The S&P 500 is down about 10% from the start of the year.
By many definitions, a 10% or more drop from a recent high is a correction, and I would agree with the sentiment that the market is officially in correction territory.
While I don’t know what’s going to happen to stock prices tomorrow or any day thereafter, volatility seems like it’s going to stick around for a while.
As such, buying a stock on Monday only to watch it drop 5% by Friday can be pretty disheartening.
This is why it’s so important to be vigilant with not only discerning the difference between price and value but also then buying a stock only when the price is as far below as its fair value as possible, offering a margin of safety.
If you believe a stock is worth $50, you don’t want to actually pay $50.
And you certainly don’t want to pay over $50.
You want to buy it for as far below $50 as possible.
When you’re able to buy a stock well below what it’s reasonably worth, you’re effectively buying an undervalued stock.
The margin of safety is then built in, meaning that even if you get some additional volatility, you’re still in good shape.
It’s essentially a foundation. You want a good foundation. Paying $75 for a stock worth $50 is building your position on a major crack. It’s basically inviting disaster.
Not only do you have to worry about normal volatility – like that we’re experiencing right now – but you also have to worry about the collective of the market realizing the mispricing that’s occurred, bringing that stock’s price down in a hurry.
However, paying, say, $30 for a stock worth $50 is building your position on a strong foundation. It means that any repricing that might occur over the long run is more likely to be in your favor than not, which is a measure that should counteract any volatility along the way.
Buying undervalued stocks that are high quality is something that I’ve aimed to do over the last six years as I’ve built up a six-figure portfolio of almost 100 different stocks.
But these aren’t just any stocks: these are high-quality dividend growth stocks.
That’s right. Every stock in my portfolio pays a dividend. And the vast majority of them have very lengthy track records of increasing those dividend payouts.
If I’m not collecting my fair share of the underlying growing profit a company generates, I don’t want to own the stock.
I typically use David Fish’s Dividend Champions, Contenders, and Challengers list as my ultimate “shopping list” when looking at stocks to buy.
That’s because Mr. Fish tracks all the US-listed stocks out there that have increased their dividends for at least the last five consecutive years, compiling them all into one fantastic (and free!) resource.
Of course, the list is just a starting point. One should always do their own due diligence before buying any stock, even a high-quality dividend growth stock.
The aforementioned margin of safety is just one benefit to buying undervalued dividend growth stocks.
The margin of safety minimizes potential downside while at the same time maximizing potential upside when looking at the stock within the framework of the stock market and the accompanying volatility.
Of course, a company’s underlying operations and fundamentals will ultimately determine how great of an investment a stock is over the long run.
But that aforementioned margin of safety is just one highly desirable aspect to buying undervalued high-quality dividend growth stocks.
You’re also looking at a higher yield, greater potential long-term total return, more potential organic income growth, and less risk.
Since we know, all else equal, price and yield are inversely correlated, a lower price will mean an investor locks in a higher yield.
A higher yield means more income in your pocket. If you could have your choice of the same stock with a 3% yield or a 4% yield, which would you take?
As someone who plans to one day live off of the dividend income my portfolio generates, it’s imperative for me to achieve the highest possible yield from every stock I buy.
In addition, since yield is a major component of total return (the other being capital gain), a higher yield means more potential total return over the long run.
That’s in addition to any upside you experience from any beneficial repricing or valuation expansion over time if/when the market realizes the stock is undervalued.
While the market can be volatile and even nonsensical over the short term, value eventually matters. And value tends to track a company’s earnings power somewhat accurately over the very long term.
Moreover, we’re talking about dividend growth stocks here. The organic dividend growth that’s driven by the dividend raises these companies announce year in and year out is what I refer to as the “secret sauce” of this investment strategy.
Well, the less you pay and the higher the yield you’re able to acquire at the time of purchase, the more potential organic dividend income growth you’re looking at.
It’s simple math. A company announces a dividend increase based on its underlying operations. A dividend increase can be expressed as percentage terms when looking at the difference between the old dividend and the new dividend.
So a company that was paying a $1.00/year dividend that moves that payment up to $1.10 just gave investors a 10% raise. That 10% is the same for every investor, regardless of what you paid for your stock. Moreover, a company doesn’t increase its dividend based on what someone paid for its stock.
However, there’s a big difference between the actual realized income growth one investor might experience compared to the next, based largely on the price they indeed paid for their stock.
