Thursday, December 20, 2012
Holding Vs. Deploying Cash
I'm just another young guy, at 30 years and counting, trying to achieve financial independence at a young age. My main mission with this blog is to chronicle my journey from a negative net worth to retirement in 12 years. As such, this being my real life, it's of the utmost importance to me that I do everything in my power to maximize the possibility of this goal actually being achieved. As many of you already know, my strategy is to invest fresh capital on a monthly basis in attractively priced high quality dividend growth stocks and to keep most of my net worth there, eventually living off the dividend income my portfolio will provide.
One concept that dividend growth investors, including yours truly, often talk about is the right time to deploy cash. When's the right time to invest? If the Dow Jones Industrial Average just moved up 300 points over the last two weeks, is it better to wait for it to come down? I just got my paycheck yesterday, but I should hold it for at least a few weeks before I inject fresh capital into my portfolio right? The Shiller PE is above 20 right now...maybe we should wait for a correction, right?
This article is going to lay out my exact thoughts on this issue. The answer is - there is no right answer. Unfortunately, as many things in life, it depends. It depends a lot on how much capital you have to invest with, how long your investing horizon is and where individual equities are at in terms of valuations. Ultimately, opportunity cost is at the heart of this matter.
Per Investopedia, the definition of opportunity cost is as follows:
"The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action."
So, by holding cash you're forgoing the opportunity to earn a potential return on your capital. By holding cash, you're going to consistently lose purchasing power as the invisible tax known as inflation eats away at the true value of your principle. On the other hand, you could also invest in an asset that loses value. Investing in dividend growth stocks (or any asset for that matter) that are significantly overvalued will lead you to conclusion #2.
Benjamin Graham, the oft-cited forefather of modern value investing wrote a bit about this phenomenon in his seminal work "The Intelligent Investor":
"We are convinced that the intelligent investor can derive satisfactory results from pricing of either type. We are equally sure that if he places his emphasis on timing, in the sense of forecasting, he will end up as a speculator and with a speculator’s financial results. This distinction may seem rather tenuous to the layman, and it is not commonly accepted on Wall Street. As a matter of business practice, or perhaps of thoroughgoing conviction, the stock brokers and the investment services seem wedded to the principle that both investors and speculators in common stocks should devote careful attention to market forecasts."
"There is one aspect of the “timing” philosophy which seems to have escaped everyone’s notice. Timing is of great psychological importance to the speculator because he wants to make his profit in a hurry. The idea of waiting a year before his stock moves up is repugnant to him. But a waiting period, as such, is of no consequence to the investor. What advantage is there to him in having his money uninvested until he receives some (presumably) trustworthy signal that the time has come to buy? He enjoys an advantage only if by waiting he succeeds in buying later at a sufficiently lower price to offset his loss of dividend income. What this means is that timing is of no real value to the investor unless it coincides with pricing—that is, unless it enables him to repurchase his shares at substantially under his previous selling price."
"By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value. A less ambitious form of pricing is the simple effort to make sure that when you buy you do not pay too much for your stocks. This may suffice for the defensive investor, whose emphasis is on long-pull holding; but as such it represents an essential minimum of attention to market levels."
Graham, a true genius when it came to investing, starts this off by talking about profiting from both timing and pricing. Timing would be trying to profit from what one perceives as upward or downward market trends and investor sentiment. You would hence sell when the market is likely to dip or dive, and conversely buy when the market is trending upwards. Profiting from timing is of no concern to me, and I pretend it doesn't even exist. I don't trade on trends, and I don't time the market. Profiting from timing is extremely consequential to traders and speculators, however.
So, we move to pricing. With pricing, and the arbitrage of such, a long-term (or long-pull as Graham calls it) investor is looking to purchase stocks sufficiently and significantly, if possible, below their intrinsic value which would allow you a margin of safety. The investor would then continue to hold this asset as long as it remains attractively priced on an ongoing basis (as profits continue to rise and allows for price expansion) or sell when the stock rises sufficiently above intrinsic value. Graham, it should be noted, was not a dividend growth investor and was not shy about selling stocks when he thought they were fully priced.
