When opportunity knocks, answer the door.
We’ve all heard that before, right?
Well, what if opportunity is constantly knocking on the door? What if opportunity is practically banging your door down?
What do you do then?
That – opportunity knocking – is kind of what’s happening every single day of our lives, assuming, by reading this article, you live in a developed country where access to all modern-day accouterments is easy.
Indeed, pretty much every adult living in the US has access to both capital and wonderful businesses that can take that capital and compound it, paying income all the way along.
That means you can take a dollar and eventually turn it into two dollars through no work of your own. Plus, you get could paid nickels in the meantime.
High-quality dividend growth stocks can do this, as they’ve done for me – I’ve been able to go from below broke at 27 to financially free at 33, building a six-figure stock portfolio in the process.
A significant chunk of that portfolio’s value came about via the hard work of others. As these companies became worth more by selling more products and/or services (thus increasing profit), the stock prices increased, growing my portfolio value.
And I’m getting paid while that process unfolds, as this real-life portfolio generates five-figure dividend income for me.
That’s dividend growth investing in a nutshell.
It’s basically just putting capital to work with high-quality companies that can grow your wealth and passive income.
You can find hundreds of companies that can do this for you by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of US-listed stocks that have paid increasing dividends for at least the last five consecutive years.
And since dividends are paid in cash from cash, they’re a great initial “litmus test” of quality and profitability.
What’s wonderful about this is that just about anyone can buy a high-quality dividend growth stock, sit on it for years, and potentially watch their wealth and passive income grow before their very eyes.
And that requires no work on one’s part, other than the initial gathering of capital and investment research.
Work once. Get paid forever.
If that’s not opportunity knocking, I don’t know what is.
But this is your chance to open that door, because I’m going to discuss one particular stock on Mr. Fish’s list that appears to be undervalued.
Undervaluation is an important distinction.
That’s because an undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
This is all relative to what the same dividend growth stock would offer if it were fairly valued or overvalued.
Price is what you pay. But value is what you get in return.
Price is what something costs. But value is what something is worth.
Due to the differences, it’s easy to see how value is the much more important piece of information.
And when value is well below price, it’s particularly advantageous.
First, price and yield are inversely correlated. All else equal, yield will rise as price falls.
That higher yield means more income in your pocket both in current and ongoing terms.
And that additional income positively impacts total return.
In addition, total return is given another potential boost via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.
If the two converge – which tends to happen over the long run – that results in capital gain, which drives total return in another way (total return is comprised of two parts: dividends/distributions and capital gain).
And that’s on top of whatever long-term capital gain would come about as a business makes more money and becomes more (thus eventually driving the stock price higher).
Undervaluation is also appealing in terms of how it reduces one’s risk.
What’s even crazier is that risk is minimized precisely when upside is maximized.
You take on the least amount of risk when your potential gains are the greatest, which is probably counterintuitive for most people.
Risk is reduced when undervaluation is present due to the margin of safety, or “buffer”, that exists when there’s a large (and advantageous) gap between price and value.
If a stock worth $50 is purchased for $30, that’s $20 worth of buffer (in addition to upside) that can serve as protection in case the business doesn’t perform as expected, or in case the company does something wrong (malfeasance, PR issues, etc.).
For all of the benefits that undervaluation possibly confers to the long-term investor, the surprising thing is that it’s not that difficult to actually value a dividend growth stock before buying so that you can determine whether or not a stock is undervalued, fairly valued, or overvalued.
One such tool that’s designed to help long-term investors estimate fair value is fellow contributor Dave Van Knapp’s valuation lesson, which is part of an overarching series of lessons on the dividend growth investing strategy as a whole.
With all this in mind, you should see why an undervalued high-quality dividend growth stock is indeed an opportunity knocking at your door.
It’s up to you to answer the door.
But I’ll show you just how hard one opportunity might be knocking…
Tractor Supply Company (TSCO) is a specialty rural lifestyle retailer that supplies the needs of farmers and ranchers through just over 1,600 stores across 49 states and an e-commerce website.
Retail has been hammered lately as fears (both realized and unrealized) of massive sales moving online have significantly negatively impacted many retailers’ stock prices.
However, while stock prices have most certainly been impacted to a large degree, operations for many of these same retailers haven’t.
Like Warren Buffett has rightfully noted, the time to be greedy is when others are fearful.
And I’m not sure any industry has seen more fear take hold than what we see with traditional B&M retailers. That ties into opportunity knocking.
Tractor Supply is a traditional B&M retailer, operating over 1,600 stores that are mostly serving rural customers that farm and ranch in recreational terms. Their scale, product offering, and niche service serve as competitive advantages. In addition, many products are heavy (meaning expensive to ship) or are needed more immediately. Those immediate products are coined C.U.E. by the company (consumable, usable, and edible).
The company’s stock is down over 42% over the last year, even while operations remain strong. So value probably hasn’t changed much, but price certainly has. That kind of difference in near-term performance (between stock performance and business performance) is what tends to lead to undervaluation.
First, let’s consider the dividend metrics.
The company has increased its dividend for eight consecutive years.
Not a particularly long streak, although the five-year dividend growth rate of 33.7% shows that the company has been committed to ramping up the dividend quickly.
With a payout ratio of 33.4%, the company still has plenty of room for more dividend increases over the long term, even absent strong earnings growth over the near term.
That said, the company targets a ~30% payout ratio, so earnings growth and dividend growth will likely roughly match each other going forward.
The only drawback might be the yield.
At 2.08%, the stock doesn’t offer a lot of yield for investors who are a bit more hungry for income.
However, the five-year average yield for this stock is just 0.9%.
So the current yield is more than 100 basis points higher than its five-year average. Said another way, the stock is yielding more than twice what it usually has, on average, over the last five years.
