Recent Investments for October 2, 2024

Good Morning,

I wanted to let you know that I added to two existing positions. Those have been positions in my taxable account that I have been slowly accumulating partial shares of every single month for the past several months. Unfortunately, these companies are getting to the top of my valuation range (along with pretty much everything else or so it seems).

In terms of valuation, I do not have some set rules or formulas. I believe that valuation is part art, part science. I do use the Warren Buffett principle that value and growth are connected at the hip.

I do believe that future returns are a combination of:

1. Dividends
2. Earnings per share growth
3. Changes in valuation (P/E ratio etc)

The first two items are portion of the fundamental return. They drive almost all shareholder returns over decades. The last item (valuation) is essentially the least important over the very long run. In the short run - up to 5 - 10 years however, it affects results a lot. For example, if you overpay dearly for a stock (e,g pay 100 times earnings), it may take you at least one decade of high growth to overcome this. During this time you will be showing little for the risk you took. On the other hand, if you pay a very low valuation for a stock (e.g. 10 times earnings), and it grows and gets revalued, your results would be amazing for a decade. Of course, the longer you hold (assuming fundamentals keep doing well),  the higher the importance of dividends and earnings growth, and the lower the importance of valuation. But this is hard to tune out, especially as we are ordinary investors who are living day to day in the present. Super investors like Buffett/Munger/Peter Lynch etc have tended to take advantage of cheap stocks, and sell when revalued/overvalued. But I believe as a buy and hold investor this can create more trouble than possibility of net gain. In other words, do not time the markets.

In general, I look at P/E ratio, along with dividend growth rates and dividend yields to gain some type of confidence of the type of company I am looking at. I also try to determine how cyclical a company's earnings stream is. Different companies from different industries have different P/E ratio valuation sets. Plus, even individual companies will have differences in valuation in terms of P/E depending on how enthusiastic/depressed Mr Market is for their prospects OR what stage of a growth cycle they are in.

This of course is in the context of looking at dividend growth companies. There are basically three types of dividend growth companies out there:

1. Low yield but high growth
2. Those in the sweet spot in terms of the trade-off between dividend yield and dividend growth
3. High yield but low growth

In general, a well diversified portfolio would have exposure to all types of companies. They all come with different sets of returns profiles and path dependencies. However, a combination of the dividend yield and dividend growth should provide an estimated return of at least roughly 10. 

However, it is not that simple. We also need to determine how defensible those earnings streams are, and how cyclical they are. Some companies are more immune to the economic cycle than others. Hence, a valuation based on say P/E or dividend yield may be "easier".

Other companies have different valuations because they have different growth or existential expectations assigned to them. If you have high growth expectations, you probably have a high P/E multiple assigned to the stock. But if those growth expectations turn out to have been lofty, you get a double whammy of valuation shrinking along with EPS not growing as fast as you want it to be (plus you probably locked in a low entry yield as well so you are paid to hold, but not too much). On the other hand, certain companies may have moderate growth expectations, but their valuations are low as well, which can result in adequate rate of compounding over the long haul. Assuming those fundamentals are not about to deteriorate of course and for the company to turn into a melting ice cube. 

Other companies may be more cyclical than others. Because earnings are lowest at the bottom of the cycle, companies tend to appear very expensive. Also, when the cycle is at the top, these companies appear cheapest, right when earnings are about to take a nosedive, as well as prices and even dividends.

These are just some random thoughts I have about valuations. I wrote a few articles on the topic on the old blog a few years back. You may find them helpful.

How to value dividend stocks

Anyway, I added to two existing positions today….