Graham, however, explicitly refers to dividends above when talking about pricing. He explains that an investor would only do well to wait on a better price (that may or may not come) if the lower price (if achieved) makes up for the lost dividend income (as opportunity cost) that the investor would have laid claim to had he invested in the stock at an earlier date.
For example, let's say you think Philip Morris International (PM) is expensive right now. At a price of $84.65 currently, you determine intrinsic value (through DCF analysis or other) of this stock at $83. Let's say PM misses analyst expectations in the third quarter of 2013 and it falls to $82.80 and you decide to pull the trigger. Would you be better off? Well, at a quarterly dividend rate of $0.85 per share you would have accumulated three quarters of dividends between now and then (ex-dividend dates in 12/12, 3/12 and 6/12) totaling up to $2.55 per share. So, $84.65 (today's price) minus $2.55 (the accumulated dividends) is $82.10. In this example, you would not be better off. Of course, this is just cherry picking an example and using hypothetical future numbers. It does, however, give you some framework on which to quantitatively base a pricing decision. And, on the other hand, that $82.80 share price may never come in which case you really lose out. PM may instead rise to $100 per share, and a pullback to $90 (well above the numbers referenced above) now represents a good entry point.
Let's instead use some real numbers from our past. In a recent article I said:
"However, what I really tend to look at is future expectations. If you buy shares in McDonald's for $86.08 a piece, as I did recently, or if you buy them for today's closing price of 84.05 will it really matter all that much 20 years from now when MCD shares are available on the market for $700 each? Probably not. That's not to say that I don't believe that purchasing stocks on a strong value basis isn't important. Quite the contrary, as I believe valuation is paramount to a dividend growth investor's long-term success and total returns."
Let's continue with the McDonald's Corporation (MCD) example. You could have purchased MCD shares back in 1992 (a timeframe I referenced in the article above) at many different prices. On January 17, 1992 a share of MCD would have been available at a split-adjusted price of $10.06. Later that year, on September 17, 1992 a share of MCD would have been trading at a split-adjusted price of $11.19 per share. That's a difference of over 11%! So, that means the investor that waited eight months to make up his mind on MCD shares paid a full 11.2% more for his shares. What a ripoff, right? Well, seeing as how MCD shares currently trade for $89.71 I think any dividend growth investor with a brain that is fully operational would be plenty happy with a cost basis of either price. This brings the point I made in the above article full-circle. When you've investing for the long-term, price swings of 3-5% today or tomorrow or the next day will have negligible effects on the values of your holdings decades from now. The key, as I've always said, is to buy high quality at an attractive price. The investor trying to catch the absolute bottom dirt cheap price on a high quality stock, or otherwise time the market, may get his reward, but may also miss out on dividend income that is compounding itself, or wait for a price that never arrives. If you're investing for the next 40 years, your future self will most certainly thank the present-day you for making such wise choices as buying high quality dividend growth stocks; your future self will not, however, chastise you for not buying your $700 MCD shares for $85 instead of $90 per share.
I often say that I believe valuation is paramount to the long-term dividend growth investor. While I treasure qualitative properties over quantitative analysis, buying even the highest quality stock with excellent future prospects at too high of a price will lead an investor to sub-par returns over the near to medium-term until the stock catches up to the market's pricing. Time heals all wounds, and it can certainly fix investing mistakes, but how much time you have is an individualistic question. So, while I practice a strategy that compels me to buy quality dividend growth stocks for the very long-term on a monthly scale, I do not recommend buying stocks if they're trading at prices significantly higher than fair value (intrinsic value). If one truly cannot find anything attractively priced in the universe of high quality dividend growth stocks (a universe of no less than 100 stocks, and much more), then I actively encourage sitting on capital and waiting for opportunities to come to the investor. I haven't experienced this yet in my still-short (3 years) investment career, but I may in the future. As I pointed out recently, the market, as an aggregate, is somewhat pricey and probably on the higher side of fairly valued. Again, I don't buy the market - but an extremely overpriced market makes it very difficult to find attractively priced individual opportunities.
