The Past 5 Years is Blinding Dividend Growth Investors

It happens all the time;

It’s the nature of the beast;

We run around in circles, because this is what it is!

 

This thought crossed my mind while doing stock analysis; I’m being blinded by the past 5 years! The funniest thing about humanity is that we have the benefit of having over 2,000 years of recorded history and yet keep making the same mistakes over and over again. It’s like everything that happened yesterday doesn’t exist at all; that the situation we face today is completely different than the last time it happened. I’ll tell you a big secret; it’s not different.

This is probably why the stock market is gyrating up and down for barely any reason at all; because we all think it’s different this time. But when you are a long term investor, you must be sure of one thing;

The stock market always goes up

Therefore, buying strong companies is more important than the timing when you buy them. However, the word strong tends to appear too often for my taste these days. I just don’t read this on other websites, but I also find myself excited by too many companies these days. It just doesn’t feel right.

How, logically, can you find so many buying opportunities after the stock market has almost doubled in the past 5 years?

 

The first explanation is that everybody looks good on their Prom Day

This is especially true for the US market; it has been 5 fabulous years since the terrible crash in 2008. Between the end of 2008 and the beginning of 2010, the valuations of most companies were brought down to their lowest. Companies were able to cut down on staff through major layoffs without hurting their stock price more than it was already. The world had lost faith in the market and it was up to companies to clean-up their balance sheet and survive the crisis.

Those who successfully reduced their cost, renegotiated their debt and focused on their main business model are now showing a very strong 5 year record. The bad years don’t appear in the metrics used by most investors. In fact, the 5 year and even the 7 year history are not enough to show if the company is strong enough or not. On the other hand, who really cares about what happened back in 1990s?

What scares me is that we are only looking at good years to make our stock picks. This is very dangerous to think the past guarantees the future.

 

Cash does not have the same value as it used too

During the same 5 years, borrowing costs have hit historic low points. Companies can borrow for nothing and can easily use leverage to grow. They use massive amounts of cash to aggressively fund share buyback programs and increase their dividend payments.

When I look at my portfolio over a short term period of 5 years, I’m very happy. The portfolio has gone up in value substantially and I cash out increasing dividends on top of it.

The cash lying in companies’ bank accounts doesn’t amount to much due to low interest rates. This is why they redistribute this money to shareholders in the meantime. It’s a good way for management to boost the stock price and cash in their generous options at their peak.

 

There is a problem with the valuation models

Because of reason #1 and #2, the valuation models we currently use are very hard to manage. I personally use two approaches to value my stock picks: I look at the 10 year PE history to see how the stock market values the stock in general and a two level dividend discount model calculation spreadsheet (the spreadsheet and the most complete valuation guide for dividend stocks are offered at Dividend Monk).

However, I find myself with a big problem when using the spreadsheet:

Which dividend growth rate to use?

If I use the past 5 years dividend growth rate, I get stuck using astronomical numbers for some companies which play use “dividend candy” to attract more investors. I’ve seen several double-digit growth rates that are unsustainable over the long term. This is what it makes it so difficult to assess a good value at the moment. I would still rather play safe and be more conservative with my approach but yet, there are too many companies trading at a 10%-15% discount.

 

The dividend payment should not be enough to make you smile

One should not be that happy to receive your dividend payment each month. I mean, it’s amazing to transform your portfolio into an ATM machine distributing payments each month. However, I don’t think being blinded by the dividend is a good thing either. At the moment, all companies look good because the economy is going well and the market is exciting. However, when things turn sour, there will be some companies that won’t be able to keep up with their high dividend growth rate and the stock value will drop accordingly.

Dividend growth is the most important metric of all of my 7 investing principles. I’ve identified this metric to be the most important one as the dividend growth rate is a direct consequence of both increasing revenues and earnings. If one or the other metrics fail to rise in the future, the dividend growth rate will eventually be affected. However, this doesn’t mean I follow only this metric. The dividend growth rate is very important to me, but it’s not everything either. I feel much more comfortable when the shares in my portfolio show a great stock appreciation rather than simply an increased dividend payment.

 

What I will be doing in the upcoming months

As I’ve mentioned before, I’ve been concerned by this situation over the past few months. I don’t think the whole stock market is going to burst, I’m not part of the Black Swan fan club. However, I think the method I use to value stocks and select strong companies will have to be reviewed in order to become stricter and therefore, find the real bargains in this crazy market.

 

Have you done anything different lately when it’s time to look at dividend stocks? Do you find that many opportunities in the market?