3 Reasons To Dread Rising Stock Prices And A Few Potential Value Names

by: Brant Prewitt

"A substantial rise in the stock market is at once a legitimate reason for satisfaction and a cause for prudent concern, but it may also bring a strong temptation toward imprudent action." - Benjamin Graham, from The Intelligent Investor.

Traditional wisdom would suggest that to make money in the stock market, obviously share prices must go up. While this is not entirely untrue, it is also not an entirely wise line of thought. While increasing share prices certainly provide the opportunity to sell and book a profit (thus the satisfaction portion of the quote above), they also hurt the long term, truly diligent, investor in a variety of ways, not the least of which is the temptation mentioned in the above quote, which in itself could be a reason to wish for low stock prices other than those reasons we are soon to cover.

With the DJIA and S&P 500 indexes recently closing at levels not seen since making all-time highs some years ago, I feel it would be prudent to review some thoughts regarding market fluctuations and their impact on common investors. The following article draws on counsel provided by Benjamin Graham interspersed with additions by his biggest proponent Warren Buffett, with the intended purpose to curb excitement regarding our current markets and provide a basic understanding of the benefit of lower share prices for long term investors. It is my hope that understanding of the following concepts will help the average investor optimize the returns of their individual accounts over the course of a career.

Along the way, for optimism's sake, I will list a very short number of companies meeting a value screen criteria that may be worth a second look for the patient, hard-working investor. With this preface out of the way, here are the 3 reasons any diligent investor with a long time horizon should hate to see stock prices surging higher.

REASON #1 - There are fewer significantly undervalued companies to be found.

With broad gains in the prices of common stocks, such as we are currently seeing with the DJIA above 14,000 and the S&P 500 index above 1,500, fewer and fewer true values may be found among stocks of companies of substantial size and with strong current financial position. It is not my contention that all stocks are overvalued, simply that many, if not most, are at least fairly valued making it more difficult to find severe discounts.

I begin most weeks and in fact most mornings, by taking a look at the list of stocks at new 52 week lows, the biggest daily decliners in the S&P 500 index, and by running a simple stock screener in an effort to uncover a stock trading at valuations meriting a closer look through the financials. The screener has 5 simple parameters that serve as a very basic starting point in much of my further research:

1. Market cap of $4.5 billion or greater - while I am certainly often on the prowl for smaller companies than this trading at bargain prices, I like for my core holdings to be of a somewhat larger size assuming I am able to buy them at a discount. This helps insure liquidity of shares, makes it more likely that there will be information on the company to glean a well-rounded thesis from, and suggests that the company has had enough staying power to get to this valuation.

2. Current dividend yield of greater than 3% and usually not greater than 6% with some exceptions (such as Master Limited Partnerships, or in the case of severe undervaluation of shares to business prospects). In brief, this 3-6% range provides healthy cash return without sending up a red flag that the company is perhaps paying too much out in the form of dividends and has little better use for the cash, or that the dividend is at risk of being cut provided it is within a safe margin of normalized earnings.

3. Price to earnings (P/E) ratio below 15 for the normalized (average) annual earnings of the company. I typically like to go back at least 5, if not 10, years to average earnings for mature companies so that I have a good understanding of fair expectations for the company.

4. Debt to total equity ratio below 45%. While healthy debt levels can offer a means by which to invest in future earnings avenues, companies that become too debt-laden rarely fare well on a go-forward basis.

5. Price/book ratio of 1.4 or below. I make all of my common share purchase below book value. In fact, buying below book value and taking advantage of share buybacks and dividend reinvestment at these low valuations is the central theme of this article. However, having a list of companies to evaluate handy that are trading near book value is beneficial, as it prepares you to pounce should a market swoon bring solid companies to a Market Capitalization below their current Net Tangible Assets (i.e. book value- this value throws out goodwill, intangibles, etc.)

NOTE: (for my purposes I omit from this screen companies traded in China as I simply do not trust these stocks on an individual basis, and those traded on OTC or PINK sheet markets as they frequently have much less liquidity in terms of shares traded daily). Screen performed using Scottrade quotes and research tools, information verified and reviewed on Yahoo! Finance.

Now, this is just the starting block of my homework, but in the past it has typically provided a fair number of companies to sift through for opportunities

However, as of February 1, 2013 this screener yielded a whopping (sarcasm) total of 10 companies. Not exactly a laundry list of opportunities here. Furthermore, there is little diversity to this group. Of the 10, two deal in insurance businesses, three are involved in the oil and gas industry, two are in metals or mining, one in semiconductors, one in specialty glass and ceramic products, and one in communications. It would be impossible to create a portfolio of acceptable diversity from this list of 10, even if they were all great investment prospects, a coincidence I find to be unlikely.

