Getting The 'What' Correct In Your Portfolio

by: Eli Inkrot

I'm about to make a sweeping generalization that I'm sure to take quite a bit of flack for. Now I would like to preface this statement by suggesting that this isn't necessarily or completely my personal investing strategy; instead this philosophy is being presented for purely argumentative consequences. However, somehow I feel that this qualifying point will nevertheless get lost in the context. Oh well, here goes anyway: I'm a dividend growth investor and I don't care about stock prices ever. Not "I am more concerned about a rising stream of dividend income once I have made my purchase" or even "I consider stock prices at the time of purchase, but become less concerned about day-to-day price fluctuations." Rather the statement simply stands as "I don't care about stock prices ever." Once again this is not my personal opinion, but instead a platform from which I would like to generate a logical premise. Hear me out.

Lottery Winnings

For those that are unsure as to where they might like life to take them, a common exercise is to prompt them with a question: "What would you do if you won $10 million in the lottery?" If you answered "fix up an old boat" or "buy and rent out a condo complex," for example, then perhaps being a nautical mechanic or landlord is in your future. The idea is to consider what you would do without financial constraints. It follows that if you can do whatever it is that you like doing as a career, then you "never really work a day in your life." I myself recently completed this exercise. After my initial expenditures, I still had the majority of the $10 million balance leftover. Of course the next move, for me, would be to invest a large portion of the money in my favorite companies. Favorite in that I felt they had the best prospects of not only growing over the next 50 years, but also in that they would continue to increase their dividend payouts through time. I came up with a list of 40 companies, most of which are regulars amongst the dividend growth crowd: Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), Colgate-Palmolive (NYSE:CL), Exxon Mobil (NYSE:XOM), Wal-Mart (NYSE:WMT), Target (NYSE:TGT), you get the idea.

Now the surprising part to me was not that I would invest in a wide array of dividend growth companies. I, among many others, have advocated such a strategy for some time now. Rather I was surprised by how I would invest. I came to the realization that instead of waiting for each security to reach a certain price point or criteria, as I currently do, I would simply invest all of my available funds in my 40 favorite companies at one time. The underlying reasoning, of course, is that the opportunity costs of holding millions of dollars would be great. Surely one could do better by strategically allocating their funds at certain times. However given the circumstances of the scenario, I could easily make $125,000 in after-tax dividend income, without caring one bit about current prices. Moreover I would invest with the expectation that this yearly income would grow by a rate that outpaces inflation over the long-term. Now I don't know about you, but I could live like a king off of $125,000 a year.

Of course the criticism of this logic is that it doesn't indicate the scarce resources that many of us are faced with. Thus we have to pay attention to prices. I would agree with this reasoning, but suggest that it has more to do with our underlying stock selections and not necessarily prices. In effect, if something works for a large amount of money, it follows that there is at least a hypothetical case for smaller sums. Thinking back to the idea of investing all of my funds at one time, why did I feel so comfortable? For one, I would suggest that $125,000 a year is enough to make anyone comfortable. But more importantly, we know that there is efficiency in the market. Surely the precise adeptness of this market efficiency can be debated, but in general information is processed quickly and markets are liquid. Thus, while it might be possible to find a better price eventually, it is likely that very intelligent people are content with the prices at least in the short-term.

Opportunity Cost of Not Investing

Perhaps the best case for not caring about prices is if your alternative is to sit on cash. That is, if your indecision freezes you from never investing. It sounds a bit absurd, but really this option is more prevalent than people might think. In fact, many people truly don't consider prices when using direct reinvestment plans or by automatically contributing to their employer's retirement plans. The likely alternative for these situations would be to simply take the cash. Mathematically, this opportunity cost is very easy to see. Consider a $10,000 initial investment in a portfolio of dividend growth stocks with a 3% yield and a 6% average yearly grow rate:

Yield Year 1 Sum Yr 10 Sum Yr 20
3.30% $330.00 $4,349.66 $12,139.25
3% $300.00 $3,954.24 $11,035.68
2.70% $270.00 $3,558.81 $9,932.11
1,2,3,4% $100.00 $2,200.00 $6,200.00

If you can currently find an aggregate yield for your desired portfolio of 3% today, then the value or disadvantage of waiting is described appropriately. If the holdings collectively decrease over 9%, or increase over 11%, we see the overall yield move to 3.3% or 2.7% respectively. Moving forward, we assume that the first three scenarios grow their payouts by 6% a year. In the first year the difference between buying today at a 3% yield or buying tomorrow at a 3.3% yield is only $30. However, we can clearly see this difference grows over time. In the fourth row I assumed a cash rate of 1% for the first three years, 2% for the next three years, 3% for the three years after that and a 4% rate in years 10-20. It's plain that even if you decide to wait to buy tomorrow and the prospective holdings increase by 11%, one would likely do better than holding cash.

