Valuation Zone Special Edition: Do Valuations Matter in Crashing Markets?

Background

As I sat down to write my monthly Valuation Zone article, the idea almost seemed silly. Why discuss a stock that is undervalued when the whole market is crashing?

So this month, instead of highlighting a single undervalued stock, let’s talk about why valuations matter even when the stock market is crashing.

I wrote this article after the close on Monday, March 9, 2020.

On that day, the Dow fell more than 2000 points (-7.8%).

The S&P 500 fell more than 225 points (-7.6%).

Here’s what the most widely used market index – the S&P 500 – has done since it hit an all-time high on February 19.

The blue dot at the top of the chart shows that the S&P 500 closed on February 19 at 3386. That was (and still is) its highest closing value ever.

The bars across the bottom show the volume of shares traded each day, and their color shows the direction of the market that day: red = down and green = up.

Since February 19, there have been 13 trading days including Monday, March 9. Eleven of those days have red volume bars, meaning the market went lower. Two of the days have green bars, meaning the market went higher.

After trading closed on Monday, the index stood at 2747. That’s 19% off its peak on February 19. A drop of 20% is considered a bear market.

With only two up days since February 19, the market feels like it is being driven by panic-selling. Factors include coronavirus, the oil price war, and falling interest rates.

So the Valuation Zone question becomes, do valuations mean anything when the market is acting like this? I am going to argue that valuations do still matter, even when the market is selling off in a panic.

Stocks Are Risky

Any time you buy a stock, you assume financial risk. If you are a dividend growth investor like me, the most relevant is the risk to the dividend.

  • Will the company be able to keep increasing its dividend every year?
  • Will the company need to freeze, or even cut, its dividend?
  • Will the company suspend its dividend (i.e., stop paying it altogether)?

After dividend risk, the other big risk is price risk. Price risk exists because stocks trade in the market, and traders have an infinite number of reasons for making trades. Besides being influenced by fundamental facts and numbers about a company, they are often influenced by emotions.

Emotions can drive markets to extremes. Obviously, in the 13 trading days since February 19, the predominant emotion has been fear. In a market like this, all stocks get caught, even the well-valued ones. Very few stocks can buck the market trend when the trend is negative 7% in a single day.

Why Valuations Matter

Here’s why I think valuations matter in a market like this. Valuations play out over long terms – months, years, even several years. Assuming that a company’s business performance remains sound, a stock that was well-valued before a market crash is even better valued during and after the crash.

Valuations give you reference points to answer whether a stock is:

  • Fairly priced: selling at about its fair value.
  • Underpriced: selling at a bargain.
  • Overpriced: selling for more than it is worth.

The valuation reference points reside in the rational, fact-based part of the trader’s mind. People buy stocks when they think they are going to make money. Valuations help point to which stocks are most likely to do that. The reasoning is that over time, a stock’s market price will gravitate toward its fair value.

Let’s take a look at my favorite stock for illustrating investing realities: Johnson and Johnson (JNJ). This FAST Graph shows JNJ’s price going back more than 20 years.

The graph has two reference lines for JNJ’s fair price at any given time.

  • The blue line is drawn at JNJ’s normal valuation – the market’s long-term average valuation for the stock – which turns out to be a Price-to-Earnings (PE) ratio of 18.4.
  • The orange line is drawn at a normal valuation for the whole market, using a PE of 15.

The black line is JNJ’s actual price. You can see that most of the time over the past 20 years, JNJ’s price has stayed between the two reference lines. That means that most of the time, JNJ’s price has been pretty fairly valued, even though it has zigged and zagged quite a bit at times.

Over the years, there have been several sharp price drops, and it’s probable that during those times, some investors panicked and sold out of JNJ, even though the wide-angle view shows that JNJ stayed fairly valued even through those price swings.

Let’s divide those 20 years into segments, numbered 1-4 on the chart above.

(1) At the beginning of the graph, from 1999 through mid-2005, the price line is above both reference lines. That means that JNJ was overvalued. It was not a great time to buy the stock. If you pick out a time in, say, 2002 and scan to the right, you can see that it wasn’t until 2012 that JNJ’s price got higher than what you paid in 2002. Valuation told you that JNJ was overvalued in real time, in 2002: It was knowable for anyone who cared to look.
(2) From 2005-07, JNJ was fairly priced. Its price was between the two reference lines.
(3) Starting in the middle of the Great Recession in 2007 through 2012, JNJ’s price was below both reference lines. It was undervalued and a great time to buy. Scanning to the right, JNJ’s price began to rise in just a few years, “catching up” to its intrinsic value.
(4) From 2012 on, JNJ’s price has zig-zagged back and forth, but it has generally remained in the territory of fair value.

You can see the same thing by looking at JNJ’s yield through the same years. The following graph’s red line shows JNJ’s yield at the end of each year.

The best time to buy a dividend growth stock is when its yield is higher than normal, because that usually indicates the stock is undervalued.

  • At the left side of the graph, JNJ’s yield was very low, barely over 1%. It stayed under 2% through 2004. It was not a great time to buy the stock.
  • In 2009-11, JNJ’s yield was well over 3%. It was the same company with the same fundamentals, but now it was offering 3 times the income as in 1999. It was a great time to buy.
  • Since then, JNJ’s yield has bounced around in the 2.5%-3% range, during the period when its valuation has been neutral.

These two charts show why valuations matter: If prices (and yields) tend over time to gravitate toward their intrinsic or natural values, then buying at good valuations makes sense. More specifically, if a stock is undervalued or its yield is more than normal, its price will tend to gravitate back to fair value, meaning it will trend up.

And while that means that current yield will come down (also gravitating to normal levels), with dividend growth stocks, it does not mean that your income will go down. Your income will be based on the yield you got when you bought it, augmented by dividend raises each year.

This principle holds true even when the markets are gyrating as they are now. In the JNJ example shown above, the timespan includes the Great Recession of 2007-2009, which was accompanied by a market crash of nearly 50% in the S&P 500. The market recovered, as it always had. So did JNJ’s price.

It can be hard to remember long-term principles when short-term craziness is all around. But that’s what I suggest that investors do.

Stay the Course

In my Dividend Growth Portfolio, I reinvest dividends when they accumulate to $1000. There’s $950 there right now, so the kitty will top $1000 in a few days. When that happens, I will do what I always do: Pick out a well-valued, high-quality dividend growth stock and buy it.

The fact that the market is way up or way down on the day, week, or month will not have any effect on that decision. I will stick to my long-term strategy.

And with prices generally down, I will be able to find a great stock at better-than-normal valuation, which means a higher-than-normal yield. That fits perfectly into my strategy of growing my dividend stream over time.

I have faith that over the long haul, prices will take care of themselves despite short-term variations, including crashes.

— Dave Van Knapp

Disclosure: I own JNJ.

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