Paying A Fair Value For The Dividend Champions

|
Includes: BEN, CL, CTBI, EV, JNJ, KO, PNR, T, THFF, TROW, WMT
by: Eli Inkrot

Summary

The Dividend Champions are a great place to look for high-quality businesses.

This article looks for companies that are currently trading below their average historical valuations.

Yet even if a company does not meet this test, this does not necessitate that it now must be a “poor” investment.

My intent for this article was to provide a list of Dividend Champions trading below their average historical valuations. The Dividend Champions, as compiled by fellow Seeking Alpha contributor David Fish, represent companies that have not only paid but also increased their respective payouts for at least 25 consecutive years.

Focusing on these companies does not guarantee success, but it can certainly up the ante in terms of quality - think Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ) or Colgate-Palmolive (NYSE:CL). As such, you might presume that there could be a bit of a "premium" valuation for a number of these companies. So it doesn't make a lot of sense to compare the valuation of the Dividend Champions to that of the market average as a whole. If you're buying a Porsche you're not going to be checking in on the latest quote for a Honda.

Instead, it can be useful to compare the current valuation to the security's own past. Now there are a number of ways to do this (pre-tax, post-tax, yield, trailing P/E, forward P/E, etc.). For this illustration I looked at the trailing P/E ratio in comparison to the 5-year average and 10-year average marks for each company.

The results were not especially compelling. Out of more than 100 companies surveyed, I found just 13 that had a trailing P/E ratio that was lower than both the security's 5-year and 10-year historical average. Granted you can make the argument that a trailing mark may not be as informative, and the past results are certainly not indicative of the future.

Still, I found that to be interesting. We're talking about average valuations here, not nominal earnings rates or something that doesn't grow as the company does. An earnings multiple doesn't expand or contract forever, so it can be a fair (albeit admittedly limited) test.

Here's a look at some of the companies that stood out:

Pentair (NYSE:PNR). Shares had routinely traded with an earnings multiple in the high-teens. Since the beginning of 2014 the share price is down about 35%, bringing the trailing earnings mark closer to 13 or thereabouts. Given that the company still expects to generate over $4 per share, the forward-looking multiple also happens to around this mark.

Asset Managers. This includes T. Rowe Price (NASDAQ:TROW), Franklin Resources (NYSE:BEN) and Eaton Vance (NYSE:EV). Incidentally, I have previously highlighted both Franklin Resources and T. Rowe Price as being potential "triple threat" investments, when it comes to earnings, dividends and a potentially compelling valuation. The upside is that the valuations are low when compared to the past. The downside is that the valuations could be low for a reason - namely declining AUM and general concerns related to the respective business models.

Regional Banks - Community Trust Bancorp (NASDAQ:CTBI) and First Financial Corp. (NASDAQ:THFF). A lot of times when you look at the history of banks, you'll notice a tremendous dividend cut during the most recent recession, a now lower payout ratio and a generally lower valuation. These two companies share in the low comparative valuation, but are somewhat distinguished in that the dividend has been increasing for decades, even during the recession. Both companies pay out less than half of their earnings as dividends and still have a 3%+ dividend yield.

Just as interesting to me is that nearly 9 out of every 10 Dividend Champions are trading at current valuations above their historical average. Personally, this underscores the notion that it's getting more and more difficult to find truly excellent businesses at "value" prices. It also reminds me of Buffett's famous quote: "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

When you do screens like the one above you're obviously going to limit the process. In the above example, there was propensity to come across financial companies; likely related to both sentiment and general concerns about future earnings.

Yet I'm reminded that just because you don't find the "best" deal, this does not simultaneously indicate that all is lost. There's all sorts of examples out there.

Take a company like AT&T (NYSE:T). The share price is up about 18% in the last six months, which naturally would dissuade a good deal of investors from buying today. By the way, I don't necessarily disagree with that sentiment. Yet it can be instructive to consider the possible returns from here anyway.

You're still starting with a 5% dividend yield. Earnings are expected to grow in the mid-single digits. Should shares later trade at say 14 times earnings, you could still be looking at 8% or 9% annual gains. The results are certainly not as impressive as they would have been, but this does not automatically signal that it now must be a "poor" investment.

Or look at something like Wal-Mart (NYSE:WMT). When shares were under $60 the security would have qualified in the screen above. Today, with a share price closer to $67, you might not be as interested; which is understandable. Yet again, this doesn't mean that all is lost.

Should the company execute on its growth plan, the company has the ability to earn perhaps $5.50 per share in the next five years. At 15 times earnings, plus the dividend, that equates to a total annualized return of 6% or 7%. If better results come about, you'd anticipate better investment performance. The idea is that once a security increases by 10%, it shouldn't automatically be dismissed from your radar, never to pop up again.

Even something like Johnson & Johnson illustrates this concept nicely. For a long time, you could have purchased shares at or below 15 times earnings. This "skewed" the average historical mark, and thus when you run a screen for this criteria this company won't come up on your list. Yet that doesn't mean it can't be a great way to build wealth. Even if shares once again trade around 15 times, with a 6% growth expectation you could still be looking at 7% or 8% annual returns.

In short, if you're looking for high quality companies trading at or below their historical valuations you'll likely notice a couple of things. First, you will come up with a list. As highlighted above, companies like Franklin Resources or Community Trust will be highlighted. These may or may not be the types of companies that you'd be interested in; so it's important to recognize the limitations that come with this exercise.

Just as noticeable are the companies that won't make that list. This doesn't mean that they still can't be solid investments. It's important to take a wide view in this sense, and consider both quality and the idea that a slightly higher valuation could still be reasonable. Nobody likes to overpay, but it should be highlighted that in the investment world, especially over the long-term, it's usually not the difference between positive and negative.

Disclosure: I am/we are long JNJ, KO, T.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.