Wednesday, October 21, 2015

Are low prices a justification to buy?

Should I use stock prices in my screen?

I read several blogs on investing. I have noticed that several authors have been talking about purchasing a stock that has gone down in price over a certain period of time. It looks like looking at a list of stocks at a 52 week low or looking at biggest losers year-to-date has been a criteria to some investors. I am going to explore this idea in this article, and share my ideas on the topic.

Before I go any further, I want to mention that I am looking for companies that I can purchase at an attractive entry price, which can grow earnings and dividends above the rate of inflation, and can generate a decent yield in the process for me.

At first, it actually seems like a nice idea to look for companies, which have declined in price. This could be one way to identify shares that could be theoretically cheap. We all know that a company’s cheap stock price can always get cheaper in the process. Of course, a stock price that has gone down presents an opportunity to buy more shares for the same amount of capital. In addition, by buying more shares, the investor can end up purchasing more dividend income in the process.

So this sounds like a win-win ( win) at first glance. Why am I writing an article about it?

Well, the problem with just looking at price relative to its high for the year or its close from the previous year is that price itself doesn’t tell you the whole story. What matters is price in relation to fundamentals, as long as those fundamentals are growing.

Investors need to have a way to systematically evaluating fundamentals using relevant information, and use this in their model in order to come up with a decision of whether a stock is undervalued or overvalued. However, if there are some changes in fundamentals, then a low price could be justified. In addition, if fundamentals have improved, a higher price might be justified.

For example, back in 1984, Coca-Cola (KO) earned $0.10/share. The stock traded between $1.02 and $1.38/share that year. The share price today is close to $40/share. This increase is justified, because earnings per share have grown to over $2/share in 2014. This growth in earnings per share has also enabled the company to continue raising its dividends for 53 consecutive years.

In another example, in early 2015, many shares of oil and gas companies looked very cheap based on the earnings from year 2014. The problem was that many investors were ignoring the fact that oil prices had declined, and therefore the earnings from year 2014 ( which was characterized by generally high oil prices) should be adjusted downwards. Prices on shares of Chevron (CVX) and Exxon Mobil (XOM) had declined a little from their highs, but they were not a good value yet. This is because the underlying fundamentals had deteriorated faster than share prices. Therefore, in early 2015 the shares were overvalued, despite the fact that they had declined in value. I bought some ConocoPhillips (COP) in early 2015 and some Exxon Mobil (XOM), but then mostly stopped my energy investments until share prices fell much lower.

In a more recent example, shares in Wal-Mart (WMT) have declined from $90 in early 2015 to less than $59 at the time of writing this article. I believe that the shares were likely overvalued in early 2015, as they were selling for close to 18 times expected earnings, which is a lot for a large slow-growing retailer. Currently, shares do look cheaper. However, as I explained in a previous article, the expectations behind the fundamental growth in earnings seem to have changed. If you believe that the business will not be able to grow earnings per share by more than 3% - 4%/year over the next decade, then the intrinsic value of the business will not grow enough to provide a satisfactory return on investment. If you however believe that the business can grow earnings by 5% - 6%/year or more, and can pay a nice 3% dividend in the process, then Wal-Mart could end up creating a nice amount of wealth and passive income for the share owner.  In my case, I am not happy that Wal-Mart has been unable to grow earnings per share for several years in a row, and that it will be unable to grow earnings per share for the next two - three years. I am also not happy by the low dividend growth over the past two years. As a result, I am going to pass on adding to my stake. The only return I could generate is speculative ( if prices go from $60 to $80). As someone who is not a market timer, but focuses on long-term fundamentals, this is a game I don't play so I won't go there.

Using a screen based on price, such as decline from a 52 week high or a decline year-to-date could be helpful in a first step process to uncover undervalued companies. I say first step, because the investor also needs to take into consideration any changes in underlying earnings power. If the earnings power is impaired, then it is quite possible that the decline in price is not only warranted but could also continue as well.

As the old saying goes, do not try to catch a falling knife. What it means is that a company whose stock is in a steep downtrend could continue being in a steep downtrend for a while. This is where purchasing small amounts regularly could help soften the blow. Another thing that could help is to wait until the price stops falling, before initiating those purchases.