As our aforementioned Benjamin Graham said in The Intelligent Investor -

A stock does not become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years.

The following chart demonstrates the 10 findings from the screen for any who may wish to dig deeper. Bear in mind this is no recommendation to buy any of those listed here, just a demonstration of the scarcity of companies near book value in current market conditions, which is reason number one I hate to see markets at their highs.

Symbol Price/Book Ratio P/E ratio (trailing 12 months) Debt/Equity Ratio Dividend Yield current
Aegon N.V. (NYSE:AEG) 0.33 10.04 38.97% 3.1%
BP plc (NYSE:BP) 1.2 8.10 41.32% 4.9%
Cincinnati Financial Corp (NASDAQ:CINF) 1.29 19.5 17.39% 3.8%
Eni SpA (NYSE:E) 1.19 9.31 39.82% 4.5%
Nippon Telegraph and Telephone (NYSE:NTT) .5 8.83 41.96% 4.6%
Royal Dutch Shell (NYSE:RDS.A) 1.18 8.36 19.88% 4.7%
Ternium S.A. (NYSE:TX) .81 9.38 33.67% 3.2%
United Microelectronics Corporation (NYSE:UMC) .70 19.5 23.26% 3.0%
Vale S.A. (NYSE:VALE) 1.29 9.02 38.49% 3.1%
Corning (NYSE:GLW) .82 10.36 16.06% 3.0%

Of these 10 stocks, I will personally cross off 4 from my list of pending detailed homework automatically for the following reasons:

Eni SpA has a current ratio below 1, indicating they are having a hard time meeting current expenditure obligations at this time.

Aegon was forced to suspend its dividend altogether from 2008 through 2012. I do not invest in companies with that kind of record unless there has been a clear turnaround. This may well be the case, but I would prefer to find companies with a better dividend track record.

I will omit Cincinnati Financial from my personal studies as 61% of the company is institutionally owned, which often results in wild rides for share holders much to my distaste. They also have a payout ratio of 72% which may make it challenging to grow the dividend, and only managed to grow their quarterly dividend by 1.2% this past year (and little more than that in recent years). I would have to be proved they will accelerate earnings and dividend growth to commit money or time to the company.

Finally, I will cross off Vale S.A. as it showed revenues decreasing 18.8% in the most recent quarter, and earnings contracting an even more appalling 57.8%. I have done no digging into the company as yet, but there are few scenarios in which this could be viewed as positive.

This leaves us with six companies remaining, and interestingly enough, at first glance each looks to merit a deeper study.

1. BP - This integrated oil company was forced to cut its dividend in half with the disaster in the gulf a couple of years back, but the shares look to have dropped correspondingly and recently it has been growing the dividend payout, with this year's growing 12.5% over last.

2. NTT - This is a large telecom company based in Tokyo, Japan. NTT generated almost $30 billion in operating cash flows over the last 12 months compared to a market cap of slightly less than $52 billion. The dividend looks safe with a payout ratio of only 40% according to Yahoo! Finance data. Additionally, the dividend payout has grown by 25% since 2010. With the current dividend yielding 4.6% and shares trading at half of book value, I will certainly be doing more homework here, but I will have to be truly convinced it has better business prospects ahead of it than our own telecom giants Verizon (NYSE:VZ) and AT&T (NYSE:T) who sport similar yields before I would own the stock. For a more comprehensive look at the stock, take a look at a fellow Seeking Alpha contributor's thoughts here.

3. RDS.A - This worldwide oil and gas company has shown a consistent track record of modest dividend growth as demonstrated here, though the payout has only grown 19.44% since 2007 (hardly an impressive average annualized increase).

4. TX - This Luxembourg, Germany steel products producer has increased its dividend 50% since 2010, and still sports a payout ratio of only 30%. Combine that with the fact that it is trading at a 19% discount to book value and you have a good reason to dig into the 10-K's and quarterly reports and conference calls for a second look, or even third. This may even be an interesting play for a European economical recovery.

5. UMC - This is a relatively small microelectronics company, which I have universally avoided in my investment years. This company has a rather inconsistent dividend history, however it currently has more cash than long term debt on the balance sheet and is trading at a 30% discount to book value so, again, I'll be diving into the financials in detail in coming days.

