Most of the stocks in my core investment portfolio – my Legacy Portfolio – are dividend-paying stocks. And since I don’t rely on cash from those dividends for current income, my practice is to reinvest it.
The common way this is done is automatically through a dividend reinvestment program (DRIP). That is an order you give to your broker to use the dividends of a stock to buy more of that same stock.
When I designed the Legacy Portfolio (with the help of Tom Dyson and Greg Wilson), I wanted very much to reinvest the dividends, but I was doubtful about DRIPs. My question to them was a simple one:
“In every other investment I’ve ever made, the price I pay for the asset matters. I assume this applies to stocks. If that’s true, why would I use DRIPs, which are designed to buy more of the same stock regardless of the price?
“What if, instead of automatically investing each dividend in the selfsame stock, we accumulated the dividends as they arrived, kept them in cash for a while, and then invested them in just one or maybe two stocks that were currently underpriced?”
Tom and Greg did a fairly extensive analysis of my proposition and came back with the encouraging conclusion that such a practice would increase overall yield. (I don’t remember the differential, but it was significant.)
I mentioned this in a recent videotaped interview that Legacy Publishing group did with Bill Bonner, Doug Casey, and me. And it prompted a viewer to write this to me:
“I’ve read your strategy for buying income-producing real estate. You determine whether the asking price is fair or not with a simple formula: 8 times gross rent. What I want to know is if you have such a simple formula for determining the value of a particular stock, both for making the initial purchase and for re-investing the dividends.”
This is what I told him…
Determining a “fair” price for a dividend stock is a bit more complicated than it is when you are valuing income-producing real estate.
For one thing, stocks are shares in businesses, and businesses are more dynamic than houses and apartment buildings.
They are dynamic and they are organic. How they change is not up to you. Rental properties, on the other hand, are fixed and tangible. Except for an event like a hurricane or fire (which can be insured against), they change only when you do something to them (add a bathroom, paint the walls, etc.).
Which is to say it’s easier to get a reliable estimate of the market value of a rental property. You compare it to similar properties in that location at that time.
That said, there are numerous ways to determine whether a particular stock, a stock sector, or the market is “well” or “fairly” priced.
As Bill Bonner pointed out in his December 7 Diary, Warren Buffett’s favorite yardstick was to measure the relationship of total market capitalization (the value of all stocks added together) to GDP. Logic dictates that a good ratio would be below 100%, because a stock cannot be worth much more than the GDP of the country that supports it.
Another, more indirect, way to look at it, Bill said, is to compare U.S. household net worth(which includes real estate, bonds, and stocks) to national output.
And yet another calculation looks at the number of hours the typical person would have to work to buy the S&P 500 Index.
What are all these measurements telling us about the U.S. stock market today?
- Market capitalization is currently worth 150% of the GDP.
- Household net worth is 5 times GDP.
- It takes 120 hours of work to buy all the stocks in the S&P, compared to just 20 hours back in 1980.
Bottom line: The stock market, in general, is overpriced. And that’s true as I write this on December 8, after recent corrections.
These are three useful ways of valuing the stock market. And they are helpful when thinking about the market in general, just as it’s helpful for me to know whether a particular real estate market (a neighborhood, a town, or even a region) is cheap or dear.
But since I don’t buy into or out of stocks in groups, I use a different tool for deciding when it’s safe/smart to buy a particular stock, just as I use the 8-times-gross-rents formula to decide whether to buy a particular piece of rental property.
I use a P/E or sometimes a P/R ratio to determine whether the stock is well priced. The P/E ratio compares the price of a company’s share to that company’s profits (or earnings). The P/R ratio compares the price of a company’s share to that company’s revenues.
If the company’s current ratio is higher than its historical average, it could be said to be too highly priced. If it’s lower than its average, it could be said to be selling at a discount.
For example, a company like Coca-Cola has a current P/E ratio of 76. Over the last two years, the industry average for businesses like it (e.g., PepsiCo and Mondelez International) is 45. And historically, for the past five years, it has been 30 times earnings.
Had you bought Coke in the summer of 2015 when its P/E ratio was 20, you would have bought the business at an all-time low.
Conversely, had you bought shares in December 2017, you would have bought an interest in Coke when it was at an all-time high.
Following this rationale, the prudent investor would not have bought stock in Coke after September 2016.
Dan Ferris did a study on this very thing some number of years ago. I remember being impressed by the numbers. And I remember Ferris’s observation on how unwise it would have been to buy when the P/E ratio was above 21.
So, as you can see, the “simple formula” I use for determining the value of stocks in and for the Legacy Portfolio is a ratio. Just as my simple formula for evaluating the price of a rental real estate property is a ratio.
This strategy can, of course, make it difficult or even impossible to buy more stock in good companies for years and years.
When the market is generally overpriced, as it is now, it’s not easy to find good companies that are underpriced. And when your portfolio consists of huge, world-dominating companies, the challenge of finding a single one that’s well priced is daunting.
There are times when you have to wait months or even years before the price of one of these great stocks comes into a safe buying range.
But giving into the frustration by overpaying is just foolish.
I do two things when I’m in this dilemma (as I am now).
I ask Dominick to look around to see if there might be some other equally good stock whose shares are NOT overvalued. And if there is, I sometimes I use the cash from my accumulated dividends to buy those shares.
I also look around at other income-producing investments – rental real estate or private debt or even bonds where I can make 6% to 8% (and sometimes more) on assets that are just as safe or safer than Legacy-quality stocks.
Let me be clear… I’m not suggesting that you should follow this protocol.
I’m answering a question.
This is what I do and have been doing for many years, and so far it’s been working well for me.
- It allows me to make money continuously, day after day, which helps me achieve my long-ago goal of getting wealthier every day.
- It allows me to invest in stocks without being an expert in the companies or the industries I buy into.
- It allows me to stay invested and not worry about when to buy and sell.
One more thing that I should mention: I’m not a market timer and don’t believe in trying to be. So when the stock market is overpriced, I don’t sell my Legacy stocks. I keep the ones I have because I believe they will still be profitable in 10 and 20 and maybe even 50 years. But I don’t buy more of them simply because my stock account is filling up with dividends.
I haven’t been working on this for as long as I’ve been working on my real estate formula, so I don’t think I’ve got it exactly right. But Dominick is helping me refine it. And so far, it is the best and safest stock strategy I can think of.
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