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Dividend Edition: Buying at Low Valuations

We’ve talked here before about the importance of buying dividend-paying stocks at low prices in order to lock in high yields. (You can read the issue here if you missed it.) Recently, I read an interesting account on the importance of buying low in another way--based on P/E ratios. Steven...

We’ve talked here before about the importance of buying dividend-paying stocks at low prices in order to lock in high yields. Recently, I read an interesting account on the importance of buying low in another way—based on P/E ratios. Steven Check, editor of The Blue Chip Investor, wrote about the newsletter’s recent gain on its position in McCormick & Company (MKC), the spice company.

In addition to the dividend, he attributes some of the success with the position to buying at a low P/E. Here’s what he wrote about his letter’s trade of McCormick:

“As of this issue, we’re selling our position in McCormick. This is a trade that worked out as we hoped, and since there are many lessons to be learned in reviewing it, we will do so in this letter.

“McCormick, while not an extremely large company, is exactly the type of firm that we like to invest in. As the world’s largest producer of spices and seasonings, it dominates its market. Domestically, it has a 48% share of the spice market, more than 10 times its nearest competitor. Its industry is slow changing, and it’s difficult to imagine McCormick being anything but the leader in 10 years.

“We bought the stock (MKC) in September 2009. At that point, it had not appreciated for nearly six years. We considered this a positive because the business had grown nicely over that timeframe, and we felt the stock represented excellent value. MKC’s price/earnings ratio (P/E) had dipped to 15 for only the third time in the prior 15 years. At the time that we bought, the stock’s P/E was 14.6. We included a 35-year chart for MKC with our September 2009 newsletter mailing.

“At a P/E of 14.6, the earnings yield was 1 / 14.6, or 6.9%. Long-term, high quality bonds were then yielding 5.1%. Interest rates had not been above 7% since 2001, and there was little indication that they’d be going back to such levels. Therefore, a 6.9% earnings yield was attractive. Also, we expected earnings to continue compounding at about 10% per year. The first thing we think about when we buy a stock is if we’d be happy purchasing the whole company at the current price and holding it for a long time. Relative to the alternative of owning long-term bonds, McCormick appeared to be the clear winner.

“We bought the stock at $33.36. Over the 30 months that we owned the stock, the company earned profits of $7.01 per share, or 21% of our purchase price. If you had owned the business privately, this would have been your return. However, buying and selling stocks provides another lever to generate potentially much-higher returns. If you buy at a low P/E and sell later at a higher P/E, that change also adds directly to your return. Presently, the P/E of McCormick stock is 19.3. The difference between 19.3 and our initial buy P/E of 14.6 is 4.7. A change of 4.7, divided by a starting value of 14.6, results in a gain of 32%.

“The trailing one-year earnings per share when we bought the stock was $2.23. Those same earnings are now $2.82. Thus, while the P/E expanded, so did the earnings used in calculating the P/E. The earnings growth was 26% [($2.82 - $2.23) / $2.23]. Finally, while we held the stock, we collected dividends of $2.71 a share. This resulted in another 8% gain ($2.71 / $33.36).

“So, let’s add it all up and see what was earned on the McCormick investment. We made 32% on the P/E expansion, 26% on earnings growth and 8% on dividends. This totals 66%. We made 66% in well under three years on what we viewed as a low-risk investment: buying an industry-dominating company at an attractive valuation. Clearly I’m biased, but I recommend both the common sense and return potential of our approach.

“It can’t be forgotten that this excellent return was made possible by the fact that we bought at an attractive P/E, a relatively rare occurrence. If instead we had bought at a P/E of 19.3 and sold at the same P/E, our return would have been only 34%, not 66%. What a difference buying at a very attractive valuation makes! This must always be remembered. It’s usually worth waiting whatever time is necessary to ensure buying at a low P/E. For our best companies, and with interest rates below 9% (note: they’re at 4% now), we generally require ourselves to buy at P/Es below 15 or 16.

“Our portfolio now consists of 20 companies. I am happy to report that 19 of the 20 holdings are higher than our purchase price. Being patient, buying right and then being patient again has its rewards.”

Buying at a low P/E ratio won’t be an important metric for every trade you make, but if your investing system is similar to the one used by The Blue Chip Investor, it could be a useful criterion to add when assessing candidates for your portfolio.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Investment of the Week