The longest economic expansion in US history is still going strong.
The US economy has grown for 121 consecutive months.
And the S&P 500 index has quadrupled off of its Great Recession lows.
As such, it’s more important than ever to be vigilant as a long-term investor.
That means buying high-quality companies at attractive valuations.
This is always important, of course.
It’s never a good idea to buy a low-quality company at an expensive price.
But it’s particularly meaningful right now, with less “wiggle room” in the market in case something bad were to happen at the broader economic level.
Investing in high-quality companies, and buying their stock at attractive valuations, has radically changed my life.
And I’ve gone about that in a very specific and strategic way, via the dividend growth investing strategy.
Dividend growth investing allowed me to go from totally broke to financially independent – in just six years.
I detail that entire process, and how it unfolded, in my Early Retirement Blueprint.
The Blueprint is a step-by-step guide that plots out a course to early retirement that almost anyone can follow.
By following the Blueprint myself, I’ve been able to build the FIRE Fund.
That’s my real-money early retirement stock portfolio.
It generates the five-figure passive dividend income I live off of.
Dividend growth investing is phenomenal in many ways, not the least of which is how intuitive and approachable it is.
I mean, just take a look at the Dividend Champions, Contenders, and Challengers list, which contains data on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Many of these companies are household names that make almost immediate sense in terms of building out a long-term investment thesis.
Every company on that list is sending its shareholders a growing cash dividend.
That’s cash money, folks. Cash you can reinvest. Cash you can also live off of, like I’m doing.
But you have to look for high quality. And valuation is critical.
Price is what you pay. But value is what you get for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
All else equal, a lower price results in a higher yield.
That’s because price and yield are inversely correlated.
The higher yield leads to greater long-term total return potential.
Total return is simply the sum of capital gain and investment income from an investment.
While investment income is given a possible boost via the higher yield, capital gain is also given a possible boost via the “upside” that exists between a lower price paid and higher intrinsic value.
If the market sees the mispricing, upside capital gain manifests itself when the corrective repricing occurs.
As if higher yield and greater long-term total return potential weren’t enough, these dynamics should also reduce risk.
This risk reduction happens when there’s a buffer, or margin of safety, present.
That favorable gap between price and value protects the investor’s downside against unforeseen problems.
Nobody has a crystal ball. It’s imperative to protect your capital.
These benefits sell themselves.
Fortunately, it’s not that difficult to spot and take advantage of undervaluation.
Fellow contributor Dave Van Knapp has made that easier than ever before.
His Lesson 11: Valuation, part of an overarching series on dividend growth investing, presents an excellent valuation framework that can be applied to pretty much every dividend growth stock out there.
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…
Bank of New York Mellon Corp. (BK)
Bank of New York Mellon Corp. (BK) is a global financial services company.
Operations are split across two principal business segments: Investment Services and Investment Management.
The US accounted for approximately 63% of FY 2018 revenue.
They are the largest global custody bank in the world, with over $32 trillion in assets under custody and administration.
The bank provides a range of investment management and financial services in more than 100 markets across 35 countries.
Bank of New York Mellon, as it exists today, was formed through a series of M&A activities. The most notable of which was the 2007 ~$16.5 billion acquisition of Mellon Financial by Bank of New York.
The combined enterprise has morphed into a powerhouse bank that provides critical services behind the global banking infrastructure.
They specialize in institutional services.
That includes trade execution, custody, securities lending, and clearance and settlement.
A broad array of accounting and administrative services are also available.
To give you some perspective on this, in terms of size, the bank cleared and settled ~88 million transactions with the Federal Reserve last year; they settled ~$230 trillion of securities 2018 globally; and they process, on average, ~$2 trillion of payments each day.
Through industry consolidation, M&A, and advancements toward sticky custody assets, Bank of New York Mellon has built an enviable business model focused on scalable, fee-based securities servicing and fiduciary businesses.
Fee revenue made up 78% of total revenue for FY 2018.
The bank also has a significant amount of assets under management, coming in at just over $1.7 billion as of the end of FY 2018.
Dividend Growth, Growth Rate, Payout Ratio and Yield
This diversification and positioning as a leader in high-value infrastructure bodes well for them.
It also bodes well for their ability to pay a growing dividend.
As it sits, they’ve increased their dividend for eight consecutive years.
The big issue with the dividend, though, is the fact that they cut the dividend during the financial crisis.
But the confluence of a generational type of financial crisis, massive recession, and recent massive acquisition by the bank is basically a “perfect storm” unlikely to ever repeat itself.
They actually already announced that they plan on increasing their dividend by 11% to $0.31 quarterly, so that dividend growth streak is about to grow to nine consecutive years. The official declaration is imminent.
Meanwhile, the five-year dividend growth rate stands at 12.4%.
Right in line what we already know the next dividend increase will be.
Said another way, this bank is regularly increasing its dividend in the low double digits.
With a payout ratio of 32.2% (based on the new dividend), there’s still clearly plenty of room for continued dividend growth.
And the stock now yields 2.81%.
That’s a market-beating yield that’s also ~110 basis points higher than the stock’s own five-year average.
The dividend offers a lot to like.
Low payout ratio, appealing yield, double-digit dividend growth, and clear commitment to future raises.
Of course, estimating what those future dividend raises might look like is very important.
After all, we invest in where a company is going, not where it’s been.
Revenue and Earnings Growth
Estimating future dividend growth will require us first to estimate future profit growth. The former should grow roughly in kind with the latter over the long run.
I’ll first show you what the bank has done over the last nine years in terms of top-line and bottom-line growth.
And then I’ll compare that to a near-term professional forecast for profit growth.
Combining the proven past with a future forecast like this should tell us a lot about the company’s potential trajectory.
