This article first appeared on Dividends & Income
Some business models are practically built to print money.
It’s just a natural course of doing business in certain cases.
This is due to inherent competitive advantages.
Inherent competitive advantages can give special businesses a big leg up on other businesses.
But one first has to identify the appropriate stocks, and recognize attractive value.
Well, that’s what today’s article is all about.
I’ve been investing in high-quality dividend growth stocks for a decade now.
Many of these stocks have those aforementioned inherent competitive advantages, which is how they’re able to stack up decades’ worth of dividend increases.
See what I mean by perusing the Dividend Champions, Contenders, and Challengers list.
Investing in these stocks has treated me very well.
I built my FIRE Fund by living below my means and plowing my excess capital into these stocks.
And that allowed me to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
I now collect and live off of five-figure passive dividend income.
Talk about reliable!
Inherent competitive advantages are shining through more than ever.
But even a great business with these advantages has to be invested in at the right valuation.
Price is only what you pay. Value is what 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.
Investing in a business with inherent competitive advantages, and doing so when the valuation is appealing, can lead to superior results over the long term.
Fortunately, the valuation part of the equation is pretty simple to figure out.
Fellow contributor Dave Van Knapp’s Lesson 11: Valuation has made it easier than ever to estimate valuation.
Part of a larger, more comprehensive series on dividend growth investing, Lesson 11 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…
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.
Founded in 1853, Travelers is now a $29 billion (by market cap) giant in the insurance space, employing over 30,000 people and doing business in four different countries.
It’s the only property and casualty insurance company in the Dow Jones Industrial Average, which shows its blue-chip colors.
Net written premiums for FY 2019 break down across the following segments: Business and International Insurance, 54%; Personal Lines, 37%; and Bond & Specialty Insurance, 9%.
I mentioned inherent competitive advantages at the outset of the article.
Insurance is a classic example of built-in profit.
Whereas a lot of people might think insurance companies make their money off of the premiums they charge for their insurance, that’s actually not the case.
The true source of an insurance company’s profit is the float.
This is the capital that builds up as a natural course of doing business.
An insurance company charges premiums up front. And they later pay out claims against those premiums.
But the lag between these two events often leads to an insurance company sitting on a lot of cash – which is a low-cost and low-risk source of capital that earns returns. It’s somewhat similar to a bank deposit scheme.
For perspective on that, Travelers manages an investment portfolio worth over $77 billion (as of the end of FY 2019).
That portfolio is more than twice as large as the company’s market cap.
Adding further color, Travelers had net income of just over $2.6 billion last fiscal year. The investment portfolio propelled most of that, with net investment income coming in at over $2.4 billion.
The float is what makes the insurance business model so lucrative.
Warren Buffett recognized the power of the float decades ago, heavily investing in (and later buying out) GEICO.
Buffett took the inherent competitive advantage of a float and supercharged it by virtue of his investing prowess, building a $200+ billion common stock portfolio in the process and becoming, arguably, the world’s all-time greatest investor.
This inherent competitive advantage tends to lead to a lot of profit – and dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Travelers has increased its dividend for 16 consecutive years.
The 10-year dividend growth rate is 10.1%, which is really solid when paired with the stock’s starting yield of 3.01%.
That yield, by the way, is more than 80 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 48.6%, the dividend is secure.
Revenue and Earnings Growth
But this is looking backward, while investors are putting today’s capital at risk for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for Travelers.
I’ll base this trajectory first on 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 for profit growth.
Blending the proven past with a future forecast in this manner should allow us to build out a reasonable idea of where the business is going, which will later aid us with estimating intrinsic value.
Travelers grew its revenue from $25.112 billion in FY 2010 to $31.581 billion in FY 2019.
That’s a compound annual growth rate of 2.58%.
I would say this is good, but it’s not excellent.
Meantime, earnings per share climbed from $6.62 to $9.92 over this same time frame, which is a CAGR of 4.60%.
A startling 45% reduction in the outstanding share count is what led to the excess bottom-line growth here.
A decade of aggressive competition in the P&C space has left fewer opportunities for profitable underwriting.
Recent years have saw a string of large-scale natural disasters, damaging profit further.
Moreover, low interest rates have hurt the company’s ability to earn an attractive return on its investment portfolio.
