The Trade Deal Soap Opera Continues
Since the August trade deal swoon, stocks are up 10% with trade-sensitive names like Apple (AAPL) up three times that amount. Following the handshake "phase one" trade deal agreement in October (that avoided new tariffs) China and the US have been talking frequently and trying to hammer out a written agreement to avoid the 15% tariffs on $160 billion in technology and apparel that's scheduled for December 15th.
Larry Kudlow, says we're "getting close to a deal", but we were "90% of the way to a deal" back in May when things fell apart. China says talks are "constructive" but according to Reuters:
A so-called phase-one agreement between the U.S. and China may not be completed until next year as Beijing presses for greater reductions in tariffs and Washington pushes back with its own increased demands."
China wants September 1st tariffs (15% on $110 billion worth of mostly apparel) eliminated in exchange for buying up to $50 billion per year in more US agricultural goods.
Talks seem to be progressing, but there is always the risk they could fall apart again.
If we don't make a deal with China, I'll just raise the tariffs even higher... They'd like to have a rollback. I haven't agreed to anything." - President Trump
Moody's Analytics considers an escalation of the trade conflict to be the biggest risk factor that could tip the US into a mild recession.
As things stand now we can't be sure whether or not those December 15th tariffs will go up or be postponed in yet another "tariff truce", of which we've seen several since the tariff conflict began in early 2018.
CEOs and CFOs are increasingly pessimistic, which isn't good since they are ones helping keep the economy afloat via a strong job market.
According to the Conference Board (a leading supplier of leading economic indicator data) "Only 4% of CEOs surveyed believe the economy would improve in the next several months, while two-thirds saw it getting worse."
John Graham, a finance professor at Duke University's Fuqua School of Business and director of the Duke CFO optimism survey found that
Business optimism has not been this low since September 2016, a time when the unemployment rate was 5 percent... Optimism is low in all regions of the world, which exacerbates any slowdown occurring in the U.S." - Duke University
The New York Fed's real-time GDP model appears to be stabilizing, though still shows very slow growth for Q4.
So that tears it then, it's best to sell all your stocks, or at least not buy new ones right? Not at all.
The median consensus on GDP is that we'll grow 1.5% in Q4. Q1 2020 is expected to see growth slow to 1.3%, but then rebound for the rest of the year, which is expected to bring us 1.5% growth in 2020.
Is that slow growth? You bet, the slowest since 2009 in fact.
But Morgan Stanley thinks growth next year will be stronger, 1.8%. And Goldman Sachs is even more bullish, expecting a phase one deal in early 2020 to result in 2.3% GDP growth.
According to Jan Hatzius, Goldman's chief economist
This easing in financial conditions suggests not only that global growth is likely to pick up somewhat in absolute terms, but also that growth may come in stronger than currently predicted by the forecaster community."
Goldman's proprietary economic model forecasts 2.3% growth in 2020 for the US and 3.4% global growth.
The second worst thing you can do is not steadily investing new money into quality companies at reasonable to attractive valuations. The worst thing you can do is sell your stocks based on the doomsday predictions of famous permabears.
Note that even shifting money out of stocks and into safe bonds, on the predictions of imminent market crashes, could have resulted in a 60% decline in your portfolio. Those who shorted the market, like John Hussman? Well, he's down 7% CAGR over the past decade, underperforming the broader market by 20%... per year... for 10 years.
Hussman Strategic Total Return Fund Returns Since 2000 Inception
Hussman was "right" about the 2000 crash, and 2008. His investors still saw -0.1% CAGR total returns over the last 20 years when the S&P 500 has delivered 5.6% annualized returns and even market timing retail investors (who avoided shorting) beat this famous hedge fund manager by 2% CAGR over half an investing lifetime.
I get that periods of high uncertainty bother most people. Pullbacks and corrections, of which we historically have one every six months, are not fun while they last. But guess what? The average pullback of 5% to 9.9% since WWII has lasted just one month, with a peak decline of 7%.
The typical correction is a 14% slide for stocks, that lasts for five months but within four months of the bottom, we're back to all-time highs.
The longest bull market in US history has seen 20 pullbacks and corrections. Each time investors worried that it was the start of "the big one", another 2007-2009 style crash.
Buffett calls investing steadily over time "betting on America" and he's right about that. 84% of the time the US economy is growing and since 1950 the stock market goes up in 82% of years (75% since 1926, including the Great Depression 90% crash).
I personally invest $750 per week, each and every week, no matter what the broader market is doing or what worries have financial media pundits all hot and bothered.
I don't invest in the broader market mind you, because the S&P 500's paltry 1.8% yield and 10% overvaluation is far inferior to the alternatives that the Dividend Kings' Master List presents me.
