The stock market has a volatile nature to it over shorter periods of time.
Up. Down. Back around.
But I challenge you to look at the market through a long-term prism.
If you do that, you’ll discover the truth.
The stock market progressively marches upward over the long haul.
It’s certainly changed my life.
I learned about this little “secret” back in early 2010.
Immediately seeing the potential, I put my money to work in high-quality dividend growth stocks for the long term.
I’m talking about stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
I started investing while I was totally broke.
Yet I ended up financially independent and retired in my early 30s – just six years after learning and taking advantage of this truth.
I even lay out exactly how I did this in my Early Retirement Blueprint.
My FIRE Fund, which is my real-money stock portfolio, generates enough five-figure passive dividend income for me to live off of.
Better yet, that dividend income routinely grows year in and year out. It grows faster than my expenses do, greatly increasing my purchasing power.
That’s because I’m a dividend growth investor who invests in stocks that pay reliable and rising dividends.
But you first have to learn, accept, and take advantage of that simple truth about the stock market.
Of course, you also have to go about investing in an intelligent manner.
Dividend growth investing is a fantastic strategy that practically builds intelligence right into it.
That’s largely due to the way it naturally limits one to some of the best stocks in the world.
Only world-class enterprises are able to pay out increasing dividends like clockwork over the long term. It’s almost impossible to run a low-quality business while simultaneously writing ever-larger checks to shareholders for years and years.
But one still needs to analyze a business before ever investing a dime.
And valuation at the time of investment is critical.
While price is what you’ll pay for a stock, it’s value that you get for your money.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
All else equal, because price and yield are inversely correlated, a lower price results in a higher yield.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
These favorable dynamics also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects the investors downside against unforeseen issues.
An undervalued high-quality dividend growth stock can be a tremendous long-term investment.
Fortunately, it’s not difficult to find these stocks.
Fellow contributor Dave Van Knapp has made the valuation process much easier.
Check out Lesson 11: Valuation.
Part of his comprehensive series of “lessons” dividend growth investing, Lesson 11 lays out an easy-to-follow valuation template for dividend growth stocks.
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…
Invesco Ltd. (IVZ)
Invesco Ltd. (IVZ) is a global asset manager that provides investment management services to both retail and institutional clients.
With $1.2 trillion in assets under management, Invesco ranks as one of the largest asset managers in the world.
Retail clients account for 71% of AUM, with the remaining 29% being from institutional clients.
Approximately 72% of the firm’s AUM is held by clients from the Americas; 12%, Continental Europe; 10%, Asia; 6%, UK.
AUM can be broken down into active (~77%) and passive (~23%).
AUM is also broken down by investment type: equity, 48%; fixed-income, 23%; alternative investment, 16%; money market, 8%; and balanced, 5%;
I started off today’s article highlighting the stock market’s progressive march upward over time.
Well, large asset managers directly benefit from that. They have huge exposure to equity markets, which means their AUM increases when the market marches upward.
Shareholders in large asset managers directly benefit from this, too.
When AUM increases, the amount of fees an asset manager can collect increases. That increases the potential for revenue, profit, and dividends.
The race to zero on fees, large capital moves to passive funds, and industry consolidation means that companies need scale to survive.
Invesco knows this. And they’re making the necessary moves.
The company recently closed on its ~$5.7 billion acquisition of OppenheimerFunds, Inc., which moved Invesco up to its position as the sixth-largest asset manager in the United States.
This move added scale in an industry where scale matters very much. It also added opportunities for synergies; Invesco believes that shareholders could expect up to $0.58 in accretion to 2020 EPS.
Invesco’s prudent management and enhanced scale bodes well for its ability to grow its dividends for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 10 consecutive years.
The 10-year dividend growth rate is 8.6%.
I’m always pleased to see a high-single-digit long-term dividend growth rate.
However, I’m particularly pleased to see that kind of dividend growth when it comes attached to a very high starting yield.
Well, check this out.
The stock yields a monstrous 7.35% right now!
This yield is more than three times that of what the market offers.
It’s also more than 340 basis points higher than the stock’s own five-year average yield.
You’d be hard-pressed to find many other stocks in the market that will offer a 7%+ yield and a long-term dividend growth rate over 8%. That’s an incredible combination.
I will note, though, that the most recent dividend increase (announced in April 2019) came in at only 3.3%.
But a starting yield of over 7% doesn’t need huge dividend raises to make sense of the numbers.
Now, this kind of yield would usually leave me wondering just how safe it is.
Yield is often (but not always) a proxy for risk. A stock yielding over 7% tends to indicate some kind of immediate trouble with the dividend sustainability.
But that doesn’t appear to be the case here.
Revenue and Earnings Growth
To calculate the payout ratio, I’m using adjusted EPS for Q2 and Q3 FY 2019, due to the way the OppenheimerFunds acquisition has skewed GAAP EPS over the last two quarters.
The payout ratio, using those adjustments, comes in at 59.9%.
A tad high. And that’s admittedly after adjusting for the recent volatility in GAAP results.
I’m not saying this is your bluest blue-chip dividend, but it doesn’t look to be in any immediate danger, either.
Of course, the past is the past.
We in invest in where a company is going, not where it’s been.
I’ll now try to build out a forward-looking growth trajectory, which will tell us a lot about what this company and its stock might be worth.
I will first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional forecast for EPS growth.
Combining the proven past with a future forecast like this should give us a reasonable path to track.
