Dividend Aristocrats Are Undervalued

Includes: AFL, DOV, SWK
by: Chuck Carnevale

Seeking Alpha is a great resource for the everyday investor in great part because of the open source nature of the information it offers. The Seeking Alpha site has only one agenda, and that is to help its readers become better prepared and smarter investors. David Jackson, Seeking Alpha's founder, recently directed readers to an article titled "New Highs, New Lows, Yield Greed" by David Merkel that he felt was important, and that subsequently generated a lively comment thread.

Often, the comment threads that a Seeking Alpha article instigates can be of greater value than the article itself. I feel that this was the case with the above-referenced article. The following excerpt from one of David Jackson's comments in the article corroborates my introductory remarks:

We've avoided commissioning articles with a specific agenda, in favor of letting our contributors and readers set the agenda because (NYSE:A) they're often smarter than we are, and (NYSE:B) the whole idea behind SA is that there's no 'house view,' but that we value a variety of opinions and trust our readers to decide for themselves. Because of that, I try to play on the same playing field as other contributors and readers, publishing very occasional articles, but more often leaving comments on articles as any other reader would. I realize that sometime people give added weight to my comments, and I grapple with that because I don't want my personal views to be identified with an SA 'house view.'

Strong Reactions From Prominent Dividend Growth Investors

All of this attention to dividend paying stocks has caused some dividend growth investors to be a little testy. Consequently, any articles -- or even comments -- on dividend growth investing that even appear to challenge the strategy are often met with a vigorous defense. In my own experience, I have most often found the dividend growth investors reactions to be warranted, but perhaps a little inflated.

Moreover, it sometimes seems that the dividend growth investor crowd is the Rodney Dangerfield of the investing community. They just don't seem to get any respect. Perhaps it's because some people see their extreme confidence in their dividend growth strategies as arrogance. Personally, I see it as exuberance that is rational.

Furthermore, I feel that the dividend growth investor crowd is misunderstood on many fronts. Dividend growth investors will often state that they are not concerned with price volatility or capital appreciation. Some people take that to be lunacy. However, those detractors are, in my opinion at least, missing a few major points.

Dividend growth investors in truth do not want to see their principal eroded. However, they tend to be more focused on their dividend income stream, and realize that their dividend income stream comes from earnings. Therefore, if they own a stock that has a long record of raising its dividend, they understand that those same stocks most likely have a long record of increasing their earnings as well. But even more importantly, dividend growth investors tend to do their homework and monitor their portfolios closely. This fact is often overlooked and, therefore, unfair criticism is bestowed upon dividend growth investors when they state that they are not concerned with volatility.

Consequently, much of the confidence in their portfolios that dividend growth investors possess comes from the recognition of the quality and strength of the businesses they own. In truth and fact, dividend growth investors tend to sleep better at night than most other investors, because they focus more on the tangible value that a quarterly dividend check provides. In other words, price volatility is ethereal, while a dividend payment can be spent or reinvested.

Nevertheless, dividend growth investing appears to be gaining in popularity as so many baby boomers are either in or imminently approaching retirement. Interest rates are low and, therefore, many suspect that investors could switch out of bonds into dividend paying stocks.

Also, there is concern, which, in my opinion, David Jackson genuinely expressed, that if this trend continues dividend growth stocks could become overvalued in the process. This could put the future returns on the portfolios of dividend growth investors at risk. Frankly, I think David Jackson's concerns are unwarranted at this time.

There Is an Upside to Discord

The following additional excerpts from David Jackson's contributions to the comment section of the above-referenced article, including one specifically directed to me, raise some very important questions and points to ponder. These comments elicited meaningful and important responses from many esteemed dividend growth investors, including David Van Knapp, David Fish, Chowder, and Robert Allan Schwartz.

Dividend stocks are in favor, because:
-- interest rates are extremely low, and some investors are switching out of bonds into dividend paying stocks.
-- a large number of people are moving into retirement, and are looking for income from their portfolio.
-- life expectancy has risen, so retirees need long term capital preservation as well as income.
-- dividends are hard to fake or manipulate over long time periods, and therefore provide a relatively reliable indicator of company performance and valuation (when combined with payout ratios).

This article touches on an important issue that's been discussed elsewhere on Seeking Alpha: that particularly due to macro factors (interest rates and demographics), dividend stocks may become overvalued. Investors who select stocks only within the universe of dividend payers (and raisers) may be exposed to long term underperformance if this happens.

David Merkel's argument is thought-provoking. Since "yield is not real. It is a residual of a larger economic process," stocks should not outperform because they pay dividends, but because their business is growing. Solid companies will translate growth into shareholder value via dividends, stock buy backs, or investment in additional growth; thus: "though the portfolio that I manage for clients has an above average dividend yield, I do not look for dividend yields; I look for solid companies, and the dividend yields find me."

If the 52-week high list is dominated by dividend payers, that suggests to him that people are buying the stocks because they pay dividends ('yield greed' or 'chasing yield') rather than because of the growth in the companies' core business outlook. This might be a red flag that dividend payers are becoming expensive.

David Jackson's Views on Valuation

In response to one of my personal comments, David Jackson again responded and expressed his concerns quite genuinely and eloquently, in my opinion. But more importantly, with his following comment he posed a critically important question and offered up some potential solutions and methodologies that he intimated would be too challenging for investors to accomplish:

Thanks for jumping in with such a great comment. Your observation that the 52-week high list doesn't say much about valuations is compelling.