As my fellow Dividend King founder Chuck Carnevale likes to say "it's a market of stocks, not a stock market."
Something great is always on sale, that can fit almost any investor's goals, risk profile and time horizon.
The Dividend Kings' Approach To Valuing And Recommending Stocks
In summary, here is what our valuation model is built on:
- 5-year average yield
- 13-year median yield
- 25-year average yield
- 10-year average P/E ratio
- 10-year average P/Owner Earnings (Buffett's version of FCF)
- 10-year average price/operating cash flow (FFO for REITs)
- 10-year average price/free cash flow
- 10-year average price/EBITDA
- 10-year average price/EBIT
- 10-year average Enterprise Value/EBITDA (factors in debt)
These metrics represent pretty much every company fundamental on which intrinsic value is based. Not every company can be usefully analyzed by each one (for example, EPS is meaningless for REITs, MLPs, yieldCos, and most LPs). But the idea is that each industry appropriate metric will give you an objective idea of what people have been willing to pay for a company.
I line up the expected and realistic growth rates of companies with time horizons of similar growth, thus minimizing the risk of "this time being different" and overestimating the intrinsic value of a company.
I maintain 9 total valuation lists, covering:
- 48 level 11/11 quality Super SWANs (the best dividend stocks in America which collectively have tripled the market's annual returns over the past 25 years)
- All the Dividend Kings
- All the Dividend Aristocrats
- All safe (level 8+ quality) midstream MLPs and C-corps
- All DK model portfolio holdings
- Our Top Weekly Buy List
- Our Master Valuation/Total Return Potential List (288 companies and counting)
4 Great Dividend Stocks Smart Investors Can Buy With Trade Uncertainty This High
Each of these companies is owned in one or more of the Dividend Kings' model portfolios (High-Yield Blue Chip, Deep Value Blue Chip, Fortress and our $1 Million retirement portfolio).
Simon Property Group: The Most Undervalued Super SWAN Is Likely To Act Defensively In A Correction
I'm sure you're wondering what the king of Class A malls is doing on this list, so let me explain. The typical recession sees GDP decline just 1.4%, not the 5.1% we saw during 2008-2009. A mild recession is what might occur if trade talks break down, and during the 2001 recession GDP declined just 0.4%. SPG's FFO/share grew 7% during this time.
Slower growth in a future recession (3% to 4% would be most likely) should make Simon, a historically low volatility stock, act defensively, falling less than the broader market in future corrections.
Outside of the Financial Crisis Simon has tended to be a very defensive stock, especially when it started out historically undervalued. At the start of the tech crash of 2000 SPG was about 45% undervalued and its peak decline (including dividends) during that multi-year bear market was -13%.
If you want further evidence of Simon's defensiveness consider the 19.8% correction we saw in late 2018. Simon started that severe correction at a P/FFO of 12.9, and its forward P/FFO is now 11.6.
From a 10% higher valuation than it sits at now, SPG fell 9% less than the broader market, and 5% less than the dividend aristocrats. In fact, all four of these Super SWANs acted defensively, meaning they outperformed the market during a period of peak fear.
SPG is actually going to grow its comparable FFO/share this year by 2%, factoring in new accounting rules and $.33 per share in debt extinguishment costs. That will make it one of just two retail REITs in America to post positive growth every year since 2010, including the "retail apocalypse" which has seen 21,000 stores close since 2017.
Simon's bank-vault balance sheet means that it can take its leverage up to 7 (according to Moody's) without risking a downgrade from its A rating. It's currently at 5.6 and likely to keep falling because the REIT is retaining $1.5 billion per year in post dividend cash flow.
That's enough to fund its entire redevelopment backlog with cash (and then some).
Here's SPG's current growth profile.
- FactSet long-term growth consensus: 4.3% CAGR
- Reuters 5-Year CAGR growth consensus: 8.6% CAGR (a tad bullish)
- YCharts long-term growth consensus: 3.7% CAGR
- Historical Growth Rate: 7.3% CAGR over 20 years (7% to 13% CAGR rolling growth rates)
- Realistic Growth Range: 3% to 8% CAGR
- Historical Fair Value: 15 to 18 FFO
SPG is currently generating $3.8 billion in FFO per year. The $7 billion total redevelopment backlog (current projects and new ones under consideration) could result in about $1.2 billion per year in annual growth spending. 7% to 8% cash yields is what SPG is generating on its investments meaning that organic growth potential from backlogs alone is 2.2% to 2.5%.
To that you can add about 2% long-term NOI growth analysts expect over the next decade, the power of the best lease spreads in the industry (22% last quarter).
That leaves SPG with total organic growth potential of 4.2% to 4.5% to which it can add strategic M&A (including overseas investments) and 1% to 2% worth of buyback fueled growth. This means that SPG's realistic growth range is from 4% to 8%, which should justify its historical valuations.
