Becoming a successful long-term investor requires overcoming a number of biases.
One of them is recency bias.
This is a phenomenon where a person most easily remembers something that has happened recently, instead of something that may have occurred less recently.
It’s never been more important to avoid succumbing to this bias.
Most of America, and a good chunk of the world, is trying to fight off a pandemic.
And global economies are in a comatose state as a result of people staying home.
But this is not a normal state.
It’s not a state we’re in 99.9% of the time. This is almost certainly not the state we’ll be in when 2025, 2035, and 2045 rolls around.
As a long-term investor, it’s imperative to remember this and invest in the most likely long-term outcomes.
That’s exactly what I’ve done as I’ve built out the FIRE Fund.
This is my real-money stock portfolio.
And it generates enough five-figure passive dividend income for me to live off of.
Not just that, but I’m only in my 30s.
As I describe in my Early Retirement Blueprint, I went from below broke at age 27 to financially free and retired at 33.
Dividend growth investing.
This strategy advocates buying and holding shares in high-quality companies that pay reliable, rising cash dividends.
You can find more than 800 US-listed dividend raisers by checking out the Dividend Champions, Contenders, and Challengers list.
Now, not every stock on that list is a great investment right now.
Fundamental analysis is critical. As is valuation.
You’ve gotta know what you own. And you have to get a good deal.
Price is what you pay. But it’s value that you get.
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. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Ignoring recency bias and getting great deals on quality businesses that will likely thrive when we return to normal sets you up for phenomenal long-term results.
Deals have seemingly become more prevalent than they’ve been in some time.
But diligent valuation hasn’t lost its significance.
Fortunately, fellow contributor Dave Van Knapp has made the process of valuation very simple.
Lesson 11: Valuation, which is part of a more comprehensive investment series he put together, provides a valuation template that you can apply to just about any 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…
Realty Income Corp. (O) is a real estate investment trust that leases freestanding, single tenant, triple-net-leased retail properties.
Founded in 1969, Realty Income has grown into one of the world’s largest retail REITs.
Their portfolio of over 6,400 properties is spread out across 49 US states, Puerto Rico, and the United Kingdom. They have over 300 tenants across 50 different industries.
Realty Income ended FY 2019 with a 98.6% portfolio occupancy. The remaining weighted average lease term was 9.2 years at the end of FY 2019.
Through incredible geographic, tenant, and industry scale and diversification, they’ve built a durable business model that’s positioned well to survive the current circumstances and thrive once we return to normal.
That’s because most of their tenants provide the products and/or services that allow us to live our everyday lives.
These industries, while subdued now, aren’t going anywhere.
Think pharmacies, gyms, convenience stores, gas stations, and grocery stores.
Best of all, buying shares in Realty Income allows you to be a “landlord” without doing any of the heavy lifting yourself.
No scouting properties, applying for loans, screening tenants, or dealing with repairs.
Plus, you immediately get exposure to a large cross-section of the American economy. Much better than just one local property in your area, which is very risky.
And they use triple-net leases, which means the tenant is responsible for net building insurance, net common area maintenance, and net real estate taxes on the leased asset.
That insulates Realty Income from a lot of responsibilities, but they’re still able to collecting those rising rent checks from tenants.
These rising rent checks get filtered down to the shareholders, which is where the rising monthly dividends come in.
Dividend Growth, Growth Rate, Payout Ratio and Yield
In fact, Realty Income has branded itself as the The Monthly Dividend Company®.
And for good reason.
They’ve paid 598 consecutive monthly dividends.
And they’ve increased their dividend for 27 consecutive years, which is every year since they’ve gone public.
The 10-year dividend growth rate is 4.7%.
This dividend growth rate hasn’t shown much acceleration or deceleration; Realty Income is incredibly consistent.
That dividend growth rate is actually pretty high when you layer that on top of the stock’s yield of 5.06%.
This yield, by the way, is more than twice as high as what the broader market offers.
It’s more than 80 basis points higher than the stock’s five-year average yield.
Their dividend is protected by a payout ratio of 85.0% (against FFO/share).
While that looks high, a REIT is legally obligated to pay out at least 90% of their net income in the form of a dividend.
Thus, REITs ordinarily operate with elevated payout ratios as a consequence of the business model.
With everything that’s going on, I would naturally expect some noticeable slowing of near-term dividend growth (perhaps even to the point of a temporary dividend freeze). However, the long-term picture (ignoring recency bias) still looks very good.
Revenue and Earnings Growth
Ultimately, though, investors are putting today’s capital on the line for future returns.
These numbers, while great, are what Realty Income has done.
We care more about what they will do.
To that end, I’ll now build out an estimated trajectory of Realty Income’s growth path.
I’ll take into account 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 prognostication of profit growth.
