The vast majority of the articles that I write are focused on the best deals in the market. Most investors are in the accumulation phase and therefore, they’re looking to add stocks to their investment portfolios. I suspect that my readers are interested in buying shares of high quality stocks at fair (or better) valuations because this is the mantra that I preach, over and over again, when it comes to making long-term investments. But, something that I don’t write about very often is my strategy when it comes to selling stock.
Oftentimes (especially in today’s relatively expensive market), when I talk about my fair value estimates for various companies that I own – which tend to come in much lower than the companies’ current share prices – people ask me, “Well, if you think company X is so overvalued, why don’t you sell?”
This is a fair question to ask. One might assume that if I’m only interested in buying the highest quality stocks when they’re trading at discounts to fair value, then I’d be interested in selling them when they’re expensive. However, as logical as that may seem (especially to traders) it’s not the case.
I’ve been burnt one too many times to ever sell shares of a blue chip company again, purely because of short-term valuation concerns.
I saw “short-term” valuation concerns because – for the most part – the reliable growth that blue chips generate over longer periods of time tend to make up for any short-term valuation spikes.
It’s important to remember that I’m talking about blue chips here. I rarely speculate on contrarian, deep value names. I rarely invest in cyclical companies with unpredictable earnings growth outlooks. I prefer to own the very best of the best when it comes to wide moat companies that are also being propelled by strong secular tailwinds. This gives me supreme confidence that 5-10 years into the future, their operations will produce profit related fundamental metrics that are much higher than their earnings and/or cash flows today. And therefore, I rest easily, regardless of present valuations, because I strongly suspect that higher fundamentals will eventually lead to higher share prices.
In other words, when I put my hard earned capital at risk in the markets, I try to minimize my risk by only partnering with companies that have solid growth prospects throughout a wide variety of potential economic environments.
Doing so allows me to sleep well at night. And, due to the fact that I primarily invest in dividend growth stocks, the reliable sales, earnings, and cash flow growth prospects that I look for when making investments also translates directly into a reliably increasing passive income stream.
Remember, for dividend growth to be sustainable, companies need to deliver regular, predictable, and reliable top and bottom-line growth.
And, with this in mind, it usually doesn’t take very long for the fundamentals of the best-in-breed types of dividend growth companies that I focus on buying to generate the fundamental results that will justify present valuations, even if they’re elevated in relation to historical averages.
Here’s an example of a mistake that I made when it came to getting cute and trying to time the market with a blue chip dividend growth holding.
This was the last mistake like this that I have made and I don’t ever plan on making a similar one again (experiential learning is the best kind and as investors, if we’re not using the benefit of hindsight to analyze our trades to learn and become better investors, we’re doing ourselves a major disservice).
In March of 2018 I decided to trim a portion of my MasterCard (MA) position because at the time, I believed that shares were overvalued.
In December of 2016 I bought a lot of MA shares for $102.47 in a tax advantaged account. In March of 2018, I sold those shares for $175.12, locking in ~71% gains.
Being that there were no tax consequences for this trade, I was pleased to lock in such large gains in a relatively short period of time. Pleased is probably an understatement – for someone dabbling in relatively short-term trading, I was ecstatic.
However, it hasn’t taken me very long to realize that had I just held onto my entire MA position, I would be much richer today, being that MasterCard currently trades for $385.94.
Since I trimmed my MA stake, MasterCard is up over 120%. During this same period of time, the S&P 500 has only risen 68.3%. In other words, MA’s performance has roughly doubled that of the broader market.
When I made that trade, I acknowledged the premise of this article, saying:
“…over the very long term, valuations in the short term may not matter all that much anyway; if MA is able to produce double-digit annual top-line growth for 15-20 years or so, it won’t matter much whether or not the stock is trading for 35x earnings today and the outsized risk that present day investors are facing due to MA’s massive premium will be well worth the rewards.”
However, due to macro fears, I convinced myself that lowering exposure to highly valued shares made sense.
…what do I always say? Falling prey to fear leads to mistakes in the market.
You see, when I originally bought those MA shares, they were trading with a price-to-earnings multiple of ~23x. When I sold them, that multiple had risen to the ~35x area.
When I bought shares, I was expecting ~15-20% long-term growth and that outlook did not change during my ~15 month holding period.
When I evaluate growth stocks, I tend to use a price-to-earnings growth (PEG) ratio as a primary metric and therefore, since the “P” increased significantly while the “G” remained the same, the stock’s multiple became unattractive.
However, even as MA’s forward PEG rose, I ignored the fact that if MA posted EPS growth in the ~20% range that I thought was realistic, it would only take a couple of years for the stock’s fundamentals to justify its 2018 share price.
