Why Share Price Does Matter When Investing in Dividends

Originally, when I published the first issue of The Money for Life Letter, the plan was to focus on being an ‘income newsletter’ which mainly recommended dividend stocks. But, quite frankly, I thought such a one-dimensional focus would get a little boring. You can only point out so many times how superior dividends are to capital gains.

Not that it stops me.

So my publisher and I decided to broaden the scope and launch a newsletter about alternative retirement strategies, income investing being just one feature. Retirement advice in Australia lacks any sort of innovative thinking these days.

People pay financial advisors big bucks to receive much the same financial advice as everyone else in the waiting room, regardless of their individual situation.

Given my dividend focused origins, what do I think about dividend paying stocks right now?

Shares are overpriced right now. Just like you wouldn’t buy a $5 coffee, I don’t think you should buy an overpriced stock. What you’re getting is not worth the price.

This can go against common dividend investing wisdom. The price shouldn’t matter much if you’re investing for dividends, as it’s the dividend return that’s crucial. What does it matter if the price falls, so long as you still get your dividend cheques?

Well, the simple truth is that price matters in two different ways when it comes to dividend investing. In more normal times, neither of these reasons matter much because share prices only fluctuate a little. But we don’t live in normal times. Big price moves are on the cards in a world of financial crises, bear markets like the current one, and government shutdowns.

The first reason the stock price matters in dividend investing is straightforward. A higher stock price reduces your dividend yield. A $1 dividend on a $10 stock is a 10% return. The same $1 dividend on a $5 stock is a 20% return. You want to buy into the same dividend stream at the lowest possible price.

Which means, if there is a stock market crash, that’s an enormous opportunity you should take advantage of as a dividend investor. Keeping ‘powder dry’ for such a moment is an important part of investing these days.

The second reason has to do with psychology. Could you really stomach watching your dividend paying shares tumble in price? Or would you sell out in a crash, even though you invested for income, not capital gains?

It’s not a question anyone can answer until a crash happens. But you do need to acknowledge the question to be prepared for that eventuality. I think such a crash is likely.  You should avoid having too much money in stocks and keep plenty of cash ready to invest.

The good news is, I’ve found an excellent way to collect income from shares without losing money if their share price falls. All you have to do is agree, in advance, to buy the shares if their share price does fall to a level you would be willing to invest in for their dividend stream.

In other words, say you would be willing to invest in company X at a price 20% below where it is now because, at that price, the dividend income would be very high. Well someone will pay you income today to agree to buy it if the price does reach that level in a few months’ time.

It sounds too good to be true, and maybe a little confusing. But I’m hoping to enlighten readers of The Money for Life Letter next month. In short, it’s the ideal dividend and income strategy for the market we’re in because it allows you to collect income while agreeing to buy great dividend paying shares ‘on the cheap’.

But why do I think that stocks are overvalued? Well, quite frankly, every possible way of analysing the stock market that I know of leads to that conclusion. But that’s far from saying the stock market won’t go up. Just that it’s not a good time to buy given the information we know. The odds are not in your favour.

Let’s take a peek at two reasons I think stocks are overvalued. If you look at the chart of the ASX200 below, you’ll notice we’ve been going sideways since the middle of 2009. Right now, we’re at the top of that sideways distribution. If the distribution continues, that implies a big drop in the stock market.

ASX200

chart showing sideways distribution of the ASX 200 since the middle of 2009
Source: Yahoo Finance

Click to enlarge

Another measure is the P/E ratio of the ASX200 as a whole. It measures how much you’re paying for a dollar of company earnings. Think about it as how much you pay per serving of coffee. The higher the P/E, the more expensive the shares.

The table below shows how the Australian and New Zealand stock markets are dangerously overvalued, above 20 on the P/E ratio (using the last 12 months earnings). They are expensive in general and compared to other countries’ stock markets.

Now both of those are simplistic measures. I’m trying to give you an idea of how people judge the value of the stock markets. Just about all ways of doing so lead to the conclusion that stocks here in Australia are expensive. And that’s why I’ve been avoiding plain vanilla dividend companies.

But I look forward to adding some of them indirectly, using the technique I mentioned above.

Nick Hubble+
Editor, The Money for Life Letter

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Nick Hubble is a feature Editor of The Daily Reckoning Australia . Nick has spent the last three years discovering lots of new, exciting and surprisingly simple ways to generate money for retirement. He’s put all these ideas into his investment publication The Money for Life Letter. If you're already a subscriber to these publications, or want to follow Nick's financial world view more closely, then we recommend you join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.


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