Why I’m Almost Always Happy To See Price Drops On Stocks, Even If I’m Done Accumulating Shares (And The Two Instances In Which I’m Not Happy)

It seems odd to me that anyone who is regularly accumulating stocks would wish for or be happy to see prices on these stocks to increase.

Looking forward to seeing the stocks you’re buying increase in price is like being excited to see the price of bread at your supermarket higher just because you have a few loaves at home (that were bought at cheaper prices), even though you know you’re going to be buying more bread for many more years.

It’s even an more strange concept to me as a dividend growth investor who has been actively accumulating (and remains accumulating, albeit to a lesser degree now) high-quality dividend growth stocks for more than six years now, which has culminated in the Full-Time Fund – it’s filled with more than 100 of the best dividend growth stocks in the world, spitting out almost $11,000 in aggregate dividend income annually.

Price And Yield

I say that it’s perhaps more strange due to the way price and yield are inversely correlated.

All else equal, a higher price will always result in a lower yield.

And as someone who has long ventured to live off of passive income, every additional basis point of yield (every additional penny) counts.

This means that a stock that pays out a $0.25 quarterly dividend ($1.00 annually) will yield 3.33% at $30 per share.

But if the price falls to $25, the stock’s yield jumps to 4% (all else equal).

That’s a spread of almost 70 basis points.

Working with real-life numbers, let’s assume you have $1,000 to invest. Your $1,000 buys 33.33 shares at $30 per share, which will pay you $33.33 per year in dividend income.

But that same $1,000 buys 40 shares when they’re priced at $25 per share. That then boosts your annual dividend income from this stock up to $40.00.

While that doesn’t seem like that much of a difference, it really is. Just multiply these results out by dozens upon dozens of stock transactions. All of the sudden, you have a delta of hundreds – or thousands – of dollars per year in lost dividend income.

Additional Compounding Power And Dividend Growth Power

Looking forward to seeing stocks at a lower price shouldn’t only be thought of in terms of additional current income but also long-term income growth and long-term compounding.

I invest primarily in stocks with longstanding track records of increasing their dividend amounts regularly (typically once a year, every year for decades).

Well, your future income growth will be impacted by the base of shares (and thus the yield) you first accumulated with your money. More shares means more income now… but also even more income later. A cheaper price point acts as a turbocharger for long-term dividend income growth in absolute terms.

Let’s continue with the same example above. Let’s assume this stock increases its dividend by a 7% annual rate for the next three years.

If you’re only able to scoop up the 33.33 shares at $30 per share, your $33.33 annual dividend income grows to $35.66 after the first 7% dividend increase; then $38.15 after the second increase; then $40.82 after the third increase. So you’re looking at a total increase in annual income of $7.49 after the three dividend increases come in, for a total of 22.47%.

But if you’re able to instead pick up 40 shares at the $25 price point, your $40.00 annual dividend income will grow to $42.80 after the first 7% dividend increase; then $45.80 after the second increase; then $49.01 after the third increase. So you’re looking at a total increase in annual income of $9.01 after the three dividend increases come in, for a total of 22.53%.

While the company did nothing different in relative terms – it’s handing out 7% increases either way – your dividend income growth is accelerated in absolute and relative terms when the price of a stock is lower, and its yield thus higher. You end up with more absolute annual dividend income in the second example ($9.01 versus $7.49), while the percentage gain was also relatively higher (22.53% versus 22.47%). This divergence only widens over time, by the way.

You simply end up with not only more income right away but more and more income all the way along.

I call this “dividend growth power”.

Your earnings power from the underlying shares that are working for you increase when the price you pay for the shares is lower from the start. It’s like you’re increasing your actual earnings power as an investor over the long run by doing absolutely nothing at all… other than paying a lower price rather than a higher price.

This also improves your long-term compounding power, too.

Long-term dividend growth of 7% would imply long-term earnings per share growth of 7%. Assuming a static payout ratio and a static valuation on the stock, this means the first investment would compound at 10.33% (7% growth plus a 3.33% yield), while the second investment would compound at 11% (7% growth plus a 4% yield). I’m ignoring taxes and inflation for this example to simply things for the sake of brevity.

A simple compound interest calculator tells us that the first investment turns into $21,320.31 after 30 years of compounding at 10.33%. This is factoring in four compounding periods for year (a quarterly dividend) and no additional investment.

The second investment, meanwhile, turns into $25,931.02, compounding at 11% (using the same assumptions, otherwise).

