How to Get Paid to Buy Low
Investors like to think of themselves as having the guts to buy low and the foresight to sell high.
But the reality is people get emotional when their money’s on the line.
Over the short term, of course, anything can happen. But over the long term, income investors will likely outperform the average investor.
That’s because companies that can afford to pay a dividend and grow it over time are going to be around for the long haul.
And the compounding effect of dividend reinvestment counts for as much as half the stock market’s long-term return.
Perhaps that’s why income investors tend to be a hardier bunch than most investors.
While dividend stocks are far less volatile than the average stock, they can still have pretty dramatic ups and downs.
But most income investors will stick around as long as a company continues to pay a dividend. That’s why they’re willing to tolerate wide swings in valuation.
Premiums and Discounts
Even so, that doesn’t mean income investors should ignore valuation. Indeed, until recently, some key dividend payers were trading at ridiculous valuations.
At varying points over the past five years, electric utilities have traded at a premium to the broad market. That’s quite a feat for such a stodgy industry.
Meanwhile, takeover interest pushed gas utilities to even higher valuations. And slow-growing water utilities were trading at valuations usually reserved for fast-growing tech stocks.
In some ways, this made life easy for longtime shareholders. After all, it’s a lot more fun watching your stocks go up while getting paid to do it.
At the same time, this situation also created a dilemma. What do you do when your favorite utilities have been trading at super-premium valuations for years and years?
You know you’re supposed to sell high. But if you do, you could lose a crucial income stream.
After all, if you’ve owned a stock for many years, odds are your effective yield—based on what you paid originally plus dividend growth—is a lot higher than the current yield.
For instance, one of the water utilities that we added to Utility Forecaster’s Growth Portfolio nine years ago already has an effective yield of 10.5%, even though its current yield is only 2.1%. Now, you see why income investors tend to stick around!
It’s hard to kick a stock like that to the curb—especially when it’s set to continue giving shareholders more earnings and dividend growth.
And if you do sell the stock, there’s no guarantee that you’ll be able to buy it low anytime soon. Again, water utilities have traded at ultra-premium valuations for years.
Plan of Action (and Inaction)
But there is another way to buy low without dumping a high-quality dividend stock.
While not all income investors have the luxury of reinvesting dividends, it’s the surest way to compound your gains and build truly enduring wealth.
But if you have some flexibility, you can do a little bit of both—reinvest and collect cash. It all depends on valuation.
Normally, I advocate a “set it and forget it” approach to reinvestment. But these days it’s pretty easy to change whether you want dividends reinvested automatically.
So here’s my modified approach to reinvestment—one that gives you cash to buy low or use as income without selling a stock you’d rather keep holding.
When a stock rises to an ultra-premium valuation, turn off reinvestment and let the dividends go to cash. Then when the stock drops back to a more reasonable price, turn on automatic reinvestment again.
Juice from the Giant
As an example, let’s look at Dominion Energy Inc. (NYSE: D). Over the past eight years, the utility giant has traded at an average price-to-earnings ratio (P/E) of 16.1.
Since utilities have been on an incredibly strong run, Dominion has traded well above that valuation for much of the past four years. In fact, in mid-December, it traded at a staggering 23.1 times earnings.
Admittedly, the process of setting rules for when to turn automatic reinvestment on and off is highly subjective.
For instance, back in 2010, at the outset of this period, Dominion’s long-term average valuation was much lower—around 8.9 times earnings. That’s because the prior decade contained two bear markets, and a sectorwide utility selloff courtesy of Enron.
Obviously, the factors more recently have changed. The biggest value drivers for utilities have not been their underlying earnings and dividend growth.
Instead, the historically low interest rate environment forced retirees to turn to dividend stocks such as utilities for income.
And continuing uncertainty following the Global Financial Crisis would occasionally see investors of all stripes flock to utility stocks as safe havens.
So it’s difficult to set hard-and-fast rules about valuation when the market, itself, is constantly changing.
If I were to set such rules, for instance, I would probably grant a fair amount of latitude. That’s because stocks tend to rise two-thirds of the time, so it’s not all that unusual for them to trade at moderate premiums.
For example, I might let my favorite utilities trade 15% above their long-term average valuation before turning off reinvestment.
Similarly, I might require them to drop back below that threshold before turning reinvestment back on again.
Over time, that threshold would change depending on the trailing time period you use. But by any reasonable standard, utility valuations began approaching absurd levels when P/E ratios rose above 18.0.
Indeed, that’s the level at which Dominion’s stock has traded for most of the past three years.
From Mid-Yielder to High Yielder
Let’s say you bought 100 shares of Dominion toward the end of 2014. If you turned off automatic reinvestment during the subsequent three-year period, you could have collected a total of $842.50 in cash.
Now, you could have used that cash as income—or you could have used it to buy beaten-down dividend payers.
During this time, for instance, the energy crash brought master limited partnerships (MLPs) down to long-term lows and extraordinarily high yields.
If you used that cash to build a position in Enterprise Products Partners LP (NYSE: EPD) during this period, you would now own around 34 shares of EPD, with an average yield of around 6.3%.
Now, imagine doing the same thing with $100,000 worth of utility stocks that had roughly the same value and payout as Dominion.
Assuming you established your positions at the end of 2014, you’d have $12,263.43 to use as income over the next three years—or for bargain-hunting in the midstream space.
That’s how you take a stock with an average yield of 4% and use it to create yields of 6%, 8%, or higher.