If you approach investing in a very pragmatic manner, you’ll probably do really well over the long run.
What I do is think of stocks like merchandise.
And I think of the stock market like a store.
The store/market offers low-quality and high-quality merchandise/stocks.
Some merchandise is expensive. Some is cheap.
[ad#Google Adsense 336×280-IA]But just like any other time I’m out to buy something, I aim to buy high-quality merchandise.
And I am to pay less than I think the merchandise is worth.
This stance has served me very well over the years.
I think that’s evidenced by the six-figure portfolio that I control in my early 30s – a real-life, real-money portfolio that’s essentially funding my early retirement.
This portfolio is chock-full of dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 700 US-listed stocks that have increased dividends each year for at least the last five consecutive years.
I write about and personally invest in dividend growth stocks because I believe they’re the crème de la crème.
See, a business that can afford to pay increasing dividends to shareholders year in and year out has to do so many things right.
You can’t run a poor business that fails to regularly register higher profit while simultaneously writing ever-larger checks to your investors. That just can’t happen – at least not for very long.
As such, I find that a lengthy dividend growth track record is a great initial litmus test for quality.
Of course, one wants to take it much further: any intelligent investor should be performing a full quantitative and qualitative analysis on any prospective long-term investment.
You want to see a healthy top line, regular profit growth on a per-share basis over a long period of time, reasonable debt, good profitability, strong management, and competitive advantages.
After all, a stock represents a slice of ownership in a real business.
We’re talking real employees. Real products and/or services. Real profit.
And we’re also talking real dividends, which can add add up to significant amounts of money over time.
These real dividends can pay real bills: my portfolio is on track to spit out more than $11,000 in real dividend income over the next 12 months.
Indeed, I became a dividend growth investor because I believed (and still believe) that it’s the best investment strategy for early retirement.
The dividends are such a simple way to convert investments into cash flow – while simultaneously keeping all of the hard-earned equity intact. That way you don’t need to worry about running out of money due to selling off assets.
Moreover, the dividend income that one collects from high-quality dividend growth stocks grows – and I find this growth generally exceeds inflation, meaning one’s purchasing power increases over the long run.
Inflation? No problem.
But just as it’s important to stick to quality stocks, one should also aim to pay less than they believe a stock is worth.
Said another way, it’s important to buy high-quality dividend growth stocks when they’re undervalued.
Undervaluation is present when the price being asked for a stock is below what the intrinsic value is believed to be.
So if a stock is priced at $40 but worth $50, it would be deemed undervalued.
Buying a dividend growth stock when it’s undervalued confers a number of benefits to the investor.
Think a higher yield, greater long-term total return prospects, and less risk.
Now, this is all relative. These benefits are obviously present when compared to buying the same stock when it’s fairly valued or overvalued.
An undervalued dividend growth stock will offer a higher yield when it’s undervalued because price and yield are inversely correlated.
All else equal, a lower price will equate to a higher yield.
This higher yield immediately positively impacts the long-term total return prospects, as yield is a major component to total return.
In addition, capital gain, the other component to total return, is potentially positively influenced by virtue of the upside that exists between the lower price paid and the higher intrinsic value of the stock.
Although stock prices can be volatile over the short term and not necessarily tethered to the intrinsic value of a business, the value of a business tends to matter over the long run.
It’s just like my earlier analogies of a stock market to a store and stocks to merchandise. Merchandise can see volatile prices over the short term, but you’ll generally see a trend over a longer period of time. And that trend is usually tied to value.
Of course, paying less also reduces the risk you’re taking on.
Paying less means you’re risking less money per share.
This also has the effect of introducing a margin of safety, whereby you have a cushion just in case something goes wrong (i.e. management makes a big mistake, or the company doesn’t perform as expected).
You don’t want to pay fair price or above fair price, as that doesn’t allow for a margin of safety.
One wrong move by the business and your investment could be upside down.
We want to stay right side up… and make some money.
The good news is that these benefits aren’t terribly hard to get your hands on.
But you first must go through the process of actually valuing a dividend growth stock.
Fortunately, fellow contributor Dave Van Knapp put together a great resource that’s designed to help facilitate the process.
If you haven’t already, you should definitely check out Mr. Knapp’s great valuation guide.
But I won’t just leave you there.
I’m going to share some information on a high-quality dividend growth stock that appears to be undervalued right now…
T. Rowe Price Group Inc. (TROW) is a global investment manager that provides asset management services for institutional and individual investors.
Seeing as how the stock market has compounded at something like 10% (before inflation) over the last 100 years, being in the asset management business tends to prove very lucrative.
After all, a company like T. Rowe Price charges fees based on its assets under management. And AUM tends to grow over time as the underlying prices increase, even before factoring in additional AUM from new clients’ money.
While T. Rowe Price Group might be disproportionately affected by stock market crashes – the sudden and severe drop in asset prices affects AUM and the fees the company can generate – the company’s long-term track record is fantastic.
One aspect of that long-term track record is the dividend growth the firm has provided its shareholders.
