Why Do Dividend Growth Investors Like Price Pullbacks So Much?

| About: The Coca-Cola (KO)

In a recent article by David Van Knapp, "Which Popular Dividend Stocks Are Always' Overvalued," the author presents 59 Dividend Growth Stocks and views them through the window of a valuation tool, F.A.S.T. Graphs. He points out that this group of stocks seem to always be selling at valuations that are mostly on the high side of things.

The comment stream on this article has been very interesting and for the most part, very thoughtful. One comment in particular caught my attention, though. It was written by a person who questioned one of the more frequent notions expressed by many DG investors. Here's what that comment said:

All you Dividend Growth Investors that claim you love it when stock prices go down so you can buy more are getting what you wished for. I never want my stocks to go down in price no matter what.

Something to Consider

Stock prices go up and they go down. If I own a stock at a cost of $35 dollars a share and the stock goes up in price to $45, I have a paper profit (unrealized gain). Unless I sell my stock at $45 a share, I will not realize that profit. If I do sell the stock and it continues to go up in price, then what?

That same stock that rises to $45 a share experiences bad market day. The price drops to $40 a share. Did I lose money? No. I lost an unrealized gain.

Now with the stock priced at $40 (which is a pullback) does it represent a buying opportunity? Maybe, maybe not. It really depends on what my investment strategy is.

Based on my own metrics of value, I purchased the stock at $35 and based on my investment strategy [DG] the fundamental reasons for having bought it in the first place are still in place. That is an income stream that will grow year over year.

I might have a value range for this stock that is between $35 and $45 dollars. So a price of $40 with no real breakdown in fundamentals, but only a market glitch, may just make $40 a good place to add even more shares to my account.

What I Know:

Dividend Growth Investing is practiced by a very diverse group of people. While there is no definitive standard for the strategy, I think that many investors who are not familiar with the strategy or who want to learn more about it by spending some time reading Lowell Miller's book, "The Single Best Investment" to become familiar with the thought process behind the concept.

All too often, it would appear that many investors who are not familiar with the strategy and the concept of investing for dividend growth make a lot of assumptions that are off target.

That's not because they want to be contrary about DGI, but more from what I believe is a lack of understanding about the strategy itself. Let's take a look at how I approach DG investing and see if I can illustrate a few points about the strategy.

What You Should Know

My first goal is to find stocks that are priced at a value to intrinsic worth. Now one might argue that valuation is a subjective exercise. I would tend to agree with them. However, over time, an investor finds a methodology for addressing valuation and when that methodology produces positive results, the average investor tends to stick with that particular methodology. If that methodology is not working then you might need to make some adjustments.

As I become more comfortable with making decisions based on my particular set of criteria used for evaluating stocks, the method tends to become more objectified. In November of 2012, I made a purchase of Safeway (NYSE:SWY) at $16.50 a share. To my criteria, SWY was priced at a value at that price. I also purchased Western Union (NYSE:WU), CA Technology (NASDAQ:CA), Staples (NASDAQ:SPLS) and CSX Corp (NYSE:CSX) at that same time.

My second goal is to find companies that have paid dividends for a long period of time. Now my own methodology allows for the purchase of companies that have a dividend payment history of at least 5 years.

The 5-year history is not, in and of itself, a deal breaker. Sometimes a company will have a more limited dividend growth time frame and that's ok. That stock might very well become a Dividend Challenger (a company with that 5-year history) soon enough.

At the same time, this goal of a 5-year history, does not prevent me from buying companies with a 3-year dividend growth history, especially if the company is priced at a value. In the example given above, Western Union and CA Technology both had dividend histories that were less than 5 years, but both can become part of the Dividend Challenger list very soon.

My third goal is to find companies that have been increasing their dividends at a rate that is historically greater than inflation. Why is that important to me?

Since I am attempting to create an income stream that will increase annually, in order to fund my retirement years, I want a Dividend Growth Rate [DGR] that stays ahead of inflation.

By the very nature of portfolio building and using valuation as an entry point, there are going to be stocks in my portfolio that grow their dividends at different rates. Addressing those companies that fail to meet my metric of exceeding inflation would make a stock like AT&T (NYSE:T) one that I might be keeping an eye on and perhaps eliminating it from the portfolio at some point in time.

Points to Consider

Now as a long term investor, there are companies that I have owned for a very long time. There are also companies that I have not owned very long, like the ones previously mentioned.

If I am going to make the decision to add to an existing holding I want that stock to be priced at a value. That means that sometimes, I won't be adding to that holding except through dividend reinvestment. That's ok. In keeping with my initial strategy (buying at a value) these existing holdings may or may not be priced at a value to intrinsic worth.

So a pullback on that company's price may present a buying opportunity to add to my existing position. If I own a particular company and I am wanting to complete my position in that company I may be better served if and when that stock "pulls-back" from current pricing levels.

If one of my metrics is a PE below 15 for example, doing the math to arrive at a price that would give me a PE below 15 is not all that difficult. The same is true with other metrics that an investor might use, such as price to sales, price to book, etc.

Coca-Cola (NYSE:KO), for example is a company that I've held since 1984. While I have a full position with this company, my wife's Roth account did not have a position in KO. With the recent pullback in price and the corresponding dividend yield point exceeding 3%, KO seemed to be priced at a point where adding it to her portfolio made sense. A pullback taken advantage of.

That brings us to the second notion concerning pullbacks. If you don't own a particular company, but want to have it as part of your portfolio, buying it at an overvalued price does not always serve you very well.

On the other hand, buying on a pullback and having an entry point at a value point relative to the true worth of a company is a pathway to success.

I don't recommend stocks for people to buy. I write articles about my different portfolios and share what companies I am looking at and which companies I am purchasing. If someone reading one of my articles decides to purchase stock in a company that I mention, I would hope that that investor would do their own due diligence before following my lead. Right now, I find that oil refiners are beginning to look attractive. I've recently purchased Holly Frontier (NYSE:HFC) and I am watching Marathon Petroleum (NYSE:MPC) and Phillips 66 (NYSE:PSX). I have also been watching fertilizer companies and have been looking at Potash (NYSE:POT), Mosaic (NYSE:MOS), and Agrium (NYSE:AGU).

Summary and Conclusion

But, don't forget that if a particular company has gotten ahead of itself, even with a pullback, it might not be at a value point that would indicate a "buy" point.

Know where the "price" needs to be, in order to meet your own standard of value and be content to wait on your stock to reach that price.

Remember, buying Coca-Cola on the recent pullback accomplishes a number of things for me. First, I bought a great addition to my wife's portfolio. Second, I bought a company that yields 3% at the price I paid for it. Third, I bought a company that has a 51 year history of paying and increasing dividends. Fourth, I bought a company that has been increasing those dividends at a DGR of 8% for the last 1, 3, 5, and 10 year periods.

Do I like pullbacks? You bet I do.

Disclosure: I am long KO, CA, WU, SWY, CSX, SPLS, PG, WMT, KMB, CL, JNJ. 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.

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