Wednesday, July 17, 2013

Dividend Investors Should Ignore Price Fluctuations

In this day and age we are bombarded with stock market information anywhere we go. You can find stock prices on many TV channels, newspapers, the internet and mobile phones or tablets. This excess of information creates information overload which creates the urge to buy and sell stocks in nanoseconds. This could prove hazardous to your wealth however. Research has shown that investors who actively trade the markets generate lower returns that index funds. In fact, investors would be better suited to just ignore price fluctuations and simply focus on fundamentals.

Investors should focus on company fundamentals in order to profit in the long run. Focusing on long term business performance would be helpful if the investor takes the time to understand the business, and determine whether the company has a chance of growing earnings over time. If earnings are increasing, chances are that the market will reward the company’s stock with a higher price, and that the company will be able to reward its shareholders with higher dividends. At times stock prices get detached from fundamentals however, which is when the patience of dividend investors is tested. During stock market euphoria, investors who own dependable dividend stalwarts tend to feel out of sync with the rest of the market, as high growth stocks tend to deliver double digit returns easily. During market corrections however, these same growth stocks tend to give up almost all of their returns, and then some. It is during market corrections that investors in sound companies continue generating a return on their investment. This return is in the form of cash that is directly deposited in investors brokerage accounts every quarter. Investors following the four percent rule of dividend investing in retirement do not worry about whether market is up or down, because their dividend checks pay for their expenses. They are essentially getting paid to hold their dividend stocks.

As dividend investors however, we should be ready to embrace periods of time where stock prices decline. I view these as opportunities to add to my existing positions and to buy stock in companies which have always been overvalued before. After that, I just sit patiently while the companies execute their strategies and prosper, even if the stock market does not recognize that for years. As long as the fundamentals are sound, and as long as the dividend is not cut or eliminated, I will hold on to my dividend stocks.

For example, between 1972 and 1985 shares of Procter & Gamble (PG) were flat. The only return that investors realized came from dividends. The reason behind this underperformance was due to P&G stock being overvalued in 1972, yielding only 1.30%. By 1985, the dividend had increased by 233%, and the stock was yielding 4.30%. For original investors who held P&G stock at lower entry prices however, their yield on cost continued to increase despite the overall stagnation in stock prices. Despite the fact that the stock price was flat for 13 years, earnings were increasing, and therefore the business was becoming more valuable.

Unfortunately investors never learn, and by late 1999, Procter & Gamble (PG) was trading at $55, and yielded only 1.20%. The stock fell on negative news all the way to $27/share, and it took four years before the stock reached its year 2000 highs. The dividend had increased by over 50% during that time period. For investors who purchased Procter & Gamble stock in the 1980s however, they were already generating high yields on cost. This meant that the volatility in stock prices should not have scared them away, as their dividend incomes continued to increase. New funds should not have been added to their P&G positions at the time however.

Other notable dividend stock declines included the decrease in McDonald’s stock price between its 1999 high of $49/share and its 2003 lows at $13/share. This was caused by overvaluation in the stock, although investors kept receiving distributions during that period. Albeit, dividend yield was less than 1% at the time, so it probably didn’t deliver much in terms of returns to shareholders.

On the other hand, some attractively priced companies became even cheaper to buy during the financial crisis of 2007 – 2009. Shares of Johnson & Johnson (JNJ), Abbott (ABT) and McDonald’s (MCD), which provided shareholders with a rising stream of dividend income, were trading at even more attractive valuations. Investors were essentially paid to hold during this tumultuous period, and could have reinvested distributions at the low prices that existed. At the same time fundamentals were improving, and investors could sleep at night with these investments, despite the fact that it seemed as if the whole world was breaking apart.

To summarize, long term dividend investors should expect to see price volatility, even if the fundamentals of their income stocks are doing fantastically. As a result, it is important to have entry criteria which would deliver some sort of return even if fundamentals do not pan out as expected. In the case of Procter & Gamble in 1972, 1999 and 2007, despite the fact that fundamentals were solid, the company’s stock price was overpriced, which led to high volatility while new investors did not see much in terms of dividend yield. Same was the result for investors in Coca Cola (KO), Wal-Mart Stores (WMT) and McDonald’s (MCD) in 1999.

The subsequent improvements in stock valuations over time should have prompted investors to add or initiate positions in these stocks. For example, right after the crash in 1987, Warren Buffett began accumulating Coca Cola stock, and by the time he was done, he had an average cost of $3.2475/share. For long term investors such as Warren Buffett, the stream of dividend income kept increasing, his yield on cost kept going up, and he kept reinvesting it in more cash flow generating assets for his company Berkshire Hathaway.

Full Disclosure: Long KO, WMT, MCD, JNJ, ABT, PG

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7 comments:

  1. I've experience a similar situation with JNJ over recently. I bought the stock and was underwater for about 12 months and never saw any paper profit during that period. Then, things got better, dividend increased along the way and my holding is now showing over 30% return. Patience pays big time!

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  2. One of my favorite quotes from Warren Buffet, "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes."

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  3. DGI, this is exactly the strategy I do myself too. I watch the stock price only to be able to add to my positions. Other than that I ignore them. Surprisingly the dividend can help you in determination whether to add or not. A great example can be JNJ. I bought when it was trading at 57 a share. The dividend then was 3.6% yield. Today the stock trades at 88 a share and the yield is 2.9%. I am not buying since the stock is too expensive for me (or the yield is below 3% threshold. If the stock drops slightly and the yield gets up above 3% I know I can be buying again. then I can wait if the correction goes on or buy. it is a very simple strategy even anybody totally unfamiliar with the stock fundamental analysis can do.

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  4. Thanks everyone for your comments. I agree that investing is simple, which is why so many people fail - they are looking for complicated formulas.

    This is why the most successful investors are the ones who sit and do nothing for decades, while patiently reinvesting dividends.

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  5. Hey DGI,

    I'm curious about the tax implications of owning canadian banks. If possible, can you write a an article about this? I do most of my investing in a Roth, so that might change things.

    Thanks,
    Zach

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  6. Yep, it nice to talk about things in the hindsight. So, based on the valuations today on the mentioned stocks, would you contribute to any of them or wait for that darn correction that doesn't rush to come?

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  7. I agree. That entry criteria every good investor needs to develop is very important. Value + Dividends = FI.

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