Blending the proven past with a future forecast in this way should give us a great idea as to where the REIT is going.
Realty Income grew its revenue from $345 million in FY 2010 to $1.492 billion in FY 2019.
That’s a compound annual growth rate of 17.67%.
Truly exceptional. The company has grown revenue at a blistering rate.
However, we have to keep in mind that a REIT often issues equity to fund growth, because of the aforementioned legal structure that prioritizes dividends.
Indeed, Realty Income almost tripled its outstanding share count over the last decade.
Looking at growth on a per-share basis provides a more accurate view.
And when looking at per-share growth for a REIT, you want to look at funds from operations instead of normal earnings.
This is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.
The company increased its FFO/share from $1.83 to $3.29 over this period, which is a CAGR of 6.73%.
Still very strong, but we can now see what the more realistic growth representation is.
Looking forward, CFRA is forecasting that Realty Income will compound its FFO/share at an annual rate of 5% over the next three years.
This projection was provided on March 5, but the pandemic situation is highly fluid.
It’s always difficult to approximate future earnings.
But it’s especially difficult right now.
The near term is very much up in the air, depending on how fast the economy can reopen.
However, the long term is a lot easier to home in on, and I think Realty Income’s FFO/share growth over the last 10 years is roughly a good baseline for future growth.
I say roughly because of the near-term uncertainty. Some of their properties may very well become impaired for a while.
In addition, I fully believe the REIT will grow slower in the future than it has in the past by virtue of its size. The larger they become, and the more properties they take on, the harder it is to grow at the same rate.
That said, they don’t have to grow fast in order to make this a very appealing investment.
With the yield of over 5.5%, and with those dividends streaming in monthly, this is a great play for consistent income in a low-rate environment.
Mid-single-digit dividend raises are more than enough for this stock to make a lot of sense.
Moving over to the balance sheet, Realty Income maintains a rock-solid financial position.
They have $8.8 billion in liabilities against $18.6 billion in assets.
Their credit ratings are well into investment-grade territory: A3, Moody’s; A-, S&P Global.
Moreover, many of their top tenants are investment-grade businesses in their own right. That includes the likes of Walmart Inc. (WMT), Home Depot Inc. (HD), and FedEx Corporation (FDX).
There’s a lot to like about Realty Income.
Buying their stock allows you instant access to an incredibly diversified commercial real estate portfolio that’s been honed and crafted over decades. You get to become a landlord without any of the headaches.
Of course, the are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Real estate is highly cyclical. Tenant health and demand for real estate are dependent on the broader economy.
This can compound problems in recessions, since the return on equity issuance is often much lower.
While broadly diversified, some of Realty Income’s tenants are facing headwinds as they relate to changes in retail.
Lastly, there’s a dearth of durable competitive advantages in real estate.
With these risks known, I still think Realty Income is a fantastic long-term investment idea.
That’s particularly true if you desire exposure to real estate. Getting monthly “rent checks” without doing the work is alluring.
And what makes this stock even more compelling right now is the current valuation.
After a 31% YTD drop in the stock price, the stock looks attractively valued for the first time in years…
Stock Price Valuation
The P/FFO ratio is 16.80.
That’s comparable to a P/E ratio.
Looking at where the broader market is, and considering the fact that this stock usually commands a P/FFO ratio around 20, this is noteworthy.
We can also look at cash flow, which is similar to FFO.
The P/CF ratio is sitting at 16.3, which is well off of the stock’s three-year average P/CF ratio of 19.1.
And the yield, as discussed earlier, is substantially higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. 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 an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 3.5%.
This DGR appears conservative when comparing it to what Realty Income has done over the last decade. Both dividend growth and FFO/share growth are measurably higher.
However, I think both near-term and long-term concerns remain about retail in general, as well as Realty Income’s size.
I would expect dividend growth to slow a bit, but that’s compensated for by the high starting yield.
The DDM analysis gives me a fair value of $64.40.
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.
The stock looks considerably undervalued from where I’m sitting.
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 O as a 4-star stock, with a fair value estimate of $65.00.
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 O as a 4-star “BUY”, with a 12-month target price of $86.00.
My valuation was within pennies of where Morningstar is at. Averaging the three numbers out gives us a final valuation of $71.80, which would indicate the stock is possibly 30% undervalued.
Bottom line: Realty Income Corp. (O) is a high-quality REIT that’s built an incredibly diversified portfolio of real estate. Buying the stock gives you instantaneous exposure to thousands of properties, allowing you to collect a monthly “rent check” without doing any work. With a market-smashing 5.6% yield, more than 25 consecutive years of dividend raises, a proven commitment to the dividend, and the potential that shares are 30% undervalued, this stock is a dividend growth investor’s dream.
— Jason Fieber
Note from DTA: How safe is O’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 86. 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, O’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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