Of course these wide swings in prices are unlikely to occur in a day's time. Rather, they are more likely to take place over months or years. Incidentally, this might cause one to "wait for a collapse" whereby the lower prices wouldn't make up for the opportunity costs of not receiving payouts. Finally, many people invest small sums over time, instead of aggregating for a single purchase. Without considering prices, this is also known as dollar cost averaging. And while it might not appear rational, we know that over long enough time horizons the market invariably tracks upward. Thus any lasting investment decision is likely to be a profitable one, perhaps not the best one considering one's risk or time horizon, but profitable nonetheless.

Quality Rarely Goes on Sale

I have a prediction that I will never see Johnson & Johnson's Listerine mouthwash go on sale for less than, or even the same as, the generic store brand. The generic literally has the same size, same bottle shape, same color even. Yet people are more than happy to pay a hefty premium, twice as much in my experience, for the name-brand Listerine. Of course the list goes on and on within a grocery store: Coke, Lay's, Jiff, Heinz, Palmolive, and Kleenex even. The fundamental reasoning is relatively simple; people flock to the names that they know and trust. It follows then, that the underlying companies are probably quite profitable. After all, aside from advertising, the generic isn't likely to be that much cheaper to make. The same is true within the stock market as we're unlikely to be able to buy the highest quality companies for generic company prices. It you're sitting around waiting for Coca-Cola or Colgate-Palmolive to trade for a price to earnings ratio under 10, then you're going to be waiting for a while.

Problem with Finding an Entry Point

Some of the best companies just keep on improving. For example, let's say that you were interested in buying Apple (NASDAQ:AAPL) in 2003, when the share price was around $8. However, you're not sure if you've quite figured out the company's future prospects, so you decide to wait for things to shake out. In January of 2004, you see a share price of $12, but you're still slightly concerned that AAPL might be a fad. In 2005 your fad concerns are put to rest, but the share price has since gravitated towards $39 a share. This, you decide, is too much to pay. You decide to invest in Apple once the shares decline a bit, say to below $35 a share. How many shares will you buy in the next seven years? Exactly zero.

AAPL Prices
2003 $8
2004 $12
2005 $39
2006 $76
2007 $85
2008 $150
2009 $95
2010 $195
2011 $330
2012 $690

Of course AAPL is a very specific case, but the concept is not a necessarily bizarre one. For example, perhaps you have funds to invest every January and want to invest in Colgate-Palmolive starting in 2003. However, much like Apple, you decide that the $52 January share price is too high and you will wait to make a purchase once shares dip below $45. In precisely the same manner, you will not own a single share of CL.

CL Prices
2003 $52
2004 $52
2005 $52
2006 $55
2007 $66
2008 $78
2009 $66
2010 $80
2011 $80
2012 $90
Today $107

Sometimes one can become overly concerned with a specific price, rather than a specific company. It is overwhelmingly true that there are other applicable alternatives out there. However, there are only so many quality companies to go around.

Buffett's got My Back

Perhaps Warren Buffett, imaginably the greatest value investor of our time, can shed some insight into this ideology:

"Coca-Cola went public in 1919. The stock sold for $40 a share. One year later it's selling for $19. It had gone down 50% in one year. And you might think that's some kind of disaster. And you might think that sugar prices increased and the bottlers were rebellious and a whole bunch of other things, you can always find a few reasons why that wasn't the ideal moment to buy it. Years later you would have seen the great depression and you'd see World War 2, and you'd see sugar rationing, and you'd see thermal nuclear weapons, the whole thing. There's always a reason, but in the end if you'd bought 1 share for 40 bucks and reinvested the dividends it'd be worth about $5 million now ... And that factor so over rides anything else. I mean if you're right about the business, you'll make a lot of money. The timing part of it is a very tricky thing. So I don't worry about any given event if I've got a wonderful business ... You can figure out what will happen, you can't figure out when it will happen. You don't want to focus too much on when; you want to focus on what. If you're right about what, you don't have to worry about when very much."

Admittedly, I have previously used this example here and surely referenced to it elsewhere, but I believe that it has a variety of lasting implications. Of course a rational person with limited resources and an eye on beating the market cannot make the argument that "they don't care about prices." However, I would use this ideology as a proxy for one's investing mindset. First and foremost, we want to figure out which exact businesses we would like to partner with. If we can't figure that out, we shouldn't be in the individual stock selecting game anyway. Next it's paramount to consider what a fair price to pay might be. From there, we must understand that our predictions do not come from a crystal ball, but merely our imperfect calculations. Thus a humble appreciation for the process, i.e. building in conservative guesses, is essential. But we're not done quite yet. Even this "due diligence" can handicap the most prudent strategy. After all, I would much rather partner with Coca-Cola, Johnson & Johnson, Procter & Gamble and PepsiCo even at say 10% over my specific price points if my alternative is to hold a pillow case full of paper.

In the beginning of the article I made the statement: "don't care about stock prices ever." As you can now tell, that was used as a shock factor instead of an appropriate thought process; but it did lead us on the appropriate path. The true finding here is that we should consider the companies we want to own before we consider the prices that the market is offering. It can be easy to be drawn to a sale, whether the product is worth owning or not. But if nothing is on sale, we still eat; and if we're fortunate enough, we enjoy buying only the highest quality items. Be fortunate.

Disclosure: I am long MCD, PEP, JNJ, PG, KO, TGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.