6. GLW - Corning's business lies almost entirely in the glass industry, making glass for LCD TV's, special glass products for phones and tablets, products for the life sciences, etc. The company trades at nearly 20% discount to book value, has been increasing the dividend at an accelerated pace, and returned $1.5 billion to shareholders in the form of repurchases last year shrinking the share count by roughly 8%. They are putting their money where their mouth is, and I believe this stock warrants an investment at this level. I outlined more comprehensive thoughts on the company here. I believe this stock is exhibiting the opportunity to take advantage of the remaining points to be made in this article.

Admittedly, a couple of these 6 stocks may provide worthwhile buys at or near these levels though I will all but guarantee not enough of them to create a diverse portfolio of significantly underpriced holdings. There are also sure to be stocks not pulled up under this screen criteria that would also probably provide good value. But the fact that there are so few discounted stocks returned by such a conservative screener highlights the thesis for my first reason to dislike markets at the highs - there are simply far too few severely discounted, viable companies available in which to put cash to work via common stock purchases.

REASON #2: Dividend yields shrink with rising share prices, and therefore the benefit of compounding derived from reinvesting dividends is lessened with each uptick in a stock's price.

If the investor wishes to hold a company for a long period of time, which he should wish to do with good companies' shares, he should wish for two things: first, that the company will maintain solid performances for years to come, and second that share prices will languish such that dividends can be invested at more attractive rates to maximize compounding effect.

Take a look at the following table summarizing the time it will take your money to double, triple, or quadruple through simple reinvestment of dividends - keep at the forefront of your mind that this table assumes constant share price and consistent dividend disbursement (I.e. no change in share price, or the change in the dollar amount returned to shareholders via dividends). As a large percentage of dividends are paid quarterly, this table assumes dividends disbursed and reinvested on a quarterly basis.

Dividend Yield: Time to double (years) Time to triple(years) Time to quadruple (years)
3% 23.19 36.76 46.38
4% 17.41 27.60 34.83
5% 13.95 22.11 27.90
6% 11.64 18.45 23.28

As you can see, the difference in a percentage point of yield via dividends can make a significant difference on the appreciation of your holdings. At higher prices, fewer solid companies yield at the 5 or 6% level, providing less opportunity for creating long term gains.

So what happens if you already own the shares when share prices go higher? Well, if the dividend payment doesn't increase by a corresponding amount, the yield shrinks (though you should always strive to identify companies with consistent dividend growth that looks to continue). You are able to buy fewer shares when this dividend is invested, your compounding effect slows down, and your total investment is worth less over the course of the holding's lifetime unless the share price maintains its high value and climbs high enough to offset lost income. While I admit that is a possibility, investor enthusiasm often precludes us from selling when the share price has indeed offset lost income and market fluctuations frequently bring our share price back down. Then we have missed both boats, and are left on the bank with fewer shares and less position value.

*As a side note, I would not wish for you to take my math for the above chart on faith alone, lest I make a mistake, so for demonstration purposes the following served as the formula which generated these numbers.

FV=P(1+(r/4))^x ---- then divide the results by 4. (the equation yields the number of quarters it would take to reach the desired mark, for example doubling or tripling. Dividing by 4 again returns the answer to a value noted in years.

FV - is the future value of the position.

P - is the original investment, or principal

R - is the dividend yield (which has been divided by 4 for quarterly compounding purposes)

Simply solve for "X" to determine the number of quarters it would take to reach "FV", then divide the answer by 4 to come to time in years.

I have included this, as I'm sure some careful or skeptical readers will wish to check my numbers. A simpler method to estimate the time it will take an investment to double is to use the rule of 72. Simply divide the current yield into 72 for a decent estimate. Examples: 72 / 6% equals 12 years to double, fairly close to the demonstrated 11.64 from the chart above, or 72 / 3 % equals 24 years to double, fairly close to the 23.19 in actuality demonstrated above again.

Forgive this rambling, and allow me to summarize: Rising stock prices detracts from compounding effect of reinvesting dividends, which reduces future earnings and ownership percentage of the company for the long term investor.

REASON #3: Share buybacks are of less benefit with shares higher rather than lower.

Let us take a closer look at a hypothetical company here, one which we have already done diligence on and found to be a good value. For entertainment's sake I will call the fantasy company "ShareholdersDream". We will assign some nice round numbers to its example for simplicity's sake:

Fantasy Market Cap = $1,000,000
Fantasy price per share = $10
Fantasy total earnings this year = $100,000
Fantasy number of shares outstanding (fully diluted of course) = 100,000
This gives us a nice round P/E of 10.