I actually agree that 'determining valuation is all about doing it one stock at a time,' because most investors purchase individual stocks (unless they are asset allocators buying broad indexes).

But how do you ascertain whether an individual stock is cheap?

Imagine you're a dividend growth investor whose stock picking universe is large-cap U.S. dividend-payers. You could value an individual stock by:

1) Comparing this stock to other large-cap U.S. dividend-payers, for example by comparing the current dividend yield or the projected dividend yield;

2) Comparing the stock's current valuation (e.g., dividend yield) to its past valuation;

3) Comparing the stock's (current or projected) yield to the yield on U.S. Treasuries (similar to the earnings yield 'Fed Model');

4) Using a DCF valuation model, which is also sensitive to interest rates via the discount rate.

Assessing Valuation

My response to David Jackson's comment was that an investor could achieve a rational analysis of valuation if they had the proper tools. Therefore, I'm going to use my tool, the F.A.S.T. Graphs™ fundamentals analyzer software tool to value the large-cap dividend paying universe, the Standard & Poor's Dividend Aristocrats, as they apply to David Jackson's fair valuation methodologies as follows:

1. Comparing this stock to other large-cap U.S. dividend-payers, for example by comparing the current dividend yield or the projected dividend yield.

Because my research tool already has the Standard & Poor's Dividend Aristocrats preloaded, I can run a portfolio review at the push of a button and choose what metrics I want to compare. Since my goal was to evaluate fair valuation I created a portfolio review that focused on valuation measurements. Furthermore, I created a portfolio review that analyzes each of the 51 companies in the Dividend Aristocrats list relative to each other based on past, present and future valuation metrics.

For the reader's convenience, I have color-coded each Dividend Aristocrat's current valuation as follows:

  • Green = Under Valued
  • Orange = Fair Value
  • Red = Over Valued

Also, the dividend yield column on each Dividend Aristocrat is color-coded in light blue.

Using strict criteria for fair valuation, the 51 Dividend Aristocrats shakeout as follows: 17 are fairly valued, 14 are undervalued, and 20 are overvalued based on widely valued formulas for valuing a business. Consequently, approximately 60% of the Dividend Aristocrats are currently fairly valued or undervalued. This should alleviate most of David Jackson's concerns, at least at this time.

Click to enlarge images.

2. Comparing the stock's current valuation (e.g., dividend yield) to its past valuation.

The same portfolio review table above lists each company's current P/E ratio (yellow highlights on the table) and compares it to its 15-year normal P/E ratio (green highlights on the table). Therefore, each company on the Dividend Aristocrat list can be easily compared to its historical valuation. Furthermore, by clicking on the symbol button for each company, a performance report can be generated which includes historical dividend yields.

For the sake of space, I offer only one specific example, the individual Earnings and Price Correlated graph with dividends, and the Performance Table on Aflac (NYSE:AFL). In 1998, Aflac was priced at fair value and its dividend yield = 1% (see graph below). Aflac's current dividend yield is 3% (see circle on graph below), which indicates undervaluation.

In a matter of minutes each of the 51 companies on the Dividend Aristocrat list can be easily looked at one at a time in this way. Based on this perspective, the Dividend Aristocrats universe depicts valuation consistent with analysis based on David Jackson's methodology No. 2.

3. Comparing the stock's (current or projected) yield to the yield on U.S. Treasuries (similar to the earnings yield "Fed Model").

The following Earnings Yield table compares an equivalent $100,000 investment into Dover Corporation (NYSE:DOV) vs. a 10-year Treasury bond. Here we see that Dover's dividend yield currently exceeds the 10-year Treasury bond and is expected to grow at an estimated 14% per annum. Once again, this same evaluation can be applied to each of the 51 Dividend Aristocrats in a matter of minutes by simply clicking on each individual company's graph.

4. Using a DCF valuation model, which is also sensitive to interest rates via the discount rate.

Our research tool creates forecasting graphs based on widely-accepted discount cash flow formulas and presents the results in graphic form. The following Estimated Earnings and Return Calculator (forecasting graph) Stanley Black & Decker (NYSE:SWK) indicates that the company is undervalued.

Based on his past experience as an analyst, David Jackson believes that analyst estimates tend to be reasonably accurate near term and less reliable long term. Therefore, the reader will note that the following graph offers actual estimates for this fiscal year and next, followed by an extrapolation of the consensus five-year growth estimate.

The following 10-year Earnings Yield Estimates table compares Stanley Black & Decker's estimated cumulative earnings vs. the riskless interest from a 10-year Treasury bond. In essence, this is looking at the discounted cash flow calculation in reverse.

Summary and Conclusion

David Jackson inspired this article because he brought up what I personally consider to be critical concepts that investors should be thinking about before investing their serious retirement monies. Recognizing whether or not the investments they are making are reasonably priced or not is a vital component of long-term success and the risk taken to achieve it. Therefore, I believe that David Jackson was highly justified considering that dividend growth investing is becoming so popular.

On the other hand, I believe that dividend growth stocks, along with most other equities, had become so undervalued during the great recession that they had a long ways to go before they approached overvaluation territory. Therefore, even though some of them have had strong recent appreciation, my analysis suggests that many remain fairly valued and undervalued. However, there are some that have also become overvalued. As the original comment thread suggested, these decisions are best made one company at a time.

Disclosure: I am long AFL.

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.