Is it tough to find a good deal on stocks when the broader market is still sitting near all-time highs?
Sure. It’s tough. But far from impossible.
First, though, what is a “good deal”?
Well, that’s a stock that’s priced below what it’s worth.
It’s the same as anything else in life.[ad#Google Adsense 336×280-IA]When you get a “good deal” on a car, you know you’re paying less than what it’s worth at that point in time.
And you have some ability to know that because there is literature out there (like, say, Kelly Blue Book) that will advise on the value of a car.
If a car is estimated to be worth $10,000 and you pay $7,000, you bought in with a fairly significant margin of safety.
Just in case the estimate is off a bit or something unforeseen happens with the car in the near future, you have a cushion there.
Value investors aim for the same thing when buying stocks.
The bad news is that we don’t have KBB to rely on. The good news is that we do have access to systems that are designed to help us gauge the value of a stock.
Fellow contributor Dave Van Knapp put together a good example of something that’s easy for almost anyone to use to reasonably estimate what a stock is worth.
One wants to pay less than a stock is estimated to be worth, and the greater the gap between price and value, the larger the margin of safety.
A margin of safety is extremely important.
After all, one can only estimate what a stock is worth. It’s pretty much impossible to come up with a figure down to the penny. So you always want to keep that in mind when buying stocks, knowing you could be off by a few percentage points or so on your valuation.
In addition to that, there could be unforeseen macroeconomic concerns that creep up on you, bringing the value of a stock down.
The recent crash in oil prices is a good example of that. You might have valued an energy stock at $80 per share early last year, but that same stock might only be worth $50 or so now, for example. So if you paid top dollar – $80 per share – or, worse, paid more than what it was likely worth, you are underwater on your investment right now.
Not the worst thing in the world if you’re a very long-term investor, especially if the stock is sending cash flow your way via dividends.
But buying in at, say, $60 per share makes the investment much more successful from the standpoint of opportunity cost and risk. You’re just plain risking less money on a per-share basis.
When you insist on a margin of safety upfront, you can withstand much more volatility before the investment starts to weigh on your emotions, which is important as an investor.
Investing is psychological warfare, but reducing your risk by having that margin of safety means you have an advantage on the battlefield.
I’ve attempted over and over again to attain a sizable margin of safety before buying stocks for my own personal portfolio.
And it appears that I’ve largely succeeded, with even most energy stocks that I own (oil is down by almost 2/3 from its recent high early last year) treading water after factoring in dividends.
That last part is important.
Most investors (especially novice investors) tend to look at price charts and assume that’s it. But it’s not.
Dividends have accounted for a significant portion of stocks’ total return over the last century. In fact, many studies point to dividends accounting for the vast majority of total return over a long holding period.
In addition, it’s been discovered that dividend initiators and growers tend to outperform (in aggregate) stocks that do not grow dividends, do not pay dividends, and/or cut dividends over longer periods of time.
So you can probably see why I concentrate on owning dividend growth stocks.
An excellent place to look for dividend growth stocks to invest in is David Fish’s Dividend Champions, Contenders, and Challengers list, which is an invaluable resource that has compiled the names of and information on more than 700 US-listed stocks that have increased their dividends for at least the last five consecutive years.
Now, that’s a massive list. So it can be a little difficult to know which dividend growth stocks on Mr. Fish’s list are not only “good deals” but also high quality, too. Especially in this market, as mentioned earlier.
But fear not.
We’re going to take a look at a high-quality dividend growth stock (that’s on Mr. Fish’s list) that appears to be significantly undervalued right now.
Magna International Inc. (MGA) is a global automotive supplier that designs, develops, manufactures automotive systems, parts, assemblies, and modules for car and light truck original equipment manufacturers. Operations span 29 countries, and they’re the most diversified automotive supplier in the world in terms of product offerings.
It’s no secret that automotive sales have been hot. Due in large part to sales stoked by consumers holding on to older cars longer in the wake of the financial crisis, most major OEMs have reported strong sales as of late.
This obviously bodes well for Magna. They supply all major OEMs with the parts they need to manufacture their end products.
But I think Magna might be one of the smartest ways to invest in the auto industry.
Whereas major OEMs face intense competition, high advertising costs, risk of recalls, slim margins, high fixed costs, and the necessity to come up with new models constantly, Magna is broadly diversified across the industry and doesn’t face many of these drawbacks.
For instance, no one major OEM constituted more than 20% of last fiscal year’s sales – General Motors Company (GM) led the way with 18%.
This means an investor is gaining broad exposure to all of the OEMs in one fell swoop. One doesn’t need to bet on GM’s ability to come up with a great car or a competitor’s truck outselling. Cars and trucks need parts, and Magna supplies the whole industry.
In addition, they’re broadly diversified across product offerings. They could practically manufacture cars all by themselves. Products range from metal stampings to electronic devices to airbag modules. They are, however, slightly less diversified in terms of products after completing the sale of their interiors operations to Grupo Antolin for $525 million.
They’re also well diversified geographically, with North America accounting for just over half of last fiscal year’s sales.
But as a dividend growth investor, I like to see a solid commitment to a growing dividend.
What’s interesting about Magna is that they actually have a “corporate constitution” that entitles shareholders of common stock to dividends that amount to at least 10% of Magna’s after tax profits for the corresponding financial year.
So you’ve got a company that takes its dividend so seriously that they actually spell it right out. The only drawback here is that if Magna takes a loss – like they did during the financial crisis – the dividend could be in danger. But that’s largely true for pretty much any company.
