If you haven’t noticed, the US stock indices have performed fairly well in aggregate over the past few months. Including several of my holdings.
What a bummer!
That’s probably not the reaction that you’d expect, but it’s rather common among long-term investors. When stock market prices go up, the paper value of a portfolio increases, but finding solid investments for currently invested capital becomes more difficult. My brother, an executive at one of the largest US defense contractors and a husband and father to a wife and three kids, is joyed to see his indexed portfolio replenished, and I can’t really blame him, but I’m disappointed to see some values lessen! I’m glad to see people get to work; I’m not disappointed about economic improvement. It’s strictly the stock valuations that can be suboptimal.
In a market with lower valuations, fresh capital can result in producing better returns, and reinvested dividends and company share repurchases result in better rates of return as well. Markets with higher valuations result in reinvested capital going to lower-return investments.
To illustrate this point, here’s an example. Company A has a P/E of 12, solid cash flow and a good balance sheet, pays out 75% of its EPS as regular growing dividends, and grows EPS by 6% per year. Company B is identical in every way, but has a P/E of 18. For simplicity, these valuations stay constant for 10 years, and dividends are pooled and reinvested once per year. I could have done this chart in multiple ways, such as making stock prices equal and having the two companies with different EPS (to reflect the differences in valuation), or I could have made EPS the same, and make the stock prices different. I choose the first approach so that we can start with the same amount of shares at the same price per share. This link shows a PDF of the charts and outcomes.
As can be seen, since both companies have the same payout ratio but company A is at a lower valuation (and therefore a larger dividend yield), investing in company A results in a larger initial amount of dividend income for the same invested value. In addition, over the next 10 years, since the valuation is lower and the yield is therefore higher, reinvesting the dividend purchases more shares, which grows the investment and the income at a quicker rate.
An investor in company A turned $12,000 into $39,403, which is an annualized return of 12.6% over this 10 year example. Meanwhile, an investor in company B turned $12,060 into $32,486, which is an annualized return of 10.4% over this 10 year example. The total dividend income growth rate matches the total return for each respective investment.
So, two identical companies had significantly different returns based simply on their valuation over that period. This is because dividends can buy more dividends when the valuation is lower (and this applies to share repurchases by the company as well). Of course, over any realistic time period, the valuation will rise and fall, but the point is, that at any given time, it’s preferable in the eyes of the long-term investor (net buyer) for the valuation to be low. Any time that’s spent with her dividend stocks at higher valuation, is money lost. Now, there are some times of course when a spike in valuation could be profitable, such as if a stock goes up to an overvalued state and the investor sells, looking for a better stock, or if the valuation increases just when a person retires and cashes out part of her stock portfolio. But for most long-term investors, especially net buyers that aren’t retiring any time soon, it’s low-valued markets that provide the better long-term returns.
Now, one could point out that valuations are directly linked to growth expectations. In other words, when the stock market changes, it’s because investors are increasing or decreasing their expectations. The example chart that I provided only remains true if fundamental growth is unchanged by the changing valuation; it assumes the differences in valuation of those two identical companies are strictly irrational rather than due to legitimate differences in expectation. But one can look at any long term graph of stock price and annual EPS for a given set of blue-chip stocks, and see irrationality in the stock price.
Buy low, look for good combinations of dividend growth and dividend yield, solid balance sheets, strong cash flows, economic moats, and hope it stays low for a while to let those shares accumulate.