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Value, growth, portfolio strategy, dividend growth investing
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Background

My retirement portfolio has another fifteen years or so to grow and develop, and is the key factor determining when or if I'll ever be able to retire. I've been reading Seeking Alpha now for over two years, and have become convinced that owning great dividend growth stocks will be key for my retirement goals.

Over the years, my investments have evolved (or devolved) from stocks of companies where I've worked (F, XOM, HON, etc.) to DRIP stocks through an investment club, to trendy mutual funds, to low fee index funds, to a mix of index funds and ETFs. Like many here at Seeking Alpha, I've found some great advice from the likes of Carnevale, Knapp, Fish, and too many others to name, and have now converted my legacy mutual funds, miscellaneous stocks, and ETFs to a portfolio of individual stocks.

I've adopted a hybrid dividend growth (DG) strategy to building my portfolio. My portfolio has both core holdings comprised of dividend champions to hold into retirement, and what I call non-core (for lack of imagination) holdings that still tend to be dividend payers, but may have a higher risk and growth profile. As I approach retirement, I'll continue to add to the core portion of the portfolio, and reduce the size of the non-core holdings. I have some great core holdings, many of the usual suspects, but in smaller allocations than I'd prefer, and there are many more on my watch list that I've yet to buy. Put simply, many of the best DG stocks that I'd like to own long term are trading above what I consider to be fair value.

Reasons for conducting this analysis

This got me thinking about entry point for stocks we plan to hold for a very long time - does the purchase price really matter? If I buy shares of Costco (NASDAQ:COST) today (figure below, courtesy of FAST Graphs), a great company on my watch list, above fair value, reinvest the dividends, will it really matter in 10 to 15 years? Perhaps in the end, time will wash away or help conceal today's bad decision to pull the trigger at a price too high? Or perhaps not. Maybe I should be patient and continue to monitor the stock for next year or more, and wait for a better valuation.

(click to enlarge)

I'm sure that it matters (buy low, sell high and all), but perhaps time will mute the effects of entry point prices. I tend to be impatient once I decide I'd like to own a stock, so I went into this hoping to see very little difference in return over a ten year or longer hold period - then I could just load up on all my favorite stocks now, regardless of valuation!

Analysis

In a "hat tip" to David Van Knapp, I decided to use real prices and dividends from an actual stock vs. artificial spreadsheet analysis (though I still found a way to use some cool spreadsheets). With Chuck Carnevale's FASTGraphs tool, I started reviewing historical price trends for various stocks I own, with an eye out for a stock that clearly fluctuated above and below fair value, at least ten years ago. I also wanted a dividend growth stock, and a stock valued by the market at roughly a PE = growth of 15.

I found a likely candidate in General Dynamics (NYSE:GD). Looking at a FASTGraph going back 18 years, GD's share price exhibited just the type of movement I was after:

(click to enlarge)

GD's historical PE ratio paid by the market is 15.2, an almost perfect fit to the orange fair value line of 15 x earnings over the company's history. Furthermore, during the area of focus in the circle, the price oscillated nicely above and below fair value over a five-year period - great for my entry point analysis.

Zooming in on the area of focus, I've listed the prices and dates for five points of interest along the share price curve, each roughly one year apart:

(click to enlarge)

Using the orange line as my fair value at each of the points, I then calculated a fair value for each of these points, and % of overvaluation or undervaluation that each exhibited. The valuation % versus fair value is shown in this figure:

(click to enlarge)

For each case above, I created a dividend reinvestment spreadsheet using actual dividends, dates, and close prices on those dates. I reinvested the dividends on the day they occurred, and continued the exercise until October 3, 2012, the date of GD's most recent dividend payment. The spreadsheet for the "at fair value" case (case #3) is shown here for reference (click to enlarge):

Running this analysis five times, once for each of the buy points discussed above, resulted in the following summary data which include total value of the investment, annual income, compound annual growth rate, and yield on original cost:

From these data, I make the following observations:

  • Entry point (price) does matter.
  • Buying below fair value really helped long-term returns in this example.
  • Buying below fair value = more shares purchased = more dividends, growth and income!
  • In this example, buying above fair value didn't "wash out" over time - it depressed returns for the entire holding period. If the stock were held for another 20 years, and the price appreciated 10 fold, then the differences in return would be very minor. But for me, with a time horizon below 20 years, entry point really matters.
  • As a comparison of Case 1 to Case 5 shows, waiting several years for an undervaluation situation to occur seems to trump the time effect of buying above fair value sooner.
  • Dollar cost averaging into these positions was not considered (perhaps a future article). It seems to me that DCA would work well as prices are dropping, but not so well while prices are rising. I tend to avoid averaging into a position if I feel the stock is trading at a discount.
  • The S&P return from the case 1 entry point to October 3, 2012 resulted in a compound annual growth rate below 1%! So the GD purchase, even at a high valuation, still beat the S&P over the same period by a wide margin.

Summary

I believe in buying stocks only when they are below fair value, and this analysis reinforced my conviction. Undervaluation leads to better total returns, less risk, more dividend paying shares, and more income down the road.

With advances in information technology; the internet, myriad financial websites, FASTGraphs, David Fish's CCC list, etc., it has become very simple to quickly identify stocks that are priced below fair value. The next time I have my heart set on a particular stock - a "must have" for my portfolio, I'm going to take a deep breath and wait until the stock trades at or below fair value - years if necessary, or deploy the money elsewhere. With the excellent tools available to individual investors today, there is no (logical) reason to overpay for a stock.

Source: Does Entry Point Matter To A Dividend Growth Investor?