Dividends , Stocks


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.

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12 thoughts on “ The importance of valuation for income investors

  1. Paul,

    I have been wanting to ask a question about the “Magic Formula”. (Actually, I did post one once, or I thought I did, but it might not have gone through…).

    My question is, what is the time period associated with the expected total return? I understand that if the current yield is say, 3% and the annual growth of the dividend yield is say, 10%, that the expected total return (without including change in valuation), would be 13%. But certainly this return is not based on a one year holding period, or even two or three. What is the time line that gets this stock to it’s 13%?



    1. David, yes the numbers used in the formula are based on yearly percentages. Take an example stock that is priced at $10, yields 10%, with a dividend growth rate of 10%. So, the $1 dividend grows to $1.1 in 1 year. Then in order for the valuation to stay the same, i.e. the yield remain at 10%, the stock price must rise to $11. If it doesn’t then the yield would go up. With the stock at $11, you made $1 in dividends plus $1 in capital gains, which is a 20% return, exactly what the formula says. Again the only way you don’t get the return calculated by the formula is is the valuation of the stock changes. Of course this happens all the time which is one of the reasons why valuation is so important.

      Make sense?


    2. Yup! That makes sense. I understand now. I can see that the valuation becomes the key. While the dividend and the increase are much more predictable, based on historical numbers, the valuation can change based on any number of internal or external factors.


  2. Thanks for another great post. This question of valuations is very important and each investor has to draw the conclusion based on not only individual equity value but also value of the overall market. Lately I am very concerned so new purchases are being decided based as always on the value of the stock but even then only 1/3 position is entered. When a significant pullback comes it will be time to buy the gems on sale with higher divy % returns.

    Keep up the great work Paul!

    1. Thanks Doug. I totally agree with you. Even though I’m still finding good values in the market I am concerned about the market valuation due to macro issues. Like you, if I’m opening a position its a smaller one than usual, and I’m selling puts when the premiums justify the risks. We could be waiting a long time for a large pullback, which is very trying, but I think we’ll be rewarded for the patience.


  3. Hi!

    Whats your take on JNJ on these levels? I think its cheap and I gonna buy more shares before the Q1 in April.

    Do you have any thoughts about JNJ?

    Thanks for a great blog!

    Erik from Sweden

    1. Hey Erik, JNJ is very cheap at these levels. It’s only been cheaper at 2 times in its entire history, 1984 and in March 2009. And even then it hasn’t been much cheaper than today. There’s is at least a 40% upside from today’s levels in order for it to get back to its average historical yield of 2.1%. My only issue with buying JNJ is that I don’t see a short term catalyst to get the shares moving. But getting paid 3.6% yield to wait is not too bad.


  4. Thanks Paul!

    I hope/wish that they increase the dividend to 60 cents. That would be great! My first goal is 75 USD 2012.

    here is a good link for you. Skagen funds, probably the best valuefunds in Scandinavia.

    https://www.skagenfonder.se/ Click on “Statusrapport” and you can read a English version every month.

    They lately have been investing in Vimpelcom, Gazprom, Roche and they like big American stocks now like Microsoft, Citigroup and Intel.

    “SKAGEN’s investment philosophy is based on investing in companies which are Undervalued, Under-researched and Unpopular”

    JNJ is undervalued, and unpopular at the moment.

    Have a great weekend!


    1. Thanks for the link Erik. The Skagen investors look like my kind of investors. I had tried to find an English version before and couldn’t. Great!

      I think JNJ will raise the dividend to at least $0.59. Although I think it could be as high as $0.61. At a $60 stock price that would be a 4% yield.


  5. Just found your blog from one of your posts on rvnetwork. I plan to RV FT in a few yrs (54 now) when my wife retires. Being in Canada changes where and how long you can spend your time. I manage my portfolio with about the same balance you show although I run a bit riskier at this point than you seem to be. When I retire I’ll be doing something more along the lines of your portfolio. Do your structure your draws to maintain the total balance right to the end or do you plan to die with 0$ (sounds morbid)?

    1. Hey Steve. I’m trying to do something different than the traditional retirement model. You can read about how I’m doing it here . Basically, I’m trying to generate enough income every year from trading that I never have to draw. But I have the majority of my portfolio as backup, in case my plans don’t work out. To your point though, in the traditional model where you draw every year, the percentage draw every year is based on long term history and is purely based on 100% survival of the portfolio. That survival may mean dying with $1 or it may mean dying with $10M. Because one doesn’t know future returns obviously you can’t tell where you’ll end up. The best one can do is every 5 years or so re look at the numbers and if one is doing much better than expected then one can adjust spending higher, etc…..

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