What does that mean for Simon's return potential at the best valuation in 10 years?
The conservative end of our total return range assumes SPG grows slower than expected, potentially due to ongoing store closings that persist for many years.
The Ben Graham fair value formula built into F.A.S.T Graphs estimates a REIT growing at 3% is worth 14.5 times FFO. This is below SPG's historical fair value range but would be appropriate if it were only able to deliver such modest results.
However, note that even with very conservative growth and valuation assumptions Simon is capable of 11% CAGR total returns.
Compared to what asset managers expect from the broader market over the next seven to 15 years, any top quality high-yield company capable of delivering double-digit returns at the conservative end of its total return range is a potentially great investment.
At the upper end of its total return range, Simon growing at 8% and returning to the upper end of its historical fair value could deliver over 20% CAGR total returns and nearly triple your investment.
Most likely SPG will grow at 4% to 5%, and applying the low end of its historical fair value range is how I create Dividend Kings' base case for the stock.
Because we expect Simon to basically double our investment over the next five years while delivering very safe and steadily growing 5.7% yield, our Fortress portfolio and my retirement portfolio has been steadily buying this Super SWAN REIT.
Enterprise Products Partners: An Energy Utility That You Can Trust When The Market Panics
Energy as a sector isn't thought of as "defensive" but it did outperform the S&P 500 in five of the six bear markets (measured by intraday lows) from 1990 to 2011.
EPD specifically, is very defensive from a fundamental perspective.
85% of cash flow is fee-based, under long-term (up to 20 years) volume committed contracts, with hundreds of investment-grade counterparties.
44% of its contracts are with A-rated companies, and its distributable cash flow is virtually immune to wild swings in commodity prices.
EPD's slight outperformance during the late 2018 correction was no fluke. At the start of that correction, EPD was trading at 9.7 times EBITDA, and today it's 8.2.
EPD started the last two market crashes at fair value and significantly outperformed the broader market. That's not surprising given its historical beta of 0.32 and energy utility-like business model.
It's raised its payout for 61 consecutive quarters (15 years), 20 consecutive years, and has actually been raising distributions for investors for 22 straight years (before its IPO).
EPD is the highest quality MLP. Its world-class management team is laser-focused on a strong balance sheet, self-funding profitable growth and delivering clockwork-like payout hikes no matter what the economy, stock market or oil prices are doing.
That's not surprising since insider ownership, via EPCO, the private general partner, is about 30%.
What does Enterprise's growth profile look like?
- FactSet long-term growth consensus: 4.0% CAGR
- Reuters 5-Year CAGR growth consensus: 7.6% CAGR
- YCharts long-term growth consensus: 6.0% CAGR
- Historical Growth Rate: 9.9% CAGR over 20 years (-8% to 25% CAGR rolling growth rates)
- Realistic Growth Range: 3% to 7% CAGR
- Historical Fair Value: 9 to 12 times EBITDA
Enterprise plans to invest about $3 billion per year in high margin growth projects, on which analysts expect it to enjoy 13% returns on investment. That means organic growth potential of about 4.5% over the next five years. That assumes no acceleration of adding growth projects to its backlog (it added $3.6 billion in Q3 alone).
What if EPD starts to run out of growth projects? Then its $2.8 billion in annualized (and growing) retained cash flow could repurchase up to 5% of its stock each year, generating an equal amount of DCF growth per unit, while sustaining very safe 5% annual distribution increases.
EPD's industry-leading combination of low-cost capital, the highest-quality and most vertically integrated network of midstream assets in the country, and enormous buyback potential could drive even stronger growth over time.
Here's Morningstar's Stephen Ellis explaining what his firm expects from EPD over the next half-decade.
We expect EBITDA to increase about 7% annually over the next five years and distributions about 7% annually on average over the same time frame, though the growth is weighted more toward the tail end of our forecast period." - Morningstar
For the conservative end of our return potential model, I use just 3% long-term growth, slower than even the most conservative analyst forecasts. Even at that growth rate, the Ben Graham fair value formula estimates that EPD would be worth 10.2 times EBITDA. I use just nine, the low end of its fair value range.
But even very slow growth and a modest valuation boost still allow this almost 7% yielding MLP to deliver double-digit and thus likely market-beating returns.
At the upper end of our total return potential range, EPD growing as fast as Morningstar expects and returning to the upper end of its fair value range could deliver about 20% CAGR total returns, slightly more than its 17% CAGR 20-year results.
Our base case is 5% growth and a mid-range EBITDA multiple of 10.5, which results in 15% CAGR total returns that double our investment.
