The importance of valuation for income investors

The price you pay for an investment is the primary determiner of risk. Plain & simple. As legendary value investor Seth Klarman puts it;

Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk.

Absolutely! I find that too many income investors are way too focused on uncertainty, i.e. volatility, as a measure of risk and often view valuation as of lesser importance. Today I want use the example of Johnson and Johnson (JNJ) to show the importance of valuation for dividend investors.

JNJ is a classic bread and butter company for dividend investors. The company has raised its dividend for 48 consecutive years! No cuts, no decreases, just increases. Since 1979, it has grown its dividend at an annual rate of 14%. Total returns have been about 12% annualized since 1979. Not a bad dividend investment to say the least. But has JNJ has not always been a great investment. Like any other investment there has been times when JNJ was over valued and times when it has been under valued. Lets look at a time when JNJ was over valued and what impact that had on two types of income investors.

The chart below shows JNJ’s historical dividend yield since December 1979. Lets consider an investment in JNJ at year end 1999.

At the end of Dec 1999, JNJ’s dividend yield was 1.2%. An dividend investor buying shares in JNJ may have expected a total return of about 15% on JNJ, the 1.2% dividend yield plus the historical dividend growth of 14%. As it turns out, as of April 2011, JNJ has had a an annual total return of 4.4% . What happened? Well, JNJ was way overvalued at the end of 1999. As the chart above shows JNJ’s dividend yield was at the extreme low end of its historical valuation. Over the subsequent 11.25 years JNJ’s 4.4% annual return was composed of its 1.2% dividend yield, its 12.75% dividend growth rate (not too far off the original forecast), and most importantly a negative 9.54% per year in valuation change. Over that time its dividend yield went from 1.2% to 3.63%. Its always critical to remember the 3rd term in the Magic Dividend Formula, change in valuation. Many investors assume that term to be zero but that is only true for an investment at fair value. Now, lets look at the impact this poor performance would have had on two different income investors.

One type of dividend investor is one who reinvests dividends. This could be an investor building wealth towards retirement or a retiree following the standard retirement model where an investor reinvests dividends and sells off assets to fund retirement. This investor was extremely disappointed in JNJ’s performance over the last decade. A return of 4.4% over that time, while better than the S&P500 probably would not have met their goals and certainly fell short of their initial expectations when investing in JNJ. In fact they would have been better off in corporate bonds. The initial price paid for JNJ really mattered to this investor. JNJ was clearly over valued at the end of 1999 and this turned out to be a not so great investment.

The second type of dividend investor to consider is a retiree who lives off their dividends. Ironically, this investor arguably fared better than the above investor. Assuming the initial investment’s 1.2% yield satisfied the investor’s yield income requirements at the time, this investor enjoyed over 11 years of dividend increases at an average rate of 12.75% per year. A $1,000 in income would have grown to about $3,900 during this time. This investors goal of a stable and inflation beating growing dividend was more than met. The downside for this investor was the lower wealth built during this time to potentially pass off to their heirs. Without reinvesting dividends this investor’s initial investment, say of $100K, grew to $143K, or 3.2% per year (the 4.4% total return minus the 1.2% initial dividend yield). If the valuation of JNJ had stayed the same during this period, justifying the initial investment assumptions, this investor’s $100K would have grown into $386K, or 12.75% per year. Certainly, valuation mattered for this investor as well but only secondarily. This investor’s primary goal of funding his retirement securely was met. Probably his or her heirs feel differently.

Finally, looking at JNJ’s historical yield chart its hard not to notice that JNJ looks pretty cheap at these levels. In fact its about the cheapest its ever been. Only in 1984 and in March 2009 was it slightly cheaper than it is today. JNJ’s average yield since the end of 1979 has been about 2%. Assuming forward dividend growth of only 10% I think an investor today could easily assume returns of 13.6% (3.63% + 10%) with no change in valuation. Moreover, one could expect significant upside if and when JNJ’s valuation returns to its historic average. Again, valuation matters. Make sure its on your side.