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My 17-year-old son has a brokerage account where he invests a small amount of money he has received in gifts or earned from various activities. I let him pick his own stocks; the first thing he picked was Apple (NASDAQ:AAPL) which as everyone knows has done very well. I try to explain the benefits of dividend growth investing to him, but he prefers to invest in technology companies that he believes will grow quickly. Like most young investors, he is looking for stocks that go up fast. Last week I mentioned a dividend-paying stock to him and he responded by saying "I don't like to buy the same companies you do, they never go up." When I responded back saying, "Yes, they do go up," he then said "they only go up 10 or 20 cents a day."

Well he had me there, the stocks I own are large, mostly multi-national dividend-paying stocks and do not rocket up 80% in a year. Owning them, in most cases, is a slow grind, but I accept that because I know the dividend will increase every year and if the business is doing well the stock price will appreciate, assuming I did not buy the stock when it was overpriced. Unlike some dividend growth investors, I do want the stock price to appreciate. Although dividend growth is my main goal, stock price appreciation is also important to me. Therefore, it's critical I don't initially overpay for stocks.

In my early years of investing, when I decided I wanted to buy a stock, I looked around for some good prospects until I picked one and bought it. It took me years before I learned the approach that Warren Buffett described with this quote. "I don't look for 7-foot bars to jump over, I look for 1-foot bars I can step over." Like Buffett, I try to only buy stock in a company when the valuation is so compelling I am confident the downside is minimal and upside is almost assured. Opportunities like the one I just described are not common and thus I spend a lot of time window shopping, and little time buying. "Not buying" is my current status as I believe most (not all) dividend growth stocks are currently expensive and should not be bought by investors hoping for price appreciation. Buying dividend growth stocks that are overpriced can severely reduce returns.

I first turned my focus to buying dividend-paying stocks back in 2006 after reading Jeremy Siegel's book "The Future for Investors." In this book, Professor Siegel documented how slow growth dividend-paying stocks had over time outperformed faster growing stocks. Professor Siegel stated, "The constant pursuit of growth--through buying hot stocks, seeking out the next big thing, or investing in the fastest growing countries--dooms investors to poor returns." The reason faster growing stocks underperform is that they are, in most cases, overpriced. Like my son, most investors want to see the constant price movement up. The trouble with fast growing stocks is you have to overpay for the growth and at some point the fast growth stops. When the fast growth stops then the stock price falls and it can then take years for the stock price to find the proper valuation.

Like growth stocks, dividend growth stocks can also stretch their valuation and then take years to recover. Two popular dividend growth stocks are Proctor & Gamble (NYSE:PG) and Johnson &Johnson (NYSE:JNJ). Loved by many for their consistent dividend raises, the stocks in recent years have been a disappointment as far as stock price appreciation. However, each stock gave you a chance to purchase them when their value was historically low. The chart below shows the stock price history for both stocks over the last five years.

Proctor and Gamble

DateClosing Price
09/27/1269.06
09/27/1163.26
09/27/1061.04
09/28/0958.16
09/26/0866.75
09/27/0770.10

As you can see by looking at the chart, had you bought P&G stock in September 2007, you would be sitting with a slight loss after 5 years. However, you had an opportunity to buy P&G at relatively good valuation in September 2009. In 2007, P&G had a P/E ratio of over 19, which exceeded the industry average of 16.69. As shown above, P&G was a bargain in 2009 when it traded in the high 50s with a P/E of around 11. Today, P&G is again trading at a P/E of 19, which I believe is overpriced.

Johnson and Johnson

DateClosing Price
09/27/1269.61
09/27/1163.82
09/27/1062.03
09/28/0960.45
09/26/0869.40
09/27/0765.54

If you bought Johnson & Johnson five years ago, you would have seen almost no price appreciation. In 2007 JNJ had a P/E over 17 while the industry average was 15.50. JNJ like P&G gave you a small opportunity in 2009 to purchase it in the $60.00 range, which was a P/E of about 12. At times in 2009 the stock fell all the way down to the mid-50s. Today, JNJ is trading with a P/E of approximately 22, which I believe is overvalued.

The simple fact is JNJ and PG were either over valued or fairly valued in 2007 and buying them then was not the most opportune time to do so. Unable to grow their earnings to keep up with the high P/E ratio, the stock price has remained flat. Had your one and only concern been dividend growth, then buying them in 2007 would have been fine as both companies have continued to raise their dividends nicely.

Now let's take a look at a dividend growth stock that gave you years to purchase it at a reasonable level.

Altria (NYSE:MO)

DateClosing Price
March 31, 2008 (First day as a stand-alone company)22.20
09/26/0820.89
09/29/0917.50
09/27/1024.10
09/27/1126.42
09/27/1233.90

In March of 2008, Altria became a stand-alone American tobacco company when Philip Morris International (NYSE:PM) was split off from Altria. At the time, most of the analysis said investors should sell their Altria and buy Philip Morris as PM would have more growth and less regulatory and litigation issues. Investors did sell and Altria's P/E fell into the single digits in 2009. The stock price fell into the teens and stayed there for well over a year before finally beginning a long slow march higher in 2010. Today MO is trading with a P/E of 16, which may not be expensive, but cannot be considered cheap.

My son was correct when he said the stocks I buy, dividend growth stocks, do not have rapid price increases. Therefore, for the dividend growth investor like me, who also wants to see some price appreciation, it is critically important to purchase a stock at the proper valuation. Paying over 20 times earnings for a company growing earnings in the low single digits will lead to poor returns.

I spend a great deal of time researching stocks and the first thing I look for when doing my research is a business that is being run successfully and is sustainable. I also prefer companies that have little or no competition. When I find a company that meets my criteria, I then look at valuation. I like the companies to be cheap, which in all honesty, they seldom are. There are just not that many companies that meet my criteria, which I admit, are rather stringent. In most cases, when I find a company that meets my business criteria I put it on my watch list and monitor the price, while also monitoring the business. There are companies that have been on my watch list for years. An example of this would be Walgreen (NYSE:WAG). For years my portfolio had no healthcare-related exposure and with the demographics of an aging population I knew I needed some. I had researched and monitored several healthcare-related stocks, but had always liked WAG. My view was there are basically only two major drug chains in the country, WAG and CVS Caremark (NYSE:CVS). As the population grows older, more prescription drugs are needed, and thus more traffic in the store. Unfortunately, WAG was an expensive stock for quite a while before dropping in price due to the dispute with Express Scripts (NASDAQ:ESRX) and the purchase of Alliance Boots. In June, the price fell under $30.00 and the P/E was in the single digits, on June 22, I took a full position in WAG at $29.80 (see my article here). At that purchase price I am comfortable owning WAG for a very long time while I watch the dividends grow.

Everyone has heard the old line about real estate being all about location, location, location. Well, I like to think that dividend growth investing is all about valuation, valuation, valuation. With the Dow and S&P 500 substantially higher for the year there are very few bargains in the market and the valuation on most dividend growth stocks is stretched. At times like this patience is rewarded, stocks do not go up in a straight line, and at some point there will be a pull back, but if you have done your research and know what company you like, you may be able to pick it up at a much better price. Everyone loves a bargain; you just have to wait for the sale.


Sources: Stock price history; Stock valuation history

Source: For Dividend Growth Investors - Now Is Not The Time To Buy

Additional disclosure: My son is long AAPL.