Investors hate stock market volatility. Watching your holdings fly up and down—especially when they’re losing value—is unsettling, and makes it very difficult to make rational investment decisions. That’s why I frequently remind readers to take a step back from the market and try to ignore the day-to-day action of their stocks. But in the latest Dividend Digest, one of our contributors went a step further, explaining how investors can use volatility to their advantage. Or, as he put it in his headline: “Another Word for Volatility: Opportunity.”
One caveat: this advisor subscribes to Warren Buffet’s sentiment that the ideal holding period is “forever.” So this strategy is only for investors who really know how to take a step back from their investments. If you can’t go on a two-week vacation without checking your portfolio’s value on your smartphone, this is not the system for you.
Still with me? Good. Then here’s Mark Deschaine, editor of Deschaine & Company’s quarterly letter, Viewpoint, on how to turn volatility into opportunity:
“Most investors have a love-hate relationship with the stock market. They love it when the stock market’s going up or is at recent highs, but they hate it when it goes down or is trading at recent lows. … Five years ago this month, the stock market, as measured by the Dow Jones Industrial, reached an all time high of 14,153. For those of you keeping track of such things, it was October 9, 2007 to be exact. The stock market then proceeded to swoon to a low of 6,747 on March 2, 2009, in the middle of the now infamous credit debacle that has come to be known as the ‘Great Recession’—a drop of 52% from peak to trough. Needless to say, a drop of that magnitude scared the life out of a lot of investors. Since bottoming in March 2009, the stock market has rallied almost uninterrupted to once again close in on the all-time high.
“So how exactly are many investors reacting to the more than 100% increase in stock prices since 2009? Why, by selling stocks and heading for the perceived safety of record low-yielding bonds and bond mutual funds. Just in the last year, investors have yanked $150 billion out of stock mutual funds and put more than $1 trillion into bonds and bond mutual funds. One of the reasons investors are shunning stocks is because most stock investors haven’t realized anywhere near the 100% return in their stock portfolio that the market’s realized since 2009. That’s because many investors sold out of stocks after the market crashed in early 2009 and have continued their stock selling spree ever since. Let’s just say it’s hard to make money in stocks when you don’t, well, actually own stocks.
“Then again, this is the nature and habit of the average investor: a long and less-than-glorious history of selling stocks at or near cyclical bottoms and buying them back again only after they’ve reached the top of a particular market cycle. It’s the very reason most investors fail at the task of investing in stocks. They react emotionally (out of fear) and sell after prices have fallen rather than take advantage of the market’s price volatility to buy more shares and add to their stock holdings at bargain prices.
Another Word for Volatility: Opportunity
“Nowhere are the benefits of fluctuating prices more evident than the September 30, 2012, details for our Equity Income Portfolio, as shown in Table 2 below. Here’s what the table shows: Since 2007, the average dividend for an Equity Income Portfolio stock has increased by 75.9%, or about 12% annually. Compare that to the flat dividend growth for the S&P 500 index over the same period (in Table 3). What the table also shows is the five-year high and low dividend yield for each stock. In other words, if we had managed perfect timing when buying the individual stocks, and bought each one at its five-year low price, we would have locked in a dividend yield of 11.3%! Note, had we done a terrible job and bought each stock at its five-year high price, the dividend yield on the portfolio would be a meager 4.3%.
