Time In, Not Timing Dividend Growth Stocks

Includes: AAPL, CL, JNJ, MCD, SPY
by: Eli Inkrot

"All-time high after all-time high", "More than 100 S&P 500 companies hit record highs" or perhaps more to the point: "When will the streak end?!" That's just a sampling synopsis of the last three articles that I happened to skip over. I don't know about you, but personally I'm a little bit sick of the latest "all-time" hype. Although it occurs to me that regardless of the situation, I've never been a fan of the short-term flimflam. (Read: constant price bantering and immediate price prognosticators) Rather I like to view investing as: "delaying gratification today in the rational expectation that I will have more purchasing power adjusted satisfaction in the future via finding wonderful businesses that I can understand, partnering with them at reasonable prices, monitoring them through the years and remaining with them as long as they continue to adequately compensate me." Other than that, I can't tell you what will happen in the next 5 years, much less next month. I've used this example before, but I believe thinking about a local business helps crystallize my view on short-term price fluctuations:

"I always think of this like owning a small hometown business, say a local pizzeria. When putting the stock market into this context, I imagine perhaps 10 customers happily enjoying your pizza product while 100 more people pack-in and constantly yell to you what they would be willing to pay for your business at any given moment. Some of them would judge their bids on how content a single customer or two appears; others on the amount of foot traffic that walks by your store front that day and the vast majority would base their bids on what the rest of the group is yelling."


Let's get back to the "52-week/all-time high" thought for a moment. First and foremost, I would at least like to indicate the obvious: inflation and businesses make more money. Prices will continue to rise and firms will continue to make more profits; that's simply the rule of the economic game. And while the path is neither continuously ascending nor linear, in the very long-term prices generally have to trend upward. Thus, a 52-week or even an all-time high isn't so much a surprise as it is a notable inevitability. In fact, by downloading the historical prices of the SPDR S&P 500 ETF (NYSEARCA:SPY) from Yahoo and then combining this with an "excel IF statement," I count no less than 480 times that this particular proxy hit a 52-week high in the last 20 years. If you ask me, something that occurred roughly twice a month on a wide average basis for two decades is nothing to text home about. It should be noted that I didn't include dividends or inflation, but that's my point: neither does all of this 52-week high hoopla that we're hearing. Additionally, I'm overwhelmingly confident that we will continue to see new highs through the years just as we'll see it being reported as "news."

One way to get around this sensational ideology -- other than simply focusing on long-term business partnerships -- is to concentrate on a rising stream of income through time; otherwise known as "dividend growth investing." Even this, I will profess, has its hang-ups with regard to being sensitive about prices reaching new highs. After-all everyone wants to "buy low and sell high" or at the very least, "buy low." However, I believe the income component adds a stabilizing force to the rationale. Allow me to set the stage for a thought experiment. Now, as described, I have no idea what's going to happen in the near future. But let's say that you have the option of investing capital today or waiting a year to see what happens. Our goal is to obtain the most income moving forward and we're constrained to investing today or in one years' time with the understanding that the upcoming "aggregation vehicle" example is a proxy for an abundance of investing decisions at our disposable. In addition, we'll think about the dividend payouts in singularity much like one would do with a CD. I'm guessing I'll lose some of you by disregarding capital appreciation, but I suppose that's the nature of a simplifying thought experiment.

Let's keep things simple. For this thought experiment, we'll assume that you can buy a $100 per share dividend growth stock that pays a $3 dividend and is expected to grow this payout by 8% for the foreseeable future. While many specific examples come to mind -- actually McDonald's (NYSE:MCD) is pretty close right now -- we'll simply assume that this is an "aggregation vehicle" such that the dividend growth universe is contained in this one aggregation. In reality, I don't think that these assumptions are all that uncharacteristic. In addition, you have $1,000 to invest and the pleasure of ignoring frictional expenses. Here's what your income would look like for the next 5 years if you bought today:

Action Year 1 Year 2 Year 3 Year 4 Year 5
Buy Today $30.00 $32.40 $34.99 $37.79 $40.81

We see that the first year of payouts equals $30 (($1,000/$100)*$3)) and grows at 8% each year. In total, these payouts aggregate to $176 after 5 years. (We won't bother with reinvesting or TVM calculations, either.) On the other hand, instead of investing your $1,000 today, you also have the option of investing $1,000 in exactly one year. Now obviously, in reality, you have many more options, but remember, this is just a thought experiment. So what does the price of the aggregate dividend growth proxy look like in one year? I have no idea. But to continue this example, let's say there are 5 possibilities: a large decrease in price, moderate decrease, same price, moderate increase or large increase. For those respective scenarios, we'll say that the possibility of each is equal and that the corresponding values are as follows: $85, $95, $100, $105, $115. What do these income streams look like? Glad you asked:

