I keep hearing this term: TINA.
There Is No Alternative.
That’s the mantra for the stock market these days; with no viable alternative, investors are piling into stocks.[ad#Google Adsense 336×280-IA]Of course, this has a way of increasing prices.
That’s the way supply and demand works.
And with the broader market regularly breaking through new all-time highs, this demand can clearly create distortion.
What’s an investor to do?
Well, I think the best thing to do is to keep your eye on the long term.
Time in the market trumps timing the market for long-term investors.
Moreover, I focus on the tangible: growing dividend income.
Stock prices go up (mostly up right now) and they go down.
But dividend income is far less volatile.
In fact, it generally only moves in one direction for me: up.
That’s because I invest in high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases.
Studies have shown that high-quality dividend growth stocks outperform the broader market over long periods of time.
Perhaps best of all, those growing dividends are a great source of passive income, which could be used to pay one’s real-life bills.
It’s the strategy I used to become financially free at just 33 years old – my personal portfolio spits out enough dividend income to cover most of my core personal expenses, with other sources of passive income making up the small difference.
What a lifestyle!
But with the broader market suffering from TINA’s rage, it’s more important than ever to focus on valuation when looking to buy dividend growth stocks.
Stocks are just like almost any thing else in this world, in that they have a sticker price but also an intrinsic value.
And it’s imperative that one aims to buy a stock for a price that’s as far below its intrinsic value as possible.
Doing so confers substantial benefits to the investor.
Think higher yield, greater long-term total return prospects, and less risk.
This is all comparing apples to apples, of course; those benefits are what’s possible relative to paying a fair price or higher for the same stock.
It’s easy to see how that works.
Price and yield are inversely correlated, meaning a lower price will almost always translate into a higher yield.
This higher yield means more income for the investor both now and later, with future dividend increases also being based upon that higher starting yield.
Moreover, this positively affects one’s long-term total return prospects, since yield is a major component of total return.
The other component, capital gain, is also positively influenced by virtue of the upside that exists between the lower price paid and the higher intrinsic value of the stock.
While a stock can stay discounted for good while, value eventually matters.
Finally, this all works to reduce your risk.
You have the option of putting up less total capital by buying the same number of shares at a lower price, which means you’re risking less of your money for the same investment.
Or you can invest a static amount of money, but you’re still paying less per share.
Either way, you’re introducing a margin of safety that gives your investment a cushion, just in case something happens to the company that would penalize its value.
But when you’re dealing with high-quality companies, something like that happening is unlikely.
What’s more likely is that the company earns more money year in and year out, boosting your dividend income, and increasing the fair value of the business and its stock all along the way, pushing your eventual upside up even more.
With all of this in mind, it seems silly that any investor would buy a stock without first determining an estimate of its fair value.
That’s why using a resource designed to ascertain that intrinsic value is so valuable and important.
One such resource was put together by fellow contributor Dave Van Knapp, which is part of his overarching series of lessons on dividend growth investing.
It’s definitely worth checking out if you haven’t done so already.
All of these tools put you in a great position.
But I’m going to potentially put you in an even better position by uncovering what appears to be a high-quality dividend growth stock that right now appears to be undervalued.
Travelers Companies Inc. (TRV) is a holding company that, through its subsidiaries, provides commercial and personal property and casualty insurance products to individuals, businesses, government units, and associations.
Insurance is just a fantastic business model.
There should be a positive difference between premiums charged and claims paid; a great insurance company will have a low combined ratio, meaning underwriting profit.
In addition, premiums are paid up front, which an insurance company can invest and earn a return off of. This source of capital is called the “float”, and it allows a company to build up a rather substantial source of profit on top of the premiums.
If the float is conservatively invested, it can provide a very low-risk and low-cost source of capital. Indeed, approximately half of the investment portfolio at Travelers is invested in municipal bonds.
These two sources of profit can provide for a lot of growing cash flow, which can drop down to shareholders in the form of growing dividends.
Well, that’s exactly what we see here with Travelers.
They’ve increased their dividend for the past 12 consecutive years.
And that dividend growth comes in at a compound annual rate of 10.1% over the last decade.
With a payout ratio of just 25.9%, it seems likely that dividend growth in that range continues on for years to come.
