Successful long-term investing is boring.
But it’s also not boring.
Sure, buying and holding great businesses for decades on end isn’t exactly an action-packed lifestyle.
However, becoming wealthy, slowly, is very exciting as it unfolds.
There’s a great investment method to ensure this process unfolds correctly over the course of your life.
That method is…
Buy and hold high-quality dividend growth stocks at appealing valuations.
I’ve proven that out via my Early Retirement Blueprint.
It recounts how I went from below broke at 27 years old to financially free at 33.
I’m now retired and living the life of my dreams – in my 30s!
I made this happen by living below my means and investing my savings into undervalued high-quality dividend growth stocks.
The result of that saving and investing is my FIRE Fund, which is my real-life and real-money dividend growth stock portfolio.
This six-figure portfolio generates the five-figure and growing passive dividend income I need to pay for my basic bills.
Suffice to say, it takes a pretty special business to be able to rack up years and years of rising cash dividend payments to shareholders.
A company that can do this is usually doing lot of things right.
And they’re often providing necessary products and/or services that make the world go round.
The Dividend Champions, Contenders, and Challengers list says it all.
Numerous blue-chip stocks are on that list. Household names abound.
Shouldn’t be surprising.
A lengthy track record growing dividends serves as a pretty good initial litmus test for business quality.
It’s pretty tough to go wrong as an investor by routinely buying quality companies.
However, it’s not just quality that matters.
Valuation is also very important.
An undervalued dividend growth should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock would otherwise offer 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.
The higher yield leads to greater long-term total return potential.
That’s because total return is simply comprised of capital gain and investment income.
A higher yield means more investment income on the same invested dollar.
In addition, capital gain is given a possible boost in this scenario via the “upside” that exists between price and value.
The market isn’t necessarily great at pricing stocks in the moment, but price and value tend to more closely correlate over the long run.
Taking advantage of a mispricing in the short term can lead to upside as pricing becomes more rational.
That’s on top of whatever capital gain would be possible as a quality company increases its profit and becomes worth more.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
It’s a buffer which protects the investor against unforeseen events that can degrade value.
Fortunately, fellow contributor Dave Van Knapp has made the valuation process straightforward.
His template can be used as a tool to help spot undervalued opportunities and take action.
That template can be accessed through Lesson 11: Valuation, which is part of an overarching series of “lessons” designed to educate investors on dividend growth investing.
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)
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 2018 occurred via the following segments: Business Insurance, 54%; Personal Insurance, 37%; and Bond & Specialty Insurance, 9%.
I mentioned earlier that these quality companies are often providing the products and/or services that make the world go round.
Well, insurance is one of those necessary products that people and businesses practically cannot live without.
Just think about losing insurance on your home, your car, or even your health.
Now just imagine some kind of catastrophe suddenly striking any of those. Odds are good that you couldn’t afford to make yourself whole all by yourself.
This is why I love investing in insurance companies.
They provide a necessary product, first of all.
Better yet, though, they’re able to take advantage of the spread and time delay between collecting premiums and paying claims.
The spread occurs because an insurance company is in business to turn a profit. They naturally aim to charge more in premiums than they’ll eventually pay out in claims. This happens through good underwriting.
But the real key is that time delay.
An insurance company can build up a “float”, which is the premiums they’re collecting upfront. Until such time they pay on claims, they can invest this low-cost capital and earn a return off of it.
This is where most insurance companies really earn their money. And it’s frankly ingenious.
Travelers manages a $70+ billion investment portfolio. The portfolio is mostly invested in fixed-income instruments.
A well-run insurance company practically mints money.
Well, Travelers is one such well-run insurance company. This benefits shareholders.
It should also benefit the company’s ability to continue paying and growing its dividend.
Travelers has increased its dividend for 14 consecutive years.
That’s a nice track record. Numerous large-scale catastrophes have come along over that period. It also stretches right through the financial crisis.
The 10-year dividend growth rate is well over the rate of inflation, at 9.6%.
With a payout ratio of 33.2%, the dividend is extremely healthy.
Meanwhile, the stock yields a fairly attractive 2.46% right now.
That beats the market, the industry average, and even the stock’s own five-year average yield.
So there’s a lot to like about the dividend. It’s a fairly large, sustainable, and growing at a fast clip.
But we invest in where a company (and its dividend) is going, not where it’s been.
Estimating future growth relies on looking at what a company has done over a long period of time, as well as building out a trajectory moving forward.
So we’ll first take a peek at the company’s top-line and bottom-line growth over the last decade, then compare that to a near-term professional forecast for profit growth.
Travelers has increased its revenue from $24.680 billion in FY 2009 to $30.282 billion in FY 2018. That’s a compound annual growth rate of 2.30%.
Not excellent. Low interest rates and competitive pricing have put a lid on the company’s ability to increase revenue.
However, there’s been a nice acceleration in revenue growth over the last five years.
Furthermore, the bottom line has fared better, largely due to buybacks.
Earnings per share advanced from $6.33 to $9.28 over this period, which is a CAGR of 4.34%.
EPS grew faster than revenue, due to a massive 53% reduction in the outstanding share count over this time frame, but the bottom-line growth wasn’t fantastic.
