It always amazes me how people try to take something very easy and make it far more difficult than necessary.
Investing is a great example of this.
Bill Ackman, the founder and CEO of Pershing Square Capital Management, a hedge fund, has made the news rounds over the last month or so after finally selling out of his massive stake in Valeant Pharmaceuticals International Inc. (VRX).
I’m not going to go over all the specifics, as this has been covered with depth by various outlets recently.
Suffice to say, it was a massive loss.
Ackman’s mistake of investing in a terrible company ended up costing the hedge fund and its investors approximately $4 billion.
Not only was it a terrible investment from the outset, Ackman also added to the position after news about potential malfeasance and impropriety came to light.
On top of all of that, the investment was a fairly concentrated one for the firm.
Summing it up, Pershing Square has badly lagged the broader market on a total return basis since at least 2013. And investors are paying massive fees for the privilege.
But whereas Ackman has taken a lot of heat for the bad call, I think those who placed their capital with Pershing Square in the first place should probably be taking a hard look in the mirror, as they took something simple and overcomplicated it.
Successful long-term investing is actually not that difficult at all. And it definitely doesn’t require the use of hedge funds.
It is completely unnecessary (and potentially harmful) to buy into a hedge fund and pay ridiculous fees for someone else to manage your money for you, especially when they typically aren’t very good at it (Pershing Square is just one example of many hedge funds doing a poor job of managing money).
I’m proof in the pudding of just how unnecessary complicated strategies are.
I used the very simple and accessible strategy of dividend growth investing to amass a six-figure portfolio chock-full of high-quality dividend growth stocks.
This collection of wonderful businesses generates enough dividend income to cover most of my core personal expenses, putting me in a position to essentially “retire” in my early 30s, if I so choose.
And I did this on a middle-class income!
It required living below my means and investing my excess capital in dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.
See? Not that complicated.
Best of all, research has shown that dividend payers and growers tend to outperform the broader market over longer periods of time.
So you get the growing income. Plus, you get the excess capital gain, too. It’s like having your cake and getting to eat it.
After all, why have cake if you can’t eat it?!
And you don’t even have to pay nosebleed fees for the privilege.
But as simple and accessible as the strategy is, you can’t go into it completely blind and uneducated.
You first want to make sure you’re investing in high-quality businesses.
Buying into a low-quality business is where Ackman made his first mistake with Valeant. You don’t want to replicate that.
So you’re going to look for a longstanding track record of growing revenue and increasing profit; a strong balance sheet; robust profitability metrics like net margin and return on equity; and qualitative aspects like pricing power, brand recognition, able management, and distribution.
But arguably just as important as analyzing a company and making sure it fits your quality threshold, one should be making sure they pay an appropriate price for a stock.
But what is an appropriate price for a stock?
Well, I’d argue it’s as far below fair value as possible.
See, price is what you pay.
But value is what you’re getting in return for your money.
Price tells you very little, while value tells you almost everything.
Value gives context to price. Without knowing value, one cannot possibly know whether or not price is reasonable.
And buying a stock far below fair value – when it’s undervalued – confers a number of benefits to the long-term investor.
An undervalued dividend growth stock should offer a higher yield, better long-term total return prospects, and less risk.
That’s all relative to what the same stock would offer at a higher valuation.
First, price and yield are inversely correlated.
That means, all else equal, a lower price will result in a higher yield.
This higher yield means more current and ongoing income in the investor’s pocket, which is a fantastic benefit in and of itself.
But the higher yield also positively impacts total return, as total return is composed of capital gain and dividends (which is where that yield comes into play).
On top of that, capital gain itself is positively impacted by virtue of the upside that exists between a lower price paid and the higher intrinsic value of a stock (assuming the stock is bought when undervalued).
So total return is given a big potential boost on both sides of the equation.
One’s risk is also lessened when undervaluation is present, as the gap between price and value (which is that aforementioned upside) also acts as a margin of safety, or a buffer for the investor.
After all, a stock worth $50 has a huge buffer when it’s bought at $30. The stock could become worth much less before the investor is upside down.
But a stock worth $50 has no buffer if it’s bought at $50. There’s no wiggle room. Any slight misstep by the company could put an investor on the wrong side of the investment quickly.
These are major benefits that I try to make sure are present with every investment I make, which means I try to buy high-quality dividend growth stocks when they’re undervalued.
Fortunately, determining fair value isn’t as hard as might first seem.
For instance, fellow contributor Dave Van Knapp put together a great series of lessons on dividend growth investing, which includes a lesson specifically devoted to the subject of valuation.
It’s a free resource for you readers, and it greatly simplifies the idea of valuing dividend growth stocks.
Once you have a high-quality stock that appears to be undervalued, it’s up to you to pull the trigger.
But before you go pulling any triggers, you may want to take a look at an example of a high-quality dividend growth stock that appears to be currently undervalued.
Enbridge Inc. (ENB) is an energy distribution and transportation company that owns and operates crude and natural gas pipelines across the United States and Canada.
Recently merged with American midstream pipeline company Spectra Energy Corp., Enbridge is now the largest energy infrastructure company in North America.
While the pricing of various energy commodities can be highly volatile, Enbridge operates what can be thought of as a “toll highway” for these commodities, collecting fees as they pass through Enbridge’s pipes.
