Retired investors should appropriately be more concerned about safety and growth of income than about earning high returns. Note that I stated growth of income and not just income. Since retired investors no longer have the opportunity for pay raises associated with working, the potential for future inflation cannot be ignored. Consequently, for the most part they must now rely on their retirement portfolios as the source of any income increases. This reality implies that a significant portion of their portfolios be invested in equities, primarily publicly traded common stocks.
Moreover, if the opportunity for a raise in pay in order to fight future inflation is important, and I contend that it is, then it seems logical that there would be no better source of potential equity candidates than the Dividend Champions provided by fellow Seeking Alpha author David Fish, or the Dividend Aristocrats provided by S&P Capital IQ. The equities on both of these lists have histories of raising their dividends for at least 25 consecutive years. Even better, many of the names on these prestigious lists of blue-chip dividend payers have increased their dividends for 40, 50 or more years in a row.
Are Common Stocks Too Risky for My Retirement Portfolio?
There are many that unilaterally consider all common stocks a risky asset class. Much of this can be attributed to the recent ubiquitous acceptance of Modern Portfolio Theory (MPT) and their concept of volatility representing risk. Personally, I consider this a gross misinterpretation not only of the true nature of risk, but also of the prejudicial view it applies to "all" common stocks. In truth, there are many thousands of stocks, and most importantly, not all common stocks are the same. To be sure, some are too risky for retirement portfolios, while many blue-chip dividend paying stocks are not.
For example, many of the most recognized blue-chip dividend paying stocks have been in business for many decades, and in some cases for a century or more. In this respect, they have endured and even prospered throughout almost every stock market or economic crisis of modern times. Moreover, many of them provide essential products and services that are required for daily living. Considering that these same blue chips have increased their dividend for 25 straight years should say something about the quality, and therefore, safety of these high quality and elite enterprises.
In other words, I believe that the notion that blue-chip dividend paying stocks are too risky for retired investors is greatly exaggerated. However, just as there is more to risk than volatility, there are other risk considerations that should be taken into account even when you are evaluating blue-chip established dividend growth stocks. These would include, but are not limited to, a review of their balance sheets, cash flow statements, credit scores and perhaps most importantly their valuation at the time they are being considered.
When Investing in Blue-Chip Dividend Growth Stocks, Valuation Is an Important Risk Consideration
As previously stated, there are many that believe that common stocks are a risky asset class. In my own experience and personal observation, I believe this prevailing view is mistakenly based on many investors not understanding the difference between price and valuation. To illustrate my point, I offer the following example from a reader who commented in part 1 of this series (found here) as follows:
No one likes Dividend Aristocrats and Dividend Champions more than I do. Whenever I buy one of those stocks, I never sell it.
But the stock market hit another all time high today. Isn't it possible buying a Dividend Aristocrat or a Dividend Champion at this time is like buying one of those stocks back in 1999 when the stock market was extremely high?
Many investors who bought stocks in 1999, even the best of the best stocks like Exxon Mobil and Johnson & Johnson, had to wait many years for the stocks to increase in value.
I made the mistake of buying a few stocks in 1999 and had to wait many years for those stocks to increase in value. In contrast, stocks that I bought when the stock market was low in 2002 and 2009 increased in value like a rocket.
It is not the best investment strategy to purchase any stocks when the stock market is near an all time high."
I believe the above comment expressed a genuine concern by the reader. However, I respectfully offer that the reader was confusing high price with high valuation. The reason it took many years for the two blue chips he cited to increase in value was not because the stock market was at an all-time high, it was simply because both of these blue chips were trading at excessive valuations or earnings multiples.
I offer the following analysis of Exxon (NYSE:XOM) starting in 1999, which was the timeframe referenced in the above comment. At the beginning of 1999, Exxon was trading at a P/E ratio of 31.23 and the P/E Ratio at year-end was 32.20. By year-end 2000, Exxon's P/E Ratio contracted to 17.25.
It was this reduction in Exxon's elevated P/E ratio that caused its stock price to languish for so long. Consequently, as the commenter so astutely pointed out, price was at an all-time high. However, what the reader failed to recognize was that Exxon's P/E ratio was north of 30 at that time and more than twice its historical norm, or more importantly, its earnings justified valuation.
Consequently, the reader was correct that Exxon's stock price languished for many years (see the red circle on the graph below) as a result of its high valuation. But my contention is that it wasn't because Exxon's price was at an all-time high, or that the stock market was at an all-time high, it was because Exxon's valuation was excessive at that time. Today, Exxon's stock price is once again near an all-time high, however, its current valuation based on a blended P/E ratio of 12.6 is below both its historical normal valuation and its earnings justified valuation. As I've stated so many times in the past, valuation and price are not synonymous concepts.