“So ask yourself this question: which dividend yield would you rather your portfolio pay you every year: 11.3% or 4.3%? If you bought the stocks as of September 30th, the portfolio would have a $28.54 dividend yielding 5.3%. In addition, the EIP’s ‘Yield on Cost,’ that is, the portfolio’s dividend income divided by what we actually paid for the stocks, is a healthy 6.6%. That means that no matter what the stock market does, the Equity Income Portfolio will generate 6.6% in annual dividend income on our invested capital (and growing as the companies continue to boost their dividends). For the record, yield on cost would be higher but for the fact that we’re consistently adding to our share positions with dividend income to build future dividend income, in a sense, ‘watering down’ our yield on cost over time, while at the same time building our dividend income in real dollar terms. …
“At the end of the day, you can either make price volatility work for you or against you, it’s really up to you. Since it’s never going to go away, it seems the logical thing to do is to make it work to our advantage. That’s what we’ve been trying to do in the Equity Income Portfolio since 2000. Doing our best to buy when individual stocks are cheap (or more accurately when their dividend yields are high) and refrain from buying when dividend yields are low.”—Mark Deschaine, Deschaine & Company’s Viewpoint, Third Quarter 2012
As I said above, this strategy isn’t going to work for every investor. It takes patience and a strong stomach. You also have to be buying the right kind of stocks: Deschsaine & Company recommends stocks that you can hold forever. In order to be confident that your bargain-priced purchase will pay off, you need to know that this company isn’t going to fail, or become an also-ran. It helps to be able to point to a long history of gradual stock price appreciation and dividend payments—preferably with periodic increases. What might this company look like? How about General Electric Co. (GE)?
General Electric (GE) is a household name. You might have a GE appliance in your home, or maybe you’ve flown on a plane or rode on a train powered by GE engine. GE was founded over 100 years ago; it was one of the original 12 companies that made up the Dow Industrial Average when it was created in 1896. And the company has paid its stockholders dividends every year since 1987. So this is a company that will most likely be around “forever,” or at least close enough.
And, it’s cheap right now! Looking at the short-term, GE is about 13% off its recent high, being dragged down by the market. But, more importantly, it’s cheap relative to the long-term too. Before the 2008 financial crisis, GE’s financial arm, which made loans to consumers and businesses, had become a huge part of the company. So it was hit hard in the ensuing collapse. But since then, GE has shrunk the financial division’s share of the business dramatically, focusing instead on those engines and appliances—and more modern technologies too, like MRI machines and electric car charging stations.
However, the stock is still 50% below its pre-crash peak. At this price, GE’s 17-cents-a-month dividend yields 3.4%. I think that makes it a pretty good candidate for Mark Deschaine’s buy-low strategy. Plus, another of our contributors likes GE as well—it was just recommended in the latest Dividend Digest by Patrick McKeough, Editor of Wall Street Stock Forecaster. He cited the company’s post-2008 turnaround and bright growth prospects. Here’s some of his recommendation:
“General Electric is one of the world’s largest manufacturers. It makes equipment for generating and distributing electricity, such as turbines; aircraft engines; health care equipment; home appliances and lighting; and locomotives. To cut the risk of further losses following the 2008/2009 financial crisis, the company continues to scale back its GE Capital subsidiary, which provides loans and other financial services to GE’s customers. This business now accounts for 31% of GE’s overall revenue and 45% of its earnings.
“In the three months ended September 30, 2012, GE’s revenue rose 2.8%, to $36.3 billion from $35.4 billion a year earlier. Revenue from the industrial businesses rose 7.4%, partly because GE bought companies that supply equipment to oil and gas producers. That offset lower sales of wind-power gear. The company continues to shrink GE Capital. As a result, this division’s revenue fell 5.4%. Earnings rose 9.9%, to $3.8 billion from $3.5 billion. Because of fewer shares outstanding, earnings per share rose 12.5%, to $0.36 from $0.32.
“GE’s industrial businesses now have an order backlog of $203 billion. That’s up 6.3% from $191 billion a year earlier. The company’s strong balance sheet will let it keep expanding its industrial operations. In all, these businesses hold cash of $8.4 billion, or $0.80 a share. Their debt is $12.1 billion, or a low 5% of GE’s market cap. The company should earn $1.55 a share in 2012. The stock trades at 14.2 times that estimate. The $0.68 dividend yields 3.2%. GE is a buy.”—Patrick McKeough, Wall Street Stock Forecaster, November 2012
Remember, this isn’t an investment that’s going to pay off tomorrow. But if you like to have a portfolio of stocks that pay you regular income and that you don’t have to check on while you’re on vacation, GE is a good candidate at today’s levels.
Wishing you success in your investing and beyond,
Editor of Dick Davis Dividend Digest