Our Fortress Portfolio targets 10+% long-term returns and our Deep Value Portfolio 15+% total return potential. This is why we own Enterprise in both portfolios and have been buying aggressively during the last few weeks.
We'll keep doing that as long as the insane 9-week (and counting) MLP losing streak continues, or until we hit our risk limits for individual companies (10%) or any single sector (25%).
Federal Realty: The Only Dividend King In REITdom Has A Bullet Proof Payout
FRT shows that even if a Super SWAN underperforms for as long as 17 years, it can still be a market-beater in the long term. During most market downturns FRT outperforms and it fell half as much as the S&P 500 during the late 2018 correction.
FRT might be a retail REIT, but its historically very low beta (0.41) and superb quality mean its dividend is the safest in the sector.
Other than Simon, no retail REIT in America has been more consistent in growing FFO/share every year since 2010 (Realty Income's growth was flat in 2010).
That's courtesy of the hands-down best properties in the industry, located in eight densely packed, affluent and fast-growing cities.
As a result, FRT enjoys the highest base rent per square foot, as well as lease spreads (new rent/old rent) that are nearly double the industry average.
FRT has a $1.4 billion redevelopment backlog, and a shadow backlog that analysts expect will allow it to invest $400 to $450 million per year at an average of 7.5% cash yields (in-line with its historical norms).
That's sufficient to drive 6% to 7% organic growth, and buybacks are always an option for Federal Realty should the share price fall too much.
- FactSet long-term growth consensus: 6.0% CAGR
- Reuters 5-year CAGR consensus: 6.7% CAGR
- YCharts long-term growth consensus: 4.5% CAGR
- management guidance: 6+% CAGR
- historical growth rate: 5.0% CAGR over the last 20 years (rolling growth rates 5% to 9% CAGR)
- realistic growth range: 5% to 7%
- historical fair value (excluding bubbles and bear markets): 20 to 23 FFO
FRT's conservative return forecast is generated with 5% long-term growth and a return to the low end of fair value.
That still delivers about 8% CAGR total returns which is higher than any long-term S&P 500 forecast.
If FRT achieves the high end of its organic growth potential, it could nearly double your investment over the next five years.
Our base case is 6% growth, and the mid-range of its fair value FFO multiple, which is sufficient to achieve double-digit total returns.
Colgate: One Of The Most Defensive Super SWANs In The World And "A Wonderful Company At A Fair Price"
Colgate matched the -15.6% decline of the aristocrats during the late 2018 correction and has shown great defensiveness during the two 50+% market crashes (not counting dividends) in 2000 and 2008.
Historically its beta is 0.51, but that merely means that, like almost all stocks, it falls less than the S&P 500 during times of high fear.
Colgate's recession-resistant business model and low historical volatility caused "bond alternative" investors to bid it up to a 25.6 P/E from which it's fallen 10% to fair value.
It's important to remember that defensive stocks lose much of their power when you overpay for them. Buying a company at fair value or better is part of prudent risk management, as well as participating fully in a company's growth.
- FactSet long-term growth consensus: 4.4% CAGR
- Reuters 5-Year CAGR growth consensus: 1.0% CAGR (factors in -5% growth in 2019)
- YCharts long-term growth consensus: 4.7% CAGR
- Historical Growth Rate: 6.8% CAGR over 20 years (0% to 8% CAGR rolling growth rates)
- Realistic Growth Range: 3% to 5% CAGR
- Historical Fair Value: 21 to 23
Colgate is a slow-growing company, and only its Super SWAN quality and dividend king status support its premium fair value P/E range of 21 to 23.
Modest growth is largely going to come from overseas, in rapidly growing emerging markets like:
- Brazil (54% market share)
- China (33% market share)
- India (40% market share vs. nearest rival's 16%)
- Mexico (70% market share)
Thanks to smart advertising (which it ramped up in 2019 thus the earnings hit) Colgate is the most trusted brand with dentists, 45% of whom recommend its brand vs. 20% for its #2 rival. It's also why store-brand generics command just 2% of market share in the US.
Colgate is a boring but beautiful business where modest growth can be counted on over time, even during future recessions.
To boost growth over time Colgate is famous for efficiency and cost-cutting. It's currently completing a $550 million to $575 million cost-cutting program for which it estimates it earns 30+% returns on investment.
Modest revenue growth (3% per year expected over time from analysts), plus modest margin gains combined with about 1% share buybacks is what's expected to drive consistent 4% to 5% growth over time.
Since it's currently fairly valued (4% undervalued for 2020's 5% expected growth) Colgate doesn't offer double-digit total return potential.
If it grows slower than expected, but still within its historical growth range, then Colgate returning to a 20 P/E multiple could deliver close to 5% CAGR total returns. By forward market standards that's decent.