That’s a pretty stark difference. And this is just one investment of $1,000. If you’re actually looking to one day live off of your passive income, you’re going to be making $1,000 investments routinely. As such, you can see how this difference becomes significant when repeated over and over again.

Averaging Down

While I’m most happy to see a stock decline in price when I’m looking to purchase shares but haven’t yet, I’m almost just as happy to see the price drop when I’ve already purchased shares but still have room for more.

This is averaging down.

If I put $1,000 into the stock at $30, yielding 3.33%, you can bet your bottom dollar I’m very excited to see the stock drop to $25, which means it would be yielding 4%.

I then have an opportunity to increase my stake in that company at a cheaper price point, gaining all of the advantages I just went over.

That lowers my cost basis, improves my yield on the investment, and puts me in a better spot in terms of dividend growth and compounding power over the long run.

I’ve done this many times over the years.

A notable example is Digital Realty Trust, Inc. (DLR). I first initiated a position at $59.34 in June 2013. The stock fell fairly precipitously shortly thereafter.

What did I do? 

I bought more, of course!

I added more shares at $54.75 in August 2013 and $46.74 in October 2013.

While some investors might bemoan a stock they just bought four months prior dropping in price by over 20%, I was positively elated. The business model hadn’t changed. I felt confident in my due diligence. The price was lower, the yield was thus higher, and my long-term prospects only improved.

The stock is now sitting at about $93 per share.

Now, it doesn’t always work out like this. But it’s worked out far more often than not, in my experience.

But What If I’m No Longer Accumulating?

It’s all well and good to be excited to see a stock that you’re actively buying drop in price. This gives you a chance to take another look and buy more shares at a cheaper price point, thus gaining all the advantages I laid out above.

But what if you have no more room for a particular stock? What if you’re as exposed as you want to be over the long run to that one company?

Well, you can think about this in one of two (or both) ways.

First, a lower price point gives you a chance to temporarily overweight a particular stock, which then means you can sell the stock down the road for a handsome profit (if it bounces back). If you don’t want more than, say, 50 shares of a particular stock in your portfolio (due to your own risk tolerance), temporarily going up to, say, 70 shares means you can unload 20 shares if/when the price recovers. Of course, this is only something that one should think about if they’re comfortable with the risks and confident that the lower price is a temporary stock issue rather than a long-term company issue.

Or one can use a tax-loss harvesting strategy (if the stock is in a taxable account) to unload older, more expensive shares in exchange for newer, cheaper shares (while being on the right side of the wash rule). This means you can keep your overall risk/exposure the same but carve out a little tax advantage in the process.

The second way to think about this – the way I most commonly think about it – is the fact that company buybacks are that much more powerful at a lower price.

Most of the companies I regularly invest in are regularly and fairly systematically buying back their own shares.

While I might be done accumulating a stock once I have $3,000 (or whatever) invested in the company, that doesn’t mean by any stretch of the imagination that the company itself is done accumulating shares.

In fact, they’re often going to be a far more aggressive buyer than me (and, likely, you).

For example, I’m no longer accumulating shares of Johnson & Johnson (JNJ). It’s my largest position, at approximately 4% of the Full-Time Fund. The position is worth more than $11,000.

However, that isn’t stopping Johnson & Johnson from buying its shares. They announced a $10 billion buyback in October 2015. And they repurchased over 18 million shares during the company’s fiscal fourth quarter for 2015. These shares were bought at average prices ranging from $96.45 to $102.30.

The stock is now priced at over $117 per share. Why in the world would I want the stock at $120? It does nothing for me. Even though I’m no longer accumulating shares, I still would prefer this stock back down below $100 so that the $10 billion Johnson & Johnson is spending goes that much further by buying that many more shares. Just like my money compounds, so does the company’s (which ends up being my money anyway, as I’m a shareholder).

I’ll quickly note here that I much prefer dividend raises over buybacks. But if a company is going to be buying back shares, I want these transactions to be as advantageous as possible. 

The First Instance In Which I Don’t Like To See Lower Prices

Now, that’s not to say I always like to see lower prices. There are a couple instances in which I’m not at all happy to see lower prices.

The first instance is if/when a company is somehow struggling with operations over a longer period of time, engages in fraud or some other illegal/questionable behavior, or announces something else that somehow permanently handicaps the business.

Essentially, what I’m not looking for is something that lowers the valuation of the business.

It’s one thing to see a stock that’s priced at $90 drop to $80, even though you believe it’s really worth $100. That’s something I applaud and celebrate (usually by buying more stock).

