The Dividend Investor's View of Market Volatility

Today marks the close of one of the wildest weeks we’ve seen in the U.S. stock markets in a long time.  At DCM, we have developed several valuation models that help us gauge where the fair value of the major indices are at any given time.  These models help us separate the emotional roller coaster of the stock market against the reality of what the fundamentals are telling us.

We know these models are never going to be 100% accurate, but they have been particularly good over the long-term.  We have used them for many years to help us navigate uncertain times.  With the markets getting choppy this week, we thought it would be helpful to show you what those models are currently saying.

Model #1: Long-Term Divearn Model (going back to 1962)  

This model uses dividends amongst a couple other variables to predict the fair value of the S&P 500 index.  This model has predicted roughly 91% of the movement of stock prices going back to 1962.  For brevity’s sake, we’ve shown only the years from 1990 through 2016 in the chart below.

The grey bars represent DCM’s predicted fair value.  The “blue shadow” represents the model’s error range.  And the red line is the S&P 500’s actual price.

As you can see, the red line (price) always tends to move towards fundamental value (grey bars). In most years, the S&P 500’s price stayed within our model’s fair value range (blue shadow).

Over the years, this model has been very effective.  The market was grossly undervalued in the early 1990s before becoming grossly overvalued in the late 1990s.  In 2002, the market came right back down to fair value. The financial crisis of 2008-09 again presented a great value.  Since then, the market has moved up towards fair value and stayed right with our predicted fair value.

At this moment, the model is predicting the current fair value of the S&P 500 is 2,148 (+8% from here).  There is an error on either side of that number.  The market’s low this past week was 1,867 – just modestly below the lower range of our model’s estimates.

Model #2: Forward Divearn Model (going back to 2009)

The second model uses the same inputs as the first, but with two differences: (1) It uses forward earnings/dividends and (2) it uses the most recent 6 years (2009-2015). It has predicted roughly 93% of the movement of stock prices going back to 2009.  

Again, you can see that the price (red line) follows closely to the fundamental value (blue bars). The market got outside of the error range (blue shadow) in just 5 out of 23 quarters.

You will note that the market got too high in the 1st quarter of 2015.  Since that brief overshoot, we’ve seen stock prices go flat and now down.  The primary culprit was the decrease in the energy sector’s forward earnings.  Once those were past us, we’ve started to see fundamental value increase as we move towards the end of 2015.

You’ll notice that the S&P 500’s price has reached the lower end of the model’s range. This would suggest that stocks are trading at a discount to their current fundamental value. According to this short-term model, the fair value of the S&P 500 over the next 12 months is 2,153 - a roughly 9% discount from the market’s price as of today (Friday).      

What Does It Mean For You?

Both of our models are saying the same thing.  As long as there is not a recession on the horizon, these models give us confidence that stocks present a good buying opportunity at this point.  As we talked about in a previous blog post, the “dog” (stock prices) can’t get too far away from their “master” (dividends) over a long period of time.

While this market volatility can shake your confidence, it presents an opportunity for the long-term investor.  Looking at the fundamentals (dividends and earnings), it appears that we are trading lower than we should be.

F.A.N.G.: The 4 Companies Driving the Stock Market

2015 has been a challenging year for investors in individual stocks. So far this year, we’ve seen the price performance of individual stocks vary much more than it had been previously.  If you haven’t been invested in the right sector or had a decent amount of your portfolio in just a few high growth stocks, it is unlikely that your portfolio has kept up with the S&P 500.

Nothing illustrates this more than the acronym FANG, which stands for the darlings of 2015: Facebook, Amazon, Netflix, and Google.  As a whole, these stocks have accounted for more than 75% of the S&P 500’s returns year-to-date.

Amazon is up 68% so far this year.  Facebook and Google are both up by 21%.  Netflix is up a staggering 153%.  These four stocks comprise just 3.5% of the S&P 500, yet have contributed 75% of its performance.  Together, they have driven the S&P 500’s total return up by 1.6%.  The S&P 500 is up by just 2.1% so far this year.

