What do you do when you find a company that you really admire, wish to invest in it, but always feel like its stock is too richly valued to invest? This is a common issue we face in managing our dividend strategy, and in this quarter’s letter we dive in to how we approach the issue:
Before we begin, we must get one obligatory definition out of the way… When I refer to high-priced stocks, I don’t mean stocks with a high dollar price per share. Relatedly this letter will not be a recommendation to just wait until a stock splits. A 50 for 1 stock split, like what Chipotle announced in March, might have NO influence on the economic value of the stock or the business. Stock splits, and their surrounding manias are a product of the psychological side of investing not the mathematical one.
For our purposes a “richly valued stock” refers to a company that generally trades at a persistently high multiple of cash flows, profits, revenues, or perhaps all 3. Usually, this is because of either rosy expectations of future growth for the business, defensive qualities of the business that increase its “staying power”, or some other factor that leads investors to be willing to “pay up” to own the name. A good example of the phenomenon is Apple. Apple has exhibited decelerating revenue growth for several years, however because of its stronghold on its customer base and the upside of Artificial Intelligence or Virtual Reality, it still trades at 26 Times its expected next 12-month earnings. (Seeking Alpha).
These characteristics provide us with a conundrum when it comes to managing our two dividend strategies. On the one hand, if we shun these expensive stocks in their entirety, we’re liable to miss some of the largest growth opportunities and experience inferior returns. On the other hand, if we pay up for these names, we’re likely to have lower dividend yields, lower dividend growth, and potentially larger drawdowns if things go awry in the business.
So, with that background, how do we tackle these situations? The process starts with our understanding of the business quality. If we find a dividend growth company that we believe is a good enough business for our allocation, we add it to our “bullpen”, generally set a “buy-price” and Dr. Bowlin will sit on every earnings call for the company. Then, we wait.
Calling back to the stock split discussion above, it’s important to reiterate that the market, like its participants, is an emotional enterprise. This can create dislocations for the long-term investor to take advantage of.
This leads us to one of our core strategies: Buy exceptional business when they are the most heavily scrutinized and hold them for a long time.
There’s a reason exceptional businesses rarely trade at a discount; because they’re exceptional!
In order for the value-oriented investor to buy shares in many of these companies, they must be ready, patient, and bold when the conditions are right. Most will fail when it comes to the last part and instead of taking a position in the company they may have watched for a decade, they get intimidated by the market volatility.
Over the past 10 years, markets have seen a wide variety of darling stocks sell off for issues ranging from E Coli Outbreaks, to executive turnover, to new competitive threats, or even an incursion by a foreign government. Those with the fortitude to see through the noise, adjust their analysis where relevant, and see the long-term picture, were rewarded for their strength on multiple occasions.
In many of these occasions, market commentators spent years prior to the drawdown waxing poetically about how they’d buy shares if only the valuation was lower… only to pass on the opportunity to buy in the “eye of a storm” for the stock.
Importantly, buying stocks after they go down is not our only strategy. It’s not even the strategy by which we acquire the majority of our positions, but it is how we get some of our best quality businesses in our allocation. Just as we discussed in last quarter’s letter: Avoiding Potholes | AAHH Allen Investments when buying stocks after they go down, you have to make sure there isn’t a systemic issue at play. For every one Microsoft that re-accelerates after creating a cloud solution, there’s another General Electric forced to cut their dividend after decades or Boeing that it turns out has been cutting corners in production for a long time.
For every company that transcends an issue the market can’t look beyond, there will be another that will prove never able to return to their former glory.
It is to the deciphering between the two, and the confidence to act when we see fit that we work.
April 2024
Dividend payments are not guaranteed and may be reduced or eliminated at any time by any company.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes.
