The Strong Often Get Stronger!

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Includes: AAPL, ADP, AFL, BAX, BDX, CAT, CL, CLX, COP, CVX, D, DE, EMR, GE, GIS, GPC, HCP, HSY, IBM, JNJ, KHC, KMB, KMI, KO, LMT, MCD, MKC, MMM, MO, MSFT, NEE, O, OHI, PEP, PG, PM, QCOM, SBUX, SHPG, SJM, SO, T, TGT, UTX, V, VZ, WBA, WEC, WFC, WMT, XOM
by: Mike Nadel

Summary

A look back at the origin of the DG50 reveals some valuation-related surprises.

Many of the biggest gainers the last couple of years have been regarded as extremely overvalued.

Chowder, one of the best-known DGI proponents, says there's a good reason for this.

If you've spent much time here in Seeking Alpha's DGI Fun Zone, you know who "Chowder" is. He is part Beantown wise guy, part Buffalo Wild Wings pitchman, part ultra-disciplined U.S. Marine, part futbol aficionado. Most relevant for us, he is the soul of Dividend Growth Investing on this site.

Just as a bowl of his namesake New England soup is chock-full of tender clams, Chowder's articles are loaded with valuable information. They also stimulate considerable conversation. His most recent piece, Business Valuations Vs. Market Valuations, has generated more than 3,400 comments so far.

Despite his success and popularity, he has only authored 12 articles (as well as 30 Instablogs) because he doesn't particularly like the writing process. He prefers to dispense his wisdom in comment streams, which are filled with "Chowderisms," such as ...

  • I've been pounding the table for utilities for years.
  • High Quality + High Yield + High Growth of Yield = High Total Return. (This is the basis of the oft-quoted "Chowder Rule," although Chowder attributes it to Lowell Miller's teachings in "The Single Best Investment.")
  • They beat earnings and they raised guidance. They're going nowhere but up!
  • Easy peasy, babee!
  • I "average up" on companies all the time. I prefer that to "averaging down," because it means my companies are healthy and successful.
  • The companies I want to own produce income that is reliable, predictable and increasing.
  • Dividend Growth Investing is total return investing.
  • Ha!

One Chowderism I've been thinking a lot about lately:

The strong often get stronger.

Click to enlarge

While compiling the data for my previous article, The Dividend Growth 50 Trumps The Market By 300%, my thoughts turned to that Chowderism. How much stronger had the strong really gotten?

I looked back at the genesis of the DG50 project, The New Nifty Fifty, Part 1 - Dividend Growth Style, in which I revealed the 50 companies selected by my panel of 10 Seeking Alpha contributors (including Chowder).

The table within that article listed stock prices at market close Oct. 13, 2014. It also showed each company's Fair Value Estimate - a proprietary data point that tells investors what a Morningstar analyst calculates each of the thousands of stocks it covers is worth.

Well, here's something really freaky, folks:

The six DG50 components Morningstar considered most "overvalued" in October 2014 have gone up, up and away in the 21 months since then.

Click to enlarge

Meanwhile (and perhaps even freakier) ...

Seven of the 12 companies Morningstar rated the most "undervalued" suffered losses during the span.

More on that in a moment. First, let me say this:

This is not intended as a knock against Morningstar. I truly appreciate the research company, and I regularly use its Fair Value Estimates, "Moat" and "Stewardship" ratings, market data and other dope. Simply stated, nobody gets everything "right."

OK, without any further ado, here is the relevant information ...

"Significantly Overvalued" Companies

COMPANY

10/13/14

M*FVE

%OV

7/22/16

%INC

Lockheed Martin (NYSE:LMT)

172.88

141.00

22.6%

257.31

48.8%

WEC Energy (NYSE:WEC)

46.23

38.00

21.7%

65.39

41.4%

Altria (NYSE:MO)

46.05

39.00

18.1%

68.86

49.5%

Genuine Parts (NYSE:GPC)

85.98

77.00

11.7%

99.90

16.2%

Automatic Data Processing (NASDAQ:ADP)

71.95

65.00

10.7%

95.44

32.6%

NextEra Energy (NYSE:NEE)

92.79

84.00

10.5%

129.81

39.9%

Click to enlarge

"Moderately Overvalued" Companies

COMPANY

10/13/14

M*FVE

%OV

7/22/16

%INC

Dominion Resources (NYSE:D)

69.99

65.00

7.7%

78.51

12.2%

Verizon (NYSE:VZ)

48.37

45.00

7.5%

56.10

16.0%

Apple (NASDAQ:AAPL)

99.81

93.00

7.3%

98.66

(-1.2%)

J.M. Smucker (NYSE:SJM)

97.41

92.00

5.9%

152.97

57.0%

Kimberly-Clark (NYSE:KMB)

106.60

101.00

5.5%

134.63

26.3%

Walgreens Boots (NASDAQ:WBA)

