Bombarded with news everyday, the price of a stock can move up or down without any justification. For a long-term investor, it helps to ignore the noise and buy a stock after it has a substantial pullback. Recently, I wrote an article to buy reliable and stable companies on a 10% pullback. This time, we'll focus on a dividend grower that has moderate growth potential.
We all have certain rules that help us make the decision of buying a stock. The rule I'm about to talk about easily applies to any fundamentally sound company that has a beta of around 1. However, to make it simpler to understand, I'm going to use Microsoft (NASDAQ:MSFT) as an example.
It comes down to defining what "a substantial pullback" is. Because Microsoft has a beta of 0.98, I set the substantial pullback at 20% from its 52-week high. For readers who may not know what beta is, here is a definition from Investopedia:
beta - A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
If the beta of a stock is 1, it moves more or less to the general market. In this case, if the general market goes up by 1%, MSFT will go up by about ~1%. If the general market goes down by 1%, MSFT will go down by ~1%.
Rule of 20% Pullback on a Dividend Grower with Moderate Growth
A 20% pullback from MSFT's 52-week high would be $26.36 using the formula:
52-week high * (1 - pullback-percentage)
= $32.95 * (1 - 0.2) = $26.36
That's the price I want to start scaling in Microsoft.
The rule keeps my patience in check, so that I don't get in on small pullbacks.
Microsoft as a Dividend Grower
Microsoft is a Dividend Contender. It has been raising its dividends for 10 years, and it currently yields ~3.4%. It's 5-yr avg dividend growth rate is 13.2%.
Brief look at Microsoft's Fundamentals
Cash from Operations - 5-year
Microsoft's ability to generate cash from operations is strong.
Its debt to equity ratio is 0.17 and has a free cash flow of more than $12,000M.
With its ability to generate cash from everyday operations, low debt levels, and abundant free cash flow, Microsoft has no problem to continue its trend in raising dividends.
Dividend Growth Projection
An investor, John Doe, saw tweets on the price of Microsoft climbing higher in January 2012, higher in February and even higher in March 2012 and the pullback he was waiting for didn't materialize in the short time span he was watching. He finally pulls the trigger, and buys 100 Microsoft shares at $32.50 when it was near its current 52-week high.
Dividends (to be) earned is one way of determining the investment's success, and it's essential to consider for a dividend growth investor. Let's say we bought Microsoft when it reached the 20% pullback mark last Friday. How would this investment perform using yield-on-cost as the metric if MSFT were to continue raising its dividend year-by-year. And let's be conservative and say that the dividend grows at 10% per year for the first 10 years and 8% for the rest.
The above table shows the yield-on-cost for 20 years. Obviously, getting in on MSFT at the lower price costs us less while getting the same number of shares so that we have more cash for other purchases. And obviously, the yield at the lower price is always higher.
However, to illustrate the gain in dividends for buying at a much lower price, we need to assume we purchased the same dollar amounts for the investments. Both investment costs $3250. The first investment, at $32.50/share buys 100 shares, while the second, at $26.36/share buys 123.29 shares.
After 20 years we would have gotten a total of $4900.24 for buying Microsoft at $32.50 or $5992.19 for buying it at $26.36. That is 22.28% more in dividends! (Added $40 to the higher price investment for getting in earlier and receiving 2 more payments of dividends.)
Microsoft reached a low price of $26.34 last Friday (Nov 16), which is below the 20% pullback based on this rule. I would have initiated a MSFT position if I have the funds.
If you don't already have a similar rule that you use as a part of your buying process, I certainly encourage you to add this rule to it and apply the 20% pullback rule to companies you want to get in on that are fundamentally sound and has moderate growth.
Chuck Carnevale, a popular SA contributor, wrote an article on Microsoft earlier this month. I encourage you to take a look. He also has an interactive graph on Microsoft that you can play with that helps you determine the company's valuations.
Note: Please use this article as initial research, and do your due diligence before buying any stock.
David Fish's DRIP Resource Center