The Beauty Of 'Coiled Spring' Stocks For Dividend Growth Investors

Includes: JPM, MSFT, WMT
by: Kenyan Investor

Many investors look back at the performance of the stock market over the past 10 years and conclude that it was a "lost decade" for investors. It is easy to see why many share this opinion. For example, the S&P 500 started the year 2002 at 1148. Over 10 years later, the S&P 500 closed July 16, 2012 at 1354, for a measly nominal return of slightly under 1.7% annualized. Worse yet, real returns for this decade have been negative, as inflation has easily outpaced 1.7% over the past 10 years.

On the other hand, anyone ignoring the stock market and focusing only on the performance of actual companies would not consider the past 10 years to have been a "lost decade" at all. In order to see why, let us look at the performance of Wal-Mart Stores Inc (WMT), one of the most common stocks that people refer to when talking about the dismal performance of the stock market over the past decade. As one can see below, WMT did indeed have poor price performance for much of the past 10 years. Before its recent price increase, the stock fluctuated around the $50 point between 2002-2010, discouraging many investors in the process.

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However, if we ignore the stock market and look only at the actual business performance of WMT over the past 10 years, the decade is anything but lost. As we can see below, WMT had a relentlessly rising EPS and dividend during the entire decade. According to WMT's website and using 2012 earnings estimates from TD Ameritrade, WMT had an EPS of $1.79 and a dividend of $0.30/share in 2002, and an estimated EPS of $4.91 and dividend of $1.59/share in 2012 (Note: the fiscal year for WMT ends in January, so I attribute the earnings of a fiscal year to the previous year to improve comparability with other numbers. For example, I attribute earnings for fiscal year 2003, which ends in January 2003, to calendar year 2002). As we can see, the increase over 10 years for earnings is 174%, and the dividend grew by a whopping 430%!

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What essentially happened is that the stock price of WMT was massively overvalued at the start of the last decade, having a P/E ratio of 28.3 in the year 2002. Investors were paying dearly for the growth that they expected to take place later on. Earnings took nearly the entire decade to grow into the exorbitant price that WMT investors were paying way back in 2002. The following chart shows this process, as the P/E ratio decreased from 28.3 in 2002 all the way down to 12.1 in 2010 (price is measured on the left axis, EPS and the P/E ratio are on the right axis). Investors went from being wildly optimistic about WMT's future in 2002 to becoming more and more discouraged, leaving a strong blue-chip like WMT undervalued in 2010.

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As WMT experienced a stagnant price with an ever growing EPS over the period from 2002-2010, the stock became like a "coiled spring", ready to explode upwards once earnings caught up to the stock price and some catalyst caused investors to return to optimism. This catalyst could be anything that causes investors to notice the company's continually increasing EPS and new undervaluation. The past three months have highlighted this phenomenon especially well, as WMT's price has jumped upward by over 20%. WMT's catalysts could have included recent beats on revenue, same-store sales growth, and earnings coupled with a renewed investor focus on defensive stocks.

Obviously, investors would not want to invest in WMT earlier in the decade when the stock was overvalued and its earnings had not yet grown into its price. The key is to keep a close eye on valuation, investing in stocks with growing earnings and low P/E ratios, even if the price has been stagnant for a long period of time. This "coiled spring" effect that occurs in high quality stocks with growing earnings but stagnant prices benefits dividend growth investors in two primary ways:

1) Dividend growth investors benefit from reinvesting dividends early on at low prices and relatively high yields as earnings finish catching up to the stock price and sentiment remains negative.

2) Eventually, as EPS continues to grow, the "coiled spring" effect will take hold and the stock's price will go up, reflecting continued earnings growth in the previously undervalued stock. After the price increase, dividend investors have the luxury of continuing to hold the stock for future dividend growth or redeploying capital into other undervalued stocks with higher current yields.

Below are two other "coiled spring" stocks that I believe are ready to explode in a manner similar to WMT. I believe that they are undervalued since growing earnings have more than caught up to a stagnant stock price; they are only waiting for a positive catalyst to jump in price. I am happy to reinvest dividends at low prices while I wait.

Microsoft Corporation (MSFT) - This company develops the Windows PC operating system, the MS Office suite of software, the Xbox 360 video game console, and is making forays into the mobile computing market. According to MSFT's website and using 2012 earnings estimates from TD Ameritrade, the share price has lost 11% between the start of 2002 and 2012, while EPS has increased by 283% in the same time frame based on 2012 estimated EPS. Its P/E ratio based on estimated 2012 earnings is 11.0.

JP Morgan Chase (JPM) - This firm is one of the largest financial institutions in the world, with over $2 trillion in assets. Though tarnished by rogue trades recently, underlying profitability remains solid and growing. According to JPM's website and using 2012 earnings estimates from TD Ameritrade, the share price has lost 4% between the start of 2002 and 2012, while EPS has increased by 469% in the same time frame based on 2012 estimated EPS. Its P/E ratio based on estimated 2012 earnings is 7.7.

Disclosure: I am long WMT, MSFT, JPM.

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