At the upper end of its return potential range, CL might deliver high-single-digit total returns, beating the market in a higher-yielding, low volatility and defensive package.
Our base case on Colgate uses the mid-range 22 P/E and FactSet's consensus growth of 4.4% to estimate 7% CAGR long-term returns.
That's equal to BlackRock's 7% forecast for the market, which is the most bullish of any major asset manager. Dividend Kings expects 6% to 6.5% CAGR total returns from the S&P 500 over the next five years.
Colgate can realistically beat that from its current fair value, making it a fine defensive choice for anyone concerned about trade talks falling apart and potentially triggering a mild recession in late 2020 or 2021.
What if none of these four Super SWANs are your cup of tea? That's where the rest of this article comes in, a step-by-step walk-through of how to screen quality companies for good to great valuations.
Morningstar Is A Good (But Not Perfect) Place To Start Looking For Good Ideas
Morningstar is typically (though not always) a good starting location for blue-chip income investing ideas.
That's because they are 100% focused on long-term fundamentals, rather than 12-month price targets like most sell-side analysts (the ones that issue "Buy, Sell, Hold" recommendations).
Most of their fair value estimates are reasonable (though not always - more on this in a moment). So, here are all my blue-chip watch list stocks that Morningstar estimates are at least 20% undervalued.
Even with the market near all-time highs, you can see that, at least, according to Morningstar, there are plenty of quality names available at bargain prices. Dividend Kings disagrees with some of these valuations (Imperial Brands (OTCQX:IMBBY) is just 36% undervalued for example), but for the most part, these are quality companies trading at attractive valuations.
But you can't just look at any one analyst's fair value estimate and know if it's a good buy. That's because every company has its own risk profile, and differing business models mean that a 20% discount to fair value of a highly cyclical company (like commodity producers) isn't the same for one with very stable and recession-resistant cash flow (like a consumer staples company).
This is where looking at Morningstar's star ratings is a good next step. These ratings, which correspond to a reasonable buy, good Buy, and Very Strong Buy recommendations, factor in a company's risk profile, industry trends, management quality, and Morningstar's definition of "Moatiness" (which I sometimes disagree with but are for the most part on the money when it comes to corporations).
Morningstar's moat definition is based on their belief that a company can maintain returns on invested capital above its weighted cost of capital (using their assumptions plugged into the CAPM model) for 20 years or longer (wide moat) and 10 years or more (narrow moat). I look for competitive advantages that allow returns on invested capital above the industry norm and above the cash cost of capital (which matters more to the ability to grow dividends over time).
Here are my watch list companies that Morningstar considers 4- or 5-star Buys and Strong Buys.
You'll note that there are a lot more 4- and 5-star stocks than ones trading 20% or below Morningstar's estimated fair value. That's because Morningstar is adjusting for quality, safety, and overall cash flow stability (via their uncertainty ratings).
This is why Altria (MO), a 9/11 quality dividend king with very stable and recession-resistant cash flow gets a four-star rating from Morningstar despite the analyst estimating it's just 13% undervalued (and having poor management, an assessment I disagree with).
Dividend Kings considers Altria is a strong buy because it's 23% undervalued right now and likely to achieve 5% to 8% long-term growth.
|Quality Score (Out of 11)||Example||Good Buy Discount To Fair Value||Strong Buy Discount||Very Strong Buy Discount|
|7 (average quality)||AT&T (NYSE:T), IBM||20%||30%||40%|
|8 above-average quality||Walgreens (NASDAQ:WBA), CVS (NYSE:CVS)||15%||25%||35%|
|9 blue chip quality||Altria, AbbVie (NYSE:ABBV)||10%||20%||30%|
|10 SWAN (sleep well at night) quality||Pepsi (NASDAQ:PEP), Dominion Energy (NYSE:D)||5%||15%||25%|
|11 (Super SWAN) - as close to a perfect dividend stock as exists on Wall Street||3M, Johnson & Johnson (NYSE:JNJ), Caterpillar (NYSE:CAT), MSFT, Lowe's (NYSE:LOW)||0%||10%||20%|
To me, a Super SWAN dividend king like 3M (NYSE:MMM) is more attractive 20% undervalued than a lower quality company like IBM (NYSE:IBM) that's 35% undervalued. But at the right price, even an average quality company that has a safe dividend that's likely to grow at all is a potentially attractive investment, at least for some people's needs.
However, while a 4- or 5-star Morningstar stock is usually a good long-term investment, it's important to remember that some of its recommendations can be far off the mark. Dividend Kings uses a 100% pure F.A.S.T. Graphs-powered historical valuation method that only looks at historical and objective data and sometimes disagrees with Morningstar.
