My previous article Does Entry Price Matter to Dividend Investors? created a lot of discussion. To summarize, it is important to have some valuation guidelines, before purchasing a dividend stock. This is to protect the investor in the very likely event that they “fall in love” with a stock and purchase it regardless of price. After all, purchasing a stock at inflated price levels might lead to sub-par returns for several years.
The typical valuation guidelines I use include a minimum yield of 2.50% for new or existing investments, as well as a maximum of 20 times earnings I am willing to pay for a company. I would sometimes purchase shares in companies I deem to have great potential, which yield less than 2.50%. My purchase of a small position in Visa (NYSE:V) is an example of this. I would never however initiate a position in or add to a position when I am paying more than 20 times earnings.
I typically accumulate my positions over long periods of time. I currently add or initiate positions in 2- 3 stocks per month. At this rate, chances are that I purchase stock in a given company about once or twice per year. In the case of companies like McDonald’s (NYSE:MCD), this means that I bought stock in 2008, 2009, 2010 and 2011. As long as the stock trades at less than $105/share, I might be able to add to my position in 2012 as well. Even if the stock zooms past $105/share, I would still have exposure to it, although I might invest my new funds elsewhere.
Unlike other investors however, I do not avoid buying stocks simply because they “went up”. Many investors missed the boat at McDonald’s at $70 or $80/share, because they figured that the stock has increased too fast, and thus waited for a dip before adding to their positions. This is the type of market timing, which should be avoided. Now, if investors didn’t want to pay more than 15 times earnings, then waiting for the dip after McDonald’s increased above $75-$80/share was a perfectly reasonable excuse. The key to successful investing is having a strategy that fits your personality, and then trying to stick to it.
Many times, I would see a stock defy gravity and trade at 25 times earnings. I would wait for a dip before initiating or adding to my position. Sometimes it might take months and even years before the stock reaches an attractive valuation either because of a stock correction or because earnings increased faster than share prices. In an era of instant investment gratification, where investors can buy and sell stocks in the matter of nanoseconds, this seems like eternity.
With dividend growth investing however, a big part of success comes not just by identifying the best companies and initiating a position in them, but also by holding onto them for as long as possible. If the stock I really want to purchase is overvalued, I would find another candidate for my money. There are over 200 dividend achievers in the US, which means that there are always investment opportunities out there for dividend investors.
For example, some of the recent buys I have made in my portfolio over the past month or two include:
Johnson & Johnson (NYSE:JNJ) engages in the research, development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 49 years in a row. The stock trades at a P/E of 14.20 and yields 3.50% (analysis).
Philip Morris International Inc. (NYSE:PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has raised dividends each year since 2008, when it was spun off from Altria Group (NYSE:MO). However, its dividend growth culture could be traced back to the four decades of dividend increases at the original Altria Group. The stock trades at a P/E of 17.10 and yields 3.70% (analysis).
Colgate-Palmolive Company (NYSE:CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised dividends for 48 years in a row. The stock trades at a P/E of 18.90 and yields 2.50% (analysis).
PepsiCo, Inc. (NYSE:PEP) engages in the manufacture, marketing, and sale of foods, snacks, and carbonated and non-carbonated beverages worldwide. The company has raised dividends for 39 years in a row. The stock trades at a P/E of 15.70 and yields 3.30% (analysis).
Just because a stock is in overbought territory, however, doesn’t mean it is a sell either. Too often I see investors disposing of their positions in otherwise fine dividend stocks, just because the price went into overbought territory. This creates taxable events for them and then they have to worry about reinvesting the proceeds in other stocks. The end result is typically similar to the scenario where they simply held on to the original stock and reinvested the distributions elsewhere.
To quote Warren Buffett, his first rule of success involves not losing money. His second rule of success involves not forgetting the first rule. The goal of dividend investing is a growing stream of income as well as capital preservation that comes with it. Investors chase overvalued stocks because they are afraid to miss the boat on future price gains and dividend increases.
Unfortunately, stocks with higher valuations have a higher chance that anything that goes wrong could have a negative effect on share price or income stream. Investors who purchase stocks at reasonable valuations however, have better chances of realizing rising price and dividend returns.
At the end of the day, dividend investing is challenging because it involves a great deal of psychology. Investors are driven by their fears and greed. By developing a strategy that works for them, and sticking to it, investors should be better able to handle the mental aspects of the game.
Full Disclosure: Long MCD, JNJ, PM, CL, PEP