Nonetheless, they’ve grown their dividend nicely over the last six consecutive years after coming out of the financial crisis.
And the rate of dividend growth has been tremendous: The five-year dividend growth rate stands at 76%!
Now, that’s obviously something that’s not sustainable. But you can see that the corporate culture takes the dividend seriously, as management obviously wanted to get things right back on track as profit returned.
And the most recent dividend increase was over 15%, meaning that significant dividend growth is likely to continue for the foreseeable future.
A payout ratio of just 18.6% adds further evidence to this assessment.
Magna is paying out less than 20% of its EPS in the form of a dividend, which leaves plenty of room for future dividend increases.
On top of that incredible dividend growth, the stock offers a fairly competitive yield of 2.12%. Not the biggest yield out there, but it’s in line with the broader market while simultaneously offering the aforementioned growth potential.
Really incredible dividend metrics here. Very low payout ratio, huge dividend growth, a competitive yield, and a corporate constitution that basically ensures a dividend for as long as the company is profitable.
One other important note is that Magna is a Canadian company. However, they declare and pay their dividends in dollars. So that means no concerns about currency exchange rates for US stockholders. That’s a nice plus.
But while the dividend is a very important part of the story, it’s far from the whole story.
Let’s take a look at the rest of the business to see how things stack up. We’ll first glance at top-line and bottom-line growth over the last decade, which will give us a lot of information we need to value the business and estimate where things are going.
Magna increased revenue from $22.811 billion to $36.641 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 5.41%.
Meanwhile, the company grew earnings per share from $1.48 to $4.35 over this period, which is a CAGR of 12.73%.
Really solid growth here. Efficiency gains obviously helped, seeing as how most profitability metrics are notably higher now than they were a decade ago.
The bottom-line growth was actually almost completely secular over this entire period except for the bottom completely falling out during the financial crisis.
It’s difficult to tell if that’s a one-off event or not, but it’s important to be mindful of Magna being exceptionally sensitive to larger macroeconomic forces, global growth, and the overall health of the auto industry.
Since many major auto manufacturers (especially in North America) were under severe duress during the Great Recession, it makes sense that Magna suffered. However, these same players have emerged stronger than ever, which I think is good news for Magna and the industry it serves.
For perspective, S&P Capital IQ is forecasting 17% compound annual growth for Magna’s EPS over the next three years, which is in line with the recent acceleration coming out of the crisis. If this comes to pass, Magna’s dividend will likely grow significantly, and it stands to reason the stock price will, too.
One other huge advantage that Magna has over the large OEMs is a very healthy balance sheet. Major manufacturers carry rather large amounts of debt due to the business model, but Magna shines here.
The long-term debt/equity ratio is under 0.1, while the interest coverage ratio is well over 50. Basically, long-term debt is negligible.
Profitability is also a strong suit here, and another advantage for Magna. Most OEMs I’ve looked at operate with razor-thin margins. But Magna has very respectable numbers here.
Over the last five years, they’ve averaged net margin of 4.35% and return on equity of 15.64%.
All in all, I think Magna most certainly qualifies as a high-quality company. Results have largely been secular for a company that operates in such a cyclical industry, and I think it stands to reason that the industry is stronger now than it was before. With the financial crisis being a type of generational event, Magna could be set up for a long runway of stable and attractive growth.
One potential near-term risk, however, might be the company’s exposure to Volkswagen AG (VLKPY), whose recent issues regarding emissions could impact Magna’s sales. Volkswagen represented about 11% of Magna’s sales last fiscal year.
A high-quality stock like this should be expensive, but it doesn’t appear to be the case here…
The P/E ratio is sitting at 8.79. That’s low even for a stock in the auto industry. Comparatively speaking, the five-year average P/E ratio is 12.2. And with an acceleration of EPS growth, I think this stock might be pretty cheap.
If it’s cheap, how cheap? What’s a reasonable estimate of fair value?
I valued shares using a two-stage dividend discount model analysis. This is to account for the very low payout ratio and potential for significant near-term dividend growth. I assumed a 10% discount rate, 15% dividend growth for the first 10 years, and 7% terminal dividend growth. The forecast for EPS growth for the foreseeable future, low payout ratio, and recent dividend growth allows some confidence in this model. The DDM analysis gives me a fair value of $60.28.
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.
It appears to me that Magna is a really high-quality stock that has a lot of exciting potential, yet also a good deal. But let’s compare my opinion with that of some professionals that have also taken a good look at 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 MGA as a 3-star stock, with a fair value estimate of $42.00.
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 MGA as a 5-star “strong buy”, with a fair value calculation of $52.40.
Looks like I’m the most sanguine, but S&P Capital IQ is also pretty enthusiastic. I like to average out the three valuations so as to get rid of a wide range and come up with one number. This also likely adds a little accuracy to it since you’re taking multiple perspectives and blending them together. That averaged valuation is $51.56, which would mean this stock is potentially 24% undervalued right now.
Bottom line: Magna International Inc. (MGA) is a really high-quality automotive supplier that, in my view, is a great way to gain exposure to the auto industry. The fundamentals are much better than any OEM I’ve ever looked at, and the diversification is broad. Moreover, a corporate constitution practically guarantees a dividend for as long as the firm is profitable. With the possibility for 24% upside on top of huge dividend growth, I recently initiated a stake in the company. I’d recommend taking a good look at this stock.
— Jason Fieber, Dividend Mantra[ad#DTA-10%]