Typically, these disagreements are minor. Sometimes, they are not. For example:
|Company||Morningstar Fair Value||Dividend Kings 2019 Historical Fair Value|
|Home Depot (HD)||$170||$199|
|Simon Property Group||$189|
|UnitedHealth Group (UNH)||$310||$214 in 2019 about $240 in 2020|
|American Water Works (NYSE:AWK)||$93||$80|
Morningstar usually has similar estimates as us for most sectors, but for popular momentum stocks (like many tech names), they often appear to try to justify rich valuations. For example, here are the P/E multiples they use to determine fair value for Super SWANs Nike, Microsoft and UnitedHealth.
- Nike: 36 /PE = Morningstar fair value (historical PE range 22 to 26)
- Microsoft: 29 P/E = Morningstar fair value (historical PE range 16 to 20)
- UnitedHealth: 21 P/E = Morningstar fair value (historical PE range 14 to 18)
How can you tell whether Morningstar's fair value estimates are reasonable or just plain crazy? By looking at objective metrics, like P/E ratios.
Price-To-Earnings Vs. Historical Norm
While no single valuation method is perfect (which is why DK uses 10 of them), a good rule of thumb (from Chuck Carnevale, the SA king of value investing and founder of F.A.S.T. Graphs) is to try not to pay more than 15 times forward earnings for a company. That's the same rule of thumb that Ben Graham, the father of value investing, considered a reasonable multiple to pay for a quality company.
This is because P/E ratios are the most commonly used valuation metric on Wall Street, and 15.0 P/E being a reasonable price for quality companies is based on Mr. Carnevale's 50 years of experience in asset management valuing companies. He bases that on an earnings yield of 6.7% (inverse of a 15 P/E) being roughly equal to the 200-year return of the stock market.
Chuck also considers 15 times cash flow to be prudent for most companies, as do all the founding Dividend Kings.
Here are dozens of blue-chip companies with very low forward P/Es and their five-year average P/Es. Note that some industries are naturally prone to lower multiples (such as financials) due to more cyclical earnings. Which is why you want to compare their current P/Es to their historical norms. (Morningstar offers 5-year average P/Es, but 10 years is better for factoring in industry/sector downturns.)
Don't forget that P/E ratios for MLPs, REITs, and yieldCos are not a good indication of value since high depreciation results in lower EPS. Price/cash flow is a better approach with such pass-through stocks.
Historical P/E and a 15.0 rule of thumb are not perfect. 5-year average P/Es can give a false reading if something extreme happened, like a bubble or industry crash, causing the energy P/E ratio averages to become absurd.
This brings me to another important metric to check: price-to-cash flow, which replaces the P/E ratio for REITs, yieldCos, MLPs/midstreams, and many LPs.
Price-to-Cash Flow Vs. Historical Norm
While earnings are usually what Wall Street obsesses over, it's actually cash flow that companies run on and use to pay a dividend, repurchase shares, and pay down debt. Thus, the price-to-cash flow ratio can be considered a similar metric to the P/E ratio but a more accurate representation of a company's value. Chuck Carnevale also considers a 15.0 or smaller price-to-cash flow ratio to be a good rule of thumb for buying quality companies at a fair price. Buying a quality company at a modest-to-great cash flow multiple is a very high-probability long-term strategy.
Again, comparing a company's price-to-cash flow against its historical norm can tell you whether it's actually undervalued. Dividend Kings uses 10-year average cash flows, and Morningstar only offers 5-year averages. For cyclical companies, sometimes, that can cause skewed results (which is why we use longer time periods and as many of our 10 valuation metrics are industry-appropriate).
Here are the companies on my watch list with the lowest price-to-cash flows.
Again, historical price-to-cash flow estimates are not perfect. TerraForm Power (TERP), a level 8/11 quality yieldCo, was run into the ground and nearly bankrupted by its former sponsor SunEdison (which did go bankrupt). Brookfield Asset Management (NYSE:BAM) rescued it and turned it into a great high-yield dividend growth stock, which justifies a much higher valuation.
Similarly, Delta Air Lines (DAL) trades at 4.4 times operating cash flow right now. That's low BUT due to the cyclical nature of its industry, the market has historically valued it at just 5.4 times cash flow.
Is Delta undervalued? Yes, it's worth $70 in 2019, so about 21% undervalued right now. But the point is that you can't assume that the rule of thumb 15 times cash flow will be appropriate for all companies. If you simply use the 15 rule of thumb on DAL's 2019 expected operating cash flow per share you might think the company is worth $191 and that it might be 71% undervalued.
Worse still, you might decide to back up the truck on Delta, assuming that a return to a 15 price to cash flow that the company has never actually traded at, might mean 37% return potential.
