On a recent train ride home from work, I was talking stocks with a friend of mine who is also an avid investor. During the conversation, he mentioned that I should look at Exelon (EXC), and mentioned the nice dividend it pays. I replied that I had looked at Exelon, but wasn't interested because I'd learned it had a large number of power contracts coming up for renewal and the negotiated price would be less than it had been previously receiving. My friend then replied, "If you are looking for the perfect stock you will never find it -- investing is half luck anyway." My response to that was, "Investing is not luck and, yes, I am looking for the perfect stock!"
I think we can all agree there is no perfect stock; all stocks, no matter how conservative they are or how great their business may be at a given moment, have risks. In addition, even the best investors make mistakes: Warren Buffett in his 2008 annual letter to shareholders admitted to making a big mistake buying ConocoPhillips (COP) when oil prices were at their peak. So how can we, the retail investor, find success investing? I would argue that through careful research and a disciplined approach to investing only in quality companies with reasonable valuations and growing dividends, your chances of success are much greater. One additional factor that can help you be successful is to find a company with a catalyst.
Warren Buffett's purchase of ConocoPhillips was not in and of itself a mistake; the mistake was paying too high a price. No single factor will have a greater effect on your returns than the price you pay when buying a stock. Unfortunately, there is no simple rule for judging valuation. Companies that are growing fast will have higher valuations than slower-growing, mature companies will. The higher valuation in some cases is justified. Some valuation metrics can be used, such as P/E (price to earnings) or the PEG ratio (price to earnings growth), which is the P/E ratio divided by the company's annual earnings growth. A simple example would be a company with a P/E of 20 growing at an annual rate of 10% (20/10), which is a PEG of 2. Many value investors look for companies with PEG near 1.
When looking at valuation, I look at a company's P/E, PEG and at a six-month or one-year chart. I am not a chartist, but charts sometimes will reveal interesting price movements.
Let's look at Coca-Cola (KO), a stock I own. Currently, the company has a P/E of 20.5 and a PEG ratio of 2.78. For a company growing earnings in the middle to high single digits, those are relatively high numbers. If we now look at a one-year chart, you will see a recent rapid climb from the low $70s to the high $70s.
If you add all that information up, it tells you Coca-Cola is not a buy here. It is a wonderful business -- I own it and will continue to own it -- but I would not buy Coca-Cola at these prices.
When it comes to valuation, there is no magic formula. But if you look at all the information that is available, you should be able to avoid purchasing a stock that is wildly overpriced. Set up a watch list to monitor the price action in the stocks you have identified as possible buys and wait for a pullback. At some point you will get a reasonable price to purchase the stock. Some of the biggest mistakes I have made involved buying stocks that were overpriced; what I have learned is that at some point all stocks give you good entry points. Patience is a virtue, especially when buying stocks.
The Seeking Alpha community is filled with investors who classify themselves as "dividend growth investors." However, this group of investors' rules for investing varies widely. Some, like myself, want capital gain with our dividend growth, while others do not care about the capital gain -- they just want an ever-increasing income stream. Some want a dividend of at least 2%, some want 3%, and I know of at least one person who has a minimum of 4%. Despite this difference in our ultimate goals, we all understand and believe in the power of growing dividends. There are many reasons for holding dividend growth stocks, like the documented proof that dividend stocks have outperformed non-dividend growth stocks over time, or the compounding effect of re-investing dividends and buying more shares. I would like to add one more reason: it helps you maintain your discipline during the bad market cycles.
When stocks go through a bear market cycle, many investors seeing their savings shrink and sell their shares, as fear of greater losses consume them. In many cases, selling is the wrong move as markets always recover from sell-offs. The savvy dividend growth investor knows that every quarter he or she is going to get a dividend payment, which is used to purchase more shares, which in turn will pay a greater dividend. The dividend investor does not dread a sell-off; he or she sees a sell-off as an opportunity to re-invest the dividend in shares that are temporarily cheaper. This awareness keeps the individual investor from selling at the worst possible time.
The market has been in sell mode the last two weeks and I have seen several of my holdings fall in price. As a long-term dividend growth investor, I have seen this pullback as an opportunity to add to some of my stocks. On Wednesday, I added to my McDonald's (MCD) position, as the price is down 10% from its all-time highs. I know McDonald's will continue to sell food and drinks throughout the world and continue to open new restaurants, and I will continue to receive its ever-growing dividend.
When looking for my "perfect stock" I am always happy when I see a catalyst that will drive shares higher. A catalyst can be anything that will affect the price of the stock: a new product, an acquisition, or even a piece of news that the market misinterprets. In December 2007, a massive ice storm enveloped the majority of the Midwest and Great Plains. The storm knocked out power for a week in numerous states. In January of 2008, McDonald's reported December sales in the U.S. that fell sharply from November. McDonald's stated sales were affected by the ice storms, but the market did not care and the stock dropped from approximately $55.00 to $50.00. I had been following McDonald's for a while at that point and saw this as my opportunity. I live in the Midwest and I knew the storms had been brutal, making transportation impossible and knocking out power in many areas for days. It seemed obvious to me that restaurant sales would be affected, so on Jan. 28th I bought McDonald's for $50.23. By the end of February the stock was back to $55.00. I bought McDonald's for the long term, but knowing I had purchased the stock at an excellent entry point was an added bonus.
Warren Buffett is quoted as saying, "I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out." Buffett has far more money than you or I, but he does not run out and buy any stock. He looks for situations that give him the greatest opportunity for success, and that is exactly what the small investor needs to do.
I may never find my perfect stock, but I want to get as close to perfect as I can before I invest my money. Like Buffett, I want the greatest possible chance at success, so I continue to look for successful companies selling at a fair valuation that pay a growing dividend and perhaps have a catalyst that will drive the price higher. Successful poker players do not play every hand they are dealt; they wait for the hand that gives them the best chance for success. Like Warren Buffett and the successful poker player, I will wait for the opportunity that gives me the best opportunity for success.