In my investing, I do not look at 52 week lows or largest drops for the year. I have found that having a list of companies that fit a certain pre-determined criteria, and then screening this list using my criteria is most helpful in uncovering good opportunities.

To summarize, a low price, or a decline in the price is not sufficient to determine if a business is bargain. Rather, the important factor to look at is the ability of the business to generate earnings. If this ability is not impaired, and the stock is selling at a low valuation, then it could be a good value to add to.  If the ability of the business to generate earnings is impaired however, the stock might be a pass for dividend growth investors.

Full Disclosure: Long WMT,KO, CVX, XOM

Relevant Articles:

The Energy Company I want to buy
Are these oil dividends safe?
How to value dividend stocks
Dividend Investing Knowledge Accumulates Like Compound Interest
Lower Entry Prices Mean Locking Higher Yields Today

22 comments:

  1. Same dilemma here. I am considering getting ARM shares as they have fallen below their peak. But not sure if this is the right moment. I bought them a few years ago when they were low and it has since risen a lot before decreasing in value recently. Same with Shell.

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  2. What I think is interesting about the WalMart situation is that it's just one of several long-term dividend growers that are in the midst of a multi-year earnings slumps, and those not chiefly caused by the stronger U.S. dollar hurting international earnings, but rather, issues with the core businesses themselves.

    Along with WalMart (42 years), I'm thinking about McDonalds (39 years), IBM (20 Years), P&G (59 years), perhaps among others.

    I think the most difficult thing here is trying to determine whether these businesses have hit a fundamental rock in the proverbial ocean and are beginning to sink and taking their stockholders with them, or, whether they're just taking a pause to regroup and reorient before resuming their long-term success.

    That strikes me as the fundamental question in trying to determine whether these stocks are "bargains" to be had now at attractive prices, or, something entirely different. One thing does seem clear, however, and that's that a history of 40/30/20 years of dividend growth, by itself, is no guarantee of future success and prosperity.

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    1. Thx for your comment. A strong past operating performance is just one piece of the puzzle. Also, one size fits all approaches are not very wise.

      If you look at MCD, it has had slow periods of dividend growth before in the 1990s. It was followed by a period of rapid dividend growth. This is why I am taking a wait and see approach with existing positions, but not adding any new money.

      Good luck in your dividend investing journey!

      DGI

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  3. I do think it's funny when I see lists of that nature or lists that add the 52 week price range. Because you get no useful information from that. Have operations improved, stayed the same, gotten worse? It can be a decent starting point just to get ideas but you still have 99% of your homework/research to do before you should invest.

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    1. Hi PIP,
      I am in complete agreement. If the price drops, but the analysis shows that the underlying earnings power is intact, then it could be a good purchase. If the earnings power is impaired, then possibly this is not a good value.
      Good luck in your passive income pursuit!
      DGI

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  4. For example IBM is a bad buy......

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    1. I work for IBM and trust me they are in a transition period. The new stuff they are focusing on with regards to cognitive analysis and healthcare are what will drive future growth. It will some time to turn it around but it will be worth it.

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    2. Agree... ALL Companies go thru the normal ups-and-downs of the Business/Economic cycles. IBM had a great dividend/cash flow history and will figure-out all of its problems.
      Anyone who has been investing for awhile, realizes that the time to buy quality companies is NOT when all the news is very positive and 'rosey', but when things look negative... that's when you get your best 'value' pricing.
      IBM at $140 is paying a 3.70% dividend-to-cost yield and worth holding LT at that price.

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    3. I am holding IBM for the time being. If they are unable to grow earnings per share however, I would refrain from adding new money.

      The sentiment towards IBM is indeed negative – this could be a profitable contrarian play if they at least maintain the earnings per share. Say they pay a 3.70% dividend yield and through buybacks retire 5% of shares outstanding in perpetuity, while keeping net income flat. This could translate into a total return of 9%/year, which is not bad. The thing to ask myself is whether they can maintain and grow earnings over time.

      If they turn the business around, the nice thing would be that they bought back shares on the cheap. So buybacks would seem like a smart move in future hindsight.
      If they fail to improve earnings over time however, then as investors we would have been better off receiving cash dividends In future hindsight.

      On the other hand, when Buffett bought IBM in 2011, he was expecting earnings per share of $20 by 2015. So at a price of say $200/share, you had a P/E of 10.