T. Rowe Price has increased its dividend for 30 consecutive years.
That three-decade period has included multiple stock market crashes – including the dot-com bust of the early aughts and the recent financial crisis.
So even though there’s that exposure to asset price volatility, T. Rowe Price continues to pump out higher dividend increases.
If that’s not impressive enough, consider the dividend growth rate.
Over the last 10 years, the company has compounded its dividend at an annual rate of 14.5%.
That dividend growth, by the way, is on top of a very appealing yield of 2.95%.
I say appealing for a few reasons.
First, it’s much higher than the broader market.
Second, it’s pretty attractive in a low-rate environment.
Third, it’s about seventy basis points higher than the stock’s own five-year average.
That’s right. Investors buying the stock today are locking in a much higher yield than what they typically could have had, on average, over the last five years.
So that’s more income now… and potentially for the life of the investment. And we already know how that can affect total return.
Meanwhile, the yield appears to be pretty safe, considering the stock’s modest payout ratio of 48.6%.
I view a payout ratio of 50% a perfect harmony. That strikes a great balance between retaining capital to grow the business and reward shareholders (the collective owners of the company) with their share of profit. Moreover, it leaves a lot of room for future dividend raises.
Well, T. Rowe Price Group is pretty much right there.
As such, I think it makes sense to expect plenty more dividend increases for years to come.
But in order to really drill down our future expectations, we first must know what kind of underlying growth the business is actually generating over a fairly long period of time.
So we’ll now take a look at T. Rowe Price Group’s top-line and bottom-line growth over the last decade, and we’ll then compare that to a near-term forecast for profit growth.
Taken together, we should be able to make some fair assumptions about the company’s future dividend growth potential.
And this will also help us later value the business and its stock, as you’ll soon see.
The company has increased its revenue from $1.815 billion to $4.201 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 9.77%.
Mighty impressive. But the bottom line fared even better.
Earnings per share zoomed up from $1.90 to $4.63 over this stretch, which is a CAGR of 10.40%.
The slight difference is largely due to moderate share repurchases.
Looking forward, S&P Capital IQ believes that T. Rowe Price will compound its EPS at a 2% annual rate over the next three years.
That’s a very conservative estimate when one looks at T. Rowe Price’s long-term results. While a correction would absolutely affect T. Rowe Price’s profit in the near term, the long-term picture still appears quite bright.
The rest of the company’s fundamentals are very, very solid.
Especially the balance sheet.
T. Rowe Price has no long-term debt on the balance sheet.
Pristine.
And the profitability is outstanding, as asset management is a lucrative business.
Over the last five years, the company has averaged net margin of 29.26% and return on equity of 23.75%.
There’s not much to dislike here, but there sure is a lot to love.
However, there are some real risks to consider.
The exposure to volatile asset prices was already mentioned.
But the bigger long-term threat to the business model, in my view, is the rise of passive ETFs and index funds, which promise passive management and lower fees.
However, the company continues to hold its own.
While a lot of peers I track have had problems with outflow of client money, T. Rowe Price has actually had a net inflow of $2.2 billion over the first three quarters of FY 2016. Indeed, AUM ended Q3 2016 at $812.9 billion, up 12% YOY.
I believe a lot of their strength is tied to relative outperformance, lending its hand to brand recognition. 84% of its mutual funds outperformed their Lipper averages on a total return basis over three years. And there’s also the target-date retirement funds, which allow workers to auto-pilot their investing.
All in all, these are sticky assets.
We have a high-quality company here with a fantastic long-term track record.
And I believe the stock is undervalued right now…
The stock’s P/E ratio is 16.51, which is well below the broader market and the stock’s five-year average P/E ratio of 18.9. Investors are also paying less for the company’s cash flow in comparison to the average over the last five years. Same goes for book value. And the yield, as noted earlier, is significantly higher than its recent historical average.
So it does look cheap. But how cheap? What might the stock be worth?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7%. I think that growth rate is fair when keeping in mind the long-term dividend growth rate and moderate payout ratio. The DDM analysis gives me a fair value of $77.04.
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.
[ad#Google Adsense 336×280-IA]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.
My analysis shows that the stock is at least slightly undervalued right now, and that’s modeling in far lower dividend growth than what the company has provided for over a very long period of time.
But let’s compare my valuation to what some professional analysts have come up with.
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 TROW as a 3-star stock, with a fair value estimate of $77.00.
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 TROW as a 4-star “BUY”, with a fair value calculation of $81.70.
Looks like there’s a pretty tight consensus here, which lends its hand to accuracy. Averaging the three figures out gives us a final valuation of $78.58, which would indicate that the stock is potentially 8% undervalued.
Bottom line: T. Rowe Price Group Inc. (TROW) is a high-quality company with a very appealing business model that basically builds in additional profit over the long run. As such, long-term dividend growth is practically built in, too. Although there are some risks, a three-decade dividend growth streak, a huge dividend growth rate, an attractive yield, and the potential for 8% upside all lead me to believe that this stock looks like a solid long-term dividend growth investment at the current valuation.
— Jason Fieber
[ad#agora]