Warren Buffett's famous "circle of competence" has two basic tenets: understanding the business and understanding the stock. But without one, the other is likely both useless and potentially dangerous. A personal example to this regard is Chipotle Mexican Grill (CMG). I like everything about Chipotle: the food, the quality, convenience, even the low maintenance décor. I think Chipotle is a fantastic company and one that will continue to make money for many decades to come. However I do not own, nor do I plan on owning, any portion of the business. The reasoning is relatively straightforward: while I love the company, I have no way of determining how much people might be willing to pay for my ownership stake in the future.
On the other hand, I am more comfortable evaluating an established firm like Target (TGT). Surely there are more formidable firms out there, but you will see why I chose TGT soon enough. On the business side I know that Target is a low-cost provider of quality goods. On the stock side, I am well aware of TGT's continued dedication to generating shareholder value.
The distinction of competence becomes particularly telling when one looks to "back-out" the amount of time that above average growth has been priced into the stock. For example, by using the growth duration model, one finds that at today's levels the market is pricing in about 13 years of 22% growth for CMG, against an industry average closer to 15%. On the other hand, at today's prices, the market is pricing in exactly 0 years of above-average growth over the industry for Target.
More specifically, if you are buying CMG at today's prices, you expect Chipotle to grow much faster than the industry for a minimum of 13 years to justify its stock price. Now I have no idea if Chipotle can grow at 22% for the next 13 years. For that matter, I have no idea if CMG is more likely to outpace the industry for the next 5 years or the next 35 years. But I do know that if you are buying Target today, you are buying in the expectation that TGT doesn't have to do anything that spectacular at all to justify its stock price. Personally I find the second option much more compelling.
So besides laying the bar near the floor, what else does Target have to offer?
Wal-Mart (WMT). There's no secret when it comes to Target's super competitor. However, unlike the Wild West, this country is quite literally big enough for both WMT and TGT. Much in the same manner that consumers make room for both Coca-Cola (KO) and PepsiCo (PEP). As a dividend growth investor I would be overjoyed to own either of these companies. Wal-Mart has increased its dividend for 38 straight years, has a 10-year average payout growth rate of 17.9% and presently yields around 2.1% with a PE around 16. In my opinion, Target has been even more impressive by growing its dividend for 45 straight years, boosting this payout by 17.5% over the last decade but even quicker in the last 5 years and currently yields 2.3% with a PE around 14. To be sure both yields might be a bit low for some income investors, but one should find relief in the fact that double-digit dividend growth rates with stable yields indicate double-digit price appreciation.
There's no doubt in my mind that Wal-Mart will remain the low-cost retail leader. However, just because there's no doubt that Coca-Cola will remain the world's beverage leader, doesn't mean owning shares of PepsiCo aren't worthwhile. Much in the same manner, Target has attractive fortes at its disposable. For example, its expansion into Canada, cleaner stores, its move to offer more grocery items and its funky designs come to mind.
As mentioned, TGT has increased its dividend for the last 45 years by a rate of around 18% a year for the last decade. Obviously history does not determine the future, but it does lend itself toward applicable motivation. This idea comes through quite precisely in one of Target's recent announcements seen here. We will get to the buyback portion, but instantly the dividend growth investor has to be attracted to this statement:
The company expects to continue to grow the dividend at a robust pace which would allow the annual dividend to rise to $3.00 or more by 2017, assuming the company meets its goal to grow annual earnings per share to $8.00 or more by that time.
Target currently pays a $0.36 quarterly dividend or $1.44 annually. Given the 5-year time frame this would indicate that Target management is outright expecting to raise the dividend by around 16% a year for the next 5 years. This would indicate that one's yield on cost would move from the current 2.3% level of today to around 4.8% in 5 years time; not bad. Additionally, if one were to assume that Target would still have the same 2.3% yield in the next half decade then this would lend itself to price around $130, or equivalently around a 16% yearly growth rate. In the more likely scenario that the dividend yield increases, say to 3%, this would indicate a price of $100 or a 10% yearly price appreciation. Even if the Target dividend yield happened upon 4%, this would indicate a $75 price and a 4% yearly price appreciation.