As a result of high valuation, but not just as a result of high price, the reader was correct that shareholders that held Exxon from the beginning of 1999 to the end of 2002 would have actually experienced a capital loss as the performance report below illustrates. However, as a tribute to the power and protection of dividends, their total return was positive, albeit a very low 1.3% per annum.
This next earnings and price correlated graph and performance report for Exxon since 2004 representing the time when its P/E ratio was similar to what it is today tells an entirely different story. Investing in this Dividend Champion when valuation was aligned with intrinsic value produced a market-beating total return. Importantly, since this series of articles is focused on dividends, cumulative total dividend income was attractive and almost double what the S&P 500 generated over the same timeframe.
13 Blue-Chip Dividend Champions at or near Sound Valuation
After carefully screening the 107 companies on the Dividend Champions list, I must admit that I only found 25 that were currently at or near sound valuation. Of those 25, only 13 were what I considered large-cap blue-chip companies. On the other hand, since safety is an important thesis of this article, I was pleased to discover that these 13 large-cap companies were spread out over 6 different sectors. In addition to paying close attention to sound valuation, adequate diversification is a primary way to reduce risk.
The following 13 large-cap blue-chip Dividend Champion research candidates are presented by sector. I caution the reader that not every company on the following list is undervalued, although some of them are. On the other hand, I don't believe any of the stocks on the following list are dangerously overvalued. The reader should also note that research candidates such as McDonald's and Procter & Gamble possess long legacies of being awarded a premium valuation by the market. However, I leave it up to the reader's own judgment as to whether they are willing to pay a premium to invest in these blue chips or not.
Parker-Hannifin Corporation: (NYSE:PH)
I have highlighted this first large-cap blue-chip research candidate in order to make the point that even though the S&P 500 (the market) is currently at an all-time high, Parker-Hannifin is clearly not. This company entered 2014 overvalued, which I contend is the primary reason it has not performed well this year. However, investors should consider that you will rarely find bargains in popular stocks. The simple fact that a stock is currently unpopular is a common reason why its stock price goes on sale.
Although Parker-Hannifin only offers a moderate current yield, its dividend growth rate since 2005 makes it a strong candidate for those retired investors interested in earning an above-average total return. Total cumulative dividends moderately exceeded the S&P 500, but capital appreciation was almost twice that of the market.
Parker Hannifin has a fiscal year-end of June 30, and there are 17 analysts expecting fiscal 2015 earnings of $7.80 representing a 12% growth from last year. Additionally, 15 analysts expect fiscal 2016 earnings of $8.70 representing an additional 12% year-over-year earnings growth rate. This is typically as far out as I like to consider consensus analyst estimates.
Consequently, and assuming the analysts are reasonably correct, I consider this company available at a sound current valuation. To be clear, it is not especially cheap, but relative to most stocks and in consideration of its potential growth, I do believe it is a sound purchase today.
Wal-Mart Stores Inc: (NYSE:WMT)
Investors would be hard-pressed to find a company with a more consistent operating record than the 800-pound gorilla of retail Wal-Mart. The following 21 calendar year operating history depicting Normalized Basic Tax Adjusted Earnings (the orange line) and dividends (the pink line) only on the following graph clearly validates the incredible operating consistency that Wal-Mart has achieved (*Note: on F.A.S.T. Graphs™ exceeding 15 calendar years only every other years data is typed in, but all data is plotted on the graph).
This next iteration on Wal-Mart presents a complete F.A.S.T. Graphs™ to include monthly closing stock prices since 2008. There are two primary reasons I present this timeframe. First of all, the reader should note that earnings growth since 2008 has slowed to 7.1% from its longer-term average earnings growth rate shown above of 11.3% per annum. This should not be surprising considering this is now a company whose market capitalization currently exceeds $243 billion. However, once again the consistency of Wal-Mart's earnings growth cannot be denied.
My second reason for utilizing this timeframe was based on the importance of fair valuation. At the beginning of 2008, as the Great Recession was ending, Wal-Mart's share price was fairly valued at approximately the same level it is today. Clearly, price has closely tracked earnings over this timeframe, which is why consistent earnings growth, such as Wal-Mart has achieved, is an important consideration.
The following performance report associated with the above graph clearly illustrates how earnings growth drives capital appreciation. Earnings growth of 7.1% per annum translated into capital appreciation of 7.2% per annum that was almost identical to earnings growth. Moreover, the above graph also highlights the important contribution that dividends (the light blue shaded area) provide. By adding cumulative dividends to capital appreciation, Wal-Mart's total return balloons to 8.9% per annum. This is significantly greater than the S&P 500's total return of 5.8% per annum.