Paying $25 for this stock means it had a yield of 4% at the time of purchase. If you have $1,000 to invest, you were able to buy 40 shares. That dividend increase announced by the company means you now can look forward to your annual income jumping from $40 to $44.
However, if you saw that $25 didn’t allow for a sizable margin of safety and instead waited until the stock dropped to $20, you instead locked in a yield of 5%. And that $1,000 was able to pick up 50 shares. So your annual income jumped from $40 to $50 right off the bat.
Even better, the dividend raise announced by the company moved your annual income up from $50 to $50.
So while the percentage terms are the same in both examples, the absolute increase in income is better for the second investor who bought the stock when it was undervalued.
And all of this also comes at less risk, since you’re risking less downside with greater financial benefits.
The good news is that this isn’t all just theory.
It’s not terribly difficult to reasonably estimate the value of any dividend growth stock, leading you to snag all of these benefits.
One such way to go about it would be to follow fellow contributor Dave Van Knapp’s lesson on valuation, which specifically focuses on valuing dividend growth stocks.
Another free resource available right here on the site, it’s worth a read.
With all of these tools at your disposal, it puts you in control.
Better yet, I’m even going to put them all to work right now by showing you a dividend growth stock that appears to be undervalued right now.
Harley-Davidson Inc. (HOG) is the world’s largest manufacturer of heavyweight motorcycles, and also a major supplier of motorcycle parts and accessories.
Needing no introduction, Harley-Davidson’s corporate roots stretch back to 1903.
As you can probably imagine, the company has been almost as adept at building shareholders’ wealth as they have been with dominating the domestic motorcycle market.
That said, their dividend growth pedigree isn’t quite what I normally like to see. This is largely due to a big dividend cut during the Great Recession.
However, I give them a pass due to what could end up being a generational event.
They’ve meanwhile built up a nice track record since, increasing their dividend for the past five consecutive years.
Perhaps making up for that aforementioned dividend sin, Harley-Davidson has increased its dividend at an annual rate of 25.4% over that period.
That’s mighty strong.
What’s also mighty strong is the stock’s yield of 3.66% right now.
That’s more than 100 basis points higher than the broader market. More importantly, it’s more than twice as high as the stock’s five-year average yield of 1.6%.
Of course, that average is skewed by the dividend cut. Nonetheless, it’s a high yield for stocks in general and certainly a stock like this.
And with a payout ratio of just 38.7%, there’s still plenty of room for the company to continue aggressively growing that dividend.
In fact, the company just announced a 12.9% dividend increase less than two weeks ago, which bodes well for long-term dividend growth investors.
With a high yield, comfortable payout ratio, strong dividend growth, and rebuilt streak, there’s a lot to like here.
But what’s key to the company’s dividend sustainability and future growth is the underlying business’s performance.
So we’ll take a look at how the company has fared over the last decade across the top line and bottom line, along with a closer look of what happened with that dividend cut.
Revenue actually decreased from $6.186 billion to $6.0 billion from fiscal years 2006 to 2015.
Essentially zero growth over this time frame, that’s a disappointment.
The business was already declining somewhat before the financial crisis, but revenue dropped sharply between FY 2006 and FY 2009, from over $6 billion to just under $4.8 billion.
However, the company has made strides since bottoming out, with almost secular growth coming out of the Great Recession.
The bottom line reacted somewhat similarly, with earnings per share down slightly from $3.93 to $3.69 over this period.
Bottoming out with a mild loss of 24 cents in FY 2009, there has been significant bottom-line growth since then almost every single year.
We can see now why the dividend was cut in 2009.
Harley-Davidson has faced a number of issues.
Primarily, they operate a fairly mature company in a very competitive industry, with most of their sales being in the US. One wonders how many motorcycles they can really sell year in and year out domestically.
As such, international expansion will likely be a key area of growth for the company. The company has plans to open between 150 to 200 new dealerships in international markets by 2020.
This international exposure, however, does come with the drawback of the strong dollar, which has weighed on recent results. FY 2015 was the first year since FY 2009 the company didn’t register YOY EPS growth. In addition, their brand doesn’t carry the same recognition or prestige abroad, which requires the company to invest heavily in the brand.
Margins have also compressed over the last decade, though they’ve also made improvements here over the last five years.
Overall, I view this as a turnaround story with a very strong brand and franchise.
