The Best Trades Could Be the Ones Not Entered

I often analyze individual stocks on the dividend growth blog. Some, if not most, of the times however, after guiding readers through the company story I end up stating that the stock is either a hold or sometimes even a sell. This irritates most investors, who see the practice of reviewing a stock which results in a negative or neutral recommendation as a waste of their time.

I definitely understand the frustration for those readers. Most investors typically want to be told what to buy, when to buy it and how much they would make when selling. This strategy always works in get rich quick books, but it seldom generates any profit in the real world. The reason why so many investors lose money on a consistent basis is because they fail to educate themselves and instead end up following gurus which don’t even trade the ideas they are pitching to their followers.

The value of a stock analysis is that it should give investors ideas about what they want to see in a stock, versus what they don’t want to see in a stock. A prime example is my analysis of Paychex (PAYX), which is overvalued relative to its competitor Automatic Data Processing (ADP). In addition to being overvalued, Paychex currently distributed most of its earnings out as dividends, which is clearly unsustainable in the long run. Thus, the relatively higher dividends yield of 4% on PAYX versus 3.3% for ADP is not enough to compensate the risk of a potential dividend cut.

Another reason why a neutral stock analysis is beneficial is that it provides investors with some insight into a company which could be temporarily overpriced. Since entry price matters to some extent, it would be unwise to pay top dollar for stocks, when there are companies with similar characteristics that are priced attractively. An investor, who does his or her homework early in the game, would be well prepared from reading the analysis to enter a position on dips, should the stock fall on general market weakness or on negative news.

The urge for constant action and the inability to wait for the best entry setups might be the difference between making money and losing money in the long run. Jesse Livermore, a famous trader from the 1920’s is known for his saying that “The big money is made by sitting, not thinking. Men who can both be right and sit tight are uncommon”

I completely agree with this assertion. Investors who purchased stocks in the late 1990’s when dividend yields were at their lowest have suffered inferior returns over the past decade. Other investors who finally saw some gains in their portfolios in 2009 might have been quick to take a profit too early, thus missing out on the majority of the rally off the March 2009 lows.

Even if you purchased great stocks such as Johnson & Johnson (JNJ) or Procter & Gamble (PG) while their yields were at multi year lows, you would have seen no capital growth at best, although your dividend income would be higher than it was a decade ago.

At the end of the day what truly matters is that investors develop a sound strategy that fits their personality and go with it. The strategy should incorporate entry and exit rules, diversification and hopefully some sort of position sizing methods such as dollar cost averaging.

Disclosure: Long ADP, JNJ and PG

Comments

[pdtor]

Good article. Dividents maybe high due to depreciation of capital. As an example the Canadian banks give good dividents, but the price of the stocks are too high.......I am waiting for the downdraft when the markets fall, and get them at a more favourable price. They are good stocks, but will suffer from the overall fall in the market. Just waiting to get in at a good price point.Cannot just buy on divident yield, you must also look for capital appreciation.

2009 Oct 29 10:39 AM

[money4eds]

You compare PAYX to ADP and state PAYX is over valued. PAYX has no debt, better current ratio, better return on equity. They also are expanding their service offerings. Higher insider ownership in PAYX. On paper it seems to be a better investment. What did I miss?

2009 Oct 29 11:48 AM

[No Free Cake]

money4eds, the author pointed out one of his key criteria which is "payout ratio" which is very high for PAYX. This is a key number for dividend investors.

A metric I like is the "Dividend Coverage Ratio" which relates to how well the free cash flow (operating) covers the dividend payment. There are various ways to look at this but suffice it to day that ADP has a much stronger FCF than PAYX.

2009 Oct 29 01:36 PM

[Graham and Dodd Investor]

"(Wo) Men who can both be right and sit tight are uncommon”

It is a fundamental law of economics that the largest returns accrue to the scarcest (most uncommon) factors of production.

2009 Oct 29 01:52 PM

[Albert Meyer]

You have not missed anything... PAYX is the superior company... revisit this story a year or two from now and long-term investors owning PAYX will be smiling... however, in the short-term anything is possible...

On Oct 29 11:48 AM money4eds wrote:

> You compare PAYX to ADP and state PAYX is over valued. PAYX has no
> debt, better current ratio, better return on equity. They also are
> expanding their service offerings. Higher insider ownership in PAYX.
> On paper it seems to be a better investment. What did I miss?

2009 Oct 30 10:03 AM

[David Van Knapp]

Good article. You are correct that lukewarm or unfavorable stock ratings often irritate investors. I've experienced that myself in reaction to a couple of articles that I have published.

Such people are missing a very important point. Over long periods of time, it is at least as important to avoid bad investments as it is to make good ones. For my annual "Top 40 Dividend Stocks" e-book, I begin with a universe of of nearly 700 companies. Then I run "stage-one" tests to whittle the candidates down. These tests are the most important thing I do. I love eliminating companies for reasons that might make them bad investments, especially if it's for non-obvious reasons that readers might miss on their own. Reducing the initial list down to, say, 70 "finalists" takes the most time, but it is the source of the most value to the final product.

Buffett is famous for saying Rule # 1 is "Don't lose," and Rule #2 is "Don't forget Rule #1." He's right, and eliminating flawed stocks is the first strp in achieving that.

2009 Oct 30 10:25 AM

[granger]

Great article. It could not be said any better. Thanks

2009 Oct 31 01:05 AM

[YoYoMama]

Good article at a critical juncture in the market. Depending on how next week goes, this is either another great time to buy, or time to sell your losers and take some profits.

2009 Oct 31 10:06 AM