There’s a lot to be concerned about right now.
Inflation, war in Europe, and political division come to mind pretty quickly.
But you know what?
You could have cited these same issues in multiple other eras throughout the last 100 years.
Yet investors who bought high-quality equities in those eras would have been richly rewarded in the ensuing decades.
I see no reason to believe this time is different.
And so it seems likely that investors who are buying high-quality equities now will be richly rewarded in the decades to come.
History might not exactly repeat itself, but it does tend to rhyme.
This kind of rhyme would be music to one’s ears.
However, it’s important to home in on the “high-quality equities” part of this thesis.
When I think of high-quality equities, my mind immediately goes to high-quality dividend growth stocks.
These stocks represent equity in world-class enterprises paying reliable, rising dividends to their shareholders.
They’re able to fund these reliable, rising dividends by producing reliable, rising profits.
And reliable, rising profits come from selling the products and/or services the world demands more and more of.
You can see what I mean by taking a good look at the Dividend Champions, Contenders, and Challengers list.
This list contains invaluable information on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
You’ll find some of the greatest businesses on the planet there.
I’ve been buying high-quality stocks for years.
And I continue to buy.
In the process, I’ve built my FIRE Fund.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
Regular buying of high-quality dividend growth stocks also helped me to retire in my early 30s.
My Early Retirement Blueprint explains exactly how this was accomplished.
Sticking to high-quality dividend growth stocks has been crucial to my success.
But valuation at the time of investment has also been vital.
While price is what you pay, it’s value that you end up getting.
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.
High-quality dividend growth stocks bought at attractive valuations almost always do well over the long term, regardless of how troubling near-term issues seem to be.
That said, being able to spot attractive valuations would first require one to understand valuation.
Fortunately, it’s not as difficult as you might think.
My colleague Dave Van Knapp has made valuation a concept that’s much easier to understand, via Lesson 11: Valuation.
Part of an overarching series of “lessons” on dividend growth investing, it lays out a valuation process that can be easily understood and applied to almost 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…
Morgan Stanley (MS)
Morgan Stanley (MS) is a multinational investment bank and financial services company.
Founded in 1924, Morgan Stanley is now a $135 billion (by market cap) banking giant that employs 78,000 people.
The company has three operating segments: Institutional Securities Group, 50% of FY 2021 revenue; Global Wealth Management Group, 41%; and Investment Management Group, 9%.
Under the steady hand of CEO James Gorman, who has led the company since 2010, Morgan Stanley has made impressive progress over the last decade and turned into one of the largest diversified capital markets banking institutions in the world.
The firm’s foundation is supported by two very powerful and profitable pillars.
First, Morgan Stanley is one of the global leaders in investment banking.
This includes capital raising activities, financial advisory services, and corporate lending.
The bank is often involved in major IPOs, mergers, and acquisitions.
Second, Morgan Stanley is one of the largest wealth managers in the world.
Recent acquisitions of E-Trade and Eaton Vance have scaled the bank’s presence in this space, further increasing its asset base and the fees it can collect.
With global asset values almost certain to continue rising over the long run, Morgan Stanley should disproportionately benefit as a result of its scale.
For perspective on this scale, Morgan Stanley ended last fiscal year with $4.9 trillion in client assets under management.
The way I see it, because of these two pillars, investing in Morgan Stanley is somewhat analogous to betting on the future of capitalism.
That’s been a great bet for the last century.
Despite near-term issues with the global economy, I’m inclined to believe it’ll be a great bet over the next century.
And that bodes well for Morgan Stanley and its ability to drive its revenue, profit, and dividend higher.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has raised its dividend for nine consecutive years.
The five-year dividend growth rate is an astounding 28.5%.
Even after many sizable dividend raises over the last several years, the payout ratio is a low 41.9%.
That would portend many more sizable dividend raises to come.
However, it’s important to point out that a jaw-dropping 100% dividend increase back in 2021 skews the average.
The most recent dividend increase of 10.7%, announced in July, is something that I see as more indicative of the kind of the future dividend raises we can expect from here.
Don’t forget, the stock yields a market-smashing 3.7% – 120 basis points higher than its own five-year average.
Pairing that kind of dividend growth rate with this kind of yield is a very nice setup.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with a high-single-digit (or higher) dividend growth rate.
Impressively, both the yield and the dividend growth rate are above the upper bounds of their respective ranges.
This is a rare dividend growth stock that seems to offer the best of both worlds.
Revenue and Earnings Growth
As impressive and rare as these dividend metrics may be, they’re largely looking backward.
But investors must face the reality that they’re risking today’s capital for tomorrow’s rewards.
And so I’ll now build out a forward-looking growth trajectory for the business, which will later be instrumental during the valuation process.
I’ll first show you what this company has done over the last decade in terms of its top-line and bottom-line growth.
I’ll then reveal a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this manner should allow us to form an idea of what the firm’s future growth path could look like.
Morgan Stanley advanced its revenue from $26.1 billion in FY 2012 to $59.8 billion in FY 2021.
That’s a compound annual growth rate of 9.7%.
Great top-line growth.
I usually look for a mid-single-digit top-line growth rate from a mature company, but Morgan Stanley blew right past that.
Because of no positive GAAP EPS for FY 2012, I’ll move up the EPS starting point one year to FY 2013.
Earnings per share increased from $1.36 to $8.03 over this nine-year period, which is a CAGR of 21.8%.
Truly outstanding.
It’s easy to see how Morgan Stanley has been able to afford 20%+ dividend increases – bottom-line growth has been funding this activity.
