Over the past couple of months, I have spent way too much time fretting about the current state of the economy and where we are heading from here. I know that I cannot control that outcome, nor can I control its impact on any of my holdings, but I can try to help myself and my clients by reviewing our holdings to see if any are overvalued. I use discounted future cash flow models, discounted future dividend models, fundamental analysis and everything else that I can think of (that I believe is legitimate) to determine if the holdings are overpriced, and if so, whether they are so overpriced that I need to sell them. I've even updated my prior research on the valuation methods themselves to determine whether there are any recent developments in stock valuation methodologies (the conclusion is the same as it was in grad school: it is still garbage-in, garbage-out and guesswork to a significant degree, and we are still probably best served with a low-cost portfolio of index funds, taking advantage of rebalancing and dollar-cost averaging but otherwise passively managed).
Being inundated with country music here in Nashville, I am reminded of an old Kenny Rogers song that I am sure has been used a few times here at Seeking Alpha: You gotta know when to hold 'em, know when to fold 'em, know when to walk away and know when to run.
For some reason, hearing Kenny Rogers sing those words is actually putting me at ease.
Margin of Safety in Selling
Just as it is difficult to determine when a stock is sufficiently undervalued to be worth buying, it is difficult to determine when a stock is so overvalued to necessitate selling. Not only are there expenses and potential tax implications in the sale, but there are often emotions involved, whether it involves admitting defeat with an investment or capping the gains on a stock that you have watched grow for so long. Many investors require a stock to trade with a margin of safety below the calculated fair value, and that same principle should apply to the determination of when to sell a stock. Providing a margin of safety on the sell-side helps cushion errors in assumptions, analysis and calculation just as it does on the buy-side. As hard as it is to sell your winners, it is helpful to keep in mind that there are thousands of alternatives for our hard earned money. Even within the dividend growth space, there are at least 500-1000 stocks to choose from.
Application to Cracker Barrel and Visa
As I look through my holdings, there are two that I believe should be sold. Both are great stocks that I will keep an eye on to purchase later, but I believe that they are overpriced by 20% or more, and there are better options available with that capital.
Cracker Barrel (CBRL) pains me the most to think about selling. I am up 50% since I purchased the stock, and I love that its dividend has exploded to $3.00/share as it grows its revenue and earnings while decreasing share count. I love how selective and deliberate CBRL is with store openings (the annual report states that 200-300 potential store sites have been identified, yet it opened 13 in 2012 and plans on opening 12 in 2013), and that conservatism will pay off in the long run. I also enjoy eating at the restaurant, although I usually regret the volume of food I eat there.
I do not like that its P/E of 20, and even its forward P/E (garbage in?) of 16 are both higher than at any time since 2006 and well above its 5 year average P/E of 12. The same excess exists for CBRL's P/B, P/CF and P/S ratios. CBRL's payout ratio of approximately 38% does not bother me, but I do not think that it is reasonable to expect CBRL to continue to grow its dividend at anywhere near the rate of the past couple of years when it has a very measured growth strategy and is not expected to grow faster than about 10% a year. My discounted cash flow and discounted future dividend models say that the stock should be trading for no more than $85. On a fundamental value basis, I get closer to the mid 70's. This is a case where, as much as it pains me, I am going to sell the stock and hope it drops so I can buy back in at what I believe is a fair price with a reasonable margin of safety.
In Visa (V), I see a great company in a money-printing industry that is not only overvalued on a relative basis, but, as a dividend growth investor, is particularly overvalued for the dividend it pays. Visa's forward dividend yield is just 0.7%. Even with a dividend growth rate of 20%, it will still take 5-6 years for the yield to get over 2%. That alone does not bother me, except when where are many other companies that are not overvalued that yield 2-3% or more and are growing their dividend at a rapid pace. Assume a 0.7% dividend for Visa growing at 20% a year compared to another good company paying a 2% dividend growing at 10% a year. By my simple calculations (I love spreadsheets), it takes 12 years for Visa's yield to catch-up to the fictional alternative. If dividends are reinvested, and the holdings started at the same amount, then assuming equal growth in the stock price it would take even longer for Visa to catch-up.
With Visa, my fair value analysis results in a range from $130-150. Note that Visa's P/E ratio is currently 51, compared to 20 for American Express (AXP) and 25 for Mastercard (MA). At the current price ($180), with a 0.7% dividend, I would sell and look into alternatives. If CRBL is a "fold 'em", then V is a "run", at least for now.
Replacements to Cracker Barrel and Visa
As much as I like Exxon (XOM), McDonald's (MCD), Coca-Cola (KO) and all of the usual dividend growth stalwarts (hold 'ems?), I think that many of them are slightly overvalued, fairly valued, or do not have a sufficient margin of safety to be great investments now. Instead, I would look a little off the beaten path, with two examples being ArcelorMittal SA (MT) and Canadian Natural Resources (CNQ). MT is a European steel maker, the world's largest, with a $19 billion market cap yielding 1.7%. It is a beat-up stock in a beat-up industry, as indicated by its P/B of 0.4 compared to a 5 year P/B of 0.8. It has cut its dividend significantly, but is believed to be at the trough of its business cycle, and the dividend should stabilize from here and start rising again over the next 2-3 years. Further, MT is saying the right things (we will see what actually happens) in terms of cost-cutting and other strategies to improve its operations. MT trades at $12 per ADR, down about 88% from its 5 year high. I believe that even conservatively, it is worth $25 (a 50% margin of safety), and I would buy and reinvest the dividends while I wait for the company and its stock to rebound.
CNQ is not quite as aggressive of a choice as MT. This Canadian oil and gas company has a forward yield of 1.7% and it has increased its dividend each of the past 10 years, just like a good prototypical dividend growth stock should. The payout ratio is still reasonable at around 29%. CNQ appears to have ample opportunities for growth and it generates significant free cash flow to fund the dividend and future acquisitions. Trading at $29, the stock is worth at least $40, for a 30% margin of safety. As with MT, I would buy CNQ now and reinvest the dividends as they come in.
Use a margin of safety for selling just as you do for buying. It takes some of the emotion out of selling, and there are too many fish in the sea to hold onto an investment that is trading above that margin of safety. Two stocks that you should consider selling are CBRL and V. Two stocks that you should investigate further for purchasing are MT and CNQ.
Additional disclosure: Although I am long CBRL, I intend to liquidate my holdings within the next 72 hours. I may initiate a long position in MT and/or CNQ within the next 72 hours.