Monday, August 26, 2013

The importance of pricing and valuation in dividend investing

There are two schools of thought when it comes to paying money for investments.

The first school of thought is that you should invest at such a good price, that even if you are wrong, you can still have a shot of making some money. This strategy follows undervalued companies, which could be hated because of a temporary setback. The risk however is that the earnings will decrease going forward, therefore causing the company to look overvalued in hindsight in the future.

Currently, shares of Microsoft (MSFT) and Intel (INTC) are undervalued. Microsoft is trading at 12.50 times earnings and yields 2.90%, while Intel trades at 12 times earnings and yields 4.10%. Many investors are fearful that the decline in PC sales will result in declines in profits for these two tech juggernauts. This could lead to steep losses for investors today. However, the prices are low enough that if profits can be at least maintained for the next decade, investors today will be able to generate good returns. In my opinion however, unless the companies manage to adapt to the new environment, the streak of dividend growth can only be continued for a few more years.

The second school of thought is that you should only focus on identifying great companies, and then trying to purchase them at a fair price, rather than focusing on buying the cheapest securities regardless of their quality. This strategy follows world class companies, which are usually loved by the market, because of their consistency in delivering results to shareholders. The risk with this strategy is that investors overpay so much for this consistent stream of earnings and dividends, that it sets them back by several years.

Currently, shares of companies like Colgate-Palmolive (CL) are trading at 24 times earnings, and yield 2.30%. The company is expanding sales and profits, and has strong brand products that demand premium pricing. Unfortunately, buying even a great company like Colgate-Palmolive at overvalued prices will result in low initial returns for the investor, even if fundamentals improve according to expectations. For example, shares of Wal-Mart Stores (WMT) were virtually unchanged for over a decade after trading at 40 times earnings in 1999. This is despite the fact that earnings quadrupled, and revenues more than tripled.

In my investing, I try to use the wisdom of the best and brightest before me, in order to come up with an investing strategy that fits me. I have followed the writings of Ben Graham, Phil Fisher, Warren Buffett, Peter Lynch, in order to come up with a variation that I can weave into a strategy, which will deliver my investment goals and objectives.

In my investing, I try to focus on companies which are attractively valued, yet have competitive advantages that would allow them to generate rising profits over time. This is therefore a blend of the two entry criteria listed at the beginning of the article. Another modification I am using is to be flexible with my purchases, depending on the specific market environment and specific company situation as well.

Whenever I look at a company I am considering for purchase, I always ask myself if I see this company being around in twenty years. If I do not believe that a company has the durable competitive advantage to last that long, and generate rising profits over time, I simply move on to the next firm. In this process, I am not worried that I might miss a great opportunity, if that results in lower probability of permanent capital loss. I would much rather miss out on the next Wal-Mart (WMT), than include the next Enron.

Sometimes however, the Wal-Marts of the world are available for everyone to scoop up, in plain sight. Yet, few investors are recognizing the opportunities. A few attractively priced stocks I am eyeing right now include:

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company trades at 14.30 times earnings, yields 2.50% and has raised distributions for 39 years in a row. The five year dividend growth is 13.50%/year. Check my analysis of Wal-Mart.

Target Corporation (TGT) operates general merchandise stores in the United States. The company trades at 15.10 times earnings, yields 2.50% and has raised distributions for 46 years in a row. The five year dividend growth is 20.50%/year. Check my analysis of Target.

McDonald'’s Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company trades at 17.50 times earnings, yields 3.20% and has raised distributions for 36 years in a row. The five year dividend growth is 13.90%/year.  Check my analysis of McDonald'’s.

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 trades at 11 times earnings, yields 4.10% and has raised distributions for 13 years in a row. The five year dividend growth is 13.10%/year. Check my analysis of ConocoPhillips.

Full Disclosure: Long CL, WMT, WMT, TGT, MCD, COP

Relevant Articles:

Best Dividend Stocks for 2013, and beyond
Buy and hold dividend investing is not dead
How to define risk in dividend paying stocks?
The predictive value of rising dividends

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