Thursday, April 29, 2021

The Ones That Got Away…

I spend a lot of time looking for quality companies available at attractive valuations. Sometimes, I find a great company that fits my fundamental requirements, but the entry price is a little high for my liking.

I try to wait until the entry price is met, before putting my hard earned capital to use. I do this, in order to maintain discipline in my investing approach. I believe that if I slip in one area of my life in terms of discipline, I will slip everywhere. This is an outcome I try to avoid as much as possible.

The purpose for not overpaying for securities, is because a lower entry price means that I have a higher potential for long-term future returns. A lower entry price also translates into a higher dividend yield from the start.

If an asset is worth a certain amount at a certain period of time, it is logical to try and invest at an entry price that can generate a high return. Paying too much can decrease those returns. A lower valuation also helps in selecting between different investment opportunities available in the marketplace.

The downside to having an investment discipline is that no investment approach is bulletproof. I play the odds when I buy securities, because in reality, not all investments will work out. Some investments may check all the boxes, but still turn out to be duds. Other investments may not look perfect, but surprise on the upside. The importance is to do well on average, over long periods of time ( think – decades).

I have not done investments in the past, where everything was perfect, but the valuation was just a tad over 20 times forward earnings. I used to avoid companies selling above 20 times earnings, which was equivalent to an earnings yield of 5%. For the period of 2008 - 2019, it has usually been the case that I could find quality companies at a P/E below 20. But I also missed quite a few too.

A very good example involves Starbucks (SBUX), which I had been monitoring in July 2018. The price was very close to my entry criteria at the time, but I didn’t invest in it, and it just ran away from me.

While I did not buy these companies for the Dividend Growth Investor Portfolio, I notified readers that I am looking at these opportunities. Some may have bought them, and profited nicely in the process. Others may have bought some later.

Another good example is Broadridge (BR), which I monitored closely in December 2018 and January 2019 as it was very close to being in the money. Unfortunately, the stock also ran away from me. I was able the buy some at the end of 2019 and in 2020 however, after monitoring it for a while and deciding it was fine to overpay a little. This happened after I wrote this article in early 2019.

A third example is PepsiCo (PEP), which was actually around 20 times forward earnings for a long period of time, but I dragged my feet and it ran away. I did buy some PepsiCo (PEP) for the first time in a long time in 2020 and then added a little more to the position.

On the other hand, I didn't invest in 3M (MMM) until it fell to or below 20 times forward earnings in 2018. While the stock's earnings were around $9 - $10/share, the stock price has fluctuated between 150 and 280.

Why am I writing this?

I see everything as a learning opportunity. This is a lesson to learn, that we cannot time the market. This is why we should stick to a process no matter what.

Investing is not a black and white process however. Investing is part art, and part science.

This is why we need to try and learn from any potential blind spots we may have. But the art part is not learning the lesson "too literally".

Sometimes, if a good company is identified at a decent valuation, it may make sense to buy the stock. This is not an excuse to buy stocks without looking of course. We sometimes learn lessons a little bit too literally, and the outcome may still be unfavorable. It merely means that sometimes, being too disciplined could be counter-productive. But if you stick to a battle-tested process that makes sense to you, you have the odds of success in your favor over the long term.

In other words, if a stock is going to be worth $100/share in a decade and would be paying a dividend of $4/share then, it does not really matter if I paid $40 for it or $41/share. The important factor is to get invested in that security.

If that security ultimately goes to zero in a decade, and eliminates dividends, it also makes little difference whether I waited to buy it at $39/share or overpaid at $41/share. While I do not actively try to buy companies that would go to zero, I do know that sometimes even the best laid plans have surprises for us.

The important model to have in my head is that P/E ratios should not be viewed in isolation, but neither should growth rates. They need to be looked at together. As Buffett has stated, value and growth are attached at the hip.

My observation over the past year is consistent with the observation from the past decade. There are usually companies that are almost always available at a good price. But there are also companies that are rarely available at a good enough entry price. As an investor, I should be focusing on snapping the ones that are rarely undervalued first, and then focusing on the ones that are frequently attractively valued. As we can see during the December 2018, and March 2020 declines can be quick and recoveries even quicker. Therefore it makes sense to have a list of companies that you want to own at a certain price, and then be ready to act if/when they are available.

While it has been an interesting lesson for me, I have started to be more willing to pay up for what I perceive as quality in 2020. I realize that this may sound like I am finally throwing the towel, but I disagree. Up until recently, a lot of good quality companies could have been found at a P/E of around 20. Even companies like Microsoft (MSFT), Moody's (MCO), Visa (V), Sherwin-Williams (SHW), S&P Global (SPGI) had long periods of time where they were available at or below 20 times forward earnings over the past decade. As rates have gone down, P/E ratios have gone up. Especially the P/E ratios for companies with earnings that can grow.

After writing this article in 2019, I actually bid for Broadridge (BR) in late 2019 and even managed to buy at a decent valuation in 2020. I have not been disappointed. It is still a learning curve however.

At the end of the day, you win some, and you lose some. But the most important lesson is to identify your investment goals and objectives, develop a process on how to achieve them, and then executive on the plan through thick and thin. Important ideas such as diversification, margin of safety and valuation are the friends of the long-term dividend investor. It is important not to abandon the process in search of quick gains, but stick to it, in order to achieve the investment goals and objectives. But it is even more important to go ahead and try to improve on that process over time, without taking lessons too literally, and remaining flexible in your approach.

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