"Accept the fact that you are unlikely to beat a market where prices are set by the consensus of thousands of professionals and where you pay a steep price for every attempt."
--Gary Gensler
This is hysterical in that he is presently manager of an actively managed fund and made his whole career at Goldman Sachs exploiting markets. Of course he made that quote when he was unemployed and trying to sell his book. That is a statement which is proudful in nature saying, "the average man cannot do as I have done, it takes too much talent". He and his ilk are in a totally different market than the one I participate in, and he is a servant to the whims of his customers and to earn his high pay must pretend to offer high value, I answer only to a very reasoned individual whose only pay is the result of dividends paid through ownership of corporations .
But enough of that, here is a simple example of how one can use dividends to spot potentially underpriced stocks, but even if the security does not rise in value the dividends still can rise faster than the inflation rate leading to an improvement of the individuals standard of living through ever increasing dividends at a faster than inflation rate which I think is most important portion of stock ownership. I will use a stock I recently selected to prove I am not cherry picking a situation.
Using the Value Line market survey, limit yourself first of all to only the stocks that pay dividends and are yielding more than 1.5% but preferably over 2%. Next only take stocks that are 1 or 2 for safety at least 3 for timliness and B+ or better for Financial strength as we want suitably strong and reliable companies. Next take companies where Price stability and Earnings predictability are both above 65 and at least one of these above 75, this gives us a predictable base to build on for forecasting results, finally pick companies with a rising dividend or difinitive plans for a rising dividend.
So one company that met this criteria was AMGN At the time I reviewed as a possible replacement for JNJ it was at a price of $144 and yielding 1.7 percent but the long term outlook for dividend increases was 15% and that would be a slowdown from the past couple of year increases. Other research showed the rise in earnings and increase of the dividend payout ratio would support the 15% dividend increases expected for the forseeable future. As a biotech company with a solid dividend policy this makes for a very good diversification candidate to an income portfolio. But what is it really worth?
I determine through other research that it is reasonable to expect the 15% dividend growth to last 10 years and that if then the dividend were to flatten out to only 2-3 percent above inflation at that point it should still in 10 years sell at a dividend yield at worst of 4 percent. So that would mean in 10 years the stock would sell 25 times the dividend which I expect to be $9.87 or $247 dollars. If you then discount that price back by 3 percent per year for the risk free return you get $182 dollars, then add the dividends discounted for the next 10 years of 47 dollars for a present value of Amgen of $229 dollars for full valuation. The Amgen fell below 130 per share earlier this month making the yield 2 percent and the potential even more enticing so I purchased at $129.65.
As time passes and my budgeted assumptions are measured against the market AMGN will move towards the price I expect if my budget is accurate. Factors that would change this are the risk free return, dividend policy, earnings outlook or a change in the board resulting in a dividend policy change. However if in one year everything is according to my budget the dividend would be $2.81 and expected growth would still be 15%. What happens in the market though is the realization that the dividend growth is more sure so the dividend yield might move from 2 percent to 1.7% Meaning in one years time i will earn the 15% increase from the dividend yield/ earnings valuation and also 20 percent for the stock falling in yield from 2 percent to 1.7% and still have a company that is undervalued, just not as undervalued as the buy point. If the stock has fallen so the yield is now over 2% then as long as the assumptions for dividend, risk free return and earnings growth are still valid I am in no peril. The key is to find stocks that are growing the dividend and paying for a predictable performance in an underpriced dividend moment.
Now when AMGN actually announced they are increasing the dividend 30% next year, assumming the remaining 9 years will be 15% growth yields an additional immediate increase in NPV of $30 or a total of $259. The closer the stock gets to that level the less upside is left and the more likely there are other better opportunities, giving you a chance to sell high. This is why I sell when the dividend yield based on the coming years expected dividend is below 1.5% which in this case yields a price of $215.
The key is to limit yourself to predictable companies and develop reasonable assumptions and measure future progress against your assumptions. This process will work no matter what the stock is. However simplistic this system seems, I am highly doubtful there is much analysis of stocks being done with this filtering and valuation criterea, as a matter of fact most purchases of AMGN are probably driven by the BIOTECH ETF and other ETF and indexes purchasing and selling in the market. The big players that can change prices are the unencumbered hedge funds and managed funds that by their nature have a 1-2 year focus as their long term focus but frequently can't get past the next end of the month fears.
Just for info purposes if the risk free discount were to be 4% then under the present scenario the NPV I am using is $235 at 5 percent it falls to $215 so while there is an interest rate sensitivity to this stock it is not severe nor even sufficient to worry about in purchasing the stock at $129.65
