I review my portfolios periodically, including my Dividend Growth Portfolio that is presented each month on Daily Trade Alert.
In a recent review, I discovered that three popular dividend growth stocks are way overvalued now.
To a value investor – which describes many dividend growth investors, including me – a great company is not always a great stock to buy. That’s often because it is significantly overvalued, meaning that investors have bid its price up to astronomical levels.
If you buy a stock at an overvalued price, you are adding risk. Here’s why: If your valuation estimate is correct, the expected future direction of the price is down. That’s easy to see on a FASTGraph:
McDonald’s (MCD) is pictured on the graph. If McDonald’s fair price is somewhere between the orange and blue reference lines, McDonald’s price would need to drop by about $35 per share to return to fair value. It’s that much overvalued.
If you look back along the 18 prior years covered by the graph, you can see that its price has almost always been between the orange and blue reference lines.
It’s only in the past 3-4 years that MCD’s price has shot way out of that range, and it’s never been so far away from fair value as it is right now.
McDonald’s is a great company firing on all cylinders.
While dividend growth investors are not unduly interested in price changes over the short term, not many of us want to see a stock’s price plunge right after we buy it.
That’s no fun.
But beyond that, an overvalued price means that you’re getting a yield far below the normal yield you might expect from that stock. McDonald’s is only yielding 2.4% at its current price. Yield and price are inversely related: When price goes up, yield goes down.
You can clearly see that on a chart that plots price and yield together:
Over the past 10 years, MCD had had yields as high as 3.7%. That’s 54% more dividend income that you could buy with your purchase money than you can get right now.
McDonald’s current low yield is not because they’ve frozen or cut their dividend. On the contrary, they’ve raised it every year. Rather, the low yield is a result of the price levitating.
The bottom line is that while McDonald’s is a great company, now is not the time to buy it.
McDonald’s is one of the three way overvalued blue-chip stocks that I want to bring to your attention. The other two are Realty Income (O) and Procter & Gamble (PG).
Here are the FASTGraphs for them.
Procter & Gamble:
You can see the same situation with each stock: Its price is way overvalued, the likely future direction of price is down, and the yield is low for that stock.
Of course, nobody can predict the future. Perhaps all three stocks are establishing permanently higher “normal” valuations than they have in the past. Maybe their prices will ride higher than historical norms for the next 20 years.
But that’s not the way to bet. I think the odds say that all three of these popular DG stocks are far overvalued, and that in the future they will be available at more reasonable valuations, and higher yields, than they are now. My suggestion would be to be patient with all of them.
I have fully valued each stock using the 4-step process described in DGI Lesson 11: Valuation. In the following table, I give a thumbnail sketch of each one, showing how much overvalued I think it is, plus a little information on better yield points that you might want to wait for.
Earlier this month, Whitney Tilson wrote on this site about the relationship of quality to valuation in picking stocks. He advised not diving into the bargain bin looking for undervalued bad companies, and I agree with him on that. Quality matters.
But he also said, “[T]he lesson is not to do the opposite and buy the stocks of great growth companies irrespective of valuation.” That’s the take-away from this article as well: When you find a high-quality company, investigate its valuation to see whether it’s a good stock to buy at its current price. As Tilson said, “[Don’t] pay too high a price for a stock, such that even if the business performs well, the stock doesn’t.
My suggestion would be not to buy any of these stocks at their current prices. If you’re investing for the long term, be patient. At some point they will come back to you. Don’t force the issue.
In the meantime, what do you buy if you have money to invest? I suggest that you investigate these four great features on Daily Trade Alert for ideas:
• My own Valuation Zone articles
• My Dividend Growth Stock of the Month selections
• Mike Nadel’s picks for the Income Builder Portfolio
• Jason Fieber’s Undervalued Dividend Growth Stock of the Week selections
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