Undervaluation can and often will result in a higher yield, and we see that playing out here.
But we don’t invest in where a business is. We invest in where it’s going.
And as a dividend growth investor, it’s imperative to have an idea as to what to expect in regard to dividend growth moving forward, which helps not only build expectations for long-term income, but also helps value the business as a whole.
In order to build that base case for dividend growth, we must first understand what kind of overall underlying growth the business is generating. Over the long haul, earnings and dividend growth should roughly mirror each other.
So we’ll look at what kind of top-line and bottom-line growth Tractor Supply has generated over the last 10 years, with 10 years being a pretty good proxy for the long haul.
We’ll then compare that to a near-term forecast for profit growth.
Combined, this should give us a pretty good idea as to what kind of earnings power Tractor Supply really has, which should more or less translate to the dividend over the long term.
From fiscal years 2007 to 2016, the company increased its revenue from $2.703 billion to $6.780 billion. That’s a compound annual growth rate of 10.76%.
Impressive growth, although this is a fairly small retailer (a market cap of slightly under $7 billion).
Tractor Supply grew its earnings per share from $0.60 to $3.27 over this same stretch, which is a CAGR of 20.73%.
Now we’re really talking. And we can also see how the payout ratio is still so low even with such strong dividend growth. The company has just been flat out growing at a blistering rate.
There’s been some significant share repurchases, which have helped drive some of that excess bottom-line growth: Tractor Supply reduced its outstanding share count by approximately 16% over the last decade.
The company has authorized a repurchase program of up to $3 billion by 2020, which is almost half the company’s market cap. The recent drop in stock price is accretive toward that end.
But margin expansion really tells most of the story, as the company has been able to expand its margins by a rather large degree. We’re talking almost doubling net margin.
However, there appears to be a flattening out of that story over the last three fiscal years, with some reversal more recently. As such, it seems like further margin expansion is probably unlikely, especially factoring in all of the ongoing changes in retail in general.
Looking forward, CFRA believes that Tractor Supply will compound its EPS at an annual rate of 15% over the next three years.
While that would be a drop from what we see above, that would still be extremely appealing growth. New store openings mitigate some issues resulting from margin compression and a drop in comps. Overall, double-digit growth is likely moving forward, which could certainly propel similar dividend growth.
The company maintains additional flexibility in terms of expansion, M&A, and dividend growth by virtue of its strong balance sheet.
The long-term debt/equity ratio is only 0.18, and the interest coverage ratio is over 100.
All in all, the balance sheet is absolutely stellar.
Profitability, as noted earlier, is a particularly strong suit.
Retailers, especially general merchandisers, generally have to contend with net margin down in the low single digits. Seeing net margin of just 2% isn’t uncommon in retail.
Tractor Supply, though, has averaged net margin of 6.36% and return on equity of 29.31% over the last five years.
These are very healthy numbers for this industry. Nothing short of outstanding, really. And keep in mind that net margin was humming around 3% to 4% a decade ago.
Overall, this is a very strong business in general – and retailer specifically.
General merchandisers seem to have a more difficult time competing in the e-commerce space, but Tractor Supply has built-in advantages with its product mix and rural footprint. Catering to a niche insulates the business somewhat, although that has a way of limiting growth ultimately.
However, there’s a cyclical nature to farming and ranching. And e-commerce could be more of a threat than an opportunity for the business over the long term.
But as noted earlier, the stock price has dropped well over 40% over the last year. Meanwhile, the business hasn’t stopped growing at all, even if there’s been a slight slowdown. It seems this stock has been caught up in the broader selloff in retail, deservedly or not (my opinion is that it’s the latter).
When a business is still growing but the stock price drops 40%, that is probably an opportunity knocking (assuming the stock wasn’t 40% overpriced before).
Indeed, the stock appears to be downright cheap now…
The stock is trading hands for a P/E ratio of 16.08, which is very low for a company anticipated to grow at 15% annually over the foreseeable future. That’s almost a PEG ratio of 1. Moreover, the five-year average P/E ratio for the stock is 28.7. I mean, earnings cost almost half of what they typically have, on average, over the last five years, attributed to that recent 40%+ drop in the stock price. And the yield, as noted earlier, is substantially higher than its recent historical average.
So the stock does look undervalued, but by how much? What’s a reasonable estimate of its intrinsic value?
I valued shares using a two-stage dividend discount model analysis to account for the low yield and high growth.
I factored in a 10% discount rate, a 12% dividend growth rate for the first 10 years, and a long-term dividend growth rate of 7.5%.
The model is fairly conservative, in my view, when looking at the buyback program, payout ratio, demonstrated long-term earnings and dividend growth, and forecast for growth moving forward.
For perspective, the company’s most recent dividend increase was 12.5%, which is right in line with the model’s near-term expectation.
The DDM analysis gives me a fair value of $67.55.
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.
The analysis is purposefully conservative, to account for the company’s risks, yet the stock still looks appreciably undervalued right now. However, my perspective is admittedly but one of many. That’s why I like to compare my valuation with what select professional analysts have concluded.
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 TSCO as a 5-star stock, with a fair value estimate of $84.00.
CFRA (formerly 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.
CFRA rates TSCO as a 3-star stock, with a fair value estimate of $73.30.
I came in the most conservative, but averaging these three numbers out gives us a final valuation of $74.95. That would indicate the stock is potentially 45% undervalued (right in line with the recent drop in price).
Bottom line: Tractor Supply Company (TSCO) is a high-quality niche retailer that has built-in advantages that should help it remain relevant and continue to grow in the face of a changing retail world. With the possibility of 45% upside on top of double-digit dividend growth for the foreseeable future, this dividend growth stock could be one of the best long-term investment opportunities available.
— Jason Fieber
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