Monday, December 22, 2014

Should you purchase dividend stocks at 52 week highs?

Many investors I know follow different investment principles, such as that to "Buy low, sell high" and "Buy and hold forever". To many investors, purchasing dividend paying stocks at 52 weeks highs or all-time-highs seems like anathema, since it would run contrary to their beliefs of buying low.

I expect businesses I own to keep expanding, selling more products, generating higher revenues and earnings, while showering me with more cash dividends each year. In the meantime, those rising earnings and dividend make businesses more valuable over time, as they increase their intrinsic value. Therefore, in a somewhat efficient marketplace for securities, I expect stock prices of successful businesses to follow and keep hitting all-time-highs over time. Of course, I do not focus on stock prices as much, as I do on values. I have found that focusing too much on meaningless short-term stock price fluctuations is not helpful to my long-term wealth building. This is because I feel the urge to do something, which is dangerous to the compounding of wealth. As a long-term investor, the goal is to set-up a portfolio, and look at annual reports, and quarterly press releases as well as major announcements such as dividend increase, mergers & acquisitions to name a few.  I focus on valuation today, compare valuations between different companies between industries, and make estimates of future growth based on sustainability of business model ( does the company have any moat).

Many of the quality businesses I focus on here tend to increase intrinsic value over time. As a result, waiting for the perfect price might let you sitting in the dust. This doesn’t mean to throw all caution out the window and buy regardless of valuation, and without requesting some margin of safety in the event that future is not as rosy as expected. However, if you find a company that sells at an all-time high and say 19 – 20 times earnings, you might have to start accumulating shares if you believe there are good prospects down the road. If earnings per share double in seven years, and the P/E compressed to 15 – 16, the stock could still end up much more expensive in 7 years. If you add in the missed compounding from reinvested dividends, the opportunity cost of sitting in cash might be pretty high.

If you think about it, the all-time high of Coca-Cola from 1987 is much lower than the range it sells for today. In fact, if you purchased Coca-Cola at 52 week highs as long as it sold below 20 times earnings throughout history, you would have done pretty well for yourself. It is true that it is much better to buy quality dividend growth stocks at the lowest prices possible. If you have a long-term horizon like me, that spans at least 15 – 20 years from now, you can afford to view one or two year periods as mere noise.

To me, it is more important to focus my attention on the best values at the moment, and then analyze them for future growth. If the best value today sells at an all-time-high, I would not be worried. I actually read a study, which found that actually purchasing companies that hit all-time-highs has resulted in above-average gains to investors. I know that this was more of a timing strategy than buy and hold, but the results are nevertheless very interesting. The more experience I gain, the more I realize that getting the right entry price is important. However, it is much more important to identify a quality earnings and dividend grower, which manages to earn more money over time, and thus making the business more valuable. If the company has the type of business that sells a unique product, has strong pricing power, and has great earnings growth visibility, then it is fine to pay 20 times earnings for it. This is the type of situation that Warren Buffett describes in his famous saying " It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

My dividend growth strategy is essentially a strategy of following long-term trends in company fundamentals, specifically their dividend rates. Essentially, once I purchase shares in a company, I hold on for as long as the company raises dividends. Even if a company stops growing dividends, I will keep holding on to it, but allocate them elsewhere. It is important to reinvest dividends selectively, into the best values and qualities found at the moment, and not mindlessly reinvest into the same company regardless of valuation. If valuations become too overstretched however, such as in situations where future growth expectations do not justify a P/E of 40, it might make sense to dispose of the security. The situation where I typically have done most of my selling is after a dividend cut. I have found in analyzing my investments that selling a mildly overvalued company to purchase a mildly undervalued is mostly a mistake. If I identify a mistake in the original thinking I may have done, that led me to an investment in the first place, I would sell as well.

On the other side of the equation, just because a company is cheap, and is selling at a 52 week low does not mean it is an automatic buy. Investors who only focus on stock prices, without understanding anything about the business, growth prospects, are probably speculating.

To summarize, just because a company is selling at a 52 weeks high, does not mean that it should not be considered or it should be sold automatically. A new investor should evaluate the value by looking at business fundamentals, catalysts for future earnings growth, and valuation before committing their hard-earned money to work. For those who already hold shares in a company which is hitting a 52 week or an all-time-high,  they should continue monitoring their investment, and check whether earnings are growing and that there are catalysts for further growth. One of the hardest things for investors to do is to just hold on to their best ideas, as they prove them right, and not sell and buy something that appears cheaper but leaves the investor worse off in the long-run.