I believe that Wal-Mart's current valuation, which is below market levels, can partially be attributed to the fact that 28 analysts expect earnings for this fiscal year-end on January 31, 2015 of $5.04 or approximately 4% higher than last fiscal year's earnings of $4.84. However, there are 30 analysts that expect fiscal year-end January 31, 2016 to grow by 9% to $5.49. Consequently, I consider Wal-Mart with an above-market average current yield of 2.5% soundly valued.
McDonald's Corp: (NYSE:MCD)
My next example from these 13 blue-chip Dividend Champion research candidates is McDonald's. I chose McDonald's as an example to illustrate the concept of the market applying a premium valuation to certain blue chips as referenced above. The dark blue normal P/E ratio valuation reference line depicts a normal P/E ratio for McDonald's since 2008 of 17.3. As the graph clearly illustrates, McDonald's stock price tends to closely track this premium valuation level.
The reader should also note that McDonald's stock price at the beginning of 2008 was trading at a P/E ratio of 20.38, moderately above its normal P/E ratio of 17.3. This will become relevant when we examine McDonald's performance over this timeframe below.
The following performance table illustrates that even though McDonald's stock was trading at a premium to its normal P/E ratio at the beginning of 2008, consistent above-average earnings growth delivered above-market returns for its long-term shareholders. Total cumulative dividend income was more than twice the S&P 500 in spite of its beginning moderate overvaluation. Safety is an important underlying thesis of this article, but so is an increasing dividend income stream.
The reader should also note that McDonald's capital appreciation of 7.3% per annum was highly correlated with its earnings growth rate of 9.6% and only slightly less because of moderately high beginning valuation mentioned above. Nevertheless, the outperformance on all counts generated by this high-quality blue-chip qualifies it as an attractive and safe dividend paying investment opportunity.
With the P/E ratio overlay option, I have added the magenta historical normal P/E ratio of 17.3 to the Estimated Earnings and Return Calculator below to illustrate that McDonald's is soundly valued today if you buy into the premium valuation concept previously discussed.
Aflac Inc: (NYSE:AFL)
My last example from these 13 blue-chip Dividend Champion research candidates presents Aflac Inc., which I consider the most undervalued research candidate on the list. The first earnings and price correlated graph covers the timeframe 2001 to current. Over this period of time, we discover that prior to the Great Recession, Aflac's stock price was typically seen above its earnings justified P/E ratio valuation level of 15.
One of the important attributes of the F.A.S.T. Graphs™ research tool is the opportunity to evaluate the stock and its normal valuation over different timeframes. Therefore, since Aflac is a financial, we discover that since the Great Recession, its normal P/E ratio has been reset to approximately 10 times earnings (normal P/E ratio 9.6).
Although I admit that this is an extended period of chronic undervaluation, and understand why many would consider this quite troubling, I personally consider it an opportunity and even a gift. To be clear, I see this low valuation as a double safety net. Since my primary motivation for investing in Aflac is to achieve a safe and reliable growing dividend income stream, I am quite happy to take advantage of this long-term opportunity.
Other investors may disagree, and I understand that because recent total return performance has been subpar. However, cumulative dividend income, which is my primary goal, has almost perfectly matched the S&P 500. I might also add that I possess more patience than most investors. Nevertheless, finding a good quality A-rated blue-chip dividend-paying stock selling for less than 10 times earnings during a time when the market (the S&P 500) is trading at an extended valuation is a long-term opportunity that I cannot pass up. However, each investor should make their own decisions based on their own risk tolerances, goals and objectives.
Summary and Conclusions
The S&P 500 sits at an all-time high and this is causing many investors to avoid investing in common stocks. More importantly, it's not just the price of the market that's high; the S&P 500's current blended P/E ratio of 17.5 is also moderately high. On the other hand, the market's current valuation is not at a bubble valuation either. Some think it is, but based on actual current earnings and a reasonable expectation of future earnings, I disagree with that view.
Nevertheless, the real purpose of this series of articles is to illustrate that not all common stocks are overvalued today. In Part 1 of this series, I presented 25 blue-chip Dividend Champion research candidates that I consider currently available at sound valuations. In this Part 2, I featured the 13 large-cap members from that list.
Disclosure: Long CVX, SWK, MCD, TGT, PG, WMT, JNJ, MDT, AFL, T, ED 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.
Disclosure: The author is long CVX, SWK, MCD, TGT, PG, WMT, JNJ, MDT, AFL, T, ED.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.