I've talked about valuation of equities and I've talked about investment horizons regarding the question at hand, but one other variable that's important is how much capital you have to invest. As any blog readers know, I typically invest anywhere from $2,000 - $4,000 per month. This is up significantly from when I started this blog due to increased earnings at my day job, as well as rising dividends. This much capital allows me to make monthly purchases and quickly rebuild my capital base for sizable purchases the following month. If you have significantly more available capital than this then I can't imagine how sitting on massive amounts of cash (that's building quickly) will benefit you. However, if you have much less to invest with ($500 per month or so), then building up capital for a few months at a time would be best as you want to maximize your available capital to reduce possible friction costs. Also, if you make a purchase and the market quickly turns south it will be quite some time before you have enough capital to make the most of that opportunity. So, the amount of capital you have to work with will definitely affect the frequency of one's purchases.
Another approach, which I might actively pursue, is to continue making monthly purchases but to also build a cash position/buffer slowly with which you can use if equities quickly move south and opportunities become extremely bountiful. This kind of approach would only be available to me if my income remains strong and I'm able to continue investing thousands of dollars per month while also funneling a few hundred dollars into cash each month. This way, if we get an annual significant dip in the market, like we did this summer or in the fall of 2011, there is a little "juice" in the form of spare capital above the usual monthly contributions, available to me to take advantage of the Mr. Market's moodiness to whatever headlines win the day. Mispricing, in this way, would be most welcome.
As I mentioned earlier, I feel that qualitative analysis outweighs quantitative analysis. Qualitative properties, like management quality, the products and reputation of those products, brand names, historical operations, the economic moat of a business, R&D and scale of operations are all extremely important. Quantitative numbers, like the P/E ratio, P/B ratio, debt numbers, earnings and dividends are all used, of course, in evaluating a company, but I really like to look at where I think the company will be 50 years from now. A cheap stock with no future prospects is not cheap at all. I'd rather pay fair price for a company's stock that has excellent chances for future success. After all, a company cannot continue paying rising dividends if there is no future growth for its earnings and cashflow.
It should be noted that I am actively adding capital to my portfolio for only 12 years, after which I plan to live off that dividend income and pursue opportunities other than paid full-time work. If you're actively adding capital for decades and decades you can certainly be less aggressive with your purchasing frequency and the amount with which you add to your portfolio on a consistent basis.
I hope this article answered some questions on whether or not you should continue holding cash, waiting for the next market correction (that may come tomorrow or next year), or continue to use fresh capital to invest in long-term attractively priced opportunities and let that investment start compounding. I truly believe in most circumstances you should aim to invest as much and as often as realistically possible for your situation. On the other hand, I also think having a little capital on the side to take advantage of extreme opportunities would also be wise. If you have little capital it's wise to limit commission fees and other transaction/friction costs and try to invest only when the transaction costs less than 0.5%. This may take a few months to build up the capital necessary to make the numbers work. But, as your portfolio builds the dividends will add up and your purchasing frequency can be increased. If you have large amounts of capital (on the order of multiple thousands per month), I strongly encourage a habit of regularly investing the money as any lost opportunity of a market correction can be quickly reversed with the fresh capital you're regularly receiving, as well as using any cash position you have set aside for such circumstances.
In the end, however, I also believe that your savings rate will far outpace your investment returns. All this talk of investing in a stock today or waiting for an unknown price tomorrow is relatively moot if you're only saving paltry portions of your net income. I truly believe that if you're saving high amounts (50%+) of your net income and investing in high quality dividend growth stocks that are attractively priced for the long-term with great qualitative qualities you're going to do quite well. Intelligent wealth building strategies, like saving a high amount of your net income, avoiding debt, investing regularly, minimizing unnecessary consumption and maximizing your income and are far more important than trying to nail down the absolutely perfect stock price.
So stop fretting over that $0.50 share price fluctuation and get busy being a part-owner of a high quality company. That company will make you back that $0.50 many, many times over if you stick with them for the next few decades or so.