What an amazing time to be alive.
The opportunities that people have in 2018 are unlike anything society has ever seen before.
Many of these opportunities have grown out of the emergence of the Internet, which has radically changed the landscape of society across numerous aspects – information, communication, capitalism, etc.
Lower cost, greater accessibility, and even ubiquity have all arisen and combined to give everyday people, like us, the chance to improve our lives.
For example, access to capitalism has never been greater than it is today.
Compare that to just a few decades ago.
You had to get financial reports mailed out, call up your broker, and pay a lot of money to buy a stock and have a physical certificate stored somewhere.
What used to take a lot of time and money now takes almost none of either.
That’s an incredible opportunity that you can’t let pass you up.
I’m a great example of how these new dynamics can be taken advantage of.
I was a broke, unemployed, college dropout as recently as 2009.
But I fortunately saw the writing on the wall as it pertains to how easy it is to participate in capitalism these days.
Living below my means and investing my excess capital intelligently led me to go from below broke to financially independent in about six years, as I’ve documented in my Early Retirement Blueprint.
Of course, having greater access to capitalism doesn’t mean you blindly jump in.
I spent a period of time in early 2010 studying just about every investment style out there, before finally concluding that dividend growth investing would be the best strategy to get a regular, everyday guy like myself to financial independence.
This strategy involves buying equity in wonderful businesses that are so prolific at regularly increasing profit, they end up with more growing cash flow than they can efficiently use – resulting in a chunk of that growing profit sent back to the shareholders (the owners of these businesses) in the form of growing dividends.
Growing dividends can be an excellent foundation upon which to build financial independence.
I took this concept and ran with it, building my FIRE Fund in the process.
That’s my real-life and real-money dividend growth stock portfolio. It generates the five-figure and growing passive dividend income I need to cover my basic bills in life, rendering me financially free in my 30s.
Now, that’s just a portfolio that I’ve built for me. It represents just a smidgen of the available high-quality dividend growth stocks out there.
You can find hundreds of dividend growth stocks by perusing the late, great David Fish’s Dividend Champions, Contenders, and Challengers list – an incredible compilation of data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
But as great as many of these stocks are, you can’t buy random stocks at random prices.
You have to do your due diligence, which includes performing fundamental analysis, judging qualitative aspects, and assessing risk.
Equally important, you also have to value a stock before you buy it.
Price is what you pay, but value is what you end up getting for your money.
Value gives context to price. Without context, price means almost nothing by itself.
The valuation at the time of investment can have a significant impact on a stock’s performance, especially over the short term.
An undervalued dividend growth stock should present an investor with a higher yield, greater long-term total return potential, and less risk.
That’s all relative to what the same stock might otherwise present if it were fairly valued or overvalued.
Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.
That higher yield positively impacts possible total return right out of the gate.
This leads to greater long-term total return potential.
That’s because total return is comprised of capital gain and investment income (through dividends or distributions).
We see how the latter is positively influenced, but the former (capital gain) is also given a boost via the “upside” that exists between a lower price and higher intrinsic value.
While the market might not necessarily be able to totally accurately price stocks in the short term, price and value do tend to more closely converge over the long run.
If you can buy when an advantageous disconnect between price and value exists, you’re setting up some nice upside.
And that’s on top of whatever capital gain will naturally be produced as a business becomes worth more (and sees its stock price rise) as it increases its profit.
Of course, this all has a way of reducing risk, too.
After all, it’s naturally less risky to pay less for an asset than it would be to pay more for the same exact asset.
And you introduce a margin of safety when you pay less than estimated intrinsic value, for it builds in a nice buffer to protect you against any unforeseen issues.
You don’t want to end up “upside down” (i.e., worth less than you paid) on your investment.
Building in a nice gap between price and estimated fair value at the time of investment gives you a cushion against that happening.
Undervaluation should obviously be what you seek any time you’re buying a high-quality dividend growth stock.
The benefits are clear.
Fortunately, fellow contributor Dave Van Knapp has made it pretty easy to spot undervaluation via one of the lessons he’s put together in his series of articles that are designed to teach the strategy of dividend growth investing.
The lesson in question is Lesson 11: Valuation.
Definitely worth a read, folks.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
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.
Net written premiums for FY 2017 were spread out across the following segments: Business Insurance, 54%; Personal Insurance, 37%; and Bond & Specialty Insurance, 9%.
