Artesian-Arts

3 Reasons Why I’m Selling Overvalued Home Depot At $280 (NYSE:HD)

Written by Sam Kovacs

Introduction

Maybe you’ve heard me say this before: I like to run my portfolio as I would run a sports team. Except this is the All Star game and I get to pick who I play. In the past decades, an interesting trend has happened in the NBA. At the turn of the century, some of my childhood idols like Kobe Bryant and Allen Iverson would regularly play 40 of the 48 minutes in a basketball game.

Between 1998 and 2003, on average there were 9 players per season who would average this many minutes. But since 2009, this number had dropped to 0.6 players per season. In other words, there have been seasons where no players have played this many minutes.

Teams have opted to bench their star players more. This has happened as teams have boosted roster participation, using and developing all their players, allowing more time for players to rest, and giving them more options for different situations.

Source: Open Domain

To preserve your star players, you sometimes need to bench them. It is the same with stocks, sometimes your star stocks perform so well, that to get the most out of your portfolio, you need to bench them. That is to say, you sometimes need to sell part of your stake. This is now the case for Home depot (HD).

Home Depot is one of my favorite stocks. In April 2019, I explained on Seeking Alpha why HD was a core position in my portfolio. The company has a large moat around its business, is run by stellar management, and is very shareholder friendly, returning generous amounts of cash in the form of dividends.

That article was the first of 3 following ones in which I made these predictions:

  • April 2019: I wouldn’t be surprised to see the stock price increase an extra 10% this year”. HD increased 7.5%
  • December 2019: I believed the stock’s price was quite rich relative to its prospects and would stagnate for the next 2 quarters. Exactly 6 months later, HD’s price had increased by 0.04%.
  • March 2020: HD was trading at just $186. I argued that it was a great deal and that “HD’s relative outperformance is likely to be sustained in upcoming months and quarters”. Since that article, HD is up 51%. The S&P 500 (SPY) is up 31%.

The year to date chart below shows the extent to which HD has exploded since the trough in March.

Source: mad-dividends.com

But just as the company delivered what most would consider the best quarter in a long time, beating both EPS and revenues significantly, I am now becoming extremely cautious, and suggesting investors sell some of their HD shares.

In the dividend strategy which Robert and I follow, there are two reasons why we sell stocks:

  1. The company’s financial prospects or a change in management threatens the dividend or its future growth.
  2. The price has become so overvalued that we can significantly increase our portfolios income by selling and reinvesting in other stocks.

Now let’s be clear: there is absolutely nothing wrong with HD’s business or ability to pay a dividend. The company remains committed to double digit dividend growth (having increased the dividend by 10% last year). This high growth is fueled by the growth in the company’s business. The dividend more than doubled in 5 years, yet payout ratios remained flat. What does this mean? One thing: growth.

While many businesses have been struggling to keep their head above water level, HD’s comparable store sales increased 23.4%. Home Depot is what Robert and I call an “All Weather” dividend stock. The sort of stock which can form a cornerstone of your portfolio. Its dividend isn’t going anywhere but up.

So then why would I be selling? Reason number 2. I believe my money will better serve me in other places. In other words, relatively to other dividend opportunities in this market, HD is now unattractive.

Now please note that I am not fully removing HD from my portfolio. It was a core position in 2019, and I added even more in March. I’m selling half of my shares, reducing my position to a much more reasonable level. Whether this makes sense for you or not will depend mostly on the tax liability of selling your position.

I will present this decision under three views: valuation, opportunity cost, diversification.

Explanation 1: HD is overvalued every way you look at it.

The traditional ways of looking at valuation include comparing the stock’s multiples to other stocks in the market, in the sector, as well as to the company’s historical multiples. Peter Lynch, who ran the Magellan fund for over a decade, liked to draw “PE lines”, showing the theoretical price the stock would trade at if it traded at a certain multiple of earnings. By overlaying these PE lines, it became obvious whether the stock was trading at a premium or discount to its normal range of valuations.

We like to plot 3 PE lines, which use the 25th percentile, median and 75th percentile of PEs over the past 10 years.

Source: mad-dividends.com

When we do this, we see that HD usually trades in a very narrow range of 19x to 22x TTM earnings. HD currently trades at 28x TTM earnings, way above this level. Even if we look at the forward PE, according to Seeking Alpha, we get a multiple of 25x.

If the price stays flat, HD will still look overvalued relative to history a year from now. This doesn’t bode to well.

The last time the stock’s price shot up this far above its historical earnings range, back in early 2018, it then traded down and didn’t show positive gains until half way through 2019. This is to say, if you buy high, even an investment in the best company can be lousy.

Earnings are one estimate. Dividends are another. For stocks with consistent dividend policies, like HD, comparing the yield to historical yields can also be a very good indicator of valuation.

Source: mad-dividends.com

During the past 10 years, HD has yielded a median 2.24%. The current yield of 2.12% is underwhelming. In 65% of the trading days in the past decade, the stock closed with a higher yield.

In retrospect, the yield of 3.11% which was on offer the last time I covered HD, was higher than 95% of instances in the past decade.