Note: I usually like to show a decade’s worth of growth. However, FY 2009 marked a trough for the bank’s numbers. The financial crisis bottomed out in that year. Using FY 2009 numbers incorrectly skews our results.
The bank grew its revenue from $13.875 billion in FY 2010 to $15.986 billion in FY 2018.
That’s a compound annual growth rate of 1.79%.
Not excellent.
I look for mid-single-digit top-line growth from a fairly mature firm like this.
However, Bank of New York Mellon, like most banks, had a hard time getting traction when coming out of the Great Recession. Heavy regulations were imposed after the GFC, and this has had the effect of limiting banks’ growth.
Meanwhile, earnings per share increased from $2.06 to $4.04 over this period, which is a CAGR of 8.78%.
That’s more like it.
A combination of buybacks and margin expansion helped to fuel that excess bottom-line growth.
The outstanding share count is down by approximately 17% over the last nine years.
And the bank recently announced a plan to repurchase up to $3.94 billion in shares by mid-2020. This is almost 10% of the current market cap ($42.25 billion).
Looking forward, CFRA is predicting that Bank of New York Mellon will compound its EPS at an annual rate of 2% over the next three years.
This would obviously be quite a drop from what transpired above.
To be fair, though, more recent growth has stalled a bit.
For their part, CFRA notes a challenging backdrop for banks in general.
Interest rates have stayed extremely low for an extremely long time. We’re in uncharted territory, and this creates a headwind for all banks.
That said, the bank heavily relies on a fee-based structure.
Even that, though, has been difficult of late, with fee revenue dropping YOY for FY 2019 Q2.
The thing is, the bank is still in a great position to continue growing its dividend at a very strong rate for years to come.
The most recent announcement of a double-digit raise was evidence of that. In fact, that dividend raise only came to pass because regulators saw the bank was in such healthy condition.
Their payout ratio is very low. And the bank continues to buy back a lot of stock.
Even if the 2% forecast comes true, the positioning is such that they have the wherewithal to continue increasing the dividend at least in the mid-single-digit range for the foreseeable future.
Financial Position
Moving over to the balance sheet, we have further evidence of great positioning.
Banks in general, since the reckoning of the GFC, have been forced by regulators to keep healthy balance sheets.
The company has a long-term debt/equity ratio of 0.72, while the interest coverage ratio is over 8.
Long-term senior debt is rated A1 by Moody’s, and A by S&P. Investment grade.
Profitability is strong.
Over the last five years, the bank has averaged annual net margin of 21.86% and annual return on equity of 9.18%.
Net margin over the last few years is particularly impressive. ROE is unfairly punished by low common equity (due to treasury stock from buybacks).
Overall, I think there’s a lot to like about Bank of New York Mellon.
They largely operate a sticky, fee-based business model that’s focused on high-value financial infrastructure. This isn’t a community bank.
Operations have improved dramatically since the GFC.
Heavy regulation is both a gift and a curse.
The curse is that growth is capped. The gift is, the risk of investing in a bank like this is substantially reduced compared to what it might otherwise be.
Large US banks are now essentially financial versions of a utility, especially Bank of New York Mellon.
Regulated growth keeps things moving in an orderly, if constrained fashion. There are the big and growing dividends. And it’s all backed by what are basically essential services.
Except banks feature much, much lower valuations than utilities.
This is probably why Warren Buffett has been busy buying up banks over the last few years, including Bank of New York Mellon.
Of course, there are risks.
Regulation, litigation, and competition are omnipresent in all industries.
A key risk for this banks, as well as all banks, is the low interest rate environment that has persisted longer than most would have anticipated. And rates may even go lower in the near term, further putting a cap on things.
Bank of New York Mellon does have a sizable asset management business, which faces its own risks (fee compression, exposure to markets, etc).
And any major global economic crisis, even if it’s not on par with the GFC, would almost surely impact Bank of New York Mellon in a significant way.
Even with the risks, though, this bank looks compelling for the long term.
Stock Price Valuation
I say that with the valuation in mind, which looks very attractive…
The stock is trading hands for a P/E ratio of 11.46.
Incredibly low against the broader market, but it’s also markedly lower than the stock’s own five-year average P/E ratio of 16.2.
The multiple on cash flow is coming in at 7.3, which is almost half of the stock’s three-year average P/CF ratio of 13.0.
Also, the book value for Q2 FY 2019 came in at $40.30. So the stock is trading for just over its book value.
And the yield, as discussed earlier, is substantially higher than its own recent historical average.
So the stock looks very cheap. 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 7.5%.
In my view, that’s a cautious DGR. I’m being conservative with the model.
The low payout ratio, continued buybacks, and healthy fundamentals should add up to a floor of 7.5%.
However, the challenging environment warrants erring on the side of caution.
The DDM analysis gives me a fair value of $53.32.
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.
My model wasn’t being aggressive.
Yet the stock still looks severely undervalued right now.
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 BK as a 3-star stock, with a fair value estimate of $48.00.
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 BK as a 3-star “HOLD”, with a 12-month target price of $48.00.
I came out a bit high. But we all agree that the stock is worth more than its price. Averaging the three numbers out gives us a final valuation of $49.77. That would indicate the stock is possibly 13% undervalued.
Bottom line: Bank of New York Mellon Corp. (BK) is a high-quality company focused on a high-value, fee-based business model that provides critical financial infrastructure. It’s one of Warren Buffett’s favorite stocks, and I can see why. With a market-beating yield, recent double-digit dividend raise, extremely low payout ratio, and the potential that shares are 13% undervalued, this stock could be an appealing long-term play for dividend growth investors.
-Jason Fieber
Note from DTA: How safe is BK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 73. 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, BK’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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