The stock market rally that has jump started the 2013 year has led many blue-chip stocks to trade above their typical P/E ratios over the past decade. While this alone is not proof of overvaluation (balance sheet, earnings quality, and growth prospects can change over time), it can be a useful signal for investors to check and re-evaluate whether the current prices of certain stock holdings have reached a point where the long-term total returns will lag the long-term earnings growth based on today's valuation.
Knowing whether to sell a stock can be a stressful decision for an investor, but it does not have to be if you identify your expectations for the holding beforehand. For me, there are two categories of investment: the permanent holdings, and the value investments.
The rules for the permanent investments are easy enough. Once I make them, the expectation is that I will be content by achieving total returns roughly equal to the long-term earnings growth of the firm while I hold it, and I will truly participate in the success of the firm as an owner by achieving long-term dividend growth that loosely correlates with the long-term earnings growth of the company.
I own Conoco Phillips (NYSE:COP), General Electric (NYSE:GE), and Johnson & Johnson (NYSE:JNJ). Those are companies that are part of my permanent holdings, meaning that I will not sell any of them unless the business deteriorates or the price spikes to such a point that the valuation becomes disjointed from reality (if we see another dotcom bubble in our lifetimes where Johnson & Johnson trades at something like 30x earnings, in which case the opportunity cost of holding the security would become so great that it would not be worth holding an excellent company where the future long-term total return potential would likely not even match half the long-term earnings growth rate. And plus, the dividend yield at that point would likely be so pitifully low that the funds could easily be redirected to better cash-generating opportunities unless the bubble pricing was widespread across asset classes).
I recently had correspondence with a Seeking Alpha reader in which I mentioned that I hold Johnson & Johnson and Procter & Gamble (NYSE:PG) without any intention of selling, even though I believe both companies to be modestly overvalued at current prices. He reacted as if I were saying "I'm a St. Louis Cardinals fan" while wearing a Chicago Cubs hat. Personally, I bought P&G and J&J with the intent to generate returns in the form of dividend growth and total returns that loosely correlate to earnings growth over the long-term.
The point with these holdings is not to maximize every dollar of profit by trying to get in and out of these kinds of stocks. There is a very short list of companies out there that have the business models in place to generate "automatic" returns of 8-12% annually (both of these companies are able to do this because they each have over two dozen brands generating $1 billion in sales that earn high returns on equity without taking leverage into consideration). When I find those firms and buy them at a rational price, I have no intent to sell. They need the advantage of time to do their thing, and I try to structure my life so I can give these two companies that opportunity.
The other bucket of investments has the objective of trying to follow in the teachings of Benjamin Graham: buy something undervalued, and sell when it reaches fair value. Where I differ from Graham is that I limit my pool of potential value investments to companies that are 1) blue-chips, and 2) pay a dividend.
The reason why I limit myself to blue-chip stocks is that, in the event that it takes a long time for Mr. Market to realize fair value, I can be assured that the earnings quality of the company is strong. I don't want to own a piece of junk for five years hoping that it goes up $10. And secondly, I screen heavily for dividends when making a value investment. John Neff, the gentleman that ran the Windsor Fund at Vanguard back in the day, said that dividends are like "hors devours that let you snack before the main meal arrives." Additionally, they give you the option to automatically buy additional shares of a company while you wait for it to reach fair value. This can turbo-charge your returns when the moment comes that the other market participants recognize the value of your holdings by bidding up the price to your estimate of fair value.
Although BP (NYSE:BP) is one of my permanent holdings, it illustrates the point well. While most of the stocks that I own have participated in the stock market rally so far this year, BP has not. The company continues to trade below my fair value estimates of $53-$57 per share. While the market continues to value BP below what I estimate its value to be, I continue to receive a dividend around 5% while I wait. Considering my purchase price is around the $40 range, I get about 1.25% of my purchase price sent to me as a cash dividend every three months. That's not bad. If I choose to reinvest, and if the price stays in the low $40 range for a couple years (which would be perfectly fine for me), those dividends reinvested at the $40 share price will look pretty sweet if and when the stock price rises to the mid $50s.
To give an example of a stock that I own once it reaches fair value, I'll use IBM. If need be, I'd be perfectly content holding the company for 10+ years. The current dividend yield of less than 2% is nothing to write home about, but the growth rate of the dividend has been historically impressive. However, if the stock rose to $260 later this year, I'd be happy to sell my shares. Why? I don't marry big banks or tech stocks. If IBM were to become overvalued, the sell decision would be easy because I had established that expectation beforehand.
This kind of thought process helps take a lot of the drama out of most sell decisions. If you notice that the price of some of your holdings have appreciated quickly this year, it can be helpful to ask yourself the question, "Did I buy this stock to become a long-term owner of the firm with the intent to derive returns related to the long-term operational results of this company, or is it my intent to benefit from price appreciation and move on?" There is no right or wrong answer to that question: the only important thing is to be honest with yourself in answering it.
Disclosure: I am long COP, GE, JNJ, BP, IBM, PG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.