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What is a value investor to do right now?
The S&P 500 is up 14.55% so far in 2013. 14.55%! And we're not even five months into the year yet. Crazy, right? Not really.
We're currently in a low interest rate environment as The Federal Reserve continues to keep interest rates down to spur lending and growth so that the economy can kick into gear again. This means that savings accounts yield almost nothing and even high quality bonds like 10-year Treasuries only yield 1.9%. That 1.9% isn't going to get you very far and likely is going to lag inflation, meaning you're going to lose purchasing power over time leading to a nominal negative return. Loss of real capital is not something many of us investors are keen on, so where else does one invest their money?
I'm obviously bullish on stocks over the long term, as you can see by my unflinching high allocation to dividend growth stocks (currently bordering on about 95%). Let me rephrase that. I'm bullish on high quality businesses over the long haul. I've discussed exhaustively why I'm so bullish on high quality companies, but it comes down to this: a high quality business can typically generate excellent returns over time due to the strength of the underlying business, which usually includes brand name products or services, loyal customers or clientele, economies of scale, diverse geographical operations and a commitment to shareholder returns.
I love the stock market. It provides a guy working a regular, middle class job like me access to equity in some of the best companies in the world. I'm now a part-owner in high quality companies like PepsiCo, Inc. (PEP), Johnson & Johnson (JNJ) and Chevron Corporation (CVX). These are fantastic companies that have global operations and sell products that people all over the world buy every single day (food, medicine, gas & oil). But even the highest quality company can become too expensive, leading to subpar returns over the long haul if purchased at too a high a price. I find that we're near a juncture like that right now with many great companies, much to my dismay.
For instance, Johnson & Johnson (JNJ) trades at 23.34 times earnings using trailing twelve months earnings. Now, I'm a huge fan of this company. It's the largest diversified health care company in the world and it's one of my biggest equity stakes. But I believe that paying over 23 times earnings will likely lead to returns that are unspectacular over the next 2-3 years. EPS will have to catch up to this valuation as I don't see how investors will continue to bid up these shares much beyond current levels. That means the price will likely stay static while the earnings catch up bringing the stock back into a normal valuation in the 15-16 times earnings range. Or, the P/E ratio can compress (price falling) which will also lead to a P/E ratio that is more attractive for this company's stock.
It should be noted that I didn't purchase my JNJ shares to hold for 2-3 years. I bought my JNJ shares to hold theoretically for the rest of my life. To be completely honest, I don't care if P/E compression occurs and the price falls or if the price stays static for the next few years while earnings catch up. This doesn't really concern me because I'm buying JNJ shares to be a part-owner in the business itself and share in the profits the company generates via dividend payouts. I purchased my shares simply to access a portion (typically 40-60%) of profits on a per-share basis. The share price means little to me unless it falls to a level where I'd be interested in increasing my stake in the company, or if it rises so substantially and ridiculously that keeping my equity stake would be an unwise allocation of capital. What I do care about, however, is whether or not JNJ continues to pay out its hefty dividend (currently $0.66 quarterly per share) and whether or not the company continues to raise that dividend on an annual basis.
This brings me to the real crux of the issue right now. I purchased my shares in JNJ to gain access to a portion of profits in one of the highest quality businesses in the world. But access to those future profits in the way of dividends means giving up capital now, and capital doesn't come easy. Succinctly, if I'm going to give up my hard earned capital I want to make sure I'm getting the best deal I can for it. Just like when I'm shopping for food, gas or clothes paying less is always better. This is never truer than when dealing with stocks and right now deals are awfully hard to come by. I plan on retiring by 40 years old by living off the passive income my portfolio generates, so it's in my best interest to build this portfolio up as quickly as I can to let the compounding snowball work its magic. However, the power of a compounding snowball rolling downhill can be slowed dramatically if you're starting up the hill higher than you need to. And right now, I believe that shares in many high quality businesses are higher up the hill than they really should be due to the low interest rate environment we're in, forcing investors to climb ever higher to reach for yield.
And that means us value investors either join 'em because we can't beat 'em, or we stay smart and continue to wisely allocate capital in all market conditions. I'll always prefer the latter.
Right now, I find myself at a point where I find few assets more attractive than stocks, but stocks themselves being unattractive in general as an aggregate. It's almost like comparing a punch in the face to a knee to the groin. I'd prefer the former, but only because the latter is so unattractive and the choice is limited between the two.
Bonds are very unattractive right now with very low yields by almost any historical measure you can throw at them, let alone the threat of inflation dragging on your return. Interest rates will eventually rise and when that happens current bond prices will fall, as new bonds become more valuable with higher yields. Gold? Other than being shiny, it does nothing. It certainly doesn't produce cash flow. Real estate? Physical real estate is attractive right now in my opinion, but the problems are the illiquid nature of it, difficulties in diversifying due to cost, high transaction costs and geographical risk. Purchasing a rental property might be intelligent right now if you're interested in becoming a landlord (not sure I am). REITs are the easy way to go here, but due to their attractive yields they've been bid up like everything else leading to expensive prices and unattractive valuations. Cash? No return over the long-term, but this might be one of the most attractive assets of all right now due to the relatively expensive alternatives. I'm not a fan of cash, however, as it's one of the worst assets over the long haul on a return basis (negative due to inflation) and this is why I have under 5% of my wealth in it. However, capital is obviously quite attractive in a situation where markets are falling and one can pick up cheaper stocks with readily available cash.
While I continue to stay away from valuing the market as a whole, I don't see much value in individual high quality businesses like The Coca-Cola Company (KO) at 22 times earnings, General Mills, Inc. (GIS) at almost 19 times earnings or The Southern Company (SO) at almost 20 times earnings. There's just very little (if any) margin of safety to be had with names like these.
So, I'm doing a few things right now. First, I'm not selling anything. I believe in being a part-owner in high quality companies and collecting a portion of the profits. Fluctuations in prices don't deter my resolve. Second, I'm allocating a higher percentage of my wealth towards cash right now. I typically have 5% or less allocated to cash due to the unattractive nature of it, but I find it a prudent move right now to build cash with little value to really be had in the high quality businesses I want to be a part-owner of. Third, I'm focusing on sectors that haven't performed as well as the aggregate like the energy and technology sectors. I currently like names like Exxon Mobil Corporation (XOM) at 9 times earnings and Cisco Systems, Inc (CSCO) at 12 times earnings.
In summary, I believe us dividend growth investors would be wise to do what we have always done: focus on value and quality. I love both but would never sacrifice one for the other. Certainly the dividend, and growth of it, are very important but it's just one aspect of a company's fundamentals and quantitative aspects. I take great pleasure and pride in building my portfolio and the passive income it generates, but what sense would it make to invest in a company that pays a dividend equating out to a 3% yield based on current market prices, only to watch the share price fall 5%? I'm certainly not advocating market timing in this article, but what I am advocating is to be mindful of valuations and focus on high quality. Don't gravitate towards a stock just because it's cheap in an expensive market, and don't buy high quality whilst being unaware of the valuation.
How about you? Are you having difficulties in allocating capital currently?
Full Disclosure: Long JNJ, PEP, CVX, KO
Thanks for reading.
Photo Credit: Yahoo! Finance