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Stocks  | October 23, 2019

Why The Fed Is Likely To Cut The Fed Funds Rate Again In October

The market LOVES when the fed cuts rates, though this has little effect on long-term rates, which, all else being equal, help elevate stock prices (if the economy is decent).

However, Moody's Analytics estimates that each 25 bp rate cut from the Fed stimulates the economy by 0.1% to 0.15% within 12 months. So, there is some fundamental justification behind the market's obsession with short-term rate cuts, which is hardly new.

From 1968 to 1976, Bank of America estimates that the market was more affected by the Fed's rate policies than any actual fundamentals.

Bond Futures Probability Of Rate Cut Estimate

Right now, the bond market is estimating an 89% probability of an October rate cut and 56% probability of at least one more by April 2020 (four in total). The Fed is data-driven, and indeed, the US economic outlook has worsened considerably over the past few months.

David Rice's Baseline and Rate of Change or BaR grid tracks 19 leading indicators that together predicted the last four recessions. Since peaking in Q3 2018, the average of all 19 indicators (measured above historical baseline and by month over month rate of change) has been steadily declining, indicating a significant slowdown in US growth.

How slow? From a high of 2.9% in 2018, the New York Fed is now estimating 1.9% growth in Q3 and 1.1% in Q4.

That model is backed up by all 19 leading economic indicators.

Mind you we're far from levels that would indicate a recession is coming anytime soon, or even at all. The average of all 19 indicators is 23.3% above baseline, and the eight most sensitive ones (including the yield curve) are 25.1% above baseline. This indicates that as long as nothing gets worse, the overall average will go up in the next few months.

According to Mr. Rice, and confirmed by the last three recessions, 20% or less above baseline is the danger zone from which a vicious cycle of pessimism by consumers and businesses can lead to a long slide into recession.

15% above baseline is the point at which Mr. Rice considers a recession to be the most likely outcome, though it can still take six to 9 months to begin even if economic fundamentals weaken to that level.

Given the weaker than expected economic reports of the last few weeks, I consider a 3rd insurance cut to be the reasonable and prudent move by the Fed, which the bond market agrees with. However, it's very possible that the financial markets are pricing in far more rate cuts than the Fed plans to deliver.

...But That's Far From Guaranteed

The latest Fed minutes indicate that several FOMC members are concerned that the market is pricing in more rate cuts than it currently considers appropriate.

It might become necessary for the Committee to seek better alignment of market expectations regarding the policy rate path with policymakers’ own expectations for that path.” - Fed minutes

Chicago Fed President Charles Evans (who voted for the first two cuts) is skeptical of the need for more this year.

“I think policy probably is in a good place right now. All told, the growth outlook is good, and we have policy accommodation in place to support rising inflation...That said, there is some risk that the economy will have more difficulty navigating all the uncertainties out there or that unexpected downside shocks might hit.” - Charles Evans (emphasis added)

Fed Chairman Jerome Powell has also stated several times that "the economy is in a good place" and so investors need to be prepared for the Fed to disappoint on October 31st.

  • several FOMC members want to wait to see how 2 rates cuts work through the economy before cutting more
  • partial US/China trade deal (not yet signed just verbal agreement) might boost business and consumer confidence in November

Basically, the Fed wants to see more data, and that's the reasonable and prudent approach all investors should strive for. According to the bond market, the 12-month recession risk is about 32%, down from 48% a month ago.

That means a 68% probability of no recession by late 2020, and slowing growth is not negative growth.

The right approach to take when making investment decisions is to focus on your long-term goals, always factoring in proper risk management, and buying quality companies at reasonable or attractive valuations that will do well no matter what the Fed, economy or stock market does in the short term.

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:

  • 47 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 (235 companies and counting)

It's from these lists that I present five potentially excellent long-term dividend growth opportunities you can safely buy ahead of the October Fed meeting, no matter the outcome.

4 Great Dividend Growth Stocks To Buy Now... No Matter What The Fed Does Next

Due to the uncertainties facing our economy due to the ongoing US/China Trade Conflict, I'm presenting a mix of defensive (recession-resistant/low volatility) and cyclical companies for your consideration.

All of these companies are owned by the Dividend Kings across our four model portfolios (High-Yield Blue Chip, Fortress, Deep Value Blue Chip and $1 Million Retirement). I also own SPG, ET, and ENB in my retirement portfolio.

I selected an even mix of defensive and cyclical companies, all of which will do well no matter what happens to interest rates and the economy over the coming years.

Super SWAN Simon Property is actually a solid defensive choice for today's market, given that the REIT is historically 60% less volatile than the S&P 500 (just like JNJ), and its cash flows tend to remain stable during mild recessions.

