that goes wrong could have a negative effect on share price or income stream. Investors who purchase stocks at reasonable valuations however, have better chances of realizing rising price and dividend returns.

At the end of the day, dividend investing is challenging because it involves a great deal of psychology. Investors are driven by their fears and greed. By developing a strategy that works for them, and sticking to it, investors should be better able to handle the mental aspects of the game.

Full Disclosure: Long MCD, JNJ, PM, CL, PEP


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8 comments:

  1. I agree with your post to an extent. There certainly needs to be some boundaries but I think you have to have the long-term perspective.

    If your portfolio is meant to be long term buy and hold, then 3-5% extra would certainly be nice,but that is not why you are buying. You are buying for inflation protection and income stream.

    What I mean in practicality, if you are watching a stock and its current P/E is 25, agree thats not a buy, but if it drops to 21 or 20.50 I personally would not hesitate to buy.

    Just my thoughts would love to hear others

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  2. I invest much as you do these days. It gives me a focal point and I find that having some rules, as you do, keeps one grounded.

    Have been reading your blog for a while now. Believe you still hold KFT. Can't help but wonder what you will do when the company splits into two. Will you sell the snacks division because it pays little or no dividend as it seems is intended? This situation is in flux, I continue to hold at the moment.
    Please let us know how you respond. Without complete information, I don't yet know what to do with it.

    Gotta like PM, doing just great!

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  3. Funny. In the last month, I purchased shares of PM, PEP, and JNJ. CL has too high of a P/E ratio for my taste. I'm not completely chasing after dividend income, but I will VERY rarely buy a stock that doesn't pay at least a 2% dividend. I would be curious what you think of IBM at the moment? It doesn't pay 2%, but it seems to follow the same pattern of PM and MCD of this stable, great growth.

    I will allow dividend reinvestment so long as the stock price is still in the "value" territory, but will stop reinvesting if I think I might sell the stock soon (like within 3-6 months).

    I sold my shares of MCD two months ago, not because there was anything particularly wrong with MCD, but because I thought my money could be better used somewhere else (I sold my MCD shares to buy shares of PM). I don't care if I sit on a stock for years on end (or forever), but I don't cling onto a particular 'dividend' stock, if there appears to be more undervalued stock from a solid company.

    ReplyDelete
  4. We have to remember that each person's investing strategy will be different. The key is not to find the exact "right one", but rather to decide on a method you like and then stick to it. I personally like to have stocks with a dividend of at least 3pc, have increased dividends for at least five years, and have a PE no higher than 16. I don't get obsessive about it, but just having SOME kind of criteria makes me feel good and adds some structure to things.

    ReplyDelete
  5. I am a dividend investor, but I also like to have a stock with potential for appreciation. Do you have a simple, preferred method for "guesstimating" an appreciation target?

    ReplyDelete
  6. I don't have any set numbers or black and white rules like you do. I think of investing as an art/science mix, so while there are things that jump out at me, like 25 P/E, I also make sure my gut has a say in it too.

    I have SU right now which has a 1.3% yield, which sounded low to me when I was buying, but I really like the company and they do a good job of increasing dividends.

    Because I plan to hold onto the stock for years I was not worried about the yield. The P/E was nothing out of the ordinary, but because I really like the company and believe they will do well I would have been able to overlook a little bit high P/E in order to get the stock when I did.

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  7. At the risk of sounding patronizing, I think that investing in an ethically reprehensible company like Philip Morris is unthinkable for a conscientious investor. With so many blue chip dividend companies out there, there is no reason to reward a company whose main source of profit is a product which kills and incapacitates millions of people worldwide.

    Must my 2 cents...

    ReplyDelete
  8. oh anon that is just too cute and funny.

    its not like PM or MO is attacking these people, or shoving it down their throats.

    It is a product (albeit addictive) that people do willingly chose to use. I don't smoke and think it is one of the most repulsive habits, but get over yourself.

    ReplyDelete

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