Tuesday, September 28, 2010

Why Capital Appreciation Must Not Be Overlooked

As dividend investors, we may find ourselves at times focusing too much energy on the dividend, not paying enough mind to capital appreciation and market value. 

We are lucky in the sense that the companies we invest in tend to be stable, growing earnings, reducing shares, and producing cash.  These are just the natural precursors to strong dividend growth.  And with these positive attributes comes capital appreciation.  Over time, as dividends and eps grow to stay in line with average yields and p/e ratios, the stock prices move accordingly. 

But we must not be complacent with sub par capital appreciation just because our dividends are still growing.  Even worse, we cannot accept major capital losses, as no amount of dividends will recoup our investment. 

The easiest way to assure good capital appreciation is to buy when a stock is undervalued.  There are many metrics we can use to evaluate this, such as p/e and p/book ratios, net asset value, and the king of them all, net present value.  By buying companies selling for less than their worth, we are creating a “margin a safety.”  This idea, developed by the godfather of value investing, Ben Graham, is as solid today as it was 50 years ago. 

The larger the gap between intrinsic worth and selling price, the better our chances of not losing money.  A stock may never again hit its boom time highs, but by purchasing good businesses at major discounts, we can be reasonably sure their value will grow.

Take for example a dividend favorite, Johnson and Johnson.  You can see my analysis of this company in the archives of this blog.  But for today’s purpose, let’s quickly look at an easy valuation metric, the p/e. 

In the year 2000, at the height of the 20 year bull market, JNJ sold for a whopping $105.94 on earnings of $1.55 a share, for a p/e of 68.35.   Then, as now, JNJ was a great business.  Earnings and dividends were growing, debt was low, and multiple revenue streams were reliable and consistent. 

In 2001 JNJ hit $49.13.  If you had bought in at the peak with $10,000, your investment decreased to about $4,367.00.  Your dividends for that year were only $65.80. 

This is why we must not overlook capital appreciation potential when we enter a stock.  Remember, Warren Buffett has said he made most of his money off of 12 investments.  So be patient, do your research, and look for discounts.  A few good decisions now will pay off handsomely later. 

1 comment:

  1. Good post.

    I certainly am mindful of capital appreciation for the long term. I focus on buying growing dividend stocks at fairly low valuations with an expectation that years from now I will look back and consider my investment to have been worthwhile.

    To a certain extent, though, I like it when my stock prices decrease. To many investors, their ideal situation consists of their stock picks increasing in value soon after they've purchased them. For me, I prefer for my stocks to keep their low valuations for as long as possible so that I can continue to buy more of their shares.