Delta actually has 8% to 13% long-term growth potential and applying its 9 to 10 historical P/E, can deliver 9% to 18% CAGR total returns over time. That's still a great return and Delta is a "good buy" on the Dividend Kings' Master List.
But when making decisions about where to invest your limited capital, you need to have to know what a company is both truly worth (or at least a reasonable estimate) and what kind of total returns are realistically possible.
P/E-Growth Ratio (Growth At A Reasonable Price) And Putting It All Together
According to Chuck Carnevale and Ben Graham, Buffett's mentor and the father of value investing, a 15 P/E is prudent for most companies, even slow-growing ones. But if a company is able to grow especially fast (over 15% over time), it deserves a higher multiple. That's because the compounding power of time means a company that grows at a faster rate can generate many times greater wealth and income for you.
How Much Your Money Will Grow Based On Company Growth Rate And Time Period
|Long-Term Growth Rate||10 Years||20 Years||30 Years||40 Years||50 Years|
Note that this table is simply meant to illustrate a point. It's not actually possible for any company to grow 50% annually for 50 years, which would mean earnings and cash flow growing nearly 1 billion-fold (it would have to literally take over the world).
Most investors, depending on their needs (and ideal asset allocation), can likely achieve 5-10% returns over time. Warren Buffett is one of the greatest investors in history, with about 21% CAGR returns over 54 years.
Since 2000, the S&P 500's earnings growth has been about 6.5% CAGR, which is why a company that can realistically grow much faster may be worth a higher-than-normal P/E (or price-to-cash flow). This is where the P/E-Growth or PEG ratio comes in.
While this method is limited by what growth assumptions you use, it's a quick and dirty way to screen for potentially attractive dividend growth investments when used in conjunction with other methods. The S&P 500's PEG ratio is currently 2.7 to 3.0 (depending on the growth estimates you use). A PEG of 1.0 or less is generally excellent.
Here are my watch list stocks with PEGs of close to one, as estimated by Morningstar's forward growth forecast (some of those growth estimates are likely to be proven wrong).
PEG is a good way to strive for "growth at a reasonable price", or GARP. However, the obvious flaw is that it's based on forward projections that can be wrong. All valuation metrics have their limitations, which is why you shouldn't rely on just one.
For example, FedEx (FDX) is a great company, trading at a nice discount, which is why Dividend Kings Deep Value portfolio bought it. But its PEG is not 0.4, which implies about 30% long-term growth (6% to 14% is realistic, depending on if we get a recession).
Here are the PEG Ratios of some of these companies, using FactSet data and consensus growth estimates
- FedEx: 9.2 forward PE/13% long-term growth = 0.71
- DAL: 9.0 forward PE/9.9% long-term growth = 0.91
- Pioneer Natural Resources (NYSE:PXD): 4.9 forward P/EBITDA divided by 21% long-term growth = 0.23
- CAT: 11.5 forward PE/12.0% long-term growth = 0.96
- Marathon Petroleum (NYSE:MPC): 3.9 forward P/EBITDA over 12.0% long-term growth = 0.33
- Broadcom (NASDAQ:AVGO): 13.2 forward PE/13.9% long-term growth = 0.95
A PEG of close to one is excellent, especially compared to the 3 PEG of the broader market. But the point is that screening a company via all of these approaches can minimize the chances of overpaying for a quality name (make sure to check that earnings and cash flow are growing, so you don't buy a value trap by mistake).
For example, Simon Property passes all these value screens except PEG.
- Dividend Kings Historical Discount To Fair Value: 29% (Very Strong Buy)
- Morningstar's estimated discount to fair value: 22% (4 stars)
- 2019 P/FFO: 11.6 (vs. 15 to 18 historical)
- PEG: 2.7 (based on P/FFO and FactSet 4.3% long-term consensus growth)
Notice how for Simon you shouldn't get hung up on PEG. That's because it's an inappropriate metric for the sector.
REITs are owned for their very stable cash flow, and thus trade at a very high PEG. The sector's PEG is currently 20.4 P/FFO over 4.7% growth, so 4.3. Is that high? Actually the REIT sector P/E has historically been about 4.3. Because REITs are experiencing a growth boom (courtesy of high share prices and low cost of capital) their 20.4 P/FFO multiple is appropriate, at least for as long as REITs can maintain such above-average growth.
Simon's 2.7 PEG is 37% below the sector average. Its expected growth rate is equal or slightly above the REIT historical norm. This disconnect between fundamentals and sector peers is how you need to consider PEG when looking at REITs.
Basically, first, you need to know what companies are worth owning (Dividend King's motto is "quality first, valuation second and proper risk management always). That's where a good watchlist is useful. Next, you need to know what a company's worth today. That involves looking at several fundamental valuation metrics such as dividends, earnings, and cash flow.
