Thoughts on starting a new portfolio – Part 3 : Does entry price matter to a dividend investor?

Stocks mentioned in post – INFY
We have been thinking a lot about developing a framework for our long term portfolio. As of now, we are quite sure that this portfolio would be based on Core-Satellite approach. For Core portion, we are almost sure that we want to use dividend investing (what?) as our primary approach. But why have we chosen dividend investing as our main approach? We found an article which words everything we had in our mind to answer this question. If you have time and are interested in dividend investing, please do read the article.
 
Though we have chosen our primary approach, we must confess that we are not 100% sure. We are confused. We have dilemmas which we hinted at in our last two posts (1 & 2) too.
 
Dilemmas
  • Does entry price matter to a dividend investor?
  • Does it make any sense to bother too much about capital appreciation of stocks chosen for their ability to give out dividends year after year?
Though we will try to resolve these dilemmas in this post, we would like you to read a financially touching article on Seeking Alpha (link). The article describes a man’s dividend investing journey and how he ensures that his income increased year after year, without any dependence on his employer. A brilliant story!
 
Note – We shall be using the term High Entry Price in text below. By high entry price, we mean that company is trading at multiples which are more than their historical averages.
 
Suppose an investor purchases share of company which is trading at high multiples. This company is a regular dividend payer. This investor would now be stuck with a low yielding security for a long period of time. On the other hand, a company trading at lower valuations, cannot go down much lower as it may already be at levels which are close to what it would cost an acquirer to pay for it. Luckily, an investor would now be stuck with a high yielding security for a long period of time. Now who would mind that?  J
Problem with high multiple stocks
The problem with high multiple stocks is that future growth is already accounted for in stock prices. This implies that long term investor could likely see little gains even if the earnings grow over time. And one quarter of missing earnings estimate, will damage stock price for a long while as these high multiple stocks are volatile (Example – Infosys) . Also, once the earnings slow down, the PE also contracts (stock is de-rated) and price either goes down or stays flat if earnings have increased sufficiently to compensate for lower multiple.
 
Problem with investors like us
Investors like us chase overvalued dividend stocks because they are afraid to miss the boat on future price gains and dividend increases. Unfortunately, stocks with higher valuations have a higher chance that anything that goes wrong could have a negative effect on share price & dividend income stream. On the other hand, investors who purchase stocks at reasonable valuations, have better chances of realizing rising price and dividend returns.
 
Did we answer the main question?
All the above discussions point to the fact that it is important to have some sort of valuation guidelines, before we purchase a dividend stock. This will help in avoiding stock purchase decisions made out of ‘love for stocks’and regardless of price. After all, purchasing a stock at inflated price levels might lead to sub-par returns for several years.
 
Would like to know your views and counter arguments.
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Written by Dev Ashish

Founder - Stable Investor Investing | Personal Finance | Financial Planning | Common Sense

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