It’s quite another thing to see a stock drop from $90 to $80 because the company screwed up, seeing its valuation drop from $100 to $80. That I do no applaud or celebrate.

So I’m happy to see the price drop; I’m not happy to see the value drop.

The Second Instance

The only other instance in which I’m not happy to see the price drop on a stock is when we’re talking about pass-through entities like master limited partnerships or real estate investment trusts.

Now, as always, it depends on what kind of time frame we’re talking about here. It also depends on what kind of drop. There is never a one-size-fits-all rule with anything in investing, in my opinion. Moreover, it depends on whether or not I’m averaging down.

As I noted in the Digital Realty Trust example above, the drop in the stock was precipitous. It was also temporary, after which the stock recovered and went on a run. (A stock can sometimes see its price and intrinsic value diverge, even wildly and substantially, over the short term. But value matters over the long run.) And I was still buying the stock, which gave me a chance to buy additional shares at a cheaper price.

I would not be happy, however, if a stock like Realty Income Corp. (O) were to drop by, say, 40% or something and then just stay there for years.

The reason why is because pass-through entities use equity (as well as debt) quite frequently as a method to raise capital and fund growth. As such, I want Realty Income (or any other REIT) to be raising capital at $64 per share, not $40 per share. Using equity to raise capital is dilutive, so shareholders should wish for that effect to be mitigated as much as possible (by getting as much money for future growth as possible from any equity issuance).

If a drop like this were to occur, a high-quality company does have other levers to pull. Realty could issue debt, or even buy back its own shares (if they’re deemed to be significantly undervalued). Shuffling a portfolio of properties is another possibility. However, too much debt can be a problem. And buying back shares just to re-issue them isn’t really where you want to be.

Kinder Morgan Inc. (KMI) is a good example of when a price drop isn’t a good thing for a pass-through entity. Although not a true master limited partnership after it consolidated its various partnerships in 2014, it continues to operate and report results as a de facto master limited partnership.

This stock dropped sharply in late 2015 on worries about its capital structure, with Moody’s Corporation (MCO) downgrading Kinder Morgan’s credit outlook from stable to negative due to the debt load and weak industry dynamics after Kinder Morgan increased its ownership in Natural Gas Pipeline Company of America LLC, which was distressed. Moody’s became concerned that Kinder Morgan was taking on too much, noting that Kinder Morgan would probably have to inject capital into NGPL, an injection which would be funded by debt.

Well, that sent the stock into a tailspin, although the stock was already having issues due to the massive changes that were occurring in the oil & gas industry in general.

But what happened here is that questions were raised about its capital structure. If its credit rating were downgraded, it would have a hard time taking on more debt, and its debt load was already becoming worrisome. Investors started to sell, which caused the price of the stock to drop, which further limited the company’s ability to raise capital via equity. Without being able to tap debt or equity, Kinder Morgan would be in trouble.

Faced with this prospect, the company cut its dividend by approximately 75% so as to conserve cash, which would allow the company to self-fund growth and reduce its debt level until operations and industry dynamics improved.

This is a great example of when I’m not happy to see a large price markdown on a stock. Although Kinder Morgan’s price is much lower, so is its valuation and dividend. It’s now worth less to me due to the smaller dividend and limited visible growth prospects for both the dividend and the business (due to changed industry dynamics and limited capital). To make matters worse, I don’t have room for more shares, even if I wanted to average down further.

(However, I also think the company will do well over the long run, so I continue to hold a rather large stake in the company. I also have more shares of the company than I did before the issues started, as I bought shares on the drop and later sold some for tax-loss purposes.)

Conclusion

I’m almost always delighted to see the price drop on a stock, whether I already own it or not and whether I’m currently buying more of it or not. Other than the specific examples I laid out, I look at short-term volatility as a long-term opportunity. For me, red is almost always green; green is almost always red.

However, I’m not pleased to see operations stumble. I don’t like seeing a company struggle. I don’t look forward to actions or inaction that can substantially negatively affect the intrinsic value of any business I’m invested in. And I’m almost never enthusiastic to see major pullbacks in the prices of any pass-through entities I’m invested in, other than the short-term variety.

Try to engage in second-level thinking. Remember that you’re a long-term investor. Keep in mind that price and value are not one and the same. If the former drops precipitously while the latter does not, that’s almost always an opportunity that should be applauded.

What do you think? Are you almost always happy to see prices on stocks (even ones you own) drop? Why or why not? 

Full disclosure: I’m long DLR, JNJ, O, and KMI.

Thanks for reading.

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