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A sudden and broad decline in the stock market can be a harrowing experience for many investors. While browsing news websites, they encounter alarming headlines that refer to fear and panic in the market. Turning on the television to a financial channel, they hear a commentator warning of further losses and recommending that investors lower their exposure to equities. Checking their portfolios, they observe a sea of red, with most or all of their stocks heading downward.

Driven by what they see and hear around them, some investors will feel compelled to take action and sell some of their stocks. They might do it either to lock in whatever capital gains remain or to limit the extent of their capital losses. They may sell while giving little or no regard to what is happening with the actual companies that underlie their stocks. That is, the stocks of stable, high-quality companies might be sold simply because their prices have suddenly dropped in concert with the rest of the market. When this happens, an opportunity arises for dividend growth investors. It is the opportunity to benefit from other persons' mistakes.

The Value In Dividend Growth Investing

In his book The Intelligent Investor, Benjamin Graham devoted an entire chapter to market fluctuations. One of the most important parts of the chapter was the following passage on p. 203 (italics in original text; bracketed text is mine):

The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage [the flexibility associated with buying and selling shares of a business in an open market] into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment.

What did Graham mean by 'other persons' mistakes of judgment? The answer lies in his approach to investing, which has come to be known as value investing. At the heart of the approach is the idea that an investor should try to buy the stocks of companies that are selling for less than their intrinsic values. The stocks may be temporarily undervalued by the market for any number of reasons, even though the companies underlying the stocks may be doing just fine. There are many ways to assess whether a company might be undervalued, ranging from mathematical models that provide estimates of intrinsic value to comparisons of a company's current fundamentals with its historic norms (e.g., whether its current P/E ratio is below its average P/E ratio over the past five years). A full discourse on valuation is beyond the scope of this article (and my capabilities), but if readers would like to know more, a good starting point would be the articles of Seeking Alpha author Chuck Carnevale, who frequently provides compelling visual examples of undervaluation with his F.A.S.T. Graphs.

When a high-quality stock is sold off to the point where it becomes undervalued, Graham argued that the sellers have made mistakes of judgment because they have sold the stocks for less than the intrinsic values of their underlying companies. The stocks may be unpopular now, but eventually the market will price them closer to their intrinsic values. This is what Graham meant in his frequently cited quote that "in the short run, the stock market is a voting machine; in the long run, it is a weighing machine". If a diligent investor recognizes when a stock has become undervalued, as might happen during a broad market decline, then he can buy the stock and simply wait for the market to value it at an appropriately higher price later, thereby producing a capital gain. If the investor already owns the stock, then instead of panicking and selling when he sees a sudden drop in its price, he can buy more of the stock and lower his cost basis. It is important to note that in both cases, I assume that the investor's due diligence has indicated that the price drop and subsequent undervaluation were unjustified.

I titled this section "The Value In Dividend Growth Investing" because many dividend growth investors are also value investors. They seek to buy the stocks of companies that have paid uninterrupted dividends for decades and increased their dividends for many consecutive years, but only if those stocks are available at attractive valuations. One advantage of buying undervalued dividend growth stocks- as opposed to undervalued non-dividend stocks- is that the investor gets paid to wait for the valuations to be corrected. It may take weeks, months, or longer than a year for a stock to go from undervalued to fairly valued, but during that time the investor can patiently collect dividends that increase from year to year.

Over the past year, I purchased several undervalued dividend growth stocks, especially on days when the market dropped heavily. These stocks included dividend growth stalwarts such as Becton, Dickinson & Co. (BDX); Illinois Tool Works (ITW); Medtronic (MDT); and United Technologies (UTX). Each is a high-quality company that has raised its dividend for over 15 consecutive years, and I judged their stocks to be undervalued when I bought them. In the months since those purchases, I have seen capital gains as the market has gradually valued the stocks more appropriately, and all the while I have been collecting their dividends.

Conclusion

Whenever there is a broad market decline, I may encounter alarming headlines, hear the dire prognostications of television commentators, and witness a drop in my portfolio's value. However, instead of panicking and selling, I try to stay calm, remind myself that I am not forced to sell, and then ask whether I can benefit from other persons' mistakes by buying undervalued but high-quality dividend growth stocks that are being sold off. This approach may not fit with the temperaments or strategies of other investors and I do not claim it is the most successful or appropriate way to deal with all market declines. Nonetheless, I do think it is a sensible approach that can help some people exercise control over their investing behavior.

Source: Dividend Growth Investing Strategy: Benefit From 'Other Persons' Mistakes'