Wednesday, December 5, 2012

Market Declines: An Opportunity to Acquire Quality Dividend Stocks

In a previous article I argued that entry price matters to investors. Even the best quality dividend growth stocks like Coca Cola (KO) or Wal-Mart (WMT) are not worth owning at any price. In fact, investors who purchased these stocks in the early 2000’s, saw lackluster returns for over a decade. While earnings and dividends were growing at a fast pace throughout that period, it took almost a decade before the low initial yields became noticeable and before the valuations appeared attractive again. In fact, despite the rise in earnings over the past decade, stock prices for these two companies didn’t have much to show for it.

On the other hand however, purchasing dividend stocks at attractive valuations can help investors lock in an accidentally high yield. I usually find at least 15 -20 attractively valued dividend stocks ready to be bought at any time in my monthly screening process. However, I also typically uncover some rapidly growing companies, which increase distributions at a double digit pace, but trade at high valuations. As a disciplined income investor, I monitor these securities on a regular basis and add mental entry points should they reach undervalued territory. In order to reach my long term dividend goals, it really does make a difference whether I purchase a company growing earnings and distributions at 7% when its yield is 2% or 3%. In the first case, after one decade, my yield on cost will be 4%. In the second case, my yield on cost would be 6%.

Once or twice per year however, markets tend to get upset about something. It could be the US sub-prime mortgage crisis in 2008 – 2009 or the fiscal cliff in August and September 2011. Once markets get upset about something, investors start selling off fearing the worst. Business news commentators flash warning signs that the economy is about to collapse, earnings will plummet, unemployment will skyrocket and how humanity would revert back to living in caves very soon. This leads to decreases in share prices, because market participants now see stocks as inherently riskier than before. Many companies that previously traded at above-average valuations will now become fairly valued.

This is the point when regularly monitoring the market will pay off for long-term dividend investors. If they had done their homework, and have confidence in their analysis that the attractively valued income stock will maintain and increase earnings power over time, then they will have the chance to buy it at bargain prices. This will be a very difficult decision, since the investor will be seemingly going against everyone else’s warning of economic decline. For example, I was able to purchase several stocks between September 2008 and February 2009 at super attractive valuations. It was a very scary period in my investment career, as I feared that this time the economy will collapse. Nevertheless, I kept to my plan to regularly investing in dividend stocks though despite all the gloom. I did have to sell a few of my dividend holdings in the period however, since they cut or eliminated distributions. I replaced these stocks with other companies that were fairly valued at the time.

For a company with a stable business model characterized by recurring revenue streams, a decrease in price by 50% doubles its dividend yield.  If the dividend is well covered by earnings, then chances are that it won’t be cut, which makes the investment attractive to income seeking individuals. For example, Aflac (AFL) traded in the high $50’s in 2008. However, during the general decline in all financial stocks, I was able to snap some at approximately $25/share in early 2009.  At the same time, the quarterly dividend was increased from 24 cents/share in last quarter of 2008 to 28 cents/share for the first quarter or 2009. The same company that yielded 1.50% less than a few months earlier was now paying a higher dividend and yielded more. I liked the fact that the company was expanding in Japan, and was building its brand in the US simultaneously, in addition to its attractive valuation.

Another quality company I was able to purchase at low valuations included Altria Group (MO). In September 2008 the stock was trading around $20/share, and paid a quarterly dividend of 29 cents/share. By December 2008, Altria was trading at $15/share, and the dividend had been increased to 32 cents/share. The yield had thus increased from 5.80% to 8.50%. I liked the fact that people are more likely to keep habits such as smoking even in tough economic times, in addition to the ridiculously low valuation.

The reason why this paid off for me was the fact that I held a diversified portfolio consisting of over 30 individual components. Each of these companies kept business as usual, as their customers kept buying products or services on a daily basis. These products or services are everyday essentials that consumers or businesses need in order to operate. For example, just because we are in a recession, people still brush their teeth, use electricity or shave every morning. The other thing that helped most of the companies I owned was the fact that they were and still are riding the long term trend where millions of consumers from emerging markets are entering middle class for the first time. This increases their customer base tremendously, and will likely do so for the next several decades.

A few attractively valued dividend stocks to consider after the recent declines include:

McDonald's (MCD) is attractively valued at 16 times earnings and yields 3.70%. The company has managed to raise dividends for 36 years in a row, and over the past decade has managed to boost them by 27.40%/year. Check here for a more detailed analysis of the stock.

Medtronic (MDT)  is attractively valued at 12 times earnings and yields 2.50%. The company has managed to raise dividends for 35 years in a row, and over the past decade has managed to boost them by 15.80%/year. Check here for a more detailed analysis of the stock.

Walgreen (WAG)  is attractively valued at 13.50 times earnings and yields 3.40%. The company has managed to raise dividends for 37 years in a row, and over the past decade has managed to boost them by 18.90%/year. Check here for a more detailed analysis of the stock.

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