60.69

58.00

4.6%

81.35

34.0%

Kraft Heinz (NASDAQ:KHC)

55.40

53.00

4.5%

88.16

59.1%

PepsiCo (NYSE:PEP)

93.94

90.00

4.4%

109.19

16.2%

Click to enlarge

"Significantly Undervalued" Companies

COMPANY

10/13/14

M*FVE

%UV

7/22/16

%INC

General Electric (NYSE:GE)

23.95

29.00

17.4%

32.06

33.9%

HCP (NYSE:HCP)

42.24

51.00

17.2%

38.90

(-7.9%)

Baxter (NYSE:BAX)

37.83^

45.63^

17.1%

46.32

22.4%

Qualcomm (NASDAQ:QCOM)

70.71

85.00

16.8%

61.15

(-13.5%)

Exxon Mobil (NYSE:XOM)

90.84

109.00

16.7%

94.01

3.5%

Chevron (NYSE:CVX)

112.03

132.00

15.1%

105.66

(-5.7%)

Emerson Electric (NYSE:EMR)

58.67

69.00

15.0%

55.81

(-4.9%)

ConocoPhillips (NYSE:COP)

68.07

80.00

14.9%

40.76

(-40.1%)

United Technologies (NYSE:UTX)

99.31

115.00

13.6%

105.13

5.9%

IBM (NYSE:IBM)

183.52

212.00

13.4%

162.07

(-11.7%)

Kinder Morgan (NYSE:KMI)

35.50

40.00

11.3%

21.22

(-40.2%)

Procter & Gamble (NYSE:PG)

83.37

93.00

10.3%

85.72

2.8%

Click to enlarge

"Moderately Undervalued" Companies

COMPANY

10/13/14

M*FVE

%UV

7/22/16

%INC

Starbucks (NASDAQ:SBUX)

36.10^

40.00^

9.8%

57.90

60.4%

Deere (NYSE:DE)

81.65

90.00

9.3%

80.12

(-1.9%)

Visa (NYSE:V)

51.07^

55.75^

8.4%

79.91

56.5%

Caterpillar (NYSE:CAT)

91.68

100.00

8.3%

79.38

(-13.4%)

McDonald's (NYSE:MCD)

90.73

98.00

7.4%

128.26

41.4%

Target (NYSE:TGT)

60.44

65.00

7.0%

74.92

24.0%

McCormick (NYSE:MKC)

67.15

72.00

6.7%

104.26

55.3%

Aflac (NYSE:AFL)

56.00

60.00

6.7%

73.49

31.2%

Philip Morris (NYSE:PM)

84.07

90.00

6.6%

99.84

18.8%

General Mills (NYSE:GIS)

49.28

52.00

5.2%

71.22

44.5%

Microsoft (NASDAQ:MSFT)

43.65

46.00

5.1%

56.57

29.6%

Realty Income (NYSE:O)

42.59

44.00

3.2%

70.41

65.3%

Wal-Mart (NYSE:WMT)

77.56

80.00

3.1%

73.55

(-5.2%)

Click to enlarge

"Fairly Valued" Companies

COMPANY

10/13/14

M*FVE

%UV/OV

7/22/16

%INC

Becton, Dickinson (NYSE:BDX)

125.83

127.00

0.9% UV

173.67

38.0%

AT&T (NYSE:T)

33.82

34.00

0.5% UV

43.11

27.5%

Clorox (NYSE:CLX)

95.92

96.00

0.1% UV

135.18

40.9%

Hershey (NYSE:HSY)

92.24

90.00

2.5% OV

109.95

19.2%

Colgate-Palmolive (NYSE:CL)

64.19

63.00

1.9% OV

74.61

16.2%

Southern (NYSE:SO)

45.85

45.00

1.9% OV

54.54

19.0%

3M (NYSE:MMM)

132.90

131.00

1.5% OV

180.44

35.8%

Wells Fargo (NYSE:WFC)

50.20

50.00

0.4% OV

48.32

(-3.7%)

Coca-Cola (NYSE:KO)

44.07

44.00

0.2% OV

45.83

4.0%

Johnson & Johnson (NYSE:JNJ)

99.12

99.00

0.1% OV

125.03

26.1%

Click to enlarge

KEY: ^ represents split-adjusted prices for BAX, SBUX and V. 10/13/2014 is each company's price at market close that day. M*FVE is Morningstar's Fair Value Estimate on 10/13/2014. %UV and %OV is percentage each company's price was under or over Morningstar's estimate. 7/22/2016 is price at market close that day. %INC is percentage each company's price has increased (or decreased) from 10/13/2014 to 7/22/2016.

Click to enlarge

Notes

I considered any company trading at a double-digit discount to Morningstar's FVE to be "significantly undervalued," and any company trading at a double-digit premium to be "significantly overvalued."