If you own individual stocks and you don’t own these four companies, your portfolio is going to have a very hard time getting close to the market’s performance.

The question that must be asked is this: If just four stocks in the S&P 500 have been doing so well, why not own these four stocks? Why not buy shares in Amazon, Facebook, Google, and Netflix?

1. None of them pay a dividend.

An investor who puts money into a stock that doesn’t pay a dividend can only profit in one way: If someone else is willing to pay them more for their shares in the future.  

We invest in companies for which their market price growth closely follows dividend growth.  A company that pays a dividend has shown that it can create cash from its business operations and is willing to share that cash with shareholders.

A company that doesn’t pay a dividend either (1) doesn’t make money consistently enough to afford to pay a dividend (2) is growing rapidly or (3) is not shareholder friendly.

Without a dividend, a company’s stock price is based far more on speculation about future earnings.  We’ve seen over time that earnings can be volatile.  In 2008-09, earnings for the companies in the S&P 500 plunged by more than 50% with price going right along with it.

2. They all trade for extremely high multiples.

The price-to-earnings (P/E) ratio is a quick way to see how optimistic other investors are about a stock’s future.  It tells us how much investors are willing to pay for $1 of that company’s earnings.  The current P/E for the S&P 500 is right around 18.  That means the average stock delivers $1 in earnings for every $18 the investor pays to own it.  That represents an annual return on investment of 5.6% ($1 divided by $18).

All four of these stocks are trading at extreme premiums to the rest of the market.  Facebook’s P/E is currently just under 100.  Netflix trades for a staggering 277 times earnings.  And Amazon doesn’t even have a P/E because it doesn’t have positive earnings over the past 12 months.   Google appears to be the “value” of the group trading at a price-to-earnings (P/E) ratio of 33.

The higher a P/E investors pay, the more hope they are putting in the future.  If the next few years don’t pan out like investors currently expect, a company trading at a sky high P/E can see its stock price fall dramatically.  Buying these stocks means signing up for a return on investment of:

• $1 divided by $33 = 3% (GOOG)
• $1 divided by $100 = 1% (FB)
• $1 divided by $277 = 0.36% (NFLX)
• $1 divided by negative profits = ? (AMZN)

If these companies don't have dramatically higher earnings in the future than they have today, their returns will be unattractive, to say the least.  The only way you can profit from these shares is if you can find someone to pay even more at some point in the future.

3. Who knows what these stocks are worth?

Are these P/E ratios too high?  Maybe.  They might also be too low. No one has any idea what Facebook, Netflix, Google, or Amazon will be worth 10 years from now.  

It’s quite possible that one or more of these companies will be trading far higher than they are today.  It’s also quite possible that at least half of these companies will have been replaced by the latest and greatest technology of the day.  

What’s clear is that earnings are not the major factor underlying the current market price per share.  Instead, it’s what each investor is willing to imagine about the company’s future.

Trying to predict the future of these companies is nearly impossible. Predicting what people will pay for them is even more impossible. We believe most investors would be better off not to try, especially not with money they need to live on in retirement.

Conclusion

Wall Street is obsessed with trying to find the next “home run”.  Who is the next Netflix or Facebook?  Who is going to triple in price over the next few years?  Betting on these types of stocks is not much different than going out to the casino and plopping down money on the roulette wheel.  Your payout is big when you win, but the odds are against you over the long-term.

We find it much easier to hit “singles and doubles” investing in high-quality dividend growth stocks.  Our multiple regression tool helps us identify stocks that are 10% to 25% undervalued.  We know these companies aren’t going to blow the doors off of the market, but we do know this: The price of nearly every company in our portfolio is highly predictable based upon its future dividend payments.  

For virtually all of the companies we invest in, the dividend has predicted 80-90% of the movement of its stock price over a multi-year period.  That gives us confidence that our portfolios will continue to grow in value over the long-term.  Investors in FB, NFLX, AMZN, and GOOG can’t say the same.

NOTE: Data as of 8/7/2015