Buying up stock in excellent businesses that are so increasingly profitable year after year that they basically end up with too much profit is a hallmark of my strategy.
What do these companies do when they end up with too much profit? Profit that can’t be efficiently and effectively used to grow the business?
A good problem to have, no doubt.
[ad#Google Adsense 336×280-IA]Well, they send that excess cash flow out to shareholders in the form of dividends.
And with increasing profit comes increasing dividend payments.
You can clearly see why this is an attractive strategy, which is why I invest in dividend growth stocks.
And that’s helped me build a six-figure portfolio on a relatively modest income.
These dividend growth stocks are stocks that regularly and reliably increase their dividends to shareholders.
And they’re able to do that because they typically register higher profit year after year.
Well, these are the stocks you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list. In fact, you’ll find more than 700 of them, as Mr. Fish tracks all US-listed stocks that have increased their respective dividend for at least the last five consecutive years – many stocks on that list, however, have increased their respective dividend for more than 25 consecutive years.
But I don’t just randomly pick any stock on Mr. Fish’s list to buy for my own portfolio.
Buying quality is certainly key. But perhaps just as important is making sure you don’t overpay for stocks.
After all, who doesn’t love a good deal?
We love haggling for a car down at the dealership. Or a house when it’s time to buy a home for your family. And who doesn’t check out the clearance section at the local department store?
Well, it’s even more important to look for deals in the stock market. Buying quality merchandise at a discount is a fantastic way to build wealth over the long term.
Just like with any other merchandise out there in the world, stock’s have a price and they also have value.
To that point, the asking price is not always or even usually the same as value. And that’s because the stock market is filled with funds, machines, traders, and investors all competing with each other. If the world’s stock markets were physical stores, they’d be absolute chaos. (You can actually go to the New York Stock Exchange to get just a taste of what that’d be like.)
But there’s a way to quiet the noise. And that’s learning how to appropriately and reasonably estimate a stock’s fair value. This gives you a fighting chance and also allows you to separate price from what a stock is actually probably worth.
In that regard, it’s worth your time to check out this valuable and insightful guide on stock valuation, published by Dave Van Knapp.
Once you’re able to separate price from value, you’re able to buy high-quality stocks for what they’re worth or less, not just the asking price at any given moment. That skill allows you to pick your opportunities. That puts you in control.
And it looks like we might have an opportunity right now…
Chubb Group (CB) is a holding company that, through its subsidiaries, provides property and casualty insurance to individuals and businesses worldwide.
As I’ve mentioned many times, insurance is one of my favorite industries. It’s an age-old industry that continues to make a lot of money and will likely do so for many years to come. It’s easy to understand, ubiquitous, and necessary for most people and businesses due to risk management.
And high-quality insurers are able to leverage what’s called the “float”, which is the money an insurance company receives for premiums, held on to until claims are paid out. In the interim, a float can become quite large and quite profitable.
It’s basically a very low-cost source of capital that an insurance company can use to generate an attractive and low-risk return. Interest rates remain low now, which constrains CB’s ability to generate a high, low-risk return. However, the possibility of rising rates at some point remains a looming potential tailwind.
And CB has done well for shareholders: First, they’ve increased their dividend for the past 33 consecutive years. More than three straight decades, which includes multiple stock market crashes, the financial crisis, and the Great Recession. That indicates a lot of resiliency.
Over the past decade, the company has increased the dividend at an annual rate of 9.8%.
That’s well in excess of inflation over this period, which means shareholders’ purchasing power is actually increasing over time.
Meanwhile, the stock yields a fairly healthy and attractive 2.32% right now, which is backed by a comfortable 27% payout ratio.
So you’re getting an above-average yield (relative to the market) with a very low payout ratio – that means the dividend should only continue to grow from here, and probably at a fairly attractive rate.
The dividend is obviously fantastic. CB might fly under the radar, but it really shouldn’t. These are excellent dividend metrics across the board.
But let’s see what the company has managed in terms of growth. Without underlying profit growth, the dividend growth will likely cease as well. We’ll take a look at the last decade and what CB has done in regards to revenue and profit growth; this will help us value the business since we need to have an idea of what kind of growth to expect.
CB’s revenue has grown from $14.082 billion in fiscal year 2005 to $14.098 billion in FY 2014. Essentially flat, which isn’t really what you want to see. Though, this isn’t uncommon across the industry over the last 10 years.
Earnings per share increased from $4.47 to $8.62 over this stretch, which is a compound annual growth rate of 7.57%. Pretty impressive considering that premium revenue has been so stagnant, which bodes well if revenue can increase over the foreseeable future.
A significant portion of that bottom-line growth was fueled by share repurchases – CB reduced its outstanding share count by approximately 40% over the last 10 years. However, that can only continue so long, so premium revenue will have to pick up at some point.
S&P Capital IQ is predicting that EPS will compound at a 6% annual rate over the next three years, citing low rates and increasingly competitive pricing across many of the business lines.
CB unsurprisingly manages a very conservative balance sheet, which is appropriate for the business. The long-term debt/equity ratio is 0.20. Senior unsecured debt retains excellent A+/A2 credit ratings.
Profitability is quite robust. Even with pricing pressure across lines, the metrics here remain incredibly solid. They’ve averaged net margin of 14.35% and return on equity of 12.48% over the last five years. Both numbers compete well with any peers.
I don’t think there’s much to dislike here. I think investors want to see revenue pick up, which could be helped by rising rates. But the fact that they’ve increased EPS by more than 7% and the dividend by almost 10% per year over the last decade even with stagnant revenue says a lot about the quality of the business.
The quality is there. But is this stock a good deal?
CB trades hands for a P/E ratio of 11.63 right now. That’s above the five-year average of 10.7, though it’s possible that this is a case of a stock that was particularly cheap before becoming less cheap now. Keep in mind that this P/E ratio is almost half that of the broader market – the S&P 500’s P/E ratio is 20.73 right now.
So what’s this stock actually worth? What price should we pay?
I valued shares using a dividend discount model with a 10% discount rate and a long-term dividend growth rate of 7.5%. I think that’s fair considering the quality of the business, the potential for rising rates, the long-term dividend growth rate as it stands, and underlying profit growth. However, stagnant interest rates could affect this model. Nonetheless, I get a fair value of $98.04.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.
I think a case could be made that CB is at least fairly valued, with a rather significant margin of safety there in the model. Rising rates could mean this stock is an incredible deal right now, however. But let’s compare my view to that of some professional analysts that follow and value this stock.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates CB as a 3-star stock, with a fair value estimate of $105.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates CB as a 4-star “buy”, with a fair value calculation of $136.20.
Some differing opinions there for sure, but all of them indicate undervaluation. If we average them out so as to come up with a final, conclusive number, we get $113.08. That means this stock is possibly 15% undervalued right now.
Bottom line: Chubb Corp. (CB) is a high-quality insurer across the board. Stagnant revenue growth clouds the potential here, but even with that the company has posted substantial growth across the bottom line and the dividend. Rising rates and/or increasing premium revenue could offer an excellent buying opportunity here, with shares appearing to offer potential 15% upside right now with a market-beating yield that pays you to wait. I’d strongly consider this stock here.
— Jason Fieber, Dividend Mantra
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