If Wide Moat Div Yield + Growth > Discount Rate, Forget Market Timing

By Lucy from manchester, uk (honklings) [CC BY-SA 2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons

Sleep per Day: (Target) 7h30m / day (Actual) 7h28m / day (76 day average)

I’ve mentioned before that I like to hold cash based on how much Shiller P/E is above the historical mean.

But reading a paragraph from Seth Klarman’s Margin of Safety changed my view where he talks about why you shouldn’t use dividends in valuing a business:

The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. Accurately predicting that far ahead is an impossibility.

But what made me think I can disregard market timing if a stock’s div. yield + growth rate is bigger than discount rate? The sentence “dividends constitute only a small fraction of total corporate cash flow”.

What this implies is a dividend-discount method of valuation is a very conservative method of valuation. If the dividends in itself provides the necessary returns to beat my discount rate, then you should go for it since it holds a large margin of safety.

But what about Seth Klarman’s complaint that “Accurately predicting (corporate cash flow projections) that far ahead is an impossibility”? This can be solved through a conservative discount rate, a conservative growth rate, a conservative payout ratio, a long dividend growth history (min. 10 years) and a wide moat.

What is deemed a conservative discount rate? Choosing the 30 Year Treasury Yield as my risk-free rate benchmark, I select the higher of either the current yield, historical mean or historical median. Then I multiply it by how many dividend aristocrats cut/eliminated dividends in 2008-2009 [1] before further multiplying it by 1.5 [2].

What is deemed a conservative growth rate? I first choose the lower of either the 1 year, 3 year, 5 year or 10 year dividend growth rate. I then discount it based on dividend growth history (if 25 or above years, discount by 1/3, if 10-24 years, discount by 2/3, if less than 10 years, treat as zero growth).

What is deemed a conservative payout ratio? I demand that the 5 year average payout ratio is below 2/3.

The rationale behind favoring stocks with long dividend growth histories is that a very long dividend growth history filters out companies that could consistently grow dividends by luck rather than possessing a wide moat, and that it is very likely that the company’s growth is predictable as a result.

Both of these considerations together combined with an extremely conservative valuation allows me to relatively accurately predict corporate cash flow projections several decades into the future.

And as a last line of margin of safety, I demand that I have at least 16 stocks for diversification purposes, which means I will only buy up to 6.25% weighting for each stock. If any of the aforementioned stocks die, my portfolio doesn’t have to die with it due to diversification, wide moat and conservative valuation.

Which is why for my newest Imaginary Portfolio Update I eliminated the Shiller P/E indicator.

After all, if a wide moat stock with long dividend growth history has its dividend yield and conservative growth rate beat your conservative discount rate, you have a huge margin of safety, thus rendering market timing useless.

[Notes]

[1] The reason why I use 2008-2009 is because I only have the statistics from that period of how many dividend aristocrats stopped being dividend aristocrats during stock market crashes. Also considering 2008-2009 was one of the most serious stock market crashes in history, it would be a good benchmark on the ability of dividend aristocrats to have its status remain intact during a black swan event.

[2] 1.5x basically implies I buy a dollar for 67 cents. The margin of safety provides safety for factors I overlooked, and also ensures I buy at an at least decent undervalued price rather than just fair value.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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