The close relationship between EPS growth and dividend growth shows great command on the part of management.
Excess bottom-line growth has been driven by share repurchases and material net margin expansion.
Looking forward, CFRA projects that Morgan Stanley will grow its EPS at a CAGR of 4% over the next three years.
This would represent a substantial slowdown in EPS growth relative to what’s played out over the last decade.
Is this forecast realistic?
I think it is.
After all, the two pillars upon which the company stands have both been severely impacted by near-term headwinds.
First, the investment banking side of the company has seen a dramatic drop in activity throughout capital markets.
Public listings, corporate activity, and general enthusiasm for the US capital markets went into overdrive during the pandemic after a flooding of liquidity via fiscal and monetary policies propelled irrational exuberance, but this has completely reversed course in 2022.
Second, the wealth management side of the company is looking at a dramatic drop in asset valuations.
The S&P 500 alone is down by more than 20% in 2022, reducing the size of AUM and the fees that can be generated from AUM.
But these are both near-term troubles.
There’s nothing structurally wrong with the company.
I think its long-term prospects are just as good as ever.
It’s disingenuous to think the last decade is something that can be repeated ad infinitum.
But even a temporary slowdown in EPS growth doesn’t put the dividend in danger.
To the contrary, by virtue of the low payout ratio, Morgan Stanley could still grow the dividend at a high-single-digit rate over the next few years.
And when markets normalize and EPS growth recovers, an acceleration in dividend growth back to a low-double-digit level could play out.
That kind of scenario is extremely interesting, especially with a stock that’s already starting off with a 3.7% yield.
Moving over to the balance sheet, the company has a rock-solid financial position.
Financial Position
Total assets of $1.2 trillion match up against $1.1 trillion in total liabilities.
Investment-grade credit ratings for the company’s long-term debt are as follows: A-, Standard & Poor’s; A, Fitch; A1, Moody’s.
Profitability is unsurprisingly strong.
Over the last five years, the firm has averaged annual net margin of 21.8% and annual return on equity of 12%.
Notably, the company was printing single-digit annual net margin 10 years ago.
Massive margin improvement.
Overall, I see very little to fault here.
Morgan Stanley is a world-class institution that has fused together two fantastic and complementary business models under one roof.
And the company does benefit from durable competitive advantages that include global scale, a network effect, switching costs, brand power, and industry know-how.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
The financial industry is highly competitive, although Morgan Stanley’s scale mitigates competitive pressure.
On the other hand, regulation is a problem that only becomes more problematic at scale.
The company is heavily reliant on corporate actions to drive profit. As we’ve seen in 2022, economic slowdowns can result in a severe curtailment of these corporate actions by way of less market exuberance.
The company has heavy exposure to global capital markets. As we’ve also seen in 2022, anything that reduces asset values and the fees that Morgan Stanley can collect (such as geopolitical flareups or economic slowdowns) will negatively impact the company’s financial results.
I see execution risks here. Recent acquisitions of Eaton Vance and E-Trade must be properly integrated and utilized.
Lastly, the last decade’s material net margin expansion is almost impossible to repeat.
I think one should carefully contemplate these risks, but the quality of this business is compelling.
And with the stock’s pricing almost 25% lower than its 52-week high, the valuation is, perhaps, most compelling…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 11.2.
That’s markedly lower than the broader market’s earnings multiple.
And while that is right in line with the stock’s own five-year average P/E ratio, I’d argue you’re getting more for the money now than before.
Because of the moves Morgan Stanley has made, which have radically improved the firm, I think it deserves a higher multiple than it’s historically received.
And the yield, as noted 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 a 10% discount rate and a long-term dividend growth rate of 7%.
This dividend growth rate isn’t as high as I’ll go.
And when you look at what Morgan Stanley has done over the last decade in terms of its EPS and dividend growth, I might be accused of being overly cautious.
But I think this caution is appropriate.
CFRA’s near-term EPS growth forecast is only in the low single digits, the global economy is troubled, liquidity has been pulled, and geopolitical tensions remain high.
Still, the payout ratio is low, and the long-term prospects for the company are terrific.
The near-term dividend raises could very well come in a bit lower than my mark, but I also believe that Morgan Stanley could easily clear this bar when looking out beyond the next 2-3 years.
The DDM analysis gives me a fair value of $110.57.
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.
I think I put together a cogent valuation model, and it shows advantageous pricing.
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 MS as a 4-star stock, with a fair value estimate of $96.00.
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 MS as a 4-star “BUY”, with a 12-month target price of $90.00.
I came out high, but we’re all in a reasonable range here. Averaging the three numbers out gives us a final valuation of $98.86, which would indicate the stock is possibly 19% undervalued.
Bottom line: Morgan Stanley (MS) is a world-class financial institution that has only gotten bigger and better over the last decade. With a market-smashing yield, double-digit dividend growth, a low payout ratio, nearly 10 consecutive years of dividend increases, and the potential that shares are 19% undervalued, long-term dividend growth investors looking for more financial exposure ought to seriously consider loading up on this name.
— Jason Fieber
Note from D&I: How safe is MS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, MS’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
A strange force has seized control of Wall Street. Hedge funds are already moving their money… and preparing for even stranger days ahead. Over 320 hedge funds have quietly sold THIS famous stock - to prepare for a dramatic market shift. Get the strange truth from a 50-year Wall Street insider... including the name and ticker of the stock hedge funds are selling hand-over-first.
Source: Dividends & Income