With only two or three exceptions, I prefer making investments with long-term investing horizons in mind at the point of purchase. When I was buying Johnson & Johnson (NYSE:JNJ) from $62 per share all the way up to $75 per share, I proceeded with the expectation that I would be owning a high-quality asset that would grow at 8-10% for years to come (considering that Johnson & Johnson's 1980-2007 record is much better than that, and considering that Johnson & Johnson managed to increase cash flow per share every year throughout the recession amidst of string of recalls, I feel comfortable with my assumptions).
I have the same intent towards when I get around to purchasing Coca-Cola (NYSE:KO) and Chevron (NYSE:CVX) because both of those companies have business models that allow them to achieve returns on total capital invested that exceed total expenditures by such an amount that 7-12% annual growth (with a few exceptions and hiccups every now and then) has justifiably come to be expected by shareholders almost every year.
Coca-Cola is on the short list of companies that make compounding seem easy because, nine years out of ten (historically speaking), they are generating more profits each year compared to the one before. This manifests itself in annual dividend increases. When you own companies that let you witness the compounding process right before your very eyes (because they grow earnings and dividend at 5% or so above inflation each year), the predictability of the growth and the high quality nature of the asset provide meaningful justifications for holding the shares of a company's stock even if it becomes 15-35% overvalued.
But what about those investments that are purchased at an undervalued price with the intention to sell at fair value? If you choose to follow the general premise of Benjamin Graham's life work by purchasing cheap assets and selling them at fair value, it can be useful to have a strategy to determine how long you would be willing to wait for an investment to reach fair value. Three years? Five years? Ten years? As long as it takes for fair value to be reached?
Here is how Benjamin Graham approached that question:
Graham reasoned that a security had little or no profit potential past that point, and that one would be better off finding another undervalued situation. If Graham had purchased a stock for $15 per share and assigned it an intrinsic value with a range of $30 to $40 per share, when the stock reached the price of $30 a share, he would sell it. He would take the proceeds and reinvest them in another undervalued situation.
Graham discovered that when you bought a stock that was selling below its intrinsic value, the longer you had to hold the stock, the lower the projected annual compounding rate of return on your investment would be. If you bought a stock for $20 a share and it had an intrinsic value of $30, and if it rose to $40 per share the first year, your rate of return would be 50%. If it took three years, your annual compounding rate of return would drop to 14.4%, in four years it would drop to 10.6%; in five to 8.4%, in six to 6.9%, in seven to 5.9%, and in eight to 5.1%...
Graham, however, had one additional problem. What happens if the stock price never rises to its intrinsic value? What happens if the market refuses to realize the stock's full intrinsic value? How long should one wait? His answer was two to three years. He reasoned that if the stock hadn't reached its intrinsic value by then, it probably never would. In that case, it was better to sell the stock and find a new situation.
By the way, the Graham approach is by no means universal. The essays released by the management teams at Tweedy, Browne indicate a desire to wait five years for intrinsic value to be reached. When Warren Buffett is asked what he does if a particular holding does not reach intrinsic value, he rejects the premise and says that it always reaches intrinsic value eventually.
In my case, I try to sidestep the potential dilemma by doing almost all value investing within the universe of dividend-paying that are expected to grow profits over future three and five year rolling periods. For me, value investing makes limited sense outside the world of dividends because you are entirely at the risk of the other stock market participants to realize the value of your holding.
Let's say that I calculate Berkshire Hathaway (NYSE:BRK.B) to be worth $135-$140 per share. Right now, it is trading between the $110 and $113 range. If the market fails to reflect that $135-$140 over the next four or five years (maybe folks are worried about the successor to Buffett, maybe some folks have concerns about specific risks in the insurance division, maybe the future value of those 700,000,000 Bank of America (NYSE:BAC) shares or the recovery potential of the housing-related businesses is not fully appreciated by other stock market participants, etc.), then there is no way for me to benefit from my ownership stake in Berkshire Hathaway until the other market participants recognize the value by agreeing to pay a higher price.
But once dividends get involved, there is much less concern about what the other market participants are willing to pay. Although I currently own BP (NYSE:BP) with long-term intentions, I will use it as my example since I believe it is both undervalued and it pays a meaningful dividend.
As of May 28th, 2013, BP is trading at $43.60. It pays out $2.16 per share in annual dividends, which works out to a current dividend yield of 4.95%. Let us stipulate that the company's intrinsic value is somewhere around $55-$60 per share. The fun thing for a value investor is that, assuming his analysis is correct, he can put himself in a win-win situation because one of two things will happen: (1) the stock will increase to that $55-$60 intrinsic value threshold and he will be to realize a nice profit when the other stock market participants recognize the fair value of the BP holding, or (2) the investor could put together a tidy income stream by reinvesting the dividends back into BP stock (since he believes the stock to be undervalued, reinvestment back into the same company seems like a reasonable course of action).
Let's explore option #2 with real numbers. Let's say an investor purchases 500 shares of BP at $43.60 for a total investment of $21,800. At the time of his initial investment, his expected annual income is $1,080 from his investment. For whatever reason, let's say that the market refuses to recognize the $55-$60 value of BP, and the price stagnates at $43.60 for the course of the year. What is the experience like for the investor reinvesting his dividends?
When he receives his first $270 dividend check, he chooses to reinvest it back into BP, automatically adding 6.19 shares to his account, bringing his new total to 506.19. When the second dividend payment rolls around, he receives a $273 check, which adds 6.26 shares to his account, bringing his new total to 512.45 shares of the oil giant. By the time he gets his third dividend check, he now gets $276 added to his account, which brings his total shares up to 518.79 shares of BP. And when he gets his fourth dividend check, he is now adding $280 to his BP total, which gives him an ownership stake of 525.21 BP shares in total.
Some people might look at the $43.60 share price a year later and think, "Ha ha, that dope Tim McAleenan got stuck holding a stock that didn't move anywhere. Talk about 'dead money.'" The reality of the situation is that those accumulated and reinvested dividends made a meaningful difference in just one year's time. At first glance, some may look at the $43.60 share price and assume that the total value of the investment is still $21,800 that has been generating $1,080 in annual dividends. In reality, the 500 shares of BP grew to 525.21 shares worth $22,899 paying out $1,134 in annual dividends.
And that is just one year's worth of dividends. Things get much more interesting if you combine three or four years' worth of dividend increases with reinvested dividends into a stock that is undervalued. That is why I prefer conducting value investing within the realm of dividend-paying stocks. Even if the price of BP stagnates and does not immediately approach your estimate of fair value, you could turn a $1,080 stream of annual income into a $1,134 stream of annual income while those staring at the price of a stock alone think you are sitting on "dead money." And the fun thing, of course, is that when the price does rise to the $55-$60 mark, you have those reinvested dividends in the low $40s that enhance your total return.
The most high-profile investor that engaged in value investing within the realm of dividend stocks was John Neff. He ran the Windsor Fund at Vanguard. As Neff would explain it, "One of Ben Franklin's wise observations offers a parallel: 'He who waits upon Fortune is never sure of a dinner.' As I see it, a nice dividend yield at least lets you snack on hors d'oeuvres while waiting for the main meal." If you own a stock that pays no dividend, you may feel a temptation to "give up" on a value investment after three or four years because you are sitting on "dead money" that does not benefit you until the price goes up. But if you have a nice starting yield (that is ideally growing), the amount of time that you can wait for your investment to reach fair value becomes much more indefinite, and the need to set an expiration date for your investment to reach fair value may even disappear entirely.
Disclosure: I am long BAC, JNJ, BP. 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.