Paired Investment Strategy

When an investor tries to find “value” with an investment purchase, there are usually two ways to do it. The first involves buying growth stocks. Here, the advantage is that the earnings per share growth rate will be greater than the S&P 500 for an extended period of time. The second involves buying value stocks. The advantage with these types of stocks is the knowledge that you’re getting a deal, and even moderate growth can deliver strong returns when coupled with P/E ratio expansion.

The downside of growth investing is that attractive businesses often trade at P/E ratios that are a bit higher than what some investors are comfortable paying, and the downside of value investing is that the discount in price is often tied to some type of ongoing problem with the business operations that may take years for the valuation to correct (because usually it takes at least a few quarters of improvements before a disfavored stock starts to regain the benefit of the doubt).

An even-keeled way to approach portfolio construction involves thinking of investments in terms of twos: selecting one stock from the growth category to pair with a stock from the value category. This blended approach provides both income and economic cycle benefits. The income advantage is that the growth stock will provide a higher dividend growth rate, and the selection from the value category will usually have a much higher present dividend yield. The growth stock tends to deliver more capital gains during ordinary and good economic conditions, and the value stock tends to fall less during tough economic conditions. This is because the growth stock often experiences its valuation go from overvalued to fairly valued to undervalued, whereas the only downside pricing risk from the value stock is going from undervalued to even more undervalued.

An example of someone doing that today might consider, say, purchasing Nike and BP simultaneously. The advantage of Nike is nearly self-evident: it has delivered nearly 19% annual returns for the past 35 years, is projected to grow sales at 13.5% annually for the next five years, and deliver 19.5% annual earnings growth through 2021. This is perfectly in line with Nike’s status quo.

The downside of Nike is that the dividend yield is only around 1%, and the company falls by a greater amount than the S&P 500 during a recession (see the $35 to $19 price decline for Nike between 2008 and 2009). Each of these items are offset by time. For instance, Nike has increased its dividend from $0.12 in 2002 to $1.08 in 2015. And the Great Recession statistics only measure Nike’s short-term performance; once you have held Nike for a few years, the results improve dramatically.

Imagine if you bought Nike in 1999. That was a time in which the stock traded at 28.1x earnings. By the low of the 2009 recession, the valuation was down to 13.8x earnings. And yet, what happened to Nike investors during this measuring period? They earned 8.5% annual returns. The quadrupling of earnings between 1999 and 2009 dragged forward the window of valuation boundaries and provided much better returns than you’d guess from a measuring period that started with a generational high and ended with a generational low.

Meanwhile, a company like BP can represent the value prong of the paired investment strategy. The current dividend yield is 7.8%, well above the 4.2% historical average for the stock. It is now cheaper than it was during the oil decline of the great recession and the immediate aftermath of the oil spill on a normalized dividend yield basis. Even with oil in the $30s, the strength of the refiners put BP in a position to earn $7 billion per year in profits. It pays out $7.2 billion in dividends, so the payout would come down if oil stayed in the $30s for a while (though BP currently has $32 billion in cash, $20.8 billion is earmarked for the litigation settlement).

The advantage of BP is that the share count quickly increases, acting as a silent accelerator even as the share price shoots all over the place (it fell from $77 to $33 between 2008 and 2009 before shooting up to $62 in 2010). This past five year stretch has been one of the worst measuring periods in BP’s history, with the stock enduring tens of billions of dollars in litigation concurrently with a very difficult oil market. And people that have reinvested throughout this period have been able to turn 100 shares of BP into 120 shares of BP, limiting the losses of the period.

Good things happen when you buy cyclical stocks at a low point and hold on, and BP figures to generate a lot of long-term income compared to the initial purchase price of $30. Even if the dividend were cut in half to $1.20, it would still only take up 55% of profits and would give investors a 3.9% yield (close to the historical average). And, from that point, a rise in oil prices would lead to substantial dividend growth (whereas maintenance of the dividend payout would lead to anemic growth in the event of an oil recovery).

The best way to think of it is this: “Integrated oil companies will deliver substantial chunks of income over a 20+ year measuring period. The moment when the payout appears threatened is exactly the time when you can lock in one of the best valuations for receiving significant dividend income from that point. Even with low prices, these firms pump out large profits, and share a significant percentage with owners.”

A value and growth approach creates wealth at different times. Between 2003 and 2007, Nike could be purchased in the $23 range. Meanwhile, BP climbed from the low $40s to almost $80, and returned almost $10 per share in dividend income during that time. All those reinvested dividends in the $40s suddenly became worth a lot more when the price shifted to nearly $80. The past five years, it has been Nike that does the heavy lifting.

My favorite investing metaphor compares a portfolio to an orchestra in which every instrument gets its moment to shine. There is a time for the saxophone, and there is a time for the tuba. When you have purchased BP in the past few years, the benefit is that you collect sizable checks compared to your purchase price. If you reinvest, those dividends will rise in value during the next turn in the oil cycle. The advantage of Nike is that the earnings growth is substantial, often overcompensating the lofty valuation. If you think of investments in increments of two, you can often satisfy the desire for growth, value, dividend growth, and high current income that can pull you in different directions. Your personal satisfaction with the investing process can increase dramatically if you think in terms of paired investments.

Originally posted 2015-12-23 03:31:18.

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