They say you can’t have your cake and eat it, too.
I beg to differ.
Dividend growth investing is the epitome of having your cake and eating it.
After all, it simply involves buying and holding shares in wonderful businesses that reward their shareholders with growing dividends.
Those growing dividends are simply a portion of the growing underlying profit a business generates.
If a company can’t generate increasing profit fairly regularly, I don’t want to invest in it.
And if a company can generate increasing profit on the regular, I think that its owners (which are the shareholders) deserve their rightful share of the growing profit pie… I mean, cake.
Indeed, the six-figure portfolio I control is on pace to send me more than $11,000 in dividend income over the course of 2017.
But check this out.
I don’t have to sell any stock to collect those dividends. I don’t have to do anything at all, in fact.
I get to collect my dividend income while keeping my portfolio perfectly intact.
If that’s not having your cake and eating it, too, I don’t know what is.
Moreover, I get to eat more and more cake over time.
That’s because the companies I invest in routinely increase their dividend payments to shareholders.
You can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is probably the most robust and complete compilation of dividend growth stocks in the world.
Mr. Fish’s list contains invaluable information on more than 700 US-listed stocks that all have paid increasing dividends to their shareholders for at least five consecutive years.
Since I almost exclusively buy dividend growth stocks like those (and including) you see on Mr. Fish’s list, you can almost surely bet on that $11,000 in dividend income growing substantially year after year.
And that’s on top of the value of the portfolio value growing, because these are businesses that become worth more over time as their profit increases.
Again, having cake and eating cake.
While I certainly love dividend growth investing – and cake – that doesn’t mean one should buy random dividend growth stocks at random prices.
One must first quantitatively and qualitatively analyze any prospective business before even thinking about investing hard-earned cash.
Beyond that, one must also make sure they’re paying the right price.
But what is the “right price”?
Well, the right price is really a price that’s as far below intrinsic value as possible.
Said another way, you should aim to buy high-quality dividend growth stocks when they’re significantly undervalued.
Undervaluation is present when the price of a stock is below its intrinsic value.
But while price is easy to ascertain, intrinsic value is a bit trickier.
However, the good news is that it’s 2016 and plenty of resources exist solely to help investors with this task.
For instance, fellow contributor Dave Van Knapp put together an excellent valuation guide for dividend growth stocks.
Part of his overarching series of lessons on dividend growth investing, it’s an excellent tool for any dividend growth investor’s arsenal.
The reasons why one should aim to invest when undervaluation is present are compelling.
An undervalued dividend growth stock will almost always offer a higher yield, greater long-term total return prospects, and less risk.
This is all relative, of course, to buying the same stock when it’s fairly valued or overvalued.
It’s easy to see how these benefits present themselves when a dividend growth stock is undervalued.
First, price and yield are inversely correlated. All else equal, a lower price means a higher yield.
That higher yield then positively impacts the long-term total return prospects, since yield is a major component of total return.
Moreover, the potential upside that exists between the lower price paid and the higher intrinsic value of the stock represents possible capital gain – capital gain is the other component of total return.
Value may get lost in the noise in the short term, but it tends to matter quite a bit over the long run.
As such, your total return prospects are given a boost via both yield and capital gain. So you’re giving yourself a potential boost on both sides of the coin.
All of this also has the effect of reducing your risk.
If you’re buying a static number of shares, you’re laying out less capital (since each share will cost less). That means you’re risking less overall capital.
If you’re investing a static amount of money, each share will still cost less, meaning you’re getting more shares for the same amount of money.
Either way, you’re introducing a margin of safety.
That means if the company doesn’t perform as expected, you have some room for error.
After all, if you pay $50 for a stock deemed to be worth $50, you have no margin of safety. If something goes wrong, the value drops and your investment is now worth less than you paid.
But if you pay $40 for a stock deemed to be worth $50, you have a lot of room for error before the investment becomes worth less than you paid.
As you can probably see by now, I’m always on the hunt for a high-quality dividend growth stock that’s undervalued.
Well, I was doing some research on a number of stocks over the last week. And I found one particular dividend growth stock that has a pretty compelling valuation right now. In fact, it’s so compelling that I invested my personal money in the company by buying its stock.
Want to know what stock it is?
L Brands Inc. (LB) is a specialty retailer of women’s intimate and other apparel, personal care products, and beauty products.
This company owns some of the most high-profile brands in the women’s specialty space.
Think Victoria’s Secret, PINK, Bath & Body Works, La Senza, and Henri Bendel.
These are dominant highly-visible brands with extremely loyal customers.
While department stores are closing everywhere because they don’t offer a brand or value proposition, L Brands offers both via high-quality branded merchandise that carries pricing power.
And while retail brands almost everywhere are facing troubles with same store sales trends, L Brands continues to grow this number. In fact, the most recent quarterly report showed a 2% comparable sales increase across all brands, largely driven by a monstrous 7% showing by Bath & Body Works.
In addition, L Brands is almost exclusively exposed to the US and Canada, meaning it has a ton of international expansion potential. Furthermore, there’s a lot of room for additional sales via e-commerce.
With all this in mind, we might expect to pay a pretty high price for the stock.
