Wednesday, November 13, 2013

Dividend Stocks Are Not a Bubble, but Many Technology High-Fliers Are Dangerously Overhyped

So far, 2013 has been a great year for investors. Stock prices are rising left and right, many participants are flush with cash, and there are few alternatives to equities at the moment.

The rising tide has left many of the usual suspects I bought over the past five – six years slightly overvalued. I am referring to the likes of Colgate –Palmolive (CL), or Automatic Data Processing (ADP), which trade above 20 times earnings. Other steady-eddies like Coca-Cola (KO) and Procter & Gamble (PG) are trading at slightly less than 20 times earnings. This is not going unnoticed however. Several times so far this year, someone is coming to attack the viability of dividend investing as a strategy, mostly due to that overvaluation. These Neanderthals proclaim the death of dividend investing all the time. In general, I think these people should be ignored, as they are dangerous to your wealth building process.

All the while these self-proclaimed gurus talk about the so called bubble in dividend investing; they are failing to recognize the real threat to investors today. This threat is simply there, in plain sight, for anyone to see. Yet, everyone seems to be focusing on the so called bubble in dividend stocks. I don’t get it how you can call Coca-Cola at 19 times earnings a bubble, when Facebook (FB) is trading at a P/E ratio of 50 times expected earnings. I guess in the modern world, a company that has an established distribution network, a loyal customer base, pricing power, a diversity of products and a culture of dealing with over 100 years’ worth of challenges, is no match for a young technology company that offers a product that might not even be there 15 years from now. On the other hand, I am pretty sure people would still be brushing their teeth, drinking liquids and shaving.

What the gurus are missing, is the sky-high valuations on a certain set of over-hyped companies. Many of these companies are justifying their valuation based on extremely optimistic projections going many years into the future. The thing that makes those projections highly doubtful is that these companies have untested business models, and are subject to rapid paradigm shifts in consumer demands. It is very difficult to make projections on sales, revenues and profits ten years into the future on new concepts. This smells more like speculation, rather than sound investing. Even if you have a great idea that would make the world a much better place, it would still not be enough for early investors to make a reasonable return on their investment. If you massively overpay for future growth, you might end up without much of a return for a long period of time.

A few of these over-hyped companies include:

Tesla Motors (TSLA), which is supposed to revolutionize the automotive industry. We have the buzz word of a visionary entrepreneurial CEO with a proven track record, the fact that a company selling a few thousand cars per month has a market cap that is half to a third of more established General Motors (GM) and the lack of profits. It is true that the company has a lot of potential, but in order for the valuation to make sense, it must sell a lot of cars. Even if Tesla cars become widespread in the world in ten years, this still does not present a guarantee of profits and stock price gains for investors who buy today. Even if Tesla sells 500,000 cars annually by 2023, this could still not be enough to justify the lofty valuation of today. Tesla has a market cap of 16.5 billion, while GM has a 50.5 billion dollar capitalization. In 2012, GM delivered 9.3 million vehicles, while Tesla will have 21,000 vehicles delivered in 2013. The company is expected to reach 500,000 vehicles in the future. While the company is great, I doubt that current valuations make sense for investors. (AMZN) is an awesome company, whose services I use very often. The company is trading at a P/E of a few hundred times earnings, and has managed to grow revenues through scaling operations, expanding into new sexy businesses such as the cloud, and disrupting the retail business. However, the company is almost 20 years old, yet still behaves like a start-up. I remember the first time everyone said that profits don’t matter in the late 1990s. I also remember the early 2000s, which were brutal for the former technology darlings. Many did go under, including the likes of and Webvan. I think that Amazon would likely be there in 20 years, however I do not know if simply growing revenues is a viable business model that can reward shareholders in the long-run. At the end of the day, the goal for a business is not to grow revenues to the sky and be a disruptive force in as many industries as possible, but to make money for the shareholders. Between 1995 and 2012, the company has earned a total of $1.9 billion dollars. Currently, the market capitalization of Amazon is 160 billion dollars. While the company is great, current valuations do not make sense for investors.

Twitter (TWTR) recently had a widely successful Initial Public Offering (IPO). The company has not yet made a profit, but at least it is generating some revenues. Just a few short years ago, Twitter didn’t even know how to monetize its wide number of users. I use Twitter, but in all seriousness, I find it very obnoxious, and pretty spammy. Of course, I do not care about the Kardashians or Jersey Shore, so maybe I just don’t “get it“. However, when a company whose business trades at 24 times expected revenues in 2014, it could take a lot of luck for this investment to work out for investors. The company’s market capitalization is $22.70 billion and analysts expect it to have revenues of $1.15 billion by 2014. In 2012, the company lost $79 million on revenues of $317 million. Current valuations do not make sense for investors in Twitter.

I understand that all of these companies can justify their lofty valuations today, if they keep growing revenues and eye-balls at a fast pace for several years to come. However, this type of valuation method assumes perfection, and we all know how in a world of ever changing technology and rapid shifts in consumer technology tastes, todays darling could become tomorrow pariah. Just look at MySpace.

If the stock prices turn lower from here, the biggest losers are going to be the investors in the three companies mentioned above.

You can call me old-fashioned, but the types of companies I find attractive enough today to buy and hold for 20 years include:

The Coca-Cola Company (KO), a beverage company, engages in the manufacture, marketing, and sale of nonalcoholic beverages worldwide. The company has rewarded shareholders with dividend increases for 51 years in a row. Over the past decade, Coca-Cola has managed to hike dividends by 9.80%/year. Currently, the stock is trading at 19 times earnings and yields 2.80%. Check my analysis of Coca-Cola for more details.

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has rewarded shareholders with dividend increases for 26 years in a row. Over the past decade, Chevron has managed to hike dividends by 9.60%/year. Currently, the stock is trading at 10 times earnings and yields 3.40%. Check my analysis of Chevron for more details.

Target Corporation (TGT) operates general merchandise stores in the United States. The company has rewarded shareholders with dividend increases for 46 years in a row. Over the past decade, Target has managed to hike dividends by 18.60%/year. Currently, the stock is trading at 15.70 times earnings and yields 2.70%. Check my analysis of Target for more details.

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has rewarded shareholders with dividend increases for years in a row. Since the spin-off from its parent Altria in 2008, Philip Morris International has managed to hike dividends by 13%/year. Currently, the stock is trading at 17 times earnings and yields 4.20%. Check my analysis of Philip Morris International for more details.

I believe that the key to investing success is not how much a company will supposedly benefit society, but rather determine what their competitive advantage is and how durable that moat really is. After that, if you manage to purchase such a company at a fair price, and you hold at least 30 such companies in your dividend portfolio, you should do quite well for yourself in the long-run.

Full Disclosure: Long KO, CVX, TGT, CL, ADP, PM

Relevant Articles:

Buy and hold dividend investing is not dead
Dividend Investing in times of a Social Media Bubbles
How to invest when the market is at all time highs?
Common Misconceptions about Dividend Growth Investing
Frequently Asked Questions (FAQ) About Dividend Investing

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