Sometimes, you can trace particular moments in a company's trading history and find periods of time when even excellent companies would look like terrible investments. If you bought $10,000 worth of Coca-Cola (KO) stock in June 1998, you would only have $14,908 today (and that is assuming optimal tax strategy) even though the earnings per share and dividend per share tripled. What caused these abysmal returns? Valuation. Coca-Cola was trading at over 51x earnings for a good portion of 1998, and investors did not even have a chance of doing well long term if they initiated a position at that price point.
Think about the growth that is necessary to achieve returns of 8-10% if you are starting out with a 1.96% earnings yield. You are almost guaranteeing disappointment at that level. And the funny thing is, Coca-Cola is a company that did well from an operational standpoint since 1998. Imagine if you overpay for a company that under performs your expectations such as General Electric (GE).
In 2000, General Electric traded at 40x earnings. If you bought $107/,000 worth of General Electric stock on June 15, 2000, you would have $675 today, and that is assuming optimal tax strategy. You would have lost a little over 3% of your initial investment each year. Interestingly, GE has actually grown since 2000, as earnings per share have gone from $1.29 to $1.43, and the dividend has increased from $0.57 per share to $0.76 per share, yet an investor would have lost money because he or she overpaid in 2000.
These two examples illustrate the timeless nature of Benjamin Graham's advice to seek a margin of safety with the positions that you initiate. In the Coca-Cola example, the business did well, but because you overpaid, your returns over the subsequent 15 years would not have kept pace with inflation. In the case of General Electric, you would have overpaid for a business that did not perform particularly well over the next 10+ years, and that is why investors lost money even as the company technically grew between 2000 and 2013.
I point out those two case studies to point out how I view Realty Income (O). By and large, the company is excellent. It recently declared its 515th consecutive monthly dividend. That is impressive any way you slice it. The tenant quality is improving, as a third of its revenues now come from tenants who are considered "investment grade." The management team demonstrates competence by taking advantage of the overpriced stock to issue over 17 million shares to lower the company's debt figures so it can expand its property portfolio by $500-$600 million by continuing its streak of seemingly annual acquisitions.
But here is the problem: whether you buy Realty Income with a focus on the dividend or on total returns, the current valuation is far and away above where it has been the past decade. Right now, the company is paying out $2.17 in annualized dividends, which get distributed monthly. On May 22, 2013, Realty Income hit a high of $55.48. That is a 3.91% dividend yield.
Here is an aerial view of the company's average annual dividend:
From 2003-2007, Realty Income's average dividend yield was between 5.7% and 6.2%.
During the financial crisis of 2008 and 2009, the average annual dividend yield for Realty Income was 6.9% and 7.6%.
In 2010 and 2011, the yield generally held steady above 5%.
As the dividend yield has entered the high 3% range, this stock has lost a lot of its appeal. When you have a 5-6% monthly paying stock, dividend investing becomes fun because you are getting 0.5% of your initial investment back each month. When Realty Income enters the upper 3% range, a lot of that appeal goes out the window because the company is returning almost all of its profits back to owners in the form of a dividend, which is not that great anymore.
If Realty Income is paying out a dividend below 4%, why wouldn't you just do something like buy Chevron (CVX)? For agreeing to a lower starting yield of ¾ of 1%, you would be getting a company that is raising its dividend by 8-11%, trading in line with historical norms during periods of stable energy prices, and more importantly, retaining 70% of profits that can be used to pay down debt, buy back stock, or start new oil projects that could fuel future earnings growth and lead to higher dividend growth down the road.
When you look at Realty Income's valuation on a P/FFO basis over the past decade, you will see that the company looks pretty overvalued:
Between 2003 and 2009, Realty Income's average P/FFO ratio only crossed the 15.0 mark once, and that was in 2005 when the company traded at a P/FFO ratio of 15.05. Most of the time in that period, the P/FFO ratio was around 14.0
In 2010 and 2011, we see the company's P/FFO ratio climb to the 17.1-17.3 mark.
This year, the company is expected to generate $2.35 in funds from operations. Relative to a price of $55.48, we see that Realty Income is trading at a P/FFO ratio of 23.60, and that incorporates two quarters of future growth, while the other figures mentioned above were trailing numbers.
This raises the question:
Compared to the 2003 to 2009 period, are you willing to pay 68% more for each dollar generated in funds from operations today?
Compared to the 2010-2011 period, are you willing to pay 37% more for each dollar generated in funds from operations today?
The dividend yield is at the lowest point it has been since 2003, and Realty Income is trading at ranges well above where it has been in this past decade. The P/FFO ratio of 23.60 is well above the 14.0 we saw during the 2003 to 2009 range. Wednesday, Realty Income fell almost 5% amidst a broad market decline in response to Ben Bernanke's comments that the Fed's bond-buying spree may eventually taper off. My question for you is this: What do you think will happen to Realty Income's stock price when interest rates rise to 3-4%? Charlie Munger said that if you are patient enough, you almost always get your price. If I wanted to buy Realty Income, at a very minimum, I would wait for its P/FFO ratio to come down to 17.