Fellow Seeking Alpha author David Van Knapp recently published a series of articles discussing the valuation characteristics of popular dividend growth stocks. His first article titled: Which Popular Dividend Growth Stocks Are 'Always' Overvalued? addressed popular growth stocks that had a penchant for being overvalued (I call it a quality premium valuation).
I prepared an addendum article to Dave's fine work in order to provide some additional clarifications on his overvalued group titled: Supporting David Van Knapp's Views On Popular Dividend Growth Stocks That Are Always Overvalued. This article is offered to provide additional insights on his second article titled: Which Popular Dividend Growth Stocks Are 'Always' Undervalued? where Dave discussed popular dividend growth stocks that have a penchant and or a legacy of being undervalued.
I felt that both of Dave's articles were addressing a very important principle regarding the valuation of common stocks that prospective retirees or dividend growth investors seeking a reliable and growing dividend income stream should be cognizant of. Throughout my history of writing articles on sound investing practices, I routinely emphasize the importance of valuation. Personally, I consider valuation one of the most important considerations that should be in the forefront of every prudent investor's mind.
With that said, I am a strong believer that there are sound and rational fundamental principles underpinning intrinsic value, fair value, sound value, true worth, or whatever you prefer to call it. These fundamental principles are rooted in the amount, reliability, velocity and even the consistency of the cash flows a given company is capable of generating on behalf of its stakeholders. More simply put, the bottom line about valuation is the cash flows and earnings that a given company (business) produces over time. After all, it is from earnings and cash flows that dividends are paid.
Moreover, there are many methods of calculating fair value, including the very popular discounted cash flow (DCF) formulas. Frankly, I consider these extremely valid and reliable approaches that investors can utilize to ascertain a reasonable understanding of the value of any business they are considering investing in. However, as it is in most all aspects of life, there will always be exceptions to every rule. Consequently, I suggest that investors think of valuation as a guide over thinking of valuation in absolute terms.
Consequently, when I first developed the earnings and price correlated research tool F.A.S.T. Graphs™, I had it programmed to provide metaphors of valuation based on two widely-accepted formulas for valuing a business utilizing variations of the discounted cash flow (DCF) methodology. This valuation tool also utilizes a third formula which is, in effect, an extrapolation between the two primary formulas. Additionally, since I recognize the fact that there is an exception to every rule, I added an additional valuation metaphor called the normal P/E ratio.
However, and most importantly, I have always understood and recognized that these valuation metaphors represented guides that can help investors make sound and rational buy, sell or hold decisions on common stocks. With that said, and understood, I could then evaluate any business I was interested in through the utilization of these valuation guides or metaphors. On the other hand, instead of insisting that these valuation guides represented fair value in the absolute sense, I suggest that they be used as "tools to think with" so that investors could properly analyze the specific characteristics regarding valuation that they reveal.
In the process of researching thousands of companies over several decades with the help of my valuation tool, I recognized the precise reality that David Van Knapp was addressing with his articles. There truly are certain companies, and even certain industries that are typically capitalized by a different standard than what widely-accepted formulas would indicate. This doesn't mean the formulas are wrong, nor does it mean that Mr. Market is constantly mis-pricing these companies. Instead, it indicates to me at least that there are other extenuating factors involved.
Perhaps, and I would embrace this notion, that understanding the source of these deviations from the norm might be extremely important knowledge or information to have. In the same vein, I believe that it might also be impossible to know for sure. In other words, we can offer hypotheses and/or theories about why Mr. Market might overvalue and/or undervalue certain companies over others, but again, I don't believe we can truly know for sure. However, in my mind's eye, it's more important to know that these valuation anomalies do in fact exist, over why it might be true.
The Energy Sector A Legacy Of Low Valuation
David Van Knapp separated his undervalued examples into two different groups and I quote as follows:
"In this search for perpetual undervaluation, I found that the stocks divided into two groups. In the first group, the stocks display persistent undervaluation for nearly the full 15 years of the study period, both before and after 2008. In the second group, they display persistent undervaluation since 2008."
I felt that Dave's observation was astute; however, I might add that I believe there are other groupings that could be presented as well. However, with this article I will stick with a discussion of the two subgroups that Dave discussed. Moreover, I will further limit the scope of my article with a discussion about two industry groups that Dave featured. The first group is the Energy sector. For whatever reasons, as I alluded to above, Energy stocks in general, and big oil concerns more specifically, have tended to command a discounted valuation in recent history.