Full Disclosure: Long KO and BRK.B

Relevant Articles:

Dividend Cuts - the worst nightmare for dividend investors
Why would I not sell dividend stocks even after a 1000% gain?
How to read my stock analysis reports
Three Characteristics of Successful Dividend Investors
Reinvest Dividends Selectively

14 comments:

  1. For years I waited to buy MMM...because it always looked too expensive. This March, I just went ahead and bought it at $133. It was at its 52-week high.

    It's now at $166, a buck or two from its yearly high. It still looks too expensive! It'll probably always look too expensive.

    It traded almost as low as $40 in 2009. I know the markets were tanking, but wow, to own companies like 3M paying almost 5% dividends...damn.

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    1. Unfortunately when they keep growing, the best dividend growth companies tend to always be fully valued to overvalued. Thus, it is a challenge/tradeoff to determine whether it is worth to pay say 21 times earnings and have a potential dud or pay a little more and have the best stock performer in your portfolio. MMM is slightly overvalued for me, but not by much. Ironically, most dividend investors in 2007 - 2010 didn't like the company, because the dividend growth was temporarily down to say 2-3%/year.

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  2. DGI,
    I disagree with your statement, "It is important to reinvest dividends selectively, into the best values and qualities found at the moment, and not mindlessly reinvest into the same company regardless of valuation." For many of us, automatic dividend reinvestment (aka DRIP) makes sense because it deploys small amounts of capital without any commission. I understand that you prefer elsewise, but that does not make DRIPs a bad idea.
    With respect,
    KeithX

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    1. Hi Keith,

      I understand your point. Your comment makes sense for the situation where the total dividend amount you generate in a given month is not high enough to justify the transaction costs of purchasing shares in a new company. For example, if you portfolio is generating $100/month and you pay $5 commissions, it would make sense to reinvest automatically.

      However, if the companies you own deliver say $1000 in monthly dividends, and they are all overvalued (say P/E of 20), it would make sense to accumulate that cash and buy something that is cheap, rather than reinvest automatically. In other words, dividends are not "free money" - they should be treated with utmost care and respect, and only invested in the best opportunities. Also, if you earn $100/month in dividends, but can add $900/month in fresh cash, it might be better to not automatically reinvest dividends.

      Check this article out:http://www.dividendgrowthinvestor.com/2014/01/the-only-reason-for-automatic-dividend.html

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    2. There are other factors than just pure math at work. If you look at the psychological aspects, removing the decision making can actually help some of us keep the money working instead of waiting on the sidelines for opportunity. Investing isn't a one size fits all. If it was, the efficient market would actually exist and we know that isn't the case. I personally DRIP most, but not all, of my dividend paying stocks.

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    3. Keith: I think you make an extremely good point about the psychological aspects of investing, one area that is far too often ignored. Yes, in an ideal world everyone would look at just the numbers and make "pure rational" decisions, but that isn't the world we happen to actually live in. For many people the psychological aspects are an extremely important part of the decision making process.

      I reinvest my dividends automatically, mostly because I prefer to view my investing as purchasing future income to supplement, and one day replace, what I earn at work. One thing I enjoy is tracking the year over year growth in the dividends being paid to me from each of my positions. While I can expect a 3% raise every year from my employer (since I am lucky enough to have one who almost always gives such a raise) I find myself very happy that my dividend stocks are rewarding me with a roughly 10% annual raise each year thanks to the combination of dividend increases and reinvestment of those dividends. I know that the mathematics say I am not getting the most out of my investments, but seeing my income growing every single quarter, even by a modest amount, makes it easier for me to continue to follow my plans.

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    4. Jodun,
      Actually the examples you describe show the pitfalls of being irrational in an investment decisions. If an investor is being irrational/emotional about the investment they are purchasing, they are suffering from psychological pitfalls which can be costly. We do live in the real world, which is why investors need to analyze data coldly, and select the best outcome for their money. Otherwise, they will suffer the consequences.

      It is irrational to treat dollars coming from your job and dollars coming from dividend companies differently. The investor who is unemotional is the one who will allocate the money in the best opportunity/opportunities available. Noone is telling you not to reinvest dividends – just when you reinvest dividends, try to do it in a cost efficient way where dollars are allocated in the places with the best potential.