Invesco grew its revenue from $2.627 billion in FY 2009 to $5.314 billion in FY 2018.
That’s a compound annual growth rate of 8.14%.
This is obviously impressive.
I usually look for mid-single-digit top-line growth from a fairly mature company like this.
Invesco blew past that.
However, I think there is a huge caveat to this story.
We’ve witnessed one of the longest bull markets in US stock market history play out over the last decade.
This has had the effect of being a tide that lifts all boats, meaning even mediocre organic AUM growth can be masked by the way total AUM (and the fees it generates) can increase in a rising market.
The company’s EPS rose from $0.76 to $2.14 over this period, which is a CAGR of 12.19%.
Again, impressive. Again, there’s that aforementioned caveat.
I will note that FY 2018 EPS included a subpar Q4, due to extreme US stock market volatility toward the end of 2018 that negatively affected Invesco’s results. Barring that, FY 2018 EPS would have come in higher and the long-term EPS CAGR would have been even better.
Share buybacks have not been significant, but the outstanding share count is down by almost 6% over the last decade.
Looking forward, CFRA believes Invesco will compound its EPS at an annual rate of 5% over the next three years.
This would be a much lower growth rate than what Invesco has produced over the last decade. But I think that’s a fair assessment.
The industry-wide downward pressure on fees is cited as a concern by CFRA. It’s a concern I share.
There is also the fact that the US stock market is much higher today than it was a decade ago – both in absolute and relative terms. Matching the past growth rate is therefore very difficult. Moreover, the enhanced scale that Invesco now has also works against the firm, due to the law of large numbers.
That said, the company has positioned itself well here.
In addition to the OppenheimerFunds acquisition, Inveso has been busy buying up ETF firms to bolster its passive exposure and further enhance scale. The 2017 acquisition of Source and 2018 acquisition of Guggenheim’s ETF business are examples of this.
Investment assets are sticky by their very nature. But passive assets are even stickier, due to the low fees, industry-wide trends, and very nature of one being hands-off with their investments.
I think a 5% EPS growth rate over the next three years would be good enough to support similar dividend growth.
And it’s hard to imagine shareholders being upset with mid-single-digit dividend growth layered on top of a 7%+ starting yield.
Moving over to the balance sheet, Invesco’s maintains a rock-solid financial position.
The long-term debt/equity ratio is 0.28, while the interest coverage ratio is just over 11.
Profitability is robust in absolute terms, but Invesco has a lot of room for improvement relative to their peers.
Over the last five years, the firm has averaged annual net margin of 18.49% and annual return on equity of 11.53%.
This stock offers a lot to like.
The company has strong fundamentals across the board. Management appears to be rising to meet its challenges. And the yield is obviously highly attractive.
But there are risks to consider.
Competition, litigation, and regulation are omnipresent risks in every industry.
Invesco has enhanced its scale and bolstered its passive offerings, but industry-wide trends remain a long-term challenge. There’s the race to zero on fees. And the secular trend toward passive offerings is clear.
The most recent quarter showed a minor net outflow in AUM. Not concerning in and of itself, but the majority of the gross outflow occurred in Invesco’s active offerings, which disproportionately reduces fees.
Invesco’s investment performance in its active offerings has been questionable over the last five years.
Stock Price Valuation
And there’s also the matter of the stock market being elevated in absolute and relative terms, which could be setting up Invesco to perform rather poorly over the next 10 years.
Even with those risks known, the valuation appears to be more than pricing all of it in…
The stock trades hands for a P/E ratio of just 8.15 (using adjusted TTM EPS).
Even for a business model with some legitimite questions surrounding it, that’s absurd.
We’re talking a P/E ratio less than half that of the market. It’s also much lower than the stock’s own five-year average P/E ratio of 14.8.
There’s also the matter of the P/S ratio, at 1.2, coming in at about 50% lower than the stock’s five-year average P/S ratio of 2.8.
And the yield, as noted earlier, is materially higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (due to the high yield).
And I assumed a long-term dividend growth rate of 3%.
This long-term DGR model is markedly lower than the company’s own 10-year DGR.
But I think there’s a very real question about whether or not the AUM is a melting ice cube. Moreover, the most recent dividend increase came in at only 3.3%. So I don’t think it’s too far off from what the real potential is.
CFRA’s three-year forecast for EPS is 5%. Assuming Invesco maintains some flexibility with the payout ratio, keeps the balance sheet in check, and looks for bolt-on acquisitions for additional passive offerings, I would expect the dividend growth to come in slightly lower than EPS growth.
Thus, I believe a 3% dividend growth rate is a reasonable, if cautious, assumption.
The DDM analysis gives me a fair value of $25.54.
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.
This was not an aggressive valuation model. Yet the stock still looks extremely cheap.
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 IVZ 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 IVZ as a 4-star “BUY”, with a 12-month target price of $19.00.
I came in high, which is surprising. Averaging out the three numbers gives us a final valuation of $21.85, which would indicate the stock is possibly 29% undervalued.
Bottom line: Invesco Ltd. (IVZ) is one of the largest asset managers in the world. The fundamentals are solid. And management is reacting to industry trends. With a 7%+ yield, 10 consecutive years of dividend raises, a moderate payout ratio, a long-term dividend growth rate near 10%, and the potential that shares are 29% undervalued, this dividend growth stock could be one of the most appealing combinations of income and growth available right now.
Note from DTA: How safe is IVZ’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 41. 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, IVZ’s dividend appears Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.
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