Perhaps this may relate to risks that the market sees in the Energy sector that they don't see in other, more traditional industries. One of these risks may relate to the modern obsession with our environment, with many people believing that big oil is a major source of polluting our environment. The legal risks may represent an offshoot of those feelings towards energy companies. Furthermore, most big oil companies also possess cyclical characteristics with their earnings results. A potential for obsolescence may also factor into people's thinking.
Nevertheless, whatever the truth may be, the fact is that the Energy sector has commonly been valued at single-digit P/E ratios by Mr. Market in recent times. Therefore, and once again I contend that it may be more important to know that this exists, than why it exists. Because once you recognize and understand the value adjustment that the market places on energy stocks, then as an investor you are better prepared to make sound decisions as to what valuations make the most sense when considering to buy, sell or hold energy stocks.
In order to illustrate the typical undervaluation of energy stocks, I will provide examples on the two major players Chevron Corp. (CVX) and Exxon (XOM). Moreover, as I did in my first article I will shorten the timeframe from the 15 years that Dave presented, to a shorter timeframe of 9 years, or since calendar year 2005. There are two primary reasons behind this decision, but neither of them have anything to do with studies. Instead, they have to do with normalizing starting valuation levels in order to more meaningfully measure performance results.
My first primary reason is to review a period of time where both of these companies were trading within a normal range of their typically discounted valuation. In other words, I am purposely eliminating a period of time where either aberrantly high or low starting valuations may have been manifest. Therefore, I will then measure performance based on the rational idea of investing in energy stocks when valuations are at logical and normal levels for this specific industry.
My second reason is to provide the reader a clear picture of what normal valuation looks like for this industry in contrast to what the typical formulas for fair value discussed above would indicate. In other words, this timeframe vividly reveals the clear low double-digit or single-digit discount P/E ratios that these businesses normally command.
With Chevron, the reader should note that a normal P/E ratio of approximately 9 represents a very strong proxy for how the market traditionally values this company. In other words, note how the monthly closing stock price (the black line) nicely tracks the calculated normal P/E ratio of 9 (the dark blue line). Importantly, the reader should further note that they should think of this as a reasonable range of valuation over an absolute number. More simply stated, you might think of it as a P/E ratio valuation range of something like 9-10.
In the case of Exxon, the same rationale applies, except that Exxon has typically been valued at a normal P/E ratio of 11.3. Just as you did with the Chevron example, note how the price tracks the normal P/E ratio line. Again, think of it as a range of valuation over an absolute. The point being for both cases a careful review and analysis would indicate these respective valuations as excellent guides with which to make investing decisions upon. More simply stated, I personally would be reticent to invest in Chevron at anything much over 9 times earnings, and similarly I would be reticent to invest in Exxon at any P/E ratio north of 11.
Exxon Mobil Corp
The Aerospace & Defense Sector
The second subset that Dave referenced in his articles dealt with companies whose undervaluation only applied more recently since 2008. One sector that stands out is the Aerospace & Defense Industry. Therefore, my next two examples will cover Raytheon Company (RTN) and Lockheed Martin Corp. (LMT), two stalwarts.
I believe the most important point that should be revealed here is that these companies are suffering undervaluation because of the shift in government policy towards their industry. In other words, prior to that shift by the government, companies in this industry, tended to sell at more normal valuation levels. Therefore, their lower valuation metrics have not been as chronic as we saw in the energy examples above. Instead, they are more indicative of a significant change (lower expected growth rates) in their abilities to continue growing at historical rates.
Therefore, I ask that the reader focuses on how the slope of the orange line on both examples flattens considerably post 2008. In other words, this represents a significant shift in the future prospects over a typical penchant to undervalue them. In many ways, I feel it is much easier to understand a reset of the valuation of this industry, than it is to understand or know why it chronically occurs in the Energy sector.
Lockheed Martin Corp
Summary and Conclusions
In closing, I hope that the reader recognizes the importance of knowing how Mr. Market may typically value certain industries or businesses. Even though they may not fit the perfect mold of fair valuation, it does not invalidate the principles of fair value. Instead, it represents the reality that there do exist factors that cause the market to assess their businesses differently than it does other companies operating in other industries. This is a critical piece of information to possess, at least in my opinion. And as the saying goes "it's not mine to wonder why," but I will add that it is mine to recognize and know.
Disclosure: Long CVX, LMT at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.