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Some investors argue that if you're buying a wonderful company for the long term, then it doesn't matter if you're buying it at a slight premium. However, the market is unpredictable, and sometimes it would even throw us some great opportunities on meaningful pullbacks. So, I like to dollar-cost average into a position instead. Besides, one may not have the funds available up front. With the volatility of the market, no one can predict which way it goes, and the results can be phenomenal.

Let's take McDonald's (NYSE:MCD) as an example. Say that at the start of 2012, we found McDonald's to be a fundamentally sound company at proper valuation, and we wanted to own 100 shares. What would our investment look like if we had purchased a full position in the beginning of the year versus purchasing ¼ of the position in the beginning of each quarter?

Let's assume:

  • we're purchasing shares at the open with the market price
  • commission costs $10 for each transaction

Strategy 1: Purchase Full Position

DatePrice# SharesCost
Jan 3, 2012$101.33100$10,143

- Dividends Received by end of 2012 = (0.70 * 3 + 0.77)*100 = $287
- Resultant yield received by end of 2012: 2.83%
- Cost basis at end of year (after subtracting dividends)
= ($10143 - $287) / 100 = $98.56 per share

The dividends received in the first year can be viewed as lowering the cost basis. This helps us determine whether buying early (before any pullback) was the correct decision or not.

Strategy 2: Purchase by dollar-cost averaging with partial positions of 25 shares

DatePrice# SharesCost
Jan 3, 2012$101.3325$2543.25
Apr 2, 2012$97.8225$2455.50
Jul 2, 2012$88.4125$2220.25
Oct 1, 2012$92.1125$2312.75
Total Cost:$9531.75

- Dividends Received by end of 2012 = $182
- Resultant yield received by end of 2012: 1.91%
- Cost basis at end of year (after subtracting dividends)
= ($9531.75 - $182) / 100 = $93.5 per share

Dollar-cost averaging guarantees the purchase of the desired number of shares, while averaging the cost of the shares, which were purchased at set intervals.

~ Pros of Dollar-Cost Averaging ~

  • Dollar-cost averaging allows you to buy some shares even if you don't have a lump sum upfront to buy the full position you desire.
  • You can start collecting dividends for the shares you own.

~ Cons of Dollar-Cost Averaging ~

  • If the stock is trending up as you're dollar-cost averaging, then your cost basis will be higher than if you bought the full position initially.

Super Powered Dollar-Cost Averaging - Dollar-Cost Averaging with a Twist

From Investopedia the definition of dollar-cost averaging is

The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.

Instead of buying a fixed dollar amount on a regular interval, what if you only started averaging into your McDonald's position after a significant pullback (say, 10% from the 52-week high of $102)? And buy more when it pulls back another (5%, then 2.5%, then 1.25%)?

The idea is that for whatever reason, if a dividend champion like MCD, pulls back by 10% (and as long as its dividend is safe and has room to grow), I think it's a good deal. So, I will start buying there. If it goes down some more by the intervals indicated above. I will buy even more. Setting these intervals lets me have a systematical way of scaling in, instead of basing it on emotions.

For strategies 3 and 4, we'll need to set limit orders on the desired entry prices.

Strategy 3: Purchase by scaling in with partial positions of 25 shares at the pullback intervals of 10%. Add when it drops another 5%. Add when it drops another 2.5%. Add when it drops another 1.25%.

DateNotePrice# SharesCost
May 9, 201210% pullback from $102$91.825$2305
Jun 1, 20125% pullback from $91.8$87.2125$2190.25
Nov 8, 20122.5% pullback from $87.21$85.0325$2135.75
Nov 15, 20121.25% pullback from $85.03$83.9725$2109.25
Total Cost:$8740.25

- Dividends Received by end of 2012 = (50 * 0.7)2 + 100 * 0.77
= $147
- Resultant yield received by end of 2012: 1.68%
- Cost basis at end of year (after subtracting dividends)
= ($8740.25 - $147) / 100 = $85.93 per share

Strategy 4: Purchase by scaling in with partial positions of 25 shares at the pullback intervals of 10%, 15%, 17.5%, and 18.75% starting from the 52-week high of ~$102
(uses even a stricter set of pullback rules than strategy 3)

DatePrice# SharesCost
May 9, 2012$91.825$2305
Jun 4, 2012$86.725$2177.5
Nov 9, 2012$84.1525$2113.75
$82.88--
Total Cost:$6596.25

- Dividends Received by end of 2012 = (50 * 0.7)*2 + (75 * 0.77)
= $127.75
- Resultant yield received by end of 2012: 1.94%
- Cost basis at end of year (after subtracting dividends)
= ($6596.25 - $127.75) / 75 = $86.25 per share

(As of writing, MCD has not reached the price of $82.88, so for the purpose of this article, I'm making the assumption that it won't reach there for the rest of the year.)

Dollar-cost averaging with a twist (or scaling in at a lower cost each time) ensures a lower cost basis than dollar-cost averaging strategy, but doesn't guarantee the purchase of the shares if the lower stock price doesn't materialize.

Conclusion

For 2013, we have these results for the various strategies, assuming we're receiving a quarterly dividend of $0.77/share.

StrategyCost BasisYield on CostDividends# Shares
1$98.563.13%$308100
2$93.53.29%$308100
3$85.933.58%$308100
4$86.253.57%$23175

We can see that going forward, for the coming years of dividend growth, strategy 3 was clearly the winner in this case. The real benefits of dividends received for these strategies is shown in future years, starting from 2013 because some dividends were missed in the last 2 strategies. That was the reason why I calculated the cost basis with received dividends from 2012 subtracted.

What to do next?

One can easily adopt a similar strategy as 3 and 4 when aiming to grow dividends with limited funds.

If you have lots of cash on hand, and find a fundamentally sound company at proper valuation which you want to own. You could either buy a full position or dollar-cost average into it using strategy 2. However, if the company you desire to own or add to is currently overvalued, then you might want to consider strategy 3 instead.

If you're tight on cash, it makes sense to build some cash reserve, so that you can apply strategy 3 or 4 on a desired company when there's some significant pullback. With the market being sensitive to any negative news, you never know what opportunities may arise. Executing a similar strategy as 3 or 4 on a fundamentally sound company on David Fish's CCC list which is fairly valued or undervalued will result in a higher yield-on-cost and provide us with a steady stream of increasing income for the long-term.

Summary

Thinking in the long-term horizon, we want to reduce the cost basis of our position. Dollar-cost averaging helps us achieve that if the stock experiences a pullback.

However, in doing so, the opportunity cost maybe to miss the initial dividends. And that's ok because it allowed us to have a higher yield on cost by the end of the year, and more funds for other purchases or purposes.

On the other hand, dollar-cost averaging with a twist for another stock (or time period) might not have worked as well if it had been in a general up trend. (Imagine you wanted to use strategy 3 or 4 on McDonald's in 2011.) You wouldn't have obtained any shares! So, the traditional way of dollar-cost averaging is the sure fire way to build a position in your desired company. However, if you want to get in with a lower cost-basis, you could try different pullback percentages for strategy 3 or 4. But keep in mind that it's possible that the price you want may not materialize. Then again, there is always some bargain on the market, isn't there?

Source: Super Powered Dollar-Cost Averaging