But because retail in general has been so troubled lately, a lot of related stocks have been indiscriminately punished.
I believe this stock is a good example of that.
First, let’s consider the dividend growth pedigree.
The company has increased its dividend for six consecutive years.
Not the kind of length I like to typically see, especially in retail, but I think that’s made up for by a number of other factors.
One factor is the dividend growth: the stock sports a five-year dividend growth rate of 24.6%.
So they’re clearly making up for the short record by handing out some absolutely huge dividend increases.
I usually see a dividend growth rate that high only on stocks with really low yields; however, this stock also offers a very appealing yield of 3.97% right now.
So you’re getting a yield that’s almost twice that which the broader market offers, and you’re getting dividend growth that’s well into the double digits.
That’s a pretty stout combination.
Furthermore, that yield is more than 160 basis points higher than the stock’s five-year average.
I mentioned a lower price and a higher yield working in tandem earlier. Well, this is a perfect example.
We should consider that the payout ratio has expanded as a result of such massive dividend growth, though. The payout ratio is currently sitting at 60.8%.
As such, I would expect the company’s dividend growth to slow rather sharply here in the near future.
Still, you’re getting a high yield and what will still likely be a dividend growth rate well in excess of inflation.
But wait, there’s more…
L Brands also regularly hands out monster special dividends.
The company paid a $2.00 special dividend in each of the last two years.
If they do that again this year, that will push the effective yield of the stock to over 7%.
So there’s just a lot to like about the dividend.
But the dividend is just one aspect, albeit an important aspect.
We must really see what kind of underlying growth the business is generating in order to estimate what kind of future dividend growth we should expect.
We’ll take a look at what L Brands has done over the last decade in terms of revenue and profit growth, and then we’ll compare that to a near-term forecast for profit growth moving forward.
Taken together, this should give us a reasonable idea as to what to expect.
Revenue for the company is up from $10.671 billion to $12.154 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 1.46%.
Meanwhile, the company’s earnings per share increased from $1.68 to $4.22 over this 10-year period, which is a CAGR of 10.78%.
The revenue growth was negatively impacted by the sale of a majority interest in Express in 2007; however, L Brands quickly turned out and retired a large number of its outstanding shares. Over the last decade, L Brands has reduced its outstanding share count by approximately 27%.
It’s really the bottom-line figure that represents the true growth of the company, in my view.
Looking out over the next three years, S&P Capital IQ anticipates that L Brands will be able to compound its EPS at an annual rate of 11%, which would be in line with what the company’s done over the last decade.
Fundamentally, the rest of the business is sound.
The balance sheet is solid, though I think it has room for improvement.
I usually show the long-term debt/equity ratio; however, L Brands has negative equity due, in part, to the sizable share repurchases.
But the interest coverage ratio, at just under 7, indicates that L Brands is on good footing.
Profitability is quite robust.
Over the last five years, L Brands has averaged net margin of 8.64%. Return on equity is obviously not measurable.
Most retailers I’ve looked at that rely heavily on mall traffic aren’t anywhere close to L Brand’s margins.
All in all, I think there’s a case to be made here as a long-term investment.
As a dividend growth investor, though, the dividend yield, special dividends, and dividend growth add up to a very pretty picture.
Of course, mall traffic is a concern. But I think L Brands is positioned far better than most retailers in their space. That’s evidenced, in part, by the sales trends.
Yet the stock has been punished just like most other retailers, with the stock down 17% over the last three months. I believe this has led to undervaluation.
The P/E ratio for LB is sitting at 15.32 right now.
That compares extremely favorably to the five-year average P/E ratio of 20.7 for the stock.
Investors are also able to pay far less for the company’s sales and cash flow right now, compared to what’s been available, on average, over the last five years.
And as previously noted, the current yield is significantly higher than its recent historical average.
So the stock does look quite cheap right now. But how cheap might it be? What’s a good estimate of its intrinsic value?
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 7.5%. This dividend growth rate is well below the five-year dividend growth rate, 10-year EPS growth rate, and forecast for EPS growth moving forward. However, the nature of retail means a margin of safety is necessary. The DDM analysis gives me a fair value of $103.20.
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.
My analysis concludes the stock is vastly undervalued right now. But let’s see how my analysis jibes with the analysis of professionals that have taken the time to value the 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 LB as a 4-star stock, with a fair value estimate of $72.00.
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 LB as a 3-star “HOLD”, with a fair value calculation of $42.00.
A 7% long-term dividend growth rate would put my number in line with Morningstar’s. However, the stock looks to be very cheap, either way you go. I’m not sure where S&P Capital IQ is going with their valuation, but consider that they have a 12-month price target of $72.00 on the stock. So there’s some kind of mismatch there. Regardless, averaging out the three valuations gives us a fair value of $72.40. I think that’s a pretty fair estimate, which would indicate the stock is 20% undervalued right now.
Bottom line: L Brands Inc. (LB) is a high-quality specialty retailer that’s growing while its mall peers are shrinking. The stock offers an incredible yield, huge dividend growth, and massive special dividends. And then you get the potential for 20% upside on top of all that. This appears to be one of the most compelling dividend growth stocks in retail right now. Long-term dividend growth investors should give this stock a good look.
— Jason Fieber
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