Should I Buy Blue-Chip Stocks Right Now?

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I received this question recently from one of my readers:

“hi tim, i love your articles. i have a question for you. With the dow at >15,000 how aggressively would you buy exxon, pg, jnj etc. would you buy 100 shares then wait for a pull back? Thanks, manoj”

Hi Manoj. When we make investments, one of the best weapons we have in our arsenal is the ability to make each investment one at a time. The fact that the Dow Jones is trading above 15,000 (or whatever figure might be dominating the headlines) says little about the valuation specifics of each company. For instance, Aflac typically traded at 250-400% of book value, and 15-25x earnings, before the financial crisis hit. Nowadays, the company trades at 100-170% of book value and only trades at 7-9x earnings, despite the fact that Aflac’s portfolio is now of higher quality than it was before The Great Recession hit.

On the other side of the equation, we have a company like Hershey Chocolate that is trading at 29-30x earnings, and the chocolate maker hasn’t traded at that kind of valuation level since the dotcom bubble burst in the late 1990s. That is why I do not get caught up with what the Dow Jones, S&P 500, or whatever index you might be using as a reference point is doing. Since I invest in individual companies, that is what is important to me. If 400 companies in the S&P 500 are “overvalued” at a given point in time, then it is my job as an investor to find at least one of the 100 other companies that are not overvalued at the time I intend to make my investment.

In your question, you pointed out three companies in particular: ExxonMobil, Procter & Gamble, and Johnson & Johnson. Here is how I would approach answering that question:

(1) First, I would determine my expectations for the company over the next decade, both in terms of total returns and total dividends produced.

(2) Secondly, I would ask myself whether that likely result would be satisfactory to me, on a risk-adjusted basis.

Take something like Exxon. The company is currently playing a game of see-saw with Apple to see which one can be the largest company in the world. With Apple currently worth $417 billion and Exxon currently worth $409 billion, it looks like Exxon is in second place right now. With a non-tech company as big as Exxon, it is unlikely that the company is going to be either excessively overvalued or excessively undervalued.

There are four or five dozen analysts that cover the company. Just about every trust fund, pension fund, and large-cap index fund in the country owns shares of Irving-based oil giant. When a company is that big, and when its earnings are that predictable (the catch, of course, is when an unexpected commodities bust cycle strikes), then it is likely that a company of Exxon’s size and predictability will typically trade within hailing distance of its intrinsic value.

Historically speaking, Exxon’s fair value is between 8-10x earnings. Right now, it is generating $9.80 per share. At the current price of $92 per share, that works out to a little above 9x earnings. I’m guessing that most reasonable people would peg Exxon as being in a range from 10-15% undervalued to 5% overvalued. That would lead me to this conclusion about Exxon: the total returns experienced by investors over the next ten or so years will likely correspond to the earnings per share growth rate of the firm, and income investors that buy Exxon may experience the treat of receiving a dividend growth rate that exceeds the growth of the company.

Some people might look at something like Exxon and think, “Ehh, I’m not interested—it only yields 2.75%.” But what that ignores is the fact that Exxon is possibly in the process of raising its dividend by 10% over the medium-term. Today’s $2.52 payout may be next year’s $2.77 payout, which may turn into 2015’s $3.04 payout, which may turn into 2016’s $3.34 payout, which may turn into 2017’s $3.67 payout. But people don’t think like this. They only look at the $2.52 annual payout and think that Exxon is unimpressive. But it is entirely possible that, if you wait four years, you could be earning $3.67 per share in dividends. All of a sudden, that 2.75% yield has turned into a 4.07% dividend yield on your initial investment, and that is not even assuming reinvested dividends (by the way, that is the best secret of blue-chip investing: combining an 8-12% dividend growth rate for 10 years with the reinvestment of dividends. You can get some pretty sweet yield-on-costs down the road if you follow that metric).

Similar stories exist for Procter & Gamble and Johnson & Johnson, although I’d guess that Procter & Gamble is a little bit more overvalued than the other two.

As you can see, I answered your question in a roundabout way. The truth is that I do not know:

(1) what the stock prices of any of these companies will be in the next six months, one year, twenty months, etc. (i.e. would you be ticked off if you purchased Exxon at $90 today and saw that you could buy it at $80 per share a year from now, or would you be content knowing that at $90 per share, you should still be able to capture total returns that mirror the growth rate of the firm?)

(2) What stocks would you pick otherwise? When I first started dividend investing, one of the things that surprised me was that many high-quality companies (Coca-Cola, Pepsi, Nestle) tended to outperform the S&P 500 over most 15+ year periods. That didn’t make sense to me. I intuitively thought that, in exchange for buying higher quality, you had to accept lower total returns. But the truth is that, when you own a high-quality company that is gushing out growing profits across dozens of countries, and is able to sustain that business model for decades, you will do quite well over long periods of time. We have all these excellent companies sitting right in front of us, and it is easier to ignore them because there is always a “more glittery” company out there somewhere.

With that said, I don’t think that Procter & Gamble, Johnson & Johnson, and ExxonMobil are on the discount rack right now. Dollar cost averaging (i.e. putting $100 per month into each company each month) is a wonderful tool for a blue-chip investor, and now may be a good time to do something like that. Considering Procter & Gamble and Exxon charge $0 to have money taken out of your checking account monthly, and considering that Johnson & Johnson charges $0 if you mail in a check, they can be a free way to get some high quality assets under your belt over time. There’s about a dozen or so companies on my “buy-and-hold forever list”, and each of those three companies would occupy one of the three slots. If you put $100 (or whatever amount you’re working with) into each of these three companies each month for the next ten to fifteen years, I cannot imagine that working out poorly. Best of luck with everything, Manoj.