Buying solid dividend growth companies at reasonable and discounted valuations is the main strategy I use to secure my financial future. With the market hitting highs, it's getting increasingly difficult to find companies which I want to own for a growing stream of income.
Although working full-time, I have limited funds set aside from my day job for investing each month. I always find I'm short on cash to invest. Looking at my past experience, I have learned to be more patient. For example, I've bought some Target (NYSE:TGT) shares when it was fully valued and hitting its normal P/E of 18.5. At the time, I was thinking that Target is a high quality discount retail with an 'A' S&P credit rating, and a long dividend growth history, such that I was willing to pay the premium price to own some shares. Its dividend growth rates are as follows:
- 1-year: 19.7%
- 3-year: 23.4%
- 5-year: 21.4%
- 10-year: 19.8%
(source: David Fish's Champions, Contenders, and Challengers list of May 2014)
They are consistently in high teens to low twenties range.
Looking back, I needed to work on my patience more and only buy at least in the fair value range, which it is at currently. This is supported by Morningstar showing Target has a forward P/E of 14.4, while its 5-Year Average P/E is 14.9. The greatest headwind for Target is its expansion into Canada. If you believe it will work the kinks out, then, Target will grow earnings at a faster rate than it has been.
Looking at the graph showing the last 5 years plus forward looking up to the end of 2015, we see that Target grew earnings at 5.8% annually.
On the other hand, the next 5 years, analyst consensus estimates Targets earnings growth at 12.2% annually.
Luckily, I only bought a sliver of Target shares at full valuation, and I will be dollar-cost averaging into it until it reaches a full position in my portfolio, which is currently about 5% of the portfolio. To avoid from buying at full valuation again (especially when the market is at its highs), I'm setting up notifications for myself.
How to Buy at Fair Valuation or Lower To Get a Higher Income:
Set Buy Points based on Valuation and Technical Charts
I use Scotiabank as my brokerage. I can set up "Alerts" there, such that when a company reaches a certain price (my buy point), Scotia will send me an email notification. I mainly set the buy points based on valuation. I determine a fair value range by referring to F.A.S.T. graphs, and Morningstar's fair value estimation. If the company is high quality and has a long history of growing dividends, then if the fair value range is reached, I can buy if funds are available. If the company is of lower quality, then set the alert price to be 20% to 30% below the fair value range.
Using Union Pacific (NYSE:UNP) as an example, looking ahead to the end of the year, the F.A.S.T. graph indicates a price of $86 at P/E 15. Morningstar gives a fair value estimate of $92. With a solid company like UNP, I calculate its fair value range using the 10% mark, giving a fair value range of $83 - $101.
Technical charts show the support areas with the moving averages. It has support around $86 - $87 on the daily and weekly charts.
If I do get in on some UNP shares at $87, that'd be a starting yield of 2.1% versus the current yield of 1.83% which is below its 5-year average yield of 1.9%. However, to get that $87 price point, the stock will need to pull back 14% from its current price of $99. Is it possible? Certainly. But if you really like the company, maybe you're willing to settle for a 2% starting yield instead of 2.1%. An 8% pullback is easier to get to than a 14% pullback. Anyhow, the main point is to set the buy zones ahead of time with as little emotion as possible.
As a nice plus, buying at a better valuation and a lower price point not only leads to a higher starting income but also leads to a higher total return.
A Look at Earnings Growth Estimates
Buying at least at fair value can only increase a portfolio's return. To further increase the return, I check the earnings growth estimates. From the 7-year Union Pacific F.A.S.T. graph above, the earnings growth was 15.7% with a normal P/E of 16.3. However, according to analyst consensus, the next 5 year's earnings growth estimate is at 9.4% (shown in the F.A.S.T. graph below). Alternatively, MSN Money gives an estimate of 12.4%. Because of the estimated slower growth, I should pay a lower valuation than P/E 16.3 for UNP shares.
To buy with as little emotion as possible, and stay rational, I determine buy ranges based on fundamental and technical analysis. Then, I set up alerts with my broker which sends me email notifications when my buy point is reached. Alternatively, one can set up buy points at Finviz.com. If the "Gain %" column is red, it means your price target is reached. I documented this strategy using Finviz in this SA article: Before Buying a Dividend Growth Stock: Things to Do, under the subtitle "Preset Buy Target Prices with a Watchlist".
This way, I'm less likely to buy at a price that is too high because every time I feel like doing that, I'll remind myself of the buy points that I set. If they're not hit, it means the security is not at a favorable enough price point for new purchases, and it maybe better to accumulate cash for the time being. Besides, if you have a long list of quality companies on your watchlist, there's probably at least one or two that is worthy to be bought at a time. And have you noticed that securities become on sale as a group? I would love to have some dry powder ready to be deployed in the next market pullback.
The only downside to this strategy is that periodically, perhaps quarterly, the buy prices need to be updated to reflect the current state of the company: its valuation, earnings estimates, and other business changes -- for better or for worse.
- Check Valuation and Earnings Growth Estimations: F.A.S.T. Graphs
- Check Fair Value Estimation: Morningstar
- Check Earnings Growth Estimations: MSN Money
- Set Buy Points: Finviz.com
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Note: Please use this article as initial research material. Do your own due diligence before buying or selling a stock.
Disclosure: The author is long UNP, TGT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.