Indeed, over 90% of the company’s cash flow is supported by long-term commercial contracts.
This stability has contributed to Enbridge’s ability to pay out increasing dividends for 21 consecutive years, which is an outstanding track record in this space.
And over the last decade, Enbridge has grown its dividend at an annual rate of 12%.
That double-digit rate is impressive all by itself, but it’s even more impressive when you consider the fact that the stock yields 4.11% right now.
It’s rare that you find a stock with a double-digit dividend growth rate coupled with a yield over 4%. But that’s what you’re looking at with this stock right now.
But whether or not that continues for much longer remains to be seen.
Consider that the five-year average yield for the stock is only 3.2%.
So the current yield is almost 100 basis points higher than its five-year average.
Remember how undervaluation can lead to a higher yield?
Well, you can see that manifest itself in this example perfectly.
Now, the dividend might look shaky when you see that the payout ratio is ~116%.
However, EPS doesn’t necessarily accurately convey the company’s true earnings power.
Like a real estate investment trust, a midstream pipeline company will recognize large depreciation costs on assets that aren’t necessarily depreciating at the corresponding rate.
One major difference between a midstream pipeline company and a REIT, though, is that there is no industry-wide replacement metric that’s recognized by a governing body (like the FFO/AFFO for REITs).
The best we have to go off of for Enbridge is their available cash flow from operations, which came in at $4.08 for last fiscal year. That would put their payout ratio at a more comfortable ~57%.
All in all, the dividend metrics are outstanding.
But before we get too excited, let’s see what kind of underlying growth Enbridge is producing.
We’ll look at the past decade in regard to top-line and bottom-line growth. And then we’ll compare that to a near-term forecast for profit growth.
Combined, this should give us an idea as to what kind of underlying business growth Enbridge should be able to generate moving forward, which will go a long way toward building our expectation of future dividend growth.
Revenue for the firm is up from $11.919 billion CAD to $34.560 billion CAD from fiscal years 2007 to 2016. That’s a compound annual growth rate of 12.56%.
That’s mighty strong; however, one must keep in mind that midstream pipeline companies, much like REITs, typically finance growth via a combination of debt and equity.
Indeed, Enbridge has increased both long-term debt and its outstanding share count over the last decade.
Enbridge increased its EPS from $0.97 CAD to $1.93 CAD over this same time frame, which accounts for the additional shares outstanding. EPS grew at a compound annual rate of 7.94%.
So the bottom line is growing at roughly 8% per year, which is still very appealing.
Looking forward, S&P Capital IQ believes Enbridge will compound its EPS at an annual rate of 10% over the next three years.
The recent merger with Spectra should allow for some acceleration, which is probably why we see that show up in S&P Capital IQ’s forecast.
For perspective, Enbridge believes it will grow its dividend at an annual rate of 10-12% through 2024. If that materializes, you have a case for monstrous total return here.
The balance sheet for the company continues the quality theme, although Enbridge does carry sizable debt due to the business model being so capital intensive.
The long-term debt/equity ratio stands at 1.71. The interest coverage ratio is approximately 4.
Profitability is also fairly robust.
Net margin has averaged 3.12% over the last five years, while return on equity has averaged 15.04% over the same period.
Overall, Enbridge looks really appealing as a business.
You’ve got a multi-decade stretch of dividend increases, with fairly substantial dividend growth at that. Plus, you get that huge yield.
The underlying business, meanwhile, is growing at a very nice clip, which should be able to support continued dividend raises for the foreseeable future and beyond. And the recent merger with Spectra just reinforces that.
As such, you might not expect the stock to be cheap.
But I’d argue it’s undervalued right now…
The stock’s P/E ratio might look high at ~29. However, as noted above, EPS isn’t necessarily a very good gauge of profit. Looking at the P/ACFFO, we get a ratio of 10.24. In addition, the five-year average P/E ratio for the stock is over 65, so you see a substantial divergence there. And the current yield, as shown earlier, is significantly higher than its recent historical average.
So it does look quite cheap here. But how cheap? What’s a good estimate of its intrinsic value?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate (due to the higher yield).
And I assumed a long-term dividend growth rate of just 6%.
That dividend growth rate is well below both the demonstrated 10-year dividend growth rate and the company’s own forecast for future dividend growth through 2024, but I always try to err on the side of caution.
DDM analysis gives me a fair value of $60.77.
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 that this stock is extremely undervalued right now. However, my perspective is but one of many. That’s why I like to compare and contrast my conclusion with that of what 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 ENB as a 3-star stock, with a fair value estimate of $43.00.
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 ENB as a 4-star “BUY”, with a fair value calculation of $39.00.
It’s interesting that S&P Capital IQ rates the stock as a buy, yet has their fair value calculation below the current price. Their 12-month target price is $47.00. Odd. Nonetheless, the average of the three valuations is $47.59, which is actually right in line with that 12-month target price. That would indicate the stock is possibly 14% undervalued right now.
Bottom line: Enbridge Inc. (ENB) is now the largest energy infrastructure company on this continent. With more than two decades of dividend increases, huge dividend raises predicted for the next seven years, a massive yield, and the potential for 14% upside, long-term dividend growth investors ought to take a good look at this stock here.
— Jason Fieber
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