Companies trading at more than a 3% discount (or premium) but less than a 10% discount (or premium) were listed as "moderately undervalued" (or "moderately overvalued").

Companies trading within 3% or less of Morningstar's FVE were considered "fairly valued." As in the other categories, this was purely my opinion. Others might have different cut-offs or ranges.

Two DG50 companies are not listed: Omega Healthcare (NYSE:OHI), because it is not covered by Morningstar; and Shire (NASDAQ:SHPG), which didn't buy Baxalta (a biopharmaceutical spin-off of Baxter) until well after the DG50 debuted.

For comparison's sake, the S&P 500 advanced 15.9% from Oct. 13, 2014, to July 22, 2016.

Yes, Chowder, The Strong Got Stronger

As a group, the six DG50 companies that were significantly overvalued 21 months ago have gained 38.9% in that time. Individually, the numbers are impressive: MO and LMT each up nearly 50%; WEC up more than 40%; NEE up 40%.

WEC Chart

In addition, even with Apple's small loss, the eight moderately overvalued companies combined to move 26.5% higher. Kraft, which was bolstered by its merger with Heinz, was up 59% and Smucker jellied and jammed its way to a 57% gain.

Put 'em all together, and the 14 companies in the Dividend Growth 50 trading at what Morningstar considered the most premium valuations back in October 2014 combined for a 32.1% gain - more than double the S&P 500's rise.

Saying "the strong often get stronger" seems overly simplistic. But it also makes sense. A quick look on the Value Line site shows these to be financially strong companies that have been growing earnings, cash flow and dividends for many years - and, importantly, are expected to keep doing so.

The Weak Got Weaker

While I was surprised to see the DG50's most overvalued companies emerge as big winners over the ensuing 21 months, I was really shocked that the majority of the most undervalued companies went on to be losers - especially given the overall bull-market conditions.

The dozen rated most undervalued by Morningstar in October 2014 combined to fall 6.3%. Yes, they included oil industry laggards ConocoPhillips and Kinder Morgan, each with a 40% loss. Even if I remove them from the list, however, the 10 remaining companies were down an aggregate 1.9%.

Heck, even if I take out COP and KMI and move up Starbucks - which was 9.8% undervalued, so arguably was at a double-digit discount if rounded up -the gain was less than 1%.

Aside from COP and KMI, losers from the "significantly undervalued" group included IBM, Qualcomm, Chevron, Emerson Electric and HCP.

IBM Chart

It is worth noting that all of those in the above chart have performed much better since the market's February pullback. Maybe positive momentum is finally starting to work for them. Maybe they are fundamentally strong enough to get stronger, after all, and patient shareholders will be rewarded.

The "significantly undervalued" group was the only one to have suffered a drawdown. Thanks primarily to strong showings from Realty Income (at 65%, the DG50's biggest gainer these last 21 months), Starbucks, Visa, McCormick and McDonald's, the 13 "moderately undervalued" companies combined to gain about 26%. That also was the aggregate rise of the 10 companies deemed fairly valued by Morningstar in October 2014.

What Does It All Mean?

Although that is up to each of us to decide, here are the two main things I take away from this study:

  1. It's not easy to determine valuations of companies. Even good research firms that employ thorough, experienced analysts sometimes struggle to assign value accurately. So it is smart to think of each estimate as guidance rather than gospel, and it is prudent to use multiple sources when trying to establish "buy zones" or "sell zones."
  2. Chowder's mantra certainly appears to have merit: The strong often DO get stronger! For example, as I wrote in this article last year, there have not been too many bad times to buy Altria.

But Altria closed at nearly $69 on July 22, and Morningstar now says fair value is $59. That means MO is trading at a premium of 16.7%.

Well sure, but Big MO was 18.1% overvalued on Oct. 13, 2014 ... only to move some 50% higher over the next 21 months. There have been few (if any) stronger companies than Altria - and it just keeps getting stronger.

Many investors I respect tremendously take profits from overvalued companies, and I would never say they are "wrong" to do so. Still, it's impossible to have a two-bagger or 10-bagger or 100-bagger if one always sells at any sign of success. That's why strategic trimming - rather than all-out selling - of strong companies makes more sense to me.

Conclusion

Maybe you feel that a recession is imminent, and those stocks that have jumped the highest will fall the hardest. Or maybe you believe that this bull still has another year or three to run, so it's worth hanging on for the ride.

Hey, I absolutely am not recommending that investors load up on shares of today's most overvalued companies. Nor am I telling investors to ignore those that have underperformed over the last year or two.

What I will say is that one could own a whole lot worse companies than those that have been strong for years and now look even stronger.

That's what Chowder would be saying right now ... if he weren't too busy washing down wings with a few cold ones while watching two English soccer clubs battle to a nil-nil draw. Ha!

Disclosure: I am/we are long ALL COMPANIES LISTED.

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.