Warren Buffett, the legendary investor and businessman, has many memorable quotes.
One of his lesser-known quotes is a favorite of mine:
“You pay a very high price in the stock market for a cheery consensus.”
Indeed, investors will pay a lot of money to feel good about a choice.
But successful long-term investors are wise to ignore the consensus and seek out great deals.
You see groupthink everywhere you look. Conforming is comforting.
But we’re not here to be comforted.
We’re here to make money.
I’ve ignored the crowd in almost every aspect of my life.
Whenever I saw a lot of people doing one thing, I’d do the opposite.
Ignoring the consensus has worked out pretty well: I retired in my early 30s, as I lay out in my Early Retirement Blueprint.
That might sound like a crazy thing to do.
But it’s only crazy when you look at the consensus.
I actually think it’s quite crazy to not become financially independent and retire young.
Part of that consensus ignoring has come in the form of investing.
I routinely sought out high-quality dividend growth stocks trading at appealing valuations.
And I built my FIRE Fund in the process.
That’s my real-money portfolio, and it generates the five-figure passive dividend income I live off of.
High-quality dividend growth stocks are some of the best long-term investments you can make.
These stocks often represent equity in some of the finest businesses on the planet, as you can see by perusing the Dividend Champions, Contenders, and Challengers list.
I never wanted to buy stocks when the consensus was cheery; I’d rather get a good deal.
The dynamics of a good deal can make a huge difference in your investment results over the long run.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated.
A lower price results in a higher yield, all else equal.
Since total return is the sum of investment income and capital gain, a higher yield leads to greater long-term total return potential.
There’s also the possible “upside” when a stock is temporarily mispriced.
This is the capital gain that could come your way if/when a stock is more correctly priced (reflecting a price closer to fair value).
Of course, this should also reduce risk.
Undervaluation introduces a margin of safety.
This “buffer” protects the investor against unforeseen issues that could erode value.
The opposite of upside is downside. You want to maximize the former and minimize the latter.
Fortunately, it’s not difficult to spot the consensus. It’s a huge crowd.
Just as well, it’s not difficult to estimate intrinsic value for just about any dividend growth stock out there.
Fellow contributor Dave Van Knapp has made this easier than ever with Lesson 11: Valuation.
That piece, part of an overarching series of articles designed to teach the strategy of dividend growth investing, explicitly lays out a valuation template.
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…
KeyCorp (KEY)
KeyCorp (KEY) is a bank holding company that, through its subsidiaries, provides a range of retail and commercial financial services.
Headquartered in Cleveland, Ohio, KeyCorp operates more than 1,100 branches across 16 different US states. Their primary markets are Ohio and New York.
This regional bank still operates mainly as a old-school community bank, providing a number of local financial functions that include deposits, lending, and financial management.
FY 2018 revenue broke down across the following two segments: Key Community Bank, 64%; Key Corporate Bank, 36%.
A bank, at its core, is one of the most appealing business models out there.
The ability to build a “float” and earn a low-risk return from the spread between what you pay and what you earn on other people’s money is about as easy as it gets. And that forms a great base from which to build out a range of other high-profit financial services.
However, pervasively low interest rates have hurt the bottom line of many banks.
There’s simply not a big spread to take advantage of.
But a diversified bank has a number of levers to pull – differentiation, building relationships, delivering value, taking advantage of local expertise – in order to pump out strong growth and ever-growing dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
That’s exactly what this bank is doing.
And it’s working.
KeyCorp has increased its dividend for eight consecutive years.
Like many financial institutions, they were impacted significantly by the financial crisis and ensuing Great Recession. They were forced to cut their dividend.
But I think it’s important to keep in mind that the Great Recession was a highly unusual event that is unlikely to repeat anytime soon.
There’s no guarantee something like that won’t happen again at some point in the near future. But it’s the kind of crisis that is statically extremely rare.
Since the trough in 2009, this bank has come back roaring.
The five-year dividend growth rate is 21.3%.
Even with huge dividend raises over the last eight years, the dividend still remains in a great position to continue growing at a high rate for the foreseeable future.
For proof of that, the payout ratio is sitting at a moderate 39.8%.
If that payout ratio and growth isn’t fantastic already, consider the fact that the stock yields a monstrous 4.01% right now.
That yield is almost unheard of for a regional bank.
It’s more than twice what the market yields.
It’s also almost 200 basis points higher than the stock’s five-year average yield!
Of course, we invest in where a company is going, not where it’s been.
Revenue and Earnings Growth
It’s those future dividend increases that we care most about.
Estimating the future dividend growth rate is thus critical, which also greatly aids us when determining what we think the stock might intrinsically be worth.
In order to build out this future trajectory, I’ll first show you what the bank has done over the last nine years in terms of top-line and bottom-line growth.
I’ll then compare that to a near-term professional forecast for profit growth.
These numbers will tell us a lot about where the bank has been, as well as where it appears to be going.
(As a note, I usually use the last decade for historical reviews like this. However, FY 2009 was the trough of the Great Recession. And the bank’s results for that year are heavily skewed by that.)
KeyCorp grew its revenue from $4.465 billion in FY 2010 to $6.240 billion in FY 2018.
