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Why You Should Pay More For A Good Company

January 8th, 2013 Leave a comment Go to comments

Investing is better accomplished with a cool mind,  good information and facts. When looking at how investors act in the market, they are far more rational and sane over extended periods of time than they get credit for. If we go back to the past 10 years, the dramatic drops in the stock market correctly occurred because future company earnings went down fast. This wasn’t an irrational response, it was a rational one.

This chart below demonstrates this point well. The earnings for the market (S&P500) were increasing up until the crisis occurred. Once the financial crisis hit, the market predicted future earnings distress. In an orderly fashion, stock prices went down.

S&P500 Earnings Versus S&P500 Index Price, 2004-2012

Chart courtesy of Market Trends.

As it became clear that earnings had bottomed during 2009, the market responded with higher stock prices. It’s that simple! If you can predict earnings you can predict stock prices. Of course, living through that time, it might not have been that simple to buy stocks. However, the market responded based upon facts that they believed. Companies can be more optimistic than the actual reality, but the marketplace figures it all out with thousands of individual decisions.

Let’s look back further in the past with this chart that goes back to the previous bull market from the 1990’s.

S&P500 Earnings Versus S&P500 Index Price, 2004-2012

Look at the year 2000! It’s clear that the market valued stocks at a much higher level then it did in the next bull market during 2007. The earnings and price levels are exactly flipped. This demonstrates that the market corrected for the previous mis-pricing of stocks in the year 2000.

What about now? The interesting comparison is that the recent recovery is behaving in the same way the previous bull market did 6 years ago. There isn’t any evidence that there has been re-pricing of earnings as had occurred previously. From this point of view, the charts show that we are about where we should be in market pricing for the level of earnings right now. Not cheap or expensive, but about right.

Making Decisions On Individual Stocks

This information is interesting, but what does it mean for buying individual stocks? It means that you need to pay more for good quality stocks over time because the earnings increase. Sure, you bought that great stock 2 years ago for 50% less than today, but it could be the case that it is cheaper now than it was then. If you keep in mind the long term trend of stock prices, earnings and expectations, what you need to do is to buy stocks when they are most attractive at any given time. This could mean buying them at higher prices than what you bought them for in the past.

Let’s look at Philip Morris (PM). I’ve owned this one before it was split off from Altria (MO). Here are the prices I paid over time:

2008: $55 (approx split price)
2010: $45
2011: $63
2012: $83

What was the value of this company over time? Here’s a chart that shows different criteria at the end of the year, for the past 5 years, plus one forward year (2013 – consensus estimates were used for earnings).

Philip Morris (PM) Stats

Year Earnings Price P/E Dividend Dividend Yield Payout Ratio
2008 3.31 43 12.99 2.16 5.02 0.65
2009 3.24 49 15.12 2.32 4.73 0.72
2010 3.92 57 14.54 2.56 4.49 0.65
2011 4.85 78 16.08 3.08 3.95 0.64
2012 5.21 83 15.93 3.4 4.10 0.65
2013 5.81 83 14.29 3.77 4.55 0.65

Here’s what I take from this information that is insightful:

  • The market predicted poor earnings in 2009, by valuing PM at about 13 (which is less than its historical average). The market was right, earnings did go down the next year. In response, PM temporarily increased it’s payout ratio to 72% to continue the dividend increases. This speaks to the quality of the management of this company, because they knew the economy would come back and when it did, they brought the payout ratio back inline with guidance (which is 65%).
  • PM’s management will increase its dividend along with it’s earnings. This makes it easier to judge how well the company is doing, just watch the dividend over time.
  • A 4% dividend yield is when PM starts to get attractive. At $83, it is only about 10% more expensive than when it traded for $57 3 years ago when the dividend yield was 4.5%. At a price of $76, it becomes cheaper.

As much as I would like to own PM at a price of $76, it may not happen. So, I decided to buy more in December 2012 when the yield reached 4.1%. This isn’t as cheap, but it’s close enough. If it falls further, I will buy more. Time is money, so, if you believe the earnings estimates for 2013, PM will likely reach the 4.5% dividend yield in the third quarter when the yearly dividend increase is expected.


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