However, I think we have to look at Travelers through a certain lens.
Namely, the last decade has been brutally tough for insurance companies.
Historically-low interest rates, the climb out of the financial crisis, strong competition, and a number of massive catastrophes have created a very challenging environment for Travelers.
Hurricane Harvey, Hurricane Irma, and the Mendocino Complex Fire are just a few large-scale catastrophes that have occurred in recent years.
Even with all of that, though, the company still did OK. And the dividend continued to grow. That speaks volumes, in my view. If that’s what they do during one of the toughest periods of the company’s history, just think about what could happen when things become easier.
Well, you don’t have to think about it for very long.
Looking out over the next three years, CFRA is predicting that Travelers will compound its EPS at an annual rate of 17%.
That’s a huge number, but I think you just have to look at it as a “normalization”. That’s because it’s coming off of a low number for Travelers. If things weren’t so challenging, EPS would already be higher than it is.
So that “normalization” could play out due to the normalizing of two major aspects of the insurance business: catastrophe claims and interest rates.
Regarding the former, 2018 already showed some easing up on the catastrophes. Knowing what we know about long-term averages, this should continue to work in the favor of Travelers. Indeed, the FY 2018 combined ratio of 96.9% came in a full 100 basis points better than FY 2017.
Regarding the latter, interest rates have already started to climb. This means more investment income on that $70+ billion investment portfolio, although this will take some time to play out.
It’s difficult to say if Travelers will produce 17% EPS growth over the next few years. But it does seem likely that they’ll do much better moving forward, compared to what they’ve done over the last decade.
Even falling short of that mark sets investors up for very solid dividend raises.
Insurance companies are often run conservatively when it comes to leverage and the balance sheet, which isn’t surprising. They’re in the business of managing risk.
The company’s long-term debt/equity ratio is 0.26.
That’s low in and of itself. But it’s even more impressive when you consider that it’s based on artificially low common equity, due to the significant buybacks.
The interest coverage ratio is over 11, which further indicates a very good balance sheet.
I think this number, too, is better than it would initially seem. That’s because the company’s EBIT is now starting to stabilize and improve.
Profitability has long been a strong suit of Travelers. The last few years have been tough, but they’ve remained a highly-profitable enterprise straight through it all.
Over the last five years, the firm has averaged annual net margin of 11.61% and annual return on equity of 12.79%.
I think there’s a lot to like about Travelers, especially if you’re a fan of the insurance industry in general.
And rising interest rates could have a substantial impact on the company’s ability to aggressively grow its dividend.
This one-two punch shouldn’t be underestimated.
I think these catalysts partially prompted Warren Buffett’s Berkshire Hathaway Inc. (BRK.B) to recently initiate a stake in Travelers.
Buffett hasn’t ever been shy about conveying his love for the insurance business. Buffett’s long-term success has been largely tied to his own insurance investments and his ability to invest float capital. Even today, insurance businesses are a big part of Berkshire Hathaway.
Being on the same side as Buffett on an investment has rarely been a bad idea.
Of course, there are some risks to consider here with the business.
If catastrophes continue to come in at a rapid clip, this will strain the company’s ability to increase its profit and run an efficient underwriting business.
Regulation, litigation, and competition are omnipresent risks in every industry.
And interest rates taking a pause could curtail the thesis.
But the company is, overall, positioned very well here.
The question then becomes whether or not the business is undervalued.
I believe the stock is attractively valued right now…
The P/E ratio is 13.47, which is shockingly low for a business with two large catalysts set to work in its favor.
That would imply a PEG ratio well below 1, if CFRA’s forecast is anywhere near accurate.
The P/E ratio is admittedly higher than the stock’s five-year average P/E ratio, but GAAP EPS has been skewed in recent years.
Notably, the P/CF ratio, which doesn’t share the GAAP limitations of the P/E ratio, is 7.7 right now. That looks pretty appealing when compared to the stock’s three-year average P/CF ratio of 9.2.
And the yield, as mentioned earlier, is higher than its own recent historical average.
So the stock does look undervalued. But what would a reasonable look at intrinsic value look like?
I valued shares using a dividend discount model analysis.
That DGR basically splits the difference between the long-term track record and some of the more recent increases.
However, the low payout ratio, near-term catalysts, and obvious commitment to a growing dividend paints this as a rather conservative look at the potential for dividend growth.
The more likely result would be something closer to 9%.
But I’d rather err on the side of caution. This leaves a lot of room for upside surprise.
The DDM analysis gives me a fair value of $132.44.
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.
Even a cautious look at the value of this business still shows us that it’s undervalued by a decent margin.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 $145.00.
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 $142.00.
I came out slightly low. Not a surprise given the way I always approach valuation conservatively. Averaging these three numbers out gives us a final valuation of $139.81, which would indicate the stock is potentially 12% undervalued right now.
Bottom line: Travelers Companies Inc. (TRV) is a high-quality company that has positioned itself almost perfectly. With a market-beating yield, low payout ratio, catalysts for accelerated growth, and the possibility of shares being 12% undervalued, this Buffett-approved dividend growth stock could be just what you need to ensure dividend growth and great returns for your portfolio.
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 70. 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 safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.