The only possible drawback to the company’s dividend is the yield.
At 2.32%, investors in need of current income might be a little disappointed.
However, the dividend growth makes up for much of that, in my view.
But in order to determine what kind of dividend growth to expect moving forward, it makes sense to look at what kind of underlying profit growth we should expect.
After all, those dividends aren’t just paid out of thin air; dividends are paid from the cash flow a company generates.
So we’ll look at a forecast for near-term profit growth to get an idea as to what to expect moving forward.
In addition, we’ll take a look at what Travelers has done in terms of revenue and profit growth over the last decade, which will further help us determine not only what kind of dividend growth to expect but also what the stock might be worth.
The company has increased its revenue from $25.090 billion to $26.800 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 0.74%.
Not particularly impressive here, although the revenue growth here at Travelers isn’t atypical for this industry.
Fortunately, profit growth has been far more substantial.
Travelers grew its earnings per share from $5.91 to $10.88 over this period, which is a CAGR of 7.02%.
What happened here is that Travelers has one of the most prolific share buyback programs I know of.
They reduced their outstanding share count by approximately 56% over the last 10 years, which is just incredible.
Looking forward, S&P Capital IQ believes that Travelers will compound its EPS by an annual rate of 1% over the next three years.
That would be a marked departure from their historical growth rate, but tepid top-line growth is a concern, as is the low-rate environment we’re in. Because of low interest rates, those aforementioned municipal bonds aren’t earning what they would be if interest rates were higher.
This could prove to be awfully conservative, but the low payout ratio still gives the dividend growth a lot of breathing room. In addition, the long-term picture is still quite bright, in my view.
Other fundamentals further indicate that the business is very high quality.
The balance sheet is one such aspect of the business.
Travelers has a long-term debt/equity ratio of 0.27, and the interest coverage ratio is approximately 14.
Profitability is also fantastic, with metrics that compete with the best in the industry.
Over the last five years, Travelers has averaged net margin of 11.05% and return on equity of 11.79%.
Overall, I think there’s a lot to like about Travelers as a long-term investment.
The insurance industry is as old as it gets. And it’s ubiquitous, as practically every individual and business requires it. Meanwhile, the very business model builds in this fantastic source of low-cost and low-risk capital.
However, that’s not to say that there aren’t risks.
Every business has risks, and Travelers faces its own set, especially in the form of catastrophic losses from weather-related incidences.
And until rates rise, its investment portfolio will suffer somewhat.
But at the right price, this stock is really appealing.
Well, the price might just be right.
The stock’s P/E ratio is sitting at 11.16 right now, which is about half the broader market. Although that’s roughly in line with the stock’s five-year average P/E ratio, it’s one of the few high-quality stocks that hasn’t appeared to suffer from TINA’s wrath. It’s pretty much trading like it was five years ago, even though there are fewer quality alternatives now.
That P/E ratio is awfully low, but what’s an appropriate price to pay? What might this 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 8%. Travelers has been incredibly consistent over the last ten or so years, handing out dividend increases that have all been right around 10%. With such a low payout ratio, that should more or less continue, even absent stronger EPS growth for the near term. Longer term, Travelers is positioned very well. The DDM analysis gives me a fair value of $144.72.[ad#Google Adsense 336×280-IA]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 my view is that Travelers is solidly undervalued. Absent a complete collapse in its earnings, which would slow dividend growth way down, the dividend growth potential is really strong here, making it quite attractive. But how does my opinion compare to that of some professional analysts that track this stock? What do they think of its valuation?
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 TRV as a 3-star stock, with a fair value estimate of $117.00.
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 TRV as a 4-star “BUY”, with a fair value calculation of $134.10.
We have three different valuations here, but I like to average them out. That should improve accuracy by blending these different perspectives together, distilling things down into one number. The final valuation is thus $131.94, which would indicate the stock is potentially 14% undervalued right now.
Bottom line: Travelers Companies Inc. (TRV) is a high-quality insurer that’s operating well in a particularly difficult environment. Nonetheless, the fundamentals are fantastic and the long-term picture is bright. The dividend growth potential is outstanding – and would be boosted further by higher interest rates. Still, what appears to be 14% upside in a market that’s dominated by TINA could be a fantastic opportunity that dividend growth investors should strongly consider.