How to Stay Solvent Longer than The Market is Irrational

I believe it is extremely important that investors focus on the value of what they own more than they do on the day-to-day machinations of price volatility. However, I also believe, and even recognize, that very few investors are capable of ignoring volatile stock price movements. When the price of a stock that they own is rising or falling, especially when the swings are large and/or violent, it is very difficult for people to maintain a steady head and hand.  Instead, emotions take over reason which often cause otherwise rational investors to make irrational decisions.

My last article dealt with how to think about stock prices in today’s volatile markets, and can befound here.

The above article was well received by readers, and generated many lively comments and questions.  One comment/question in particular that attracted my attention was also the inspiration to offer this follow-up regarding how to think about stock prices.  I have cleaned up the comment and paraphrased it as follows:

“In your Dividend Growth articles, it’s always been highlighted that certain premium dividend stocks often seem to be fully or slightly overvalued, except in the case of a severe financial crisis. e.g. Kimberly Clark (KMB), Coca Cola (KO), Walmart (WMT) ,and then there are certain stocks which often seem to be chronically undervalued by the market, for years and years at a time–take Teva (TEVA), for instance. Is there a strategy to deal with buying these outliers that takes this mispricing into account? I’m wondering how to navigate chronic under and overvaluation…”

The above comment led me to realize that it’s one thing to accept the idea that stock markets can be irrational at times and misprice companies, over or under, however, it’s another thing altogether to develop and follow a strategy that allows an investor to exploit other people’s folly.  First of all, in order to do this successfully, investors have to be able to discern and differentiate between times when the market is behaving rationally and when it is not.  My point being, that there are times when wild price swings are rational, and of course times when they are not.  Therefore, it is implicit that the correct strategy be predicated on distinguishing between the times when price behavior is rational and when it is not.

To my way of thinking, that was the essence of the question that the reader was asking in the above comment/question.  Therefore, I offer this article to illuminate upon the types of behavior and research required to ensure as best you can, that the proper strategy and actions are being implemented. At this point, I would like to interject that the correct strategy regarding navigating “chronic” overvaluation and/or undervaluation must be based on the proper determination and realization that overvaluation or undervaluation actually exists. This can only be accomplished when the investor is focused on the business first and foremost, and then, and only then, on stock price.

The point I’m driving at here is that stock prices are often, as I pointed out in my previous article, pathological liars.  They can be misleading and often are deceiving, thereby generating extreme emotional responses.  It’s hard to have confidence in your company when its market price is falling precipitously.  Moreover, and equally as dangerous, it is very easy to become complacent and overconfident about a business when stock price is on an upward tear.

On the other hand, I believe it is much easier to determine the intrinsic value of a business, than it is to attempt to forecast where its price may go in the short run. As I did in my previous article, I will turn to the wisdom of legendary investors to illustrate my points. The following quote by Martin J. Whitman supports my last statement:

“I remain impressed with how much easier it is for us, and everybody else who has a modicum of training, to determine what a business is worth, and what the dynamics of the business might be, compared with estimating the prices at which a non-arbitrage security will sell in near-term markets.” Martin J. Whitman, Chairman of the Board, Third Avenue Value Fund

Navigating Overvaluation

Procter & Gamble (PG) – A Quality Premium Form of Overvaluation

When dealing with overvaluation, there many types and degrees that can occur.  For example, certain blue-chip companies can typically be awarded what I call a quality premium by the market. In many ways, I consider this type of overvaluation to be one of the most difficult to navigate.  First of all, because the overvaluation is chronic, it is less obvious, and therefore, more difficult to ascertain or judge.  But more importantly, it is up to each individual investor as to whether or not they would ever be willing to pay the premium the market typically is asking in order to own the security.

A classic case in point is the blue-chip dividend growth stock The Procter & Gamble Company (NYSE:PG). Procter & Gamble has paid a dividend for 122 consecutive years since its incorporation in 1890, and has increased its dividend for 56 consecutive years. On this basis, it is easy to see why the market historically affords the company a premium valuation.  Quality and consistency, the likes of which that The Procter & Gamble Company (NYSE:PG) has achieved and delivered for shareholders, is very rare.

The following FAST Graphs™ review Procter & Gamble for the years 1997 – 2007 in order to illustrate the quality premium that the market has typically applied as referenced in the above paragraph.  I chose this time frame for two reasons.  First of all, it clearly shows typical premium pricing by the market, and includes the infamous irrational exuberant period that ended in 2000. Therefore, it illustrates two types of overvaluation, the normal quality premium and a period where overvaluation becomes extreme.  The second reason I chose this time frame was because it shows Procter & Gamble up to, but just before the great recession of 2008.

The orange line on the graph plots earnings-per-share and represents a PE ratio of 15 which would typically be applied to a company growing at approximately 10% per annum like The Procter & Gamble Company (NYSE:PG) has. The blue line on the graph represents the normal PE ratio of 22.2 (the quality premium valuation) that the market was typically capitalizing Procter & Gamble shares at. Therefore, it is clear from this graph that if you were ever to own Procter & Gamble during this time, you had to be willing to pay the premium valuation as the company’s price never touched its theoretical fair value (the orange line).

When you review the performance associated with the above historical time frame where Procter & Gamble was always priced at a premium, you discover that the shareholder rewards were very attractive. Procter & Gamble delivered cumulative total dividends that would have exceeded the general market as measured by the S&P 500, and capital appreciation ($2729.02 for Procter & Gamble versus $1982.29 for the S&P 500) was also significantly above average.

Consequently, even though you were forced to pay this premium valuation in order to own this blue-chip, the rewards were clearly worth it. However, at the same time you should also have been aware that you were taking a