      Now the earnings per share are going to be something like $15. At a P/E of 10, this means that the price should be around $150.

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  5. My strategy is once a stock drops by -7.5%, I average down. My next average down would be -30%.



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    1. I buy dividend stocks that I like and would like to hold for the next 50 years.

      Fundamental changes from companies such as DD, BAX/BAXL, WMT, IBM,etc. don't bother me. I believe these companies are long term holds. The only time I would sell if the dividend is fully cut.

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  6. Good advice, DGI. I had an open order to add to shares of WMT, but closed it after doing more homework. I haven't sold any of our shares either. I think this is one of those times where inaction is the best action. We are being a little bit more aggressive, though, purchasing shares via reinvested dividends. If the price stays below $60 for the next three years, we will have a 10% higher stake when management expects earnings to get back on track. But no new capital otherwise.

    I look at growth of earnings and dividends and relative valuation, meaning the 5 year average P/E for the security in question. I won't buy if the P/E is over 20 even if the average is higher unless earnings and dividends are growing over 10% per year. (I'm over simplifying because I don't want my comments to exceed the length of your post! HA)
    Best wishes,
    Keith

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    1. Hi Keith,

      Perhaps you could write about it on your site or post an article on Seeking Alpha? (and generously link to the source of your inspiration wink wink)

      I think Warren Buffett said it perfectly:

      “The stock market is a no-called-strike game. You don’t have to swing at everything–you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, ‘Swing, you bum!’” – Warren Buffett

      I am also reinvesting WMT dividends in tax-deferred accounts ( though they are smaller than taxable). I use cash dividends in taxable to allocate. When I add projected dividend growth of 2% - 3%/year with a yield of 3.30%, I cannot get excited.

      Enjoy your retirement!

      DGI

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  7. DGI... Good analysis and alot of valid points... However...
    I'm 39 and building a LT-DRIP portfolio (of about 12-15 stks) for 15-20 yrs out...
    Just purchased WMT yesterday at $59 with the thought that this is still a very solid company, with good financials, a great div-history and strong Cash Flow. My thoughts for the LT are, this company will figure-out all of its short-term problems/challenges and adjust accordingly. In the interim, I'm getting a 3.25% yield-to-cost with 'modest' div-growth for the next year-or-so, that will be reinvested/compounded. Am also looking at IBM today ($140) with the same thoughts!

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    1. Thanks for stopping by and commenting! I certainly wish you good luck in your investments!

      Dividend Growth Investor

      PS I would be curious to revisit this article in 4 - 5 years, and check what happened.

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    2. DGI... your articles and analysis always provide some great information and perspective for Dividend-Investors, and I always look forward to them.
      Keep 'em coming and keep up the good work!

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  8. A small reminder, as KeithX said above, WMT will retire over ten percent of market cap in the next few years. This should improve EPS and presumably boost dividend growth.
    Also worth mentioning that PG has had similar stretches of low growth while they got their house in order.
    Always appreciate your output, D!
    -J

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  9. Thanks for the provocative question and great thoughts, DGI.

    Price does indeed matter (a lot), but metrics like current price relative to 52-week low aren't inherently meaningful. While I'm continually refining my personal process, in general I'm first trying to filter the companies I'm interested in based on fundamentals, and then establish a valuation for their shares.

    Only at that point does current price matter: for the companies that I'm interested in, in a given month I'm most likely to allocate new funds to those companies that are trading at the largest discount to the previously-determined value. So to put it another way, I'm not just looking to buy companies that are on sale, but rather focusing on the companies that I already want to buy that are most on sale right now.

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  10. Good points DGI,

    Oil and gas companies are experiencing big fundamental changes. As you mentioned, buying them based on last year earning is not a good idea.

    However, IBM and WMT are going through a short-term pain, but both companies are spending big amount of money to buy back their own shares at very low price. It is absolutely smart move. When they move back to growth, we could see a big gain in share price.

    Best Regards,

    -FJ

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  11. Very well written article. Thanks for sharing. I was like you. I bought some energy stocks in the end of 2014 but quickly realized that they would go down a lot further than I initially expected. I think it is a good time to buy Oil and Gas stocks again so I am waiting for a little more attractive time which will come soon under this volatile market.

    Cheers!

    BSR

    ReplyDelete

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