When you find a company that is both above-average quality and trading at a below-average valuation, then you have truly found a powerful tool for achieving your long-term financial goals.
Quality Stocks At 52-Week Lows Are Great Screening Candidates
Note that, like any valuation screening tool, 52-week lows are not sufficient but a place to begin your research.
I maintain a master list that takes every company I track for Dividend Kings and applies an 11-point quality score based on dividend safety, the business model, and management quality.
- 7: average quality, seek 20% discount to fair value and limit to 2.5% of invested capital or less
- 8: above-average quality company, seek 15% discount to fair value or better, limit to 5-10% of invested capital
- 9: blue-chip company, limit to 5-10% of invested capital and seek 10% discount to fair value
- 10: SWAN stock, buy with confidence at 5% or greater discount to fair value or better, limit to 5-10% of invested capital
- 11: Super SWAN (as close to an ideal dividend stock as you can find on Wall Street), fair value or better, limit to 5-10% of your invested capital
A score of 7 is average quality, which means a 2% or smaller probability of a dividend cut during a recession, based on how much S&P 500 dividends have been cut in past economic downturns (2% was the highest average cut during the 1990 recession, all other recessions were less).
I've programmed that watch list to track prices and use the 52-week low as a means of knowing when a blue-chip or SWAN stock is within 5% of its 52-week low and, potentially, a Buffett-style "fat pitch" investment. This means a quality company is:
- Trading near its 52-week (or often multi-year) low
- Undervalued per other valuation methods
- Offers a high probability of achieving significant multiple expansion within 5-10 years, and thus delivering double-digit long-term total returns over this time period
Another method you can use is to target blue chips trading in protracted bear markets, such as sharp discounts to their 5-year highs. Buying a company at multi-year lows is another way to reduce the risk of overpaying and boost long-term total return potential.
In the above table, I've set it up to show all the methods we've discussed today. You can thus see that most of the above companies are potentially fantastic long-term buys, based on many important valuation metrics, including Morningstar's qualitative ratings (of management quality, moat, and margin of safety).
This is what I mean by "fat pitch" investing - buying them when they are at their least popular ("Be greedy when others are fearful"). It doesn't mean buying some speculative, small company with an untested business model in hopes it becomes the next Amazon (NASDAQ:AMZN).
The goal is to buy quality blue chips whose fundamentals are firmly intact, and whose valuations are so ridiculously low that modest long-term growth can deliver 15-25% CAGR total returns as the market realizes its mistake.
Mind you, it can take a long time for coiled springs like these deep value blue chips to pop (sometimes 5-10 years), but as long as their business models remain intact and they keep growing cash flow and dividends, they eventually will, which is why seven of the nine best investors in history have been value investors.
Bottom Line: No Matter What Happens Next With Trade Talks, The World Isn't Ending And There Are Great Companies Smart Investors Can Safely Buy
I can't predict with certainty what will happen with trade talks or the stock market over the long term. But here's my educated guess:
- phase one talks drag on into 2020 but December 15th tariffs don't go up (based on Reuters report that a deal is "more likely than not)
- the market, starved of earnings news, and with the Fed sitting pat on rate policy, trades flat in a relatively tight range.
Could I be wrong? Absolutely. But the way to exponentially compound income and wealth over time, and thus achieve your long-term financial goals, isn't to obsess over the short term but focus on the long term.
The US/China trade conflict will NOT last forever. Right now 12-month recession risk is about 29%, backed up by 19 leading indicators that are still 22.8% above their historical baseline.
Slower growth in 2020 is NOT negative growth, and any pullback or correction is NOT likely the start of the next great mega-crash.
Putting new money to work over time, in quality companies at reasonable to attractive valuations is how you convert active income you have to work for, into passive income that can support a prosperous retirement.
Simon Property Group, Enterprise Products Partners, Federal Realty and Colgate are four great ideas for smart investors to consider during this time of elevated trade uncertainty.
These four low beta Super SWANs all have rock-solid balance sheets and very safe dividends that will keep growing steadily no matter what happens next with trade talks.
All four are also likely to be defensive in the event of a correction caused by a collapse in trade talks and outperform the broader market. More importantly, all four are likely to outperform the broader market over the next five years (even slow-growing Colgate) while delivering generous, safe and steadily rising income.
If you don't want to buy those four, then there are plenty of great alternatives available. You just need to use a methodical and evidence-based approach to screening quality companies for reasonable to attractive valuations.
How many dividend stocks are worth buying today? Looking at the Dividend Kings Master List, out of 288 companies
- 138 are trading at fair value or better
- six dividend kings are trading at fair value or better
- 19 dividend aristocrats are at fair value or better
- 13 Super SWANs are trading at fair value or better
That's even with the market near all-time highs and about 10% historically overvalued.