The insurance space has long been one of my favorites as an investor.
That’s because it takes what’s a fantastic business model at its core (insurance) and greatly amplifies it by taking advantage of the spread and time delay between collecting premiums and paying claims.
A great insurance company will run a very profitable enterprise based solely on prudent underwriting.
Said another way, a good insurance company will responsibly and profitably manage its pricing, risk, and insurance products so that it collects more in premiums than it’s paying out in claims.
However, most insurance companies – especially the exceptional ones – collect most of their profit via the float that’s built up from that spread and time delay.
Premiums are collected upfront (until an insurance company needs to pay out on claims).
This is a large, low-cost source of capital that can be conservatively and profitably invested by an insurance company, eventually building up a significant pile of assets that generate a lot of investment income.
In the case of Travelers, they currently manage a $72 billion investment portfolio that’s mostly invested in fixed-income instruments.
Indeed, that portfolio’s investment income is what drove most of the company’s profit in 2017.
And with rates surely set to rise over the longer term, this bodes well for the company moving forward.
That’s particularly true when considering that 2017 was an extreme year in terms of catastrophes – Hurricane Irma (the strongest hurricane ever observed in the Atlantic in terms of maximum sustained winds), Hurricane Harvey (tied with 2005’s Hurricane Katrina as the costliest tropical cyclone on record), and the Tubbs Fire (the most destructive wildfire in California history) were all massive catastrophes last year.
A normalizing of catastrophes back to the long-term average also bodes well for Travelers.
This all adds up to bode well for the company’s ability to pay and increase its dividend.
The company has increased its dividend for 14 consecutive years already, which is as long as this track record could be since this iteration of Travelers was created out of a merger in 2004.
The 10-year dividend growth rate is sitting at 9.6%.
There has been a slight deceleration in dividend growth more recently, but I think that’s just due to the company’s conservative nature. They’re being cautious in light of catastrophic issues and very low interest rates.
But with a payout ratio of just 42.4% on depressed earnings (due to aforementioned catastrophes), the company has plenty of room left to continue increasing the dividend as earnings normalize.
And the stock yields a respectable 2.46% right now, which is actually quite appealing in the insurance space.
It’s also almost 40 basis points higher than the stock’s own five-year average yield.
I don’t see why investors shouldn’t be able to expect high-single-digit dividend growth looking out over many years with this business, which is awfully attractive when you’re starting with a yield near 2.5%.
Assuming a static valuation, the sum of yield and dividend growth will approximate one’s total return.
So Travelers just operating normally should get you to a place where long-term total return is in the low double digits or so, without doing anything extraordinary or investing in a business model that’s considerably risky.
But in order to build that base case as to what to expect in terms of dividend growth moving forward, we must first look at business growth – it’s the growth of the underlying business that will drive the dividend growth.
We’ll first look at what kind of top-line and bottom-line growth Travelers has generated over the last decade, and then we’ll compare that to a near-term professional forecast for profit growth.
Combining the known past and estimated future in this manner should allow us to extrapolate some ideas as to where Travelers is likely going moving forward, which will also help us value the business and its stock.
Travelers increased its revenue from $24.477 billion to $28.902 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 1.86%.
Not really what we’d like to see here as far as top-line growth goes.
A tight pricing environment and very low interest rates have conspired against insurance companies lately, but a company like this always has multiple levers to pull in order to produce excess bottom-line growth.
Looking at that, the company’s earnings per share grew from $4.81 to $7.33 over this same period, which is a CAGR of 4.79%.
This would be slightly disappointing if I thought it was indicative of the company’s true earnings power and growth, but I don’t think it is.
2017 saw Travelers deal with numerous substantial catastrophes that affected its EPS to a great degree, causing EPS to drop from over $10 in FY 2016 to what we see above in FY 2017. The consolidated combined ratio came in at 97.9% for FY 2017.
Keep in mind that they were still profitable even while dealing with all of these issues simultaneously, which I believe says a lot about their resiliency and viability.
It’s likely they’ll register EPS well over $10 for FY 2018, bouncing right back to where they were before.
For perspective on that, CFRA is forecasting that Travelers will compound its EPS at an annual rate of 17% over the next three years, no doubt aided by coming off of such a low number.
