One of the recurring comments I read on the Dividends and Income board periodically is investors wishing for prices to decline. Based on comments by other investors along those same lines it also appears to be one of the most misunderstood comments as well. In many cases it is either taken or used out of context.
On the surface it appears to be a no-brainer. Of course you want prices to go up. That's how your portfolio increases in value, when the prices of your stocks appreciate. But in reality there is more than one way to look at the stock price (I'm excluding shorts). So should a dividend growth investor, especially one such as myself who is retired, want stock prices to go up or be content with them going down?
It's Not Just The Price Decline
There are multiple reasons for an investor to hope for lower prices but the price fluctuation should never be separated from the intrinsic value of the company to which the price pertains. In other words stock price should be considered hand in hand with intrinsic value to determine if a company is at a "value" worth spending your hard earned capital on at any given time. In his 2011 annual letter to Berkshire Hathaway (NYSE:BRK.B) shareholders (annual letters from 1977 to 2012 are available at this link) Warren Buffett said "The first law of capital allocation - whether the money is slated for acquisitions or share repurchases - is that what is smart at one price is dumb at another." If we as dividend growth investors are treating our investments as a business, which we should be, then we should view our purchase considerations as capital allocations and treat them accordingly. To put it bluntly, we should buy when it's a wise use of our money, and when it's not, don't. That should be obvious but quite often it's not.
Buffett went on to discuss share repurchases in detail in his 2011 letter and there is a corollary to the dividend growth investor wishing for price declines. Using International Business Machines (NYSE:IBM) as his example he demonstrates how if the IBM stock price remains stagnant while IBM is repurchasing shares Berkshire winds up owning more of the company than if the price rises. Consequently, the Berkshire share of the earnings would be greater under the lower price scenario than the higher price scenario and would result in the total share ownership being worth more at a later point.
This paragraph from Buffett I believe is worth quoting in its entirety: "The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply."
Many people read this and automatically jump to the conclusion that Buffett simply wants stock prices to decline so he can buy more. But to paraphrase the late Paul Harvey let's discuss the rest of the story. Buffett prefaced his IBM remarks with the fact that IBM management was extraordinary, had used debt wisely, was financially flexible, and had made good use of their cash. But of enormous importance to Buffett were IBM's earnings over the next five years. He wanted the share prices to languish "provided" that the earnings continued to grow, the company remained a valuable company, and shares were being repurchased. He stated as much when he said "First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock underperforms in the market for a long time as well."
The corollary for the dividend growth investor here is that Buffett wanted the share price to languish because he (or IBM) was going to be a net buyer of IBM stock over the next 5 years, and he was confident he knew the "intrinsic value" of the company. For example, if an investor is confident that the stock of a quality company is worth at least $75 per share and that investor can buy that company for less than that, then that investor should want the price to stay below $75 while still buying. But it is contingent upon the company continuing to be worth $75 per share or even increasing in value. In reality it doesn't often work that way. In my opinion what Buffett was really saying, and what the dividend growth investor should take away, was that while he was accumulating shares he wanted the shares to be "mispriced."
If a company is continually increasing earnings, is a well run company with a viable product or service, cash flow is increasing and debt is well managed, stock prices will typically rise along with the increasing earnings, and the dividend growth investor in accumulation mode may be forced to pay higher prices. Increasing earnings and declining prices do not go hand in hand. On occasion however, Mr. Market, in one of his manic-depressive moments will misprice a stock at which time it behooves the investor to take advantage of that mispricing opportunity, provided appropriate due diligence has been performed.
Price Pullback or Falling Knife
Unfortunately it doesn't necessarily happen often with the particular stocks one may be looking to purchase so we have to take advantage of other times when the mispricing may not be so obvious. For example, in 2011 Walgreen (NYSE:WAG) had a spat with Express Scripts (NASDAQ:ESRX) and its price dropped from a $45 per share range down to a $30 per share range, staying down for roughly a year and finally hitting a low of $28.53. The DGI at that time had to decide if WAG was still a quality company, was its dividend still reliable and if the company at that time was priced at a point below its intrinsic value. In other words, was WAG worth more than the ~$30 at which Mr. Market was pricing it?
In June 2012 WAG and ESRX settled their differences and WAG's stock price jumped and today sits around the $54 to $55 mark. The DGI that decided WAG was still a quality company, actually had a higher intrinsic value and was temporarily mispriced, and took advantage of the price to acquire shares has been rewarded.