And then you have the business coming out of a major recession back in 2010.
This is probably the toughest decade you could possibly throw at Travelers, yet they still put up some decent numbers.
Looking forward, CFRA forecasts that Travelers will compound its EPS at an annual rate of 6% over the next three years.
They note an immaterial amount of risk from COVID-19 related claims, but lower demand for insurance in general (due to a contraction in economic activity from the pandemic) will be felt over the near term.
In addition, low interest rates are pervasive and appear to be more of a long-term, systemic issue.
However, CFRA also notes prudent underwriting, strong buybacks, and the above-average balance sheet.
The company had a combined ratio of 96.5% last fiscal year, proving out that prudent underwriting in a tough environment. It’s about as quality as it gets in the P&C space.
I think a 6% growth forecast is appropriate, if cautious.
I’ve looked at Travelers many times over the years, and they’ve historically compounded their EPS closer to the 10% range.
So 6% is already a pretty steep drop from that, which factors in many of the issues that now confront Travelers.
Still, with a starting yield much higher than their recent average, and with expectations now so low, it wouldn’t be difficult to muster an appealing long-term result from Travelers.
Moving over to the balance sheet, the company has a rock-solid financial position.
It’s common in the insurance space to maintain a conservative balance sheet, due to the assumption of risk.
The long-term debt/equity ratio is 0.23, while the interest coverage ratio is over 7.
Their credit ratings are well into investment-grade territory.
The company’s senior debt has the following ratings: A, Standard & Poors; A2, Moody’s; A, Fitch.
The investment portfolio itself is also conservative.
94% of the investment portfolio is in fixed maturity and short-term investments. And 43% of the carrying value is exposed to fixed maturities with a credit rating of Aaa.
Profitability is robust, although the competitive nature of the industry does constrain the business somewhat.
Over the last five years, the firm has averaged annual net margin of 9.43% and annual return on equity of 11.39%.
This is a well-run business and a blue-chip stock.
With the inherent competitive advantage that is the float, it’s an attractive industry to expose oneself to.
And when looking at Travelers specifically, its scale and ability to spread risk allows for prudent underwriting and a strong competitive position.
Of course, there are risks to consider.
Competition, litigation, and regulation are omnipresent risks in every industry.
Natural catastrophes are always a risk for any insurer, and the volatile nature of disasters can make it difficult to properly underwrite policies.
Low interest rates limit profit for the company’s investment portfolio.
And with the company’s exposure to municipal bonds means it faces risk of defaults if the finances of governments worsen.
Overall, I see this Dow Jones component as a low-risk, blue-chip stock that can make for an excellent long-term investment.
And the valuation appears attractive after a 25% drop from the stock’s 52-week high…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 16.42 – and that’s off of depressed earnings.
That’s certainly much lower than the broader market.
Then there’s the P/B ratio of 1.1, which is notably lower than the stock’s five-year average P/B ratio of 1.4.
We can also see that the P/CF ratio, at 5.2, is disconnected from its three-year average of 8.9.
And the yield, as noted earlier, is significantly higher than its 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 a 10% discount rate and a long-term dividend growth rate of 7%.
This DGR is quite a bit lower than the company’s proven dividend growth rate over the last decade.
And with a low payout ratio, large dividend increases would seem likely to persist.
However, I’m also factoring in industry headwinds, the CFRA EPS growth forecast, a severe economic contraction, and the fact that much of the previous decade’s dividend growth was fueled by an expansion in the payout ratio.
The DDM analysis gives me a fair value of $121.27.
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 analysis concludes that this stock is at least moderately undervalued.
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 $144.00.
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 3-star “HOLD”, with a 12-month target price of $126.00.
I came out on the low end here. Averaging the three numbers out gives us a final valuation of $130.42, which would indicate the stock is possibly 13% undervalued.
Bottom line: Travelers Companies Inc. (TRV) is a high-quality, blue-chip stock that benefits from one of the most powerful inherent competitive advantages out there. With a market-beating 3% yield, low payout ratio, 16-year track record of dividend raises, and the potential that shares are 13% undervalued, this could be an opportunity to invest like Buffett at a discount.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
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 78. 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.
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Source: Dividends and Income