This is not to say that HD can’t continue going higher. After all in the past decade it has yielded as little as 1.6%. Looking at the stock’s momentum, it is trending.

Source: mad-dividends.com

Any period you take to create a moving average – whether it be 5, 10, 20, 50, or 200 days– shows a clear signal, the stock is going up. But after earnings, the stock peaked premarket before trading down. The stock is headed for the 5 day SMA which has served as resistance for the past two months. If it fails to hold up, HD could be in for a volatile few months.

This level of risk-reward is very unattractive, and suggests that removing some chips from the table could be a good idea.

Explanation 2: You can significantly increase your income by selling.

This is one of the quirks of our dividend investing strategy which is significantly different to many dividend investors who are purely buy and hold.

We don’t criticize buy and holders for their choice. We simply suggest that by NEVER selling, you are cutting a lot of your options. A rational approach would suggest that if you buy low, you should be willing to sell high, otherwise you never realize the value which you uncovered.

The math is quite simple. The concept has come to be known as yield on sale. Although not known by many, because it implies estimating tax rates, and doing some algebra, which many don’t want to bother with.

What yield on sale calculates, is the yield at which you would need to reinvest the proceeds from a sale to totally replace your income.

The concept is explained in detail in our article “How to sell your dividend stocks to increase your income”.

The formula is as follows:

Yield on Sale = annual dividends / ((price – avg cost) * (1 – tax %) + avg cost)

So if we take an $190 price for HD, and assume say a 25% capital gains tax rate, we would get a yield on sale of:

$6 / ((280-190) * (1-0.25)+190) = 2.33%

Obviously these numbers would change depending on your purchase price (you can sell your most expensive lot) and on your capital gains tax rate (probably not much you can do here).

But in the theoretical case, it would suggest that after selling HD and paying taxes, you could totally replace your existing income by investing a stock which yields 2.33%, and significantly increase it by investing in anything which yields more. Are there any opportunities which fit the bill? Yes plenty.

Why do we say that capital gains make up for lousy dividend growth?

If you buy a stock when it yields 3%, sell it when it yields 2% and buy another 3% yielding stock, the gain you realize is equivalent to 27 years of dividends, assuming 10% dividend growth, or 23 years, assuming reinvestment.

Source: Author’s chart, data from mad-dividends.com

Now, I don’t know about you, but for me, booking the equivalent of 23 to 27 years of dividends in 4 months sure sounds attractive.

Buy low, sell high. Rinse and repeat. It’s investing 101. It is also point of resistance number 1 from many dividend investors.

Explanation 3: More diversification

As a college student, it took me a while to understand the value of diversification. I thought if I have a 10 bagger which is only 1% of my portfolio, the impact is much lesser than that of a 10% position.

Warren Buffett seemed to embrace this successfully in his hedge fund years, and when I was studying, Bill Ackman was the hot shot investor which embodied the concentrated portfolio strategy.

When Ackman invested 8.5% of his fund in Valeant, now Bausch Health Companies (BHC), and subsequently sunk $3billion of his investors cash, my appreciation for diversification changed.

The core insight from the Chicago school of insight concerning diversification, that as you increased the number of positions in a portfolio, you reduced the volatility without sacrificing total return, and that there was a number of positions which reduced idiosyncratic risk, is probably the only applicable insight from their school of thought.

In an article I wrote in June titled “The history of 50 dividend aristocrats and what it means for your retirement”, I analyzed dividend growth and its relationship to volatility in dividend growth.

There was some medium correlation between both.

Source: data from mad-dividends.com (Dividend growth on the x axis, standard deviation of dividend growth on the y axis)

But just like Markowitz, I found that by combining assets, you reduced the volatility of dividend growth, all while maintaining high dividend growth averages.

What we found was that with 5 stocks, you’d get about 5% standard deviation in the growth of dividends. At 10 stocks, this drops to 4%, and at 20 stocks this drops to 3%. By the time you got to 50 stocks, the standard deviation of dividend growth dropped to 2.3%.

This matters, because high standard deviation of dividend growth means it is harder for you to plan your future dividend income: it could be a lot higher or a lot lower than the median projection you might make.

To a certain extent, and insofar as there are other attractive dividend opportunities, diversification for its own sake is worth it.

By selling part of your Home Depot position and redeploying it into another asset, whether a fair weather or an all weather stock, you can improve your portfolios health.

Conclusion

Home Depot is a fantastic stock. But it is overvalued. Selling part of your position now limits your position downside by:

  • Shifting your portfolio to value. You always want to have a value tilt on your portfolio. As positions become overvalued, you want to rebalance into better value names
  • Increasing your income: A consequence of shifting to value, which significantly increases your income. Do this enough times, and your retirement will be a whole lot more fun.
  • Safeguarding your nest egg: by moving your gains into a new high quality dividend opportunity, you increase your portfolio’s health.

The decision of whether to buy and hold, or sell some of the gains on the way up is ultimately yours. It would take more than this for me to consider selling ALL my position. However, given its size in my portfolio, I am happy to remove half at current prices.

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Disclosure: I am/we are long HD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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