Outcome Price Shares Year 1 Year 2 Year 3 Year 4 Year 5 Total Dividend
Large Decrease $85 11.76 $0.00 $38.12 $41.17 $44.46 $48.02 $171.76
Decrease $95 10.53 $0.00 $34.11 $36.83 $39.78 $42.96 $153.68
Same $100 10.00 $0.00 $32.40 $34.99 $37.79 $40.81 $146.00
Increase $105 9.52 $0.00 $30.86 $33.33 $35.99 $38.87 $139.05
Large Increase $115 8.70 $0.00 $28.17 $30.43 $32.86 $35.49 $126.95

Here we see $0 in the first year, as we're holding cash. Technically you would have interest income, but we'll say it was kept "safe" under your mattress. With the first two outcomes, one is able to buy shares cheaper in a year and thus the total dividends paid are higher. The third outcome is precisely similar to the "buy today" scenario except that one does not receive dividends this year. Finally, in the last two outcomes, one is able to buy fewer shares and consequently, has lower dividend payments going forward. If we look at the total dividend income over 5 years, we see that buying today provided the most income. If you believe that each option has the same likelihood, then we find an expected aggregate value of $147.49 over half a decade. Now obviously, some qualifiers need to be made. Moving forward, buying at the lower price will always provide more income over the very long term. In fact, in this example, the large decrease in price to $85 a share results in aggregate dividends beating the buy today scenario in year 6; likewise, the $95 price in one year results in -- nominally -- more payouts after 14 years. It should be noted that with time value of money calculations, the true effect would take a bit longer, but it should not be discounted that buying at a lower price eventually beats buying today. Accordingly, the other three outcomes would always lag the dividend income of buying today.

But here's the interesting part to me: I profess no special knowledge in determining what the market will do, especially in a year's time. Yes, we've hit 52-week and in some cases all-time highs, but as established earlier, that's somewhat of a common and required occurrence. Clearly, I would rather buy at a lower price than today, but I can't tell you if that will happen in a year or 5 years. Given that we gave equal weightings to each scenario, here's the basic range of outcomes that resulted: nominally beat buying today in 6 years, nominally beat buying today in 14 years, always lag today by a year's worth of dividend payments, always lag by more than a year's worth of payouts and always lag by a wide margin. In other words, within the framework of this thought experiment and without professing special knowledge, there are 2 "good" possibilities and 3 "bad" possibilities. Thus rationally, one would favor buying today rather than buying in a years' time. Or in Warren Buffett's words: "Since the basic game is so favorable… the risks of being out of the game are huge compared to the risks of being in it."

Of course, some of you out there are saying "Yeah, yeah. I get the math and the assumptions, but I can see that prices are high right now and they will go down, so I'll wait and see." And to be perfectly frank, I don't altogether disagree with you: I too believe that prices will eventually be lower. I just can't tell you when. Thus, it follows that not only do you have to believe in your ability to predict the short-term, but you also have to believe it such that the probability of your favorable outcome (in our case the 40% attributed to the $85 and $95 prices) outweighs the probability of a negative outcome (the 60% leaning towards the $100, $105 and $115 prices). Perhaps you can justify that, but then again, perhaps you're only marginally sure prices will be lower in a year.

Finally, one must consider their timeframe within this framework. If, for example, you had a 100% conviction that prices would drop to $85 in one year but you had a 5-year timeframe, then the best income move would still be to buy today. Likewise, if you had a 13-year time horizon, you would have to be overhwelmingly sure about the lowest price in a year to counteract the possibility of being wrong. It's interesting to consider that if you think prices are high today, and thus you would rather wait, then the absolute worst thing to happen is for an ongoing up-market to occur. I like to think of this in the context of Colgate-Palmolive (NYSE:CL) or even Apple (NASDAQ:AAPL) if you want. If you thought prices for these two securities were too high in 2003, and that you would just wait until they came down before you bought, then between 2003 and 2012 you would have bought exactly zero shares. They have since far exceeded those prices, not once stopping by in nine years to say hello. Waiting for quality to become cheap can undermine even the most astute strategy. Personally, I would rather own say Johnson & Johnson's (NYSE:JNJ) Listerine at a fair price, then I would a liter of sewer water, no matter how cheap. Quality rarely goes on sale. Or as Buffett frames it: "It's far better to own a portion of the Hope diamond than 100 percent of a rhinestone."

I agree that a plethora of simplifying assumptions were made. Omitting capital appreciation is likely the main one, but I will grant that there are surely dozens more. However, given that one is inclined to covet a growing stream of income over time, I merely wanted to showcase the idea that the amount of time that you partner with a wonderful company could theoretically be as important as getting the correct price. Without question, when you go about your investing decisions, "price is paramount." But I would merely consider the idea that delaying your partnerships might not provide the best outcome, even if you happen to be correct about today's prices being too high.

Disclosure: I am long JNJ, MCD. 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.