That’s a compound annual growth rate of 4.27%.
Strong growth here.
Well in line with a mid-single-digit growth rate I’d expect for a business like this.
They have made a number of acquisitions in recent years, which have all helped with revenue growth.
While some of these acquisitions have been more bolt-on in nature, such as the purchase of fintech firm HeroWallet in 2017, the acquisition of First Niagara Financial Group for $4.1 billion in 2016 was quite sizable and added $29 billion in deposits and approximately 300 branches to its footprint (at that time).
That acquisition immediately increased KeyCorp’s scale, as well as giving it a major foothold into the Northeast US.
Bottom-line growth has been stellar, easily outpacing revenue growth.
Earnings per share increased from $0.44 to $1.70 over this nine-year stretch, which is a CAGR of 18.41%.
Really incredible.
And that’s even after the bank issuing plenty of shares to fuel growth and take on acquisitions.
This tells me those acquisitions have been accretive. And the bank has been smartly taking care of the basics.
Looking out over the next three years, CFRA predicts that KeyCorp will compound its EPS at an annual rate of 10%.
That seems like a reasonable estimation when looking at more recent results.
CFRA is modeling in modest net interest income growth, continued loan growth, and modest net interest spread
expansion.
It’s a pretty low hurdle to clear for the bank, assuming we don’t have any kind of economic meltdown on the horizon.
Rates almost have to rise from here over the long run.
Meanwhile, they’ve produced outstanding results in a challenging environment for banking.
If things improve even just a little bit, this bank could have a big tailwind in front of them.
But if EPS compounds at 10% over the near term, which doesn’t seem to be an aggressive forecast, the dividend could easily grow in kind.
Indeed, we have some clarity on this.
KeyCorp announced with its Q1 2019 earnings release that it plans to increase its quarterly dividend from the current $0.17 level to $0.185 during Q3 2019.
Admittedly, that would be a bit lower than what’s come of late.
But that’s an 8.8% increase coming on top of a ~4% yield. If that’s not a lot to like, I don’t know what is.
And it’s not aggressive when you look at overall operations. It’s a rather conservative move. I like that.
Financial Position
Moving over to the balance sheet, the long-term debt/equity ratio is 0.88.
That’s a solid number for the industry.
Standard & Poor’s rates their senior long-term debt at BBB+. Moody’s rates it at Baa1. Investment grade.
Showing the asset quality, Q1 2019 showed net loan charge-offs to average total loans at .29%. That’s well below the 0.47% average industry rate (per FRED).
Profitability is solid, although it’s not the best I’ve run across.
Over the last five years, the bank has averaged annual return on assets of 0.95% and annual return on equity of 9.05%.
There’s been an improvement in profitability in recent years, though. FY 2018 was outstanding. Net interest margin came in at 3.17% last fiscal year.
Overall, this is a very strong regional bank. And the last few years have shown stellar results and management.
Of course, there are risks to consider.
Regulation, competition, and litigation are omnipresent risks in every business. Regulation, in particular, is always looming over banks.
Low interest rates remain a challenge.
Credit quality is great right now, but a deterioration there could harm profitability.
Speaking of which, a broader economic slowdown or recession is something that tends to disproportionately affect banks.
One issue that can trip up some regional banks is an aggressive expansion outside of their footprint or circle of competence. But KeyCorp’s communications regularly discuss focusing on their core competencies in their markets.
Stock Price Valuation
This looks like a solid bank. And at a reasonable price, it could be a great investment over the long run.
Well, the price looks more than reasonable after a 17% drop over the last year…
The stock is trading hands for a P/E ratio of 9.87.
Single-digit P/E ratios are hard to come by in this market.
That favorably compares to the stock’s own five-year average P/E ratio of 15.2.
This is cheap, even for a bank.
The P/CF ratio, at 5.4, is less than half of its three-year average of 13.4.
And the yield, as noted earlier, is substantially higher than its recent historical average.
This stock looks very cheap at first glance, but how cheap might it be? What would a rational estimate of intrinsic value look like?
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%.
This is a fairly conservative estimate of future dividend growth potential.
A low payout ratio, 10% near-term EPS growth rate forecast, and upcoming 8%+ dividend raise all add up to the likelihood of dividend growth well in excess of 7%.
But I like to err on the side of caution, especially knowing where the economic cycle and interest rates are at.
The DDM analysis gives me a fair value of $24.25.
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 doesn’t look like I was being particularly aggressive with the valuation, yet it paints the picture of an extremely cheap stock.
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 KEY as a 4-star stock, with a fair value estimate of $21.00.
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 KEY as a 4-star “BUY”, with a 12-month target price of $21.00.
I came out a little high. Averaging these three numbers out gives us a final valuation of $22.08, which would indicate the stock is possibly 31% undervalued.
Bottom line: KeyCorp (KEY) is a high-quality and well-run regional bank. With great fundamentals, a 4% yield, a low payout ratio, a clear commitment to dividend growth, and the potential that shares are 31% undervalued, dividend growth investors should absolutely have this stock on their radar.
-Jason Fieber
Note from DTA: How safe is KEY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 77. 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, KEY’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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