A better pricing environment, rising rates, and the company’s prodigious buyback activities (Travelers has reduced its outstanding share count by over 50% over the last decade) are all factored into that forecast.
So the company basically has two catalysts working in its favor right now: the upward movement of interest rates is the first catalyst, and the normalizing of catastrophic events is the other.
Moving over their balance sheet, Travelers is conservatively managed, which isn’t surprising for an insurance company like this.
The long-term debt/equity ratio is 0.25. That’s actually quite low, but it’s made to be even more impressive when you consider how much common equity has been impacted by the buybacks.
Meanwhile, the interest coverage ratio, at a bit over 8, is artificially low, since net income was impacted by the events that occurred over the course of 2017. This number is usually between 12 and 15, which is very solid.
Profitability is robust.
Over the last five years, the company averaged annual net margin of 11.61% and annual return on equity of 12.97%.
Both numbers were negatively skewed by a very challenging 2017 (and even a subpar 2016).
Looking ahead, though, the company is positioned quite well.
The investment portfolio is massive. Underwriting is prudent, bolstered by the fact that the combined ratio stayed below 100% during a year in which three of the most devastating disasters ever to hit the US simultaneously occurred. And management is very conservative.
With interest rates rising and a disaster environment returning to historical norms, Travelers should do quite well for the foreseeable future.
Of course, it’s no guarantee that natural disasters won’t be worse this year (or the next).
And interest rates not materially rising from here could cause the growth trajectory of the company to slow.
In addition, Travelers has risk through its investment portfolio in the sense that it’s exposed to municipal bonds. Any issues with municipalities and their ability to cover obligations could affect Travelers and its investment portfolio.
Overall, though, this company looks like a smart investment over the long run.
The right valuation would only serve to strengthen that case.
Well, the valuation does look attractive right now…
The stock is trading hands for a P/E ratio of 17.199, which doesn’t look bad at all when you compare it to the industry average or the broader market.
However, that doesn’t compare well to the stock’s own five-year average.
But that’s because of the major catastrophic losses in 2017, which lowered EPS (and thus increased the P/E ratio).
On a forward-looking basis, the P/E ratio is about 12.5 right now, which compares mightily favorably to the industry and the market.
Revenue is also sporting a lower multiple than its five-year average.
And the yield, as noted earlier, is higher than its recent historical average.
So the stock is trading at a very low multiple, but how cheap might it be? Where would a reasonable estimate of intrinsic value peg its worth at?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
That DGR basically splits the difference between the long-term trend and some of the more short-term results.
But with a very low payout ratio (on normalized numbers), consistent buybacks, prudent underwriting, and rising rates, I think that’s a pretty cautious look at the company’s long-term dividend growth potential.
If anything, I think it’s likely they’ll deliver something closer to 9% over the long run (in line with what they’ve already done over the last decade), but I do like to err on the side of caution in these long-term projections.
The DDM analysis gives me a fair value of $132.44.
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 perspective is that this is a high-quality insurer with multiple catalysts working in its favor, all wrapped up in a package that’s slightly undervalued (on a pretty conservative valuation model).
But let’s compare my valuation to what two professional stock analysis firms have come up with, which should add plenty of depth to our bottom line.
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 4-star stock, with a fair value estimate of $142.00.
CFRA 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 TRV as a 4-star “BUY”, with a 12-month target price of $150.00.
I came out with the lowest valuation, which makes sense with my cautious look at the future. Averaging out the three numbers gives us a final valuation of $141.48, which would indicate the stock is potentially 13% undervalued here.
Bottom line: Travelers Companies Inc. (TRV) is a high-quality insurer that has worked through some of the worst natural disasters the US has ever seen – yet the company still remained very profitable straight through. With rising interest rates, a huge investment portfolio, a conservative management team, 14 consecutive years of dividend raises, long-term dividend growth near the double digits, and the possibility that shares are 13% undervalued, dividend growth investors may want to look to this stock to ensure plenty of future dividends.
Note from DTA: How safe is TRV’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 85. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, TRV’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.
Perfect Stock Caught Trading Under Secret Name... [sponsor]
It trades under a secret name... for just under $5. But thanks to a developing situation that could create nearly 50,000 American jobs and $10 billion in facilities... this may soon be the most talked about stock in America. Find out more about the "secret stock" here. Find out more about the "secret stock" here.