WAG is an example of a price pullback with a specific reason for pulling back, in this case the ESRX dustup. Quite often though a price pullback will occur and the DGI has to decide if it's still a quality company or if he or she is trying to catch the proverbial falling knife. For instance I have written twice previously about a purchase of Norfolk Southern (NYSE:NSC) here and here. I made a conscious decision it was a quality company, not a falling knife, and decided to buy on the pullbacks. But companies like Intel (NASDAQ:INTC) or Pitney Bowes (NYSE:PBI) may present different looks to different investors.
Intel has been struggling moving from a PC dominated market to a mobile market whereas PBI is in an altogether declining product market and is struggling to remain relevant. Many DGI investors will use a dividend cut as a signal to get out of a stock but in reality the signal is quite often given sooner than that. For example, PBI's operating income, earnings, and cash flow were going down while the dividend payout ratio was going up. That's a signal for an impending collision. Red lights should be flashing.
I've never owned PBI but am still long INTC. However, my focus in watching INTC is not on the price but rather it's on the business factors of the company and the dividend story. I'm more interested in if the company is going to make the transition and remain the dominant semi-conductor company in the industry. To do that I watch the earnings, payout ratio, and free cash flow and other pertinent business metrics and news, and not so much the stock price. Intel's Capex has been high recently as it builds up to move in to the mobile market, which impacts its free cash flow, and which is an example of the metrics that have to be taken into consideration in watching the business fundamentals.
In regard to the dividend story in 2012 Intel (data from its website) paid $0.87 cents per share dividend. In 2013 it paid or declared a $0.90 cents per share dividend so by Intel Management's viewpoint it remained a dividend growth company. But to many dividend growth investors it has gone six straight quarters with the same payment amount, which has tilted those DGI's against it and they sold, which is understandable. Since Intel is currently 2.74% of my portfolio by my reasoning I can afford to be patient, but only up to a point.
The investor who believed in Intel may have used the decline or price pullback from August to November 2012 as an opportunity to go long or add to their position in INTC, as opposed to viewing it as catching a falling knife. This is the quandary the DGI often faces in wishing for price declines, which was what I referred to earlier. The "normal hope that earnings of the business will increase at a good clip for a long time to come" often don't match the timing of the price declines, in fact it is the opposite. The price declines because the earnings are declining.
The above examples of the DGI wishing for prices to decline do not include the entire market pulling back, whether in a general pullback, or in an economic fright such as 2008. There are all kinds of other factors associated with those types of price declines, but all in all they're usually great opportunities for the astute investor to obtain quality companies at bargain prices. But you have to first overcome the fear that comes with the entire market dropping like a rock.
Different Strokes For Different Folks
In many cases one of the more significant reasons for the dividend growth investor wanting, or not wanting, price declines lies in their individual perspectives and circumstances. Since I am a retired investor I tend to take a retiree's outlook on my investments. Although I am not currently dependent upon the distributions from my investments many retirees use the income from their investments and the resultant distributions for their monthly living expenses.
A retiree dependent upon those distributions may want prices to continually rise in order to prevent the worry or stress that may come with declining prices. When their entire portfolio remains above water it is human nature to feel better about the portfolio and the investments. Retirees are less concerned with buying additional shares at bargain prices because they're usually no longer an overall net buyer of stocks. They're letting their investments do the heavy lifting on income they were intended for and are more concerned with preservation of the assets rather than accumulation of additional assets. But a younger investor may want prices to decline in order to establish a larger position with the goal of ultimately owning more of multiple companies.
In regard to price declines I believe the dividend growth investor should be careful of what they wish for. At the very least they should never wish for a stock price decline without being cognizant of the financial metrics, future potential, and intrinsic value of the company in which they are interested. The way that I look at it (in the context of this article) is that the stock price is a metric I use to measure the value I'm getting for a company I want to own. The stock price is important but it doesn't tell me what the company is worth, the earnings, free cash flow, and future earnings/cash flow potential tell me that. The stock price tells me when it is or is not a good deal in relation to its value. As quoted earlier, what is smart at one price is dumb at another.
In reality, what I as a retiree really want is for the companies in which I'm invested to continue doing well, increasing revenue, earnings, and cash flow, growing their dividends at a rate at least twice that of inflation, and remaining a viable business with easily manageable debt and an economic moat. And when they do I know that higher prices will eventually follow, which is also what I want. And if they want to take their time getting to that higher price while I'm reinvesting dividends and the company is repurchasing shares, I'm quite okay with that. While that is going on I'm growing my income each quarter and each year and compounding those dividends. And that keeps this retiree happy and sleeping well.
Additional disclosure: I am not a professional investment advisor, just an individual handling his own account with his own money. You should do your own due diligence before investing your own funds.