Paul Price: You Can’t Buy Past Performance

Analysts love to recommend mutual funds and stocks that have already gone up. They feel comfortable touting securities that are currently “in favor” and which exhibit positive share price momentum.

Mutual funds that focus on holding large-cap shares of “Dividend Aristocrats,” defined as stocks that have raised their payouts at least annually for at least 25 straight years, have become very popular. They’ve performed well in recent years. The S&P High Yield Dividend Aristocrat ETF (SDY) and the Vanguard Dividend Appreciation ETF (VIG) are two examples of funds that utilize the rising dividend criteria in selecting their holdings.

What could be wrong with owning stocks with steadily growing yields? In our ZIRP world those stocks can get overpriced. Funds that hold overpriced shares will be prone to underperformance going forward. Let’s examine a typical Dividend Aristocrat to see why I say that.

Examining a Dividend Aristocrat

Leggett & Platt (LEG) was called a “forgotten” issue even though it had surged by greater than 80% over three years. That magnitude, by definition, means LEG has not really been flying under the radar. The question becomes: “If the price is up big already can a stock or mutual fund still be a good buy?” To determine future prospects you’ll need to know the value of the shares in relation to where they’ve traded historically. Leggett & Platt was a great buy during 2010 – 2014 when the shares sold for P/Es of 11.6x – 17.1×.

As of Dec. 20, 2014, LEG was commanding one of its highest valuations in recent history. Its yield, at 2.95%, was far below its 4.6% average during the four years prior to 2014. Company insiders obviously did not think LEG shares were a great bargain. They sold personal holdings 27 times from February through October of this year without recording even one insider buy.

By objective standards LEG appears overpriced. A regression towards a more normal, 16x, P/E would only support a 12-month target price of $34.40, even if the forward estimate plays out as projected.

What good is a 3% dividend if the shares generating that yield decline by 18%?

The Bottom Line

Mutual funds that are chock full of shares that look similar to LEG are likely to mimic the risk described for Leggett & Platt. Buying the hottest mutual funds, right after large run-ups is a dangerous game. Wishing you’d been on board for what just finished happening is normal. Never forget, though, that you can’t buy past performance.

Disclosure: No positions in LEG, SDY or VIG