Let us assume that you have purchased a reasonable 1,000 shares costing you $10,000. Congratulations, you own a nice round 1% of a solid company.

Now let us assume that the company has stated in certain terms that it will spend $50,000 annually for 6 years repurchasing and retiring shares to increase remaining shareholder value. Which do we want, a higher price or a lower price for our shares if we do not intend to sell before the 6 year repurchase period is up or for long after for that matter? A couple of quick (exaggerated for emphasis) demonstrations give us the answer.

Scenario 1: The stock price does not move at all - it remains exactly $10/share for 6 solid years. In 6 years the company has spent $300,000 on share repurchases, retiring 30% of the original shares. There are now 70,000 shares outstanding, you still own 1,000 but those shares now give you 1.43% of the total company, and you haven't spent a single dollar extra out of your pocket.

Scenario 2: The stock price goes up on the announcement of the big share repurchase, now averaging $15 per share for the 6 year repurchase period. The company spent the same $300,000 on repurchases, but was only able to retire 20,000 shares. You now own 1,000 of 80,000 shares or the equivalent of 1.25% of the company, less than you would have owned if the shares had simply stayed put at $10/share.

Scenario 3: The stock price drops to an average of $5 per share thanks to a prolonged bear market. However, our company has performed consistently well in the face of tough economic conditions, and has spent the same $300,000 on repurchases. In this scenario, 60,000 shares have been retired meaning you now own 1,000 of 40,000 shares remaining or 2.5% of the company, significantly more than you started with! 2.5x to be exact with this example. This means that if the company simply maintained its earnings it began the 6 year period with, your owner earnings would be $2,500 dollars rather than $1,000 dollars they started as.

If you were a truly sage investor, in Scenarios 1 and 2 you were also reinvesting dividends paid at attractive share prices in addition to the buybacks the company was undertaking. You have now increased your percentage of future company earnings you own as a shareholder or partial owner of the business, all without having taken out your checkbook once.

To summarize this last point: You benefit vastly more from share buybacks if the stock remains depressed, or at least fairly and conservatively valued than you would if the share price rises due to optimism or enthusiasm. Please do not take my thoughts on the subject of share buybacks and stock prices at face value. Take a look at the great Warren Buffett's example using his real life ownership of International Business Machine (NYSE:IBM) stock, found in his 2011 letter to shareholders.

For perhaps a more competent summary, and certainly a more experienced and successful one, allow this quote to drive the point home:

The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

- Warren Buffett

I do not expect all who read this article to agree with and apply this reasoning. Many people in the investment world have a bent towards utilizing their intelligent minds activity towards trading or other options in an effort to make a quicker buck than this method provides. However, I hope this article appeals to the patient, diligent, investor, and demonstrates that languishing stocks over a course of time is not inherently a bad thing, and rapidly rising stock prices are not inherently good things.

In other notes, I realize the numbers dealt with here, specifically pertaining to dividends and doubling or better investments, do not take into account taxes. Tax effects were omitted for simplicity's sake, and for that matter as this article is intended for longer term holdings, readers may derive the demonstrated results in tax beneficial retirement accounts of one form or another.

In conclusion - Buying and holding (or continuing to own) persistently undervalued companies, and adding to your position via dividends reinvested or share buybacks at these persistent discounts, gives rise to opportunities of capitalizing on the increased ownership in the future in multiple ways. At some point the company could be a takeover target, which would surely require the purchaser to pay at a minimum fair book value for the company. Or the public can finally realize the value of the company and bid the shares up to fair or possibly greater value. Either way, you have benefited by allowing your ownership percentage of the total company to increase via buybacks or dividend reinvestment at prices more advantageous to you. Higher share prices would have precluded you from this benefit.

All thoughts on the benefit of lower share prices in this article are discussed within the intended context of a business whose earnings are not deteriorating due to poor management, or business headwinds that are unlikely to subside. In the presence of continued and ongoing business success, declining share prices provide great opportunities and owner earnings enhancement. However, in the presence of deteriorating businesses, no levels of share declines justify owning a declining and persistently challenged or poorly run business. Investors should always decide which of these two scenarios the companies they hold or observe are in before acting to either buy, continue owning or accumulating, or sell shares of any company.

These concepts are outlined for the True Investor's benefit, which Benjamin Graham describes as one whose "primary interest lies in acquiring [AND] holding suitable securities at suitable prices."

Thanks for reading. Please let me hear all opinions, commentary, and insights.

Disclosure: I am long GLW. 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.