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Long-term horizon, dividend investing
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As a general rule, I am mostly interested in trying to purchase undervalued securities. This is straightforward enough: the price we pay for something is a great determinant of our future returns, and the notion of buying at low prices to increase a margin of safety was the grand thesis that underscored almost all of the late Benjamin Graham's work. But what I want to talk about today are the dividend-paying companies that are of such quality that it is worth paying a reasonable price for: in essence, the types of companies where the objective is to "not overpay" instead of "buy cheap."

In terms of income, there are three qualities that I evaluate on the dividend side of the investment: the level of the current dividend yield at prevailing market prices (generally juxtaposed against the firm's total profits on an annualized basis), the safety of the current dividend payout, and the projected growth rate of the dividend over my contemplated holding period.

When you pay fair value for a company, you are often making a sacrifice of the first element (that is to say, you generally accept a lower yield) in exchange for a dividend payout that is both quite secure and likely to grow at a significant rate over the course of your ownership. That's what makes it difficult for me to say something like "buy Coca-Cola (NYSE:KO) today" or "buy Colgate-Palmolive (NYSE:CL) today". One one hand, both of these companies have very safe dividend payouts, based on the quality of their earnings and long track records of paying dividends. Coca-Cola has been raising its dividend for half a century, and Colgate-Palmolive has not missed a dividend payment since the late 1800s. Likewise, both companies have great track records of growing the dividend by a significant rate. Colgate-Palmolive has a compounded dividend growth rate of over 11% since 1992, and just shy of 14% since 2002. Coca-Cola has a compounded dividend growth rate of 10.5% since 1992, and just shy of 10% since 2002.

Coca-Cola and Colgate-Palmolive are truly excellent businesses. The appeal of owning excellent businesses is that they do not require as much work on your part-you acquire the surplus capital to invest, allocate it to the excellent business, and then spend a couple hours each year reading the annual report to make sure that everything remains on track while the larger dividend checks roll in each quarter and your share of the retained profits seems to grow just about every year like clockwork. Even though you may be purchasing these companies at fair value, that is all right because these companies are earning such high returns on unleveraged equity that this can create one of the most effortless ways of earning returns of around 8-11% imaginable (and I'm speaking both in terms of income growth and the total returns from the underlying capital appreciation of the security).

How do you know if paying fair value for a high-quality stock suits your personality? First, you need to determine whether it meets your goals to accept a low payout today in the pursuit of a future profit stream when some distant tomorrow comes. For instance, IBM (NYSE:IBM) has a cash cow. It has been raising its dividend at a compounded annual growth rate of 15.5% since 1997. While IBM's dividend growth rate may decline a bit over the coming years, the pursuit of a double-digit dividend growth rate comes at an opportunity cost: current investors only receive a 1.79% starting yield. If you're planning on holding the stock for twenty years, a purchase of IBM from an income perspective may likely make sense (with a note of caution that IBM may require more monitoring than the Coca-Cola and Colgate-Palmolive examples listed above). However, if you're only looking to hold the company for a couple years, paying fair value for IBM makes much less sense.

As a general rule, the best time to purchase an excellent company at fair value is when the contemplated holding period is a long time. This is the case because there are two margins of safety when making a stock purchase. One is the quality of the company-that is to say, even though Johnson & Johnson (NYSE:JNJ) traded at 30-40x earnings around 2000-2001, the underlying strength of the business turned out to be so strong that the company delivered 4-5% annual returns to the present time, which is nothing short of a miracle given the outrageous valuation of the company at the start of the millennium. But the other margin of safety is price. When you're paying fair value for something, you are not relying on the price as a form of safety. To compensate for this, you should be sure not only that you are dealing with companies that have a very high likelihood of growing earnings by 8-11% annually, but that you will be able to hold on to the stock long enough to realize the benefits of the compounding.

Essentially, the type of investor that should consider paying fair value for an excellent firm is a person with a long time horizon. If you paid 18x earnings for Procter & Gamble (NYSE:PG) in 1990 and only had a two-to-three year horizon, you could have seen your $10,000 investment taken down to $8,400. However, if you paid 18x earnings for P&G in 1990 with a twenty-two year horizon, you would have seen your $10,000 investment turn into $165,000 while paying out $5,500 in annual dividends. That's a 55% yield-on-cost for the patient investor: not a bad tradeoff considering that you only had to make an initial investment and then spend a couple hours each year making sure that the economics of the business model remain sound. If you're considering paying fair value for an excellent company, the best time to go through with the purchase order is when you're confident that you can hold the company for 10+ years. There's no getting around it: time is the necessary ingredient.

Source: When To Pay Fair Value For An Excellent Dividend Stock

Additional disclosure: A special thanks to SA Contributor Robert Allan Schwartz. His website tessellation.com/dividends/ is a resource of incalculable value in researching historical dividend information.