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  3. KeithX, part of DGI's view is probably based on the amount of extra funds he deposits monthly. If he can do a monthly purchase from new cash anyway, adding the dividend to that new cash is trivial. For a smaller investor that might only purchase a few positions per year and can't reinvest the dividends quickly within a new purchase, DRIPs would seem a good idea.

    A number of companies provide a discount as well when using a DRIP, but I've not taken the time yet to compare the list of DRIP discount companies to the dividend champions list to see if there is any overlap.

    What I personally decided to do is open my SEP-IRA at Fidelity where you can easily toggle DRIP on/off for your positions any time you wish. By default I'll DRIP everything, but any stock that I mentally move into a "stop accumulating" status I'll just toggle the DRIP off.

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    1. My portfolio generates over $1000 a month in dividends and I use DRIPs. There are advantages to this as there are advantages to selective reinvesting. To each his/her own.

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  4. Let's go back to Pareto's 20/80 principle for a moment. Suppose I am smart enough to identify the 20% of my portfolio which will produce 80% of the long run returns. Would it be best to always "mindlessly" reinvest my dividends in just those stocks, or might I actually succeed in increasing my dividend stream by reinvesting in some "fair companies and wonderful prices" (to borrow Buffet's phrase)? How clever would I have to be in identifying the wonderful prices to make this work?

    I assume that this is a calculus problem which is, in principle, solvable. Alas, not by me because my math is not good enough. But I would like to know the answer, because this is how I attempt to reinvest my dividends.

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  5. Keith,

    I invest money every month. I deposit from my say day job and money from dividend stocks for the month, and buy what I think is good value, has good prospects, and I am not overly allocated. I treat fresh deposits from my day job and dividends received as the same – a dollar is a dollar. Why should a dollar of fresh deposits be treated any differently than a dollar received from a dividend? Plus, I am not wasting much time in compounding by waiting to deploy dividends for 15 days.
    It is true that investors could make mistakes if they make too many decisions. But they can also make suboptimal decisions if they are not objectively evaluating their capital allocation. And everyone does things differently. But then just because you think something is right, doesn’t mean you shouldn’t objectively think about it and challenge it. For example, I own BF/B which sells for close to 30 times earnings. I wouldn’t reinvest at 30 times earnings. That’s because I wouldn’t buy a stock at 30 times earnings. If I won’t buy a stock at 30 times earnings, then why should I reinvest at 30 times earnings? This is why, I could buy DEO, which sells for less than 20 times earnings. Growth prospects are different for both, but diversification of products and scale is different also.
    In a game of probabilities such as investing, you are less likely to do well for your dollars if you reinvest them in companies selling at say 25 – 30 times earnings and above. That is just poor capital allocation. This is what I call mindless dividend reinvestment – because the odds of success when you overpay for a security are rapidly reduced.

    Could you please expand on pros/cons of automatic/selective dividend reinvestment if you still disagree. I am curious.

    Best Regards,

    DGI

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    1. I couldn't tell if my prior post got accepted by the blog or not, so to be safe, here is an article Chowder wrote on this topic last year. He's a believer in using DRIPs and not selectively reinvesting.

      http://seekingalpha.com/instablog/728729-chowder/1627581-dividend-reinvestment-yes-or-no

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  6. 2Reb,

    1) If you do not think you are good enough to select fair companies at wonderful prices in the first place, then why does it make sense to reinvest those dividends mindlessly? Your logic doesn’t make sense to me.

    2) The thing is that you do not know in advance what the best 20% of your companies are going to be. You can control what you select, and how you minimize losses, or whether you just want to swing for the fences.

    3) Also, even the best companies are not worth overpaying for. If you do not have any margin of safety, you are taking a big risk in case things change.

    By the way I see why people are commenting on dividend reinvesting – the word “mindlessly reinvesting” is potentially making people defensive. However, if someone is reinvesting their money in overvalued securities, overpaying for future growth, they are likely shooting themselves in the foot. It’s common sense.

    Best Regards,

    DGI

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  7. Hey DGI,

    Very interesting post. I follow a very similar long-term approach to yours, but I have to admit that many times I had trouble deciding to buy shares due to them being at 52wk highs. Like you said, it really seems to go against the principle of buying low. However, this is purely psychological and recently I have managed to break away from that view. If a given rate of growth is expected it makes sense to look at price and calculate the expected returns at that growth rate, it doesn't matter if the stock is at a 52wk high or low.

    Best Regards,
    DividendVenture

    ReplyDelete

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