Friday, June 16, 2017

This is why you shouldn't overpay for stocks folks

You have probably read the news that Amazon is going to acquire Whole Foods Market (WFM) in cash for $42/share. This will increase competitive pressures in the grocery business, which has sent shares in companies like Target (TGT) and Wal-Mart (WMT) lower. Even retailers such as Ross Stores (ROST) and TJX Companies (TJX) are taking a beating. This decline could provide an opportunity to acquire quality merchandise at lower prices.

However, the issue I am going to discuss briefly deals with valuation. If you look at the chart of Whole-Foods over the past five years, you can see that the share price routinely sold above $42/share.

Whole Foods earned $1.26/share in 2012, and roughly $1.50/share every year through 2016. Therefore, anyone paying more than $30/share was likely overpaying for the stock. The company is worth $42/share in a going private transaction. However, if the buyout hadn't materialized, a discount to that price would have been warranted.

Most investors who bought Whole-Foods between 2012 and 2015, are going to lose money on their investment (even if you account for stock dividends). They overpaid massively for their shares, possibly due to hopes of brighter futures.

The lesson here is not to overpay for shares. Even the best company in the world is not worth overpaying for. You need to have a margin of safety. This was one of the reasons for the lost decade in stocks in the early 2000s when companies like Coca-Cola and Wal-Mart grew earnings and dividends, but share prices went nowhere due to steep overvaluation in 1999 - 2000.

The other reason investors in Whole Foods lost money in the buyout is because they are robbed of the future growth potential in the business. I never owned Whole Foods though, since it didn't meet my entry requirements. Unlike others, I would have been unhappy when a company I own is about to be acquired.

As dividend growth investors, we make money when we identify a company that grows earnings, dividends and intrinsic values over time, and we purchase it at an attractive valuation. Our job is then to hold on patiently to our investments for the long-term.

Full Disclosure: Long TGT, WMT, TJX, ROST

Relevant Articles:

The Real Risk With Dividend Growth Investing
How to value dividend stocks
Should you celebrate when your dividend paying company is about to be acquired?
Dividend Stocks make great acquisitions

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