Low Current Yield
Certainly some might shy away from low current yield; although to be sure with the expected dividend growth rate, either the yield goes up or the price rises significantly. However, one should always consider an investment in relation to its best alternative. Given dividend growth investing, this likely means companies with a long track record of increasing dividends and a higher current yield. Take Procter & Gamble (PG) and Chevron (CVX) for example. PG has increased its dividend for the last 55 years by a pace of around 10% over the last decade and currently yields around 3.5%. Chevron has increased its dividend for the last 25 years by a pace around 8% a year over the last decade and currently yields around 3%. We can summarize the information for the next 5 years in the following way:
The dollar amounts represent the amount of dividends earned per dollar invested. TGT has its dividend growing at 16.8%, PG at 10% and CVX at 8%. Notice that it takes TGT 4 years to catch up with the payout of CVX and it does not catch up with the payout of PG. If we accumulate the dividends per dollar invested, we find the following:
As expected, in the next 5-years one would receive the least amount of income by investing in Target, due to the lower initial yield. However, because of the larger dividend growth rate TGT must eventually pan out as the more rewarding income provider. We see that TGT beats CVX in the 6th year and eventually ousts PG in the 10th year. Two important points must be made. First, once TGT has surpassed one of these companies, given a higher dividend growth rate, TGT will always provide more income. Second, these assumptions are made based on linear dividend growth rates. It is very possible that TGT could slow its rate of growth or PG and CVX could increase theirs. The true question for the long-term investor is not whether or not you are concerned about the low current yield, but more aptly whether or not you believe TGT can continue its robust dividend growth pace.
Earnings Per Share
One might have noticed the second bit of the $3 dividend statement: "assuming EPS of $8 or more." Let's work with that $8 EPS number for a moment. In the last 5 years, people have been willing to pay roughly between 11 and 19 times for Target's earnings. The average has been around 14, which is about where the stock is today and doesn't exactly scream a bargain. But assuming TGT is able to earn $8 a share in 2017 and people are willing to pay 14 times for that, this equates to a $112 price or a yearly price growth of 12.5%. Even at 11 times earnings, this equates to an $88 price and a 7.3% yearly price appreciation. Let's lay this out for a clearer look:
The dividend doesn't precisely match the $1.44 number that was quoted due to Target's mid-year dividend increases. Incidentally, this is also why I used a dividend growth rate of 16.8% earlier. The first 3 EPS numbers are directly from the company's website found here. The next 3 are based on the long-term growth rate of 11.6%, which as described previously, is below the industry average. We also see that the dividend payout ratio remains below 40%, suggesting great sustainability.
Finally one should likely ask: "Well all these numbers look good and well, but are they obtainable?" To this point, we see that great price appreciation can be had with an average PE multiple and a below industry growth rate. Better yet, TGT engages in a share buyback program that allows for the numbers to be reached much more easily. In the first quarter of 2012 Target finished a $10 Billion share buyback program and announced a new $5 Billion program to be completed in the next 2-3 years. Here is a summary of next 5 years with regard to potential repurchases:
|Repurchase||$900 million||$1.89 Billion||$1.89 Billion||$1 Billion||$1 Billion||$1 Billion|
|Retired||14 million||27.8 million||23.4 million||11.1 million||9.96 million||8.92 million|
|Shares out||658 million||630 million||607 million||596 million||586 million||577 million|
Note that I condensed the numbers for easier viewing. According to the January 28th 10-K, TGT had about $5.27 Billion to use toward repurchasing shares. Looking at the April 28th 10-Q we see that TGT repurchased approximately $600 million in shares from January 28th to April 28th. This leaves about $4.67 Billion in the plan to be repurchased in the next 2-3 years. The company provided guidance for this year in that it would repurchase about $1.5 Billion in shares for 2012. A number that would likely be lower than the following years due to increases in capital expenditures for the new store openings in Canada. As seen in the table, this translates to roughly $900 million to spend for the rest of 2012 and linearly $1.89 Billion in 2013 and 2014. For the average price I used the EPS numbers with a multiple of 14. In years 2015-2017 I assumed an even $3 Billion repurchase authorization. This in no way has been mentioned, but seemed to be a relatively reasonable assumption based on Target's past programs.
The bottom line when it comes to share repurchases is that it makes the overall earnings numbers easier to formulate. For example, 658 million shares outstanding in 2012 with an EPS of $4.30 equates to a net earnings number of about $2.829 Billion. In 2011 TGT made $2.929 Billion in earnings, which means that the company can actually make less money and still grow earnings per share this year. To reach its 2014 EPS goal, given 607 million shares outstanding, TGT would only have to grow total earnings by about 6% a year. Finally, in 2017 with 577 million shares outstanding, Target would need to grow total earnings by about 9.5% a year for earnings per share to grow at 11.6% a year.
Warren Buffett has a go-to quote that is particularly applicable: "I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over." Think about that in context of Target. If TGT grows at a slower pace than the industry, continues to payout less than 40% of its earnings and people are willing to pay an average multiple of 14 for their earnings, then you would have a $50 price appreciation and would collect around $12 in dividends in the next half decade. I don't know about you, but if you told me that I could nominally double my investment in 5 years without the company doing anything that extraordinary at all, then I might be interested.