The COVID-19 pandemic threw a bit of a wrench into that scenario, with MA posting -17% EPS growth in 2020. However, the company is expected to grow its earnings at a ~25% annualized clip over the next 3-5 years, which means that even with today’s elevated multiple (MA shares currently trade with a blended P/E ratio of approximately 51x) by the end of 2023, MA should be trading with a multiple that is nearly in-line with its long-term average.
And, if you’re willing to bet that MA will continue its strong double digit growth trajectory over the next decade or so (like I am), then you’ll quickly realize that by 2031, this stock could be looking at upwards of $40.00/share in earnings, which would mean that today’s ~$385 price point represents a single digit forward earnings multiple (granted, a decade down the road).
Slap what would likely be a conservative 20x multiple on that bottom-line figure and we’re talking about a stock valued at $800. Honestly, for a company growing at 20% annually, a 30x multiple makes more sense, which would imply a $1,200 share price. Either way, we’re talking about triple digit gains from here.
What’s more, assuming that MasterCard continues to post strong bottom-line growth, not only will its share price be much higher, but so will its annual dividend.
MasterCard has a perfect annual dividend growth streak since becoming a publicly traded company and I expect this stock to be a dividend aristocrat one day.
I could easily imagine MasterCard maintaining a 40% payout ratio in 10 years (right now, MA’s forward EPS payout ratio nearly 22%; however, as dividend growth companies mature, they tend to pay out higher an higher percentages of their cash flows to shareholders, so 40% seems reasonable to me in a decade’s time).
40% of that estimated $40/share in earnings represents a $16.00/share dividend. This is roughly 9x higher than today’s $1.76 annual dividend.
It’s impossible to say whether or not MA will continue to post the 20% annual growth which would allow these fantastic total return estimates to become reality and therefore, I’m still looking for a more attractive margin of safety when it comes to accumulating shares in today’s market.
However, just because I’m not looking to buy MA today doesn’t mean that I’m not completely content to hold onto the shares that I already own.
I think it’s worth noting that prior to 2020, MA had never produced annual EPS growth that was less than 10% and from 2009-2019, the stock produced an EPS CAGR of 21.37%.
Simply put, this company is a double digit earnings growth machine and I don’t see any reason why MA’s growth trajectory is likely to change in the latter half of this decade.
This leads me to believe that even given MA’s 50x P/E multiple today, shares are likely to be (much) higher in 10 years or so.
My goal as an investor is to generate a reliably increasing passive income stream. It seems obvious that MA is going to help me achieve that goal.
So, with that belief in mind, what reason do I have to sell shares today?
The answer is: there isn’t any.
Frankly speaking, the only way that I’ll ever see $175/share on MA again is if the stock splits. In other words, this one has completely run away from me.
Thankfully, I only sold 50% of my position in 2018, so I continue to benefit from the stock’s tremendous growth. However, if I could go back and do it all over again, I certainly wouldn’t have pulled the trigger on that MasterCard trade.
Historically, when it comes to blue chip dividend growth stocks, I’ve found that sitting on my hands when I have the urge to sell shares is usually the best course of action. Over the years, I’ve become more disciplined and relatively immune to those urges and now, the simple buy and hold strategy is the plan that I preach to my subscribers.
No one knows what the future will hold. However, when it comes to compounding wealth in the stock market, I firmly believe that long-term investors are best off buying and holding shares of blue chips over the long-term instead of attempting to time the market with short-term trades.
These days, so long as the dividends that my blue chip holdings pay continue to grow at an acceptable annual rate, I’m content to hold onto them. Really, it’s that simple. Building wealth doesn’t have to be complicated. All investors have to do is buy best-in-breed companies when they’re trading with attractive valuations and have the discipline to hold onto those shares over the long-term.
That’s what we do at The Intelligent Dividend Investor and the IDI portfolio is beating the S&P 500 by a wide margin since it was launched. If focusing on long-term ownership of blue chips, building a reliably increasing stream of passive income, and sleeping well at night, knowing that your financial future is being secured by the best companies in the world is something that you’re interested in, please come check us out!
Disclosure: Nicholas Ward is long MA.
Nicholas Ward is a research analyst who currently writes for Seeking Alpha, The Dividend Kings, iREIT, and Forbes Real Estate Investor. Before that, he was Founder and Editor-in-Chief of The Dividend Growth Club, as well as the Income Minded Millennial. Nicholas has also contributed to Sure Dividend, Investing Daily, and The Street, where he covered stocks in Jim Cramer's Action Alerts PLUS Portfolio.
Nicholas holds a bachelor of arts from The University of Virginia, where he studied English and studio art. Prior to transitioning into the financial industry, he managed a vineyard in the foothills of the Blue Ridge Mountains.
