Home>Video>Don't Overpay for Quality Dividend Stocks

Don't Overpay for Quality Dividend Stocks

Sun, 29 Jun 2014

P/Es could still rise further, but dividend investors should consider putting a ceiling on their purchase prices so they can maintain desired yields without paying too much.

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Video Transcript

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. DividendInvestor editor Josh Peters thinks that the market might be at a pivot point, and he's here to talk about why.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start by looking at where the market is from a valuation standpoint right now. I know it's a topic we've touched on a few times in the past. Where are stocks? How do you view the overall valuation level?

Peters: One of the great things for stock-pickers is that you have the opportunity to go and pick individual stocks; you don't just have to accept the market average. However, what we've seen here this year is a lot of unanimity, really over the last couple of years. Everything tends to rise and fall in tandem, and valuation multiples tend to be pretty similar across even very different sectors of the market.

What I find here recently is that the bulk of the total return from the stock market over the last couple of years is explained by a rising P/E ratio on an operating basis, excluding nonrecurring gains and losses for S&P reports, that has come up from about 13 times earnings to 17 times, a little over 17 times here recently. That's right smack dab in the middle of its 30-year range.

So, if stocks were cheap a couple of years ago, and that set us up for us some additional gains, now we've got it. When I think in terms of a pivot point, my concern is that if stocks continue to go up significantly faster than earnings from here, which is a definite possibility, now longer-term investors are looking at the P/E being a headwind, that valuation multiples will come down in the longer run. At a fixed P/E, you earn a return that's equal to your dividend yield plus the earnings-growth rate for the companies you own or the market overall.

If the P/E is too high and that number comes down, you don't earn as much as the companies actually are providing in the form of return components. So this is making me a little nervous. It's not overvalued territory yet, at least on these shorter-run valuation metrics. Certainly the Shiller P/E will suggest something very different, that the stock market is significantly overvalued.

But even in that, if you are looking at just the last 20 or 30 years of data, it's kind of in the middle of its range. I'm thinking this might be a time to consider very carefully whether or not the prices we're paying for individual stocks make sense.

Glaser: If this is a time that investors do need to be more careful, though, how do you think about an individual security selection? Are you looking at anything different now than you might have when the market was much cheaper?

Peters: I'd say the most important thing at this point in the cycle and maybe at all points in the cycle, but especially now, is quality. To me, that is a function of several factors. First of which, most important is a narrow or wide economic moat to protect the profitability of the business. You also want a strong financial position. I would say you should also look for businesses that are relatively defensive in nature. They are not riding the roller-coaster of the economy. They are on a little bit more of an even keel.

Ben Graham, who wrote The Intelligent Investor, in the final edition of that book that he worked on, he pointed out that even though there was a risk certainly that you could pay too high a price for a high-quality securities, it is much more dangerous at advanced stages of the economic and market cycle to be paying for lower-quality securities. You might actually think they are kind of cheaper than those higher-quality names, but the value just doesn't hold up in the next downturn. So, that is one framework.

Then second, if you are insisting on higher dividend yields, that tends to put kind of a ceiling on the price that you are willing to pay for stocks in general. Now I use a dividend yield and our price/fair value ratios for individual stocks as my primary valuation metrics. I also look at P/Es.

But a simple way to look at it is this: If you are looking at a stock that is yielding 5%, and you require that at least the company is earning enough to fully fund that dividend, then that translates to a P/E of 20 times, so you would never pay more than that.

In the case of my two model portfolios, my unusual minimum yield is 3%, which means if a company is paying out 100 cents on $1 and stock yield is 3%, then that's a P/E of 33. But typically I'm not going to buy something that pays out 100 cents on $1, it might be $0.50 or $0.60, but you still wind up with a ceiling of around 20 times earnings give or take even for these higher-quality companies.

So, there is some price disciplined involved. I'm willing to pay up to a fair price, but I'm not willing to chase either very high prices for high-quality companies or lower-quality companies that might look cheaper, no matter what the price might be.

Glaser: But if you have that potential ceiling, as we're getting closer to that ceiling potentially in some cases, what happens if then there is nothing to buy, nothing to provide income? You know if you are just sitting in cash, it certainly could be challenging from an income standpoint.

Peters: Yes, it might be challenging from an income standpoint, but I'll go back to what I pointed out earlier, which is that once the P/E's move too high, yes, you might be collecting a good dividend yield. Hopefully, you are. Even if not, then, hopefully you have some earnings growth or something to improve the tangible value of the stocks you own over the course of a market cycle.

However, if that P/E has to contract by the end of that time frame, you are going to give some of that return back. You might give all of that return back. So I don't think we're here yet, but there is a point out there that we may yet see that it would actually be better to just sit on cash for a fairly large chunk of your portfolio conceivably.

If you need income then you just make withdrawals from that cash because you can have some confidence that you'll be able buy the stocks that you want to own at cheaper prices further down the line and you don't need to suffer the losses that might come along in between.

We're not there yet, but I could see that happening because when you look at a chart of the market's P/E over long periods of time, it doesn't go up to the average and then stay there. It overshoots and then on the way back down it overshoots on the downside. So it's something worth paying attention to, but at this point I don't think any dramatic changes to people's portfolios are required.

Glaser: So dividend yields alone won't save you from a very overvalued market, but given that we're not there yet, do you have some ideas that dividend investors might want to take a closer look at today?

Peters: Well, one name that comes to mind that I have actually bought more of here recently is Procter & Gamble. The stock is yielding over 3% right now; trading at a pretty reasonable entry price. I think on a yield basis or a P/E basis, it's trading actually at a pretty nice discount to our fair value estimate of $89 a share.

A lot of people have just kind of written it off. It's a huge company. Almost everybody probably uses some of their products over the course of a day or a week. But it had been a sluggish performer for a while. You had an activist investor come in and shake things up.

The old CEO who did very well for P&G, A.G. Lafley, came back. He is now turning the business around, and beneath the currency-conversion effects and other things that are sort of plaguing short-term results for them now, you can see that improvement taking place. But Wall Street really doesn't care. And even that very high-profile activist investor has moved on for greener pastures.

At these prices to get over a 3% yield and a likelihood of 7% dividend growth or better,--historically last three years they've done exactly 7% each year--I think that makes a very compelling total-return profile. You're not taking as much of a risk with this business as you would with the average stock or with the S&P 500 Index. But you're getting a lot more income, you're getting a much higher-quality business than average. That's the rare name that I think is not just at a fair price, but actually a fairly attractive one.

Glaser: Josh, thanks for your thoughts today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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