Results over the last five years have been strong, and the company’s strong dealer network (1,460 worldwide full service dealerships and secondary retail locations) help localize sales while the company continues to build out its e-commerce platform.
The company has an enviable share of the domestic heavyweight motorcycles, estimated at 50%, which means there’s strong loyalty to the brand here in the US.
Looking at the turnaround potential, S&P Capital IQ is calling for 11% compound annual growth for Harley-Davidson’s EPS over the next three years. Additional international expansion, continued share buybacks, and additional focus on e-commerce are key areas of focus here. Looking at recent results, I think this is possible, though it’s notable that the company’s financial results dropped slightly in the most recent fiscal year.
Notably, the company reduced its outstanding share count by more than 20% over the last decade, and they just recently authorized the repurchase of up to 20 million shares, which comes on top of the 9 million shares remaining on the prior board-approved repurchase plan. With an outstanding share count of less than 200 million shares as of the most recent quarter, this is substantial.
One area of the company that is also a bit confusing at first is the balance sheet.
A long-term debt/equity ratio of 2.63 is quite high.
But the company offers financing options for its clients, seeing as how its heavyweight motorcycles are a large and aspirational purchase for many. This skews the numbers a bit.
Meanwhile, the interest coverage ratio for the company is actually approaching 100.
So there’s clearly no issue whatsoever with the company’s level of leverage or its ability to service its interest expenses.
Profitability would assumed to be quite strong with a brand like Harley-Davidson.
Well, the numbers are pretty compelling.
Over the last five years, the firm has averaged net margin of 10.57% and return on equity of 23.14%.
Competitive numbers with strong margins, though the ROE does trail major competitor Polaris Industries Inc. (PII).
The good news here is that both numbers have steadily improved over the last few years after a negative trend leading up to and through the Great Recession.
Overall, there’s a lot to like here.
The yield is very appealing in this low-rate environment. The company is buying back huge blocks of its shares, which should allow for plenty of dividend growth moving forward even absent big (or any) EPS growth for the foreseeable future. The brand name is second to none, the market share is strong, and the fundamentals are there.
But it also remains to be seen whether or not Harley-Davidson can really put some long-term growth together. The last decade hasn’t been that great, and the discretionary and expensive nature of its products means any stumble in the economy could lead to more volatility in its results.
Domestic shipments amounted to almost 65% of FY 2015’s total worldwide shipments. So the company is heavily tied to a favorable domestic market.
However, the strong dollar will still weigh on the firm. And it’ll be tough for them to really experience the same strong brand presence abroad that they do here in the US.
With all of that in mind, we want a large margin of safety on shares. Is one present?
The stock’s P/E ratio is sitting at 10.56 right now. That’s about 50% of the broader market’s P/E ratio. It’s also almost half that of the stock’s own five-year average P/E ratio. So one could say that this stock is almost “half off”. With a yield more than twice as high as its five-year average and most other metrics somewhere around 50% their recent historical averages, this seems to be a reasonable assumption.
Wow. This could very well be a stock that’s “half off”. What would then be a reasonable estimate of the intrinsic value?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. I think that growth rate is fair when looking at the modest payout ratio, forecast for EPS growth moving forward, massive buyback taking place, and the dividend growth over the last five years. This could be very well on the conservative side absent another major recession. The DDM analysis gives me a fair value of $49.93.
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.
So I would argue there’s a sizable margin of safety present, along with all of the benefits I laid out earlier. But I’m not the only one looking at this stock. Let’s compare my thoughts with that of some professional analysts that have taken the time to 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 HOG as a 4-star stock, with a fair value estimate of $54.00.
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 HOG as a 4-star “buy”, with a fair value calculation of $56.90.
My estimate came in the most conservative, and even my estimate makes this stock appear very undervalued. Blending the three numbers together gives us a final valuation estimate of $53.61, which would mean this stock is potentially 41% undervalued right now.
Bottom line: Harley-Davidson Inc. (HOG) is a turnaround play. But this isn’t a struggling company. Revenue is still near an all-time high, the balance sheet is very strong, and the domestic market share is dominant. Meanwhile, investors buying in today are locking in a yield that’s historically extremely high for the stock. And with the possibility for 41% upside, I see a lot to like here. If they can sustain long-term growth, this could be a home run of an investment.
— Jason Fieber
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