Dealing With The 'Problem' Of Owning Overvalued Dividend Growth Stocks

by: Mike Nadel


As the bull market rampages through Year 9, many stocks appear to be considerably overvalued.

Those who own stakes in such companies now have to deal with that "problem."

How one Dividend Growth Investing practitioner is approaching some seemingly overvalued positions.

When I was a teenager, one of my friends was so good-looking and personable that the ladies all but threw themselves at him. Poor dude had to talk to a "regular guy" like me for objective advice on which girl he should date.

Back in my days as a newspaper sportswriter, I covered a few high school athletes who had so much talent and intelligence that they literally could have attended any college in the country on full scholarship. Decisions, decisions.

Just last week, one of my non-"follically challenged" buddies was talking about the difficulty of choosing which hairstyle he wanted to go with next.

Each of the above falls squarely into the Nice Problems To Have category.

Even though I'm not fortunate enough to have faced any of the aforementioned "problems," a look at my 44-stock portfolio - built using mostly the Dividend Growth Investing strategy - does present some interesting conundrums.

Specifically, thanks to a bull market that has been truckin' along since 2009, quite a few companies I own have valuation metrics that are enough to make me say, "Yowsa!"

As an example, here are 11 of my holdings, ranked by position size within my portfolio:

COMPANY Pct PE F-PE 5-PE Price M* Yld 5Yld
Johnson & Johnson (JNJ) 6.8% 24.3 18.1 19.8 $139.56 $118 2.4 2.9
McDonald's (MCD) 5.9% 24.0 23.5 19.7 $165.59 $170 2.4 3.2
3M (MMM) 5.8% 25.4 23.8 19.1 $227.45 $184 2.1 2.3
WEC Energy (WEC) 4.8% 22.3 20.5 18.9 $67.92 $56 3.1 3.2
Coca-Cola (KO) 4.5% 44.8 23.3 22.7 $46.54 $46.50 3.2 3.0
Chevron (CVX) 3.0% 34.2 27.6 19.3 $117.18 $106 3.7 3.7
Microsoft (MSFT) 2.8% 29.6 24.8 20.5 $83.87 $89 2.0 2.6
Boeing (BA) 1.5% 24.1 23.6 18.3 $260.85 $217 2.2 2.3
Lockheed Martin (LMT) 1.0% 25.2 23.5 15.9 $311.17 $284 2.6 3.2
Visa (V) 0.9% 41.6 27.6 32.4 $111.88 $108 0.7 0.7
Costco (COST) 0.7% 28.2 26.5 27.0 $171.36 $159 1.2 1.0

(Key: Pct is percentage each company makes up in my portfolio; PE is trailing 12 months P/E ratio; F-PE is forward P/E ratio; 5-PE is 5-year average P/E ratio; M* is Morningstar Fair Value Estimate; Yld is current dividend yield; 5Yld is 5-year average yield. Data provided by Morningstar, as of market close Friday, 11/10/17.)

Observations & Notes

  • For this exercise, I tried to choose a good cross-section of my holdings, including three industrials, two tech stocks, two consumer staples, and one each from the health care, consumer discretionary, utility and energy sectors. They also range from my four largest holdings to two of my smallest.
  • Not a single one of the stocks has a trailing P/E ratio lower than its 5-year average. I don't find this to be alarming, especially in a bull market, but I thought it interesting enough to point out.
  • JNJ, V and COST are the only companies with forward P/E ratios lower than their 5-year averages. Such projections based upon anticipated earnings can be useful, but sometimes they end up looking like they had been little more than guesses.
  • KO and COST are the only companies with higher dividend yields than their 5-year averages. My fellow Seeking Alpha contributor David Crosetti calls this the "Dividend Yield Point Metric."
  • The first four stocks listed (JNJ, MCD, MMM, WEC) combine to make up about 23% of my portfolio.

Position Gazing

Here are my thought processes on each of the positions listed in the table.

Johnson & Johnson: I consider this the quintessential DGI company, a health-care conglomerate that has been increasing its payout to shareholders for decades. Just look at its beautiful dividend-growth "step pattern"!

Chart JNJ Dividend data by YCharts

Although JNJ has been overvalued for quite some time in many analysts' eyes, its forward P/E ratio is lower than its 5-year average. I am not looking to buy more, but I wouldn't blame anybody who does. I can't imagine ever selling any of my JNJ.

McDonald's: Although Morningstar actually considers Mickey D's to be fairly valued, pretty much every metric says it is very expensive. Its forward P/E exceeds its 5-year average by nearly 20%, and its current dividend yield is 25% lower than its 5-year average yield. MCD actually is one of the few positions on which I have turned off the drip to take divvies in cash. I have instructed my brokerage to alert me if MCD moves down to $154 - 10% below the all-time high of $170.92 - so I can decide if I want to preserve capital and lock in significant gains by selling some or all of the position.

3M: Of all the stocks I own - not just these 11, but all 44 in my portfolio - MMM is the only one that Morningstar assigns a 1-star valuation, meaning its analysts consider 3M to be extremely overvalued and therefore a candidate to be sold.

Nevertheless, I am not planning to sell or trim my 3M position. One reason is financial; it is one of only three companies I hold in my taxable account, and selling it would move me into a higher tax bracket. (Fun fact: 228 years ago Monday, Ben Franklin wrote what would become one of his most-quoted phrases in a letter to his friend, Jean-Baptiste Leroy: "In this world, nothing can be said to be certain, except death and taxes.")

Another reason I plan to hold onto my MMM: I am a DGI guy who appreciates MMM's 59-year history of dividend growth. Yet another reason: I value quality above all other things, and there is no doubt that 3M is one of the world's high-quality companies.

