Monday, August 5, 2013

Should I buy dividend stocks now, or accumulate cash waiting for lower prices?

Prices of stocks have increased a lot in 2013. As a result, many dividend investors are shunning purchases, citing high stock prices. This means that they are not reinvesting dividends, and keeping any fresh portfolio contributions in cash. The issue with this strategy is mostly psychological.

These investors are hoping for a correction, that would make investments affordable again. They believe that they are better off waiting for better prices, rather than buy shares at or above the maximum prices they are willing to buy at.

First, an investor can easily afford to wait for attractive valuations. However, it would be difficult to hold on to your cash when it earns practically nothing, but the positions you had set your sights to balloon in value, increase distributions and enjoy rising profits. From a psychological point, you might admit defeat at some point, which unfortunately could be too late.

In general, individual investors are really bad at timing market moves. As a group, they tend to sell near bottoms, and finally give up and buy at the top. This is why most individual investors are better off simply buying and holding stocks, and not making many investment decisions.

Second, because I doubt I am good at market timing, I simply try to allocate my cash at the best valued companies at the moment. I find these best companies by looking at dividend streaks, historical earnings and dividend growth, competitive advantages and existing portfolio positions. Once I have cash on hand, I try to purchase best values available, by taking into account valuation, prospects, and portfolio weights. I therefore try to buy shares every month or so. I do search for values, and although could sacrifice on a dividend streak or minimum yield, I would never sacrifice on quality and valuation. As long as I can find bargains, I would keep doing so.

For example, during the late 1990s, many quality dividend growth stocks such as Coca-Cola (KO), Wal-Mart Stores (WMT) and Johnson & Johnson (JNJ), became grossly overvalued. However, astute dividend investors could have found attractive values in REITs, financials and energy for example. In addition, there were pockets of opportunity from time to time in sectors that temporarily went out of favor such as tobacco for example.

Third, I try to allocate money whenever I get them, because I do not want to miss out on the power of compounding. In theory, I could wait until the perfect price. In reality, I could end up missing out on the perfect price for a long period of time. Therefore, my money would not earn anything for me. For example, assume that my entry criteria requires to invest in a company yielding 3% in real terms. However, I could only find companies yielding 2%. What if I decided to put my money to work at 2%, but I could not find any 3% yielders for five years? It would take ten more years for an investment at 3%, to reach out the same amount of net worth as the 2% yielding one.

However, if you had a high allocation to cash in 2007 - 2008, you might have been able to deploy it very well at attractive valuations. Many otherwise quality companies were selling at ridiculously low valuations during this tumultuous time period. The risk of having too much cash however is that it might have been deployed too quickly, at the beginning of the crisis, rather than slowly. 

In the present market, I find some great companies at low valuations, which unfortunately have imperfections. These imperfections are mostly low streak of dividend increases and low yields. I would hate to start breaking my rules on a more consistent basis however. This might be risky as I might end up overpaying in hindsight or buy something I should not have touched in the first place. I could overpay in hindsight if I purchase a cyclical with a low P/E, whose earnings decrease precipitously and then stay there. This could be the cause with many commodity companies. The list of companies that currently fit my entry criteria is dwindling as we speak, but unfortunately many of these are companies I already have a very high concentration into.

At this time, one of the cheapest sectors is oil and gas services. The three energy companies to consider today include:

ConocoPhillips (COP) explores for, produces, transports, and markets crude oil, bitumen, natural gas, liquefied natural gas, and natural gas liquids on a worldwide basis. The company has managed to increase dividends for 13 years in a row. Over the past decade, it has managed to boost distributions by 15.10%/year. Currently, the stock trades at 10.90 times earnings, and yields 4.20%. Check my analysis of COP.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has managed to increase dividends for 26 years in a row. Over the past decade, it has managed to boost distributions by 9.60%/year. Currently, the stock trades at 9.40 times earnings, and yields 3.10%. Check my analysis of Chevron.

Exxon Mobil Corporation (XOM) engages in the exploration and production of crude oil and natural gas, and manufacture of petroleum products. The company has managed to increase dividends for 31 years in a row. Over the past decade, it has managed to boost distributions by 9%/year. Currently, the stock trades at 9.40 times earnings, and yields 2.70%. Check my analysis of Exxon.

I would not advise putting more than 15-20% of one’s portfolio in a given sector however, in order to reduce risk. If oil prices fall back to the levels we saw during the financial crisis, and stay there for a few years, oil companies might be unable to continue with their generous share repurchases and dividend increases. This doesn't mean this would happen, but the intelligent dividend investor needs to think about probabilities, and build a portfolio that would not permanently lose value and income should a string of unfortunate activities materialize.

In addition, I have gotten a little more creative with companies I like, that are slightly overvalued. For example, I like shares of Coca-Cola, which are trading at a forward 2013 P/E of 19.15 and forward P/E of 2014 of 17.70.

Because I find the stock a little rich to my taste right now, I sold one January 2014 put, with a strike of 40, at around $1.85/contract. If the stock price trades below $40/share at the time of expiration, I would buy the shares at the strike price. However, my cost would be essentially $38.15. This equates to a P/E ratio of 18.20.

Furthermore, I also sold a January 2015 put with a strike of $40 at $4.30/contract. If exercised, this will translate into a cost basis of $35.70/share or a P/E of 15.70.

I like the long-term economics of Coca-Cola, which should benefit from rising demand in emerging markets and integration of North American bottling operations. The company has strong brand name, which provides pricing power and solid profitability. Check my analysis of Coca-Cola.

Full Disclosure: Long WMT, JNJ, KO, CVX, COP,

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