And yes, I admit emotions are in play, too. I sold about half of my MMM back in 2012 for silly reasons, including perceived overvaluation. I have gone on to consider that one of my biggest mistakes as an investor, and I am determined not to repeat the mistake.

WEC Energy: Could this well-regarded utility's price eventually revert to the mean? Of course. But its dividend is reliable and growing, and its moderate overvaluation doesn't worry this long-term DGI practitioner. One of the great thing about utilities is that their services are essential and their customers almost always pay their bills.

So if I'm going to sell WEC because its price might go down, I need to sell every company I own. After all, isn't the same true for all of 'em?

Coca-Cola: There are reasons to be concerned about this company's slowing growth and the headwinds its industry faces. Still, I believe that any deterioration would be very gradual, and therefore I would have many opportunities to exit KO with a sizable profit if I see fit. It's a "Hold."

Chart KO EPS Diluted (TTM) data by YCharts

Chevron: I not only kept my stake throughout the oil glut that drove CVX's price below $70 in 2015, but I also added to it. Chevron and Exxon Mobil (XOM) are my only oil companies, and I view them as very long-term holdings. I believe CVX has turned the corner from a free-cash-flow basis, and it should be able to both post profits and cover its dividend.

Chart CVX Free Cash Flow (TTM) data by YCharts

Microsoft: I consider this a "blue-chip technology" company, and I am high on its future. I bought MSFT primarily for its growing dividend, but I'm pleased with its expanded role in my portfolio now that it has gotten back to the rapid growth of its business.

Boeing: When visiting my daughter Katie and son-in-law Ben in Seattle two months ago, we had a very interesting tour of the company's airliner assembly facility. (I would highly recommend it for others who venture up that way.)

While the tour didn't mention BA stock, my brief discussions with a few Boeing employees revealed they had a lot of pride in their company - and a lot of happiness about the advance of the stock price. The economy has been especially good for its commercial division, and the geo-political climate has buoyed its defense division.

I was fortunate enough to buy Boeing at $115/share in January 2016, meaning the position has more than doubled over these last 22 months. But has its price moved too high too quickly?

Although I consider BA to be a fine company, and I appreciate a dividend that has grown 30%, 20%, 25% and 50% the past four years, it is not a "core" holding for me and I have placed an alert for $240, which is 10% below its all-time high. I considered reducing my position by the size of my original investment - a move that would let me "keep playing with house money" - but I see no reason at this point to limit potential gains.

Lockheed Martin: Here's another one that appears to be significantly overvalued, but I'm willing to ride the defense-company wave.

Plus, LMT is a fairly small position that I hold in my taxable account. So I'll just chill out and say, "Well, the world might blow itself to pieces, but at least it will do so with Lockheed Martin war products." How's that for seeing the glass as half-full?!?!

Visa: I established my position at $99.29 in July and added at $105.05 in September. I obviously am very bullish on Visa's growth prospects and I am looking for excuses to buy, not sell. The dividend is so low that it's only a nice little bonus for me; this is a growth company, plain and simple, and I love its business model.

Two months ago, Chuck Carnevale wrote an interesting article on what he considers Visa's "extreme" overvaluation. But even "Mr. Valuation" concluded that the company's growth story makes it too good to sell right now. That's the "problem" V owners have faced for years!

Costco: I finally bought a decent-sized stake in COST in June after years of writing articles and comments praising the company. Like my Visa stake, it is a smaller position that I am looking to build. Unlike Visa, Costco is not a company growing by leaps and bounds, so I'm being a little more choosy about the price I'm willing to pay for shares.

Chart V EPS Diluted (TTM) data by YCharts

General Thoughts On Selling

Every time I buy a company, my plan is to build the position and hold onto my shares forever. But as I have learned, there are many legitimate reasons to sell companies.

I sold Ensco (ESV) after the officer of a rival oil-drilling company warned investors of serious industry trouble. Considerable analysis of Kinder Morgan (KMI) gave me concern about it being too large a stake in my portfolio, so I sold half of my position. I thought General Electric (GE) was a hot mess, so I dumped it and bought more MMM; GE's price has been in a freefall, and on Monday the company halved its dividend.

Last February, after Kraft Heinz (KHC) tried to buy Unilever (UL), KHC's already sky-high price spiked to nearly $100. It was a ridiculous run-up, so I sold a quarter of my position with the idea that I might buy it back one day (I haven't yet).

Chart KHC data by YCharts

My three most recent sells were of Avista (AVA), a utility that got purchased by a Canadian company; Target (TGT), a retailer I have little faith in going forward; and Scana (SCG), a utility facing a host of troubles.

Obviously, I've had some bad sells, too. I got frustrated with Deere's (DE) frozen dividend and stagnant share price and sold it about 7 seconds before it went up a bazillion percent. D'oh! Other less-than-optimal sells were of Baxter (BAX), National Health Investors (NHI), Reynolds American and ... yes ... 3M, always 3M!


My "default setting" is Hold. I am a "let the winners run" kind of guy. I don't like selling stocks, period, especially those I consider "core positions."

Nevertheless, that doesn't mean I fully ignore the concept of taking profits on extremely overvalued companies. That's why I put a close watch on those I feel fit that description.

Bottom line: I want my dividends to grow. I want my total return to increase. I want my net worth to move ever higher. So I welcome "problems" like the ones involving the 11 companies I profiled in this article.

Heck, I wish every stock I owned could be so problematic!

Disclosure: I am/we are long KO, V, MSFT, COST, MMM, LMT, MCD, JNJ, BA, CVX, KHC, KMI, XOM.

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.

Additional disclosure: I also hold small stakes in BAX, DE, GE and TGT within the DG50 portfolio project.

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