  • 2000 FFO/share growth: 7%
  • 2001 FFO/share growth: 7%
  • 2002 FFO/share growth: 8%

During the late 2018 correction, the worst in a decade in which the S&P 500 plunged 17% in the final three weeks, Simon outperformed Super SWAN dividend king Johnson & Johnson (JNJ) as well as the dividend aristocrats.

It helps that Simon is 28% undervalued for 2019's expected results and about 30% relative to 2020's consensus expectations. As my fellow Dividend King founder Chuck Carnevale says "undervaluation, quality, and growth make any company defensive".

Simon was actually up modestly in early December before recession panic gripped the market and sent even the highest quality defensive names tumbling.

Defensive just means recession-resistant cash flow and historically low volatility that USUALLY outperforms by falling less during market downturns. Defensive does NOT mean "bond alternative that's guaranteed to go up when stocks are falling."

Notice how my risk management guidelines, created after consulting with colleagues with 150 years of combined asset management experience, begins with asset allocations, which is the cornerstone of a properly constructed SWAN portfolio.

All my stock recommendations are purely meant for the equity portion of your portfolio.

Why are the Dividend Kings buying Simon steadily right now? First, the valuation is the lowest in a decade, meaning VERY low expectations for this high-quality REIT's long-term growth expectations. With earnings coming up October 30th, SPG could be poised for a pop well above its current prices.

Quarter after quarter, Simon's industry-leading assets and management team defy the "retail apocalypse" and bearish predictions that this REIT is doomed.

Simon's core fundamentals, like occupancy, lease spreads, same-store Net Operating Income or NOI growth, and sales per square foot continue to be stable or trend positive.

YearUS Mall OccupancyLease Spread
2019 (YTD)94.8%29.8%

Occupancy rates are above their 17-year average and well above the early to mid-2000s which saw the REIT deliver strong 6% to 8% annual cash flow growth.

I'm not saying Simon is certain to soar after earnings once more vindicate the long-term fundamental thesis, but with the REIT so undervalued, expectations are very low creating an easy bar to clear to send the stock above my personal $151 buy price (my cost basis).

What's the immediate benefit of buying Simon today? The 5.6% yield is very safe and pays you handsomely to wait out the excessive current pessimism. And given that most asset managers expect the S&P 500 to deliver 5% to 8% CAGR total returns over the next five years, Simon's current dividend alone (which is very likely to grow steadily even during a recession) might outperform the broader market over that time.

But the reason that I and Dividend Kings are steadily building our Simon Positions is the REIT's very strong long-term return potential.

  • YCharts long-term growth consensus: 3.8% CAGR
  • FactSet long-term growth consensus: 4.8% CAGR
  • Reuters' long-term growth consensus: 8.6% CAGR
  • 20-Year CAGR FFO/share growth: 7.3%
  • Realistic long-term growth range: 4% to 9%

Simon, like most REITs, isn't going to be a growth demon, but expand cash flow and dividends at a modest rate. This is where the power of its very safe high-yield and the lowest valuation in a decade comes in.

Outside of bubbles and extreme bear markets, Simon's market-determined fair value cash flow multiple range is 15 to 18. Applying these fair value multiples to the REIT's realistic 4% to 9% long-term growth potential allows us to approximate a realistic long-term CAGR total return potential range.

Even highly conservative estimates result in 12% CAGR total return potential over the next five years, nearly doubling our investment.

The upper end of the total return potential range is 23% CAGR, nearly tripling your investment.

T. Rowe Price is a Super SWAN dividend aristocrat (33-year payout growth streak) and my favorite active asset manager. T. Rowe's mutual funds consistently outperform its peers and benchmarks resulting in continued strong net asset inflows, including $2.5 billion in Q2. That was a low number due to a 6% market pullback in May.

T. Rowe's assets under management are now at $1.1 trillion and in Q2 rose 7.7% despite the market being highly volatile and basically going nowhere over the past year.

Over the long term, analysts expect TROW to enjoy stable operating margins of about 40% (42% in Q2), which is far above the 25% level that's considered good for asset managers.

Those high margins are expected to drive strong long-term earnings and cash flow growth

  • 6.1% CAGR long-term Reuters' consensus
  • 7.8% CAGR long-term FactSet consensus
  • 9.3% CAGR long-term YCharts consensus
  • 10.7% CAGR over the past 20 years
  • Realistic long-term growth range: 5% to 10% (depending on market performance and timing of recessions/bear markets)

TROW's fair value PE outside of bubbles and bear markets is between 17 and 21, depending on medium-term growth rates.

5% long-term growth and the low end of historical PE gets you 10% CAGR long-term return potential. This is not just above the market's 9.1% CAGR historical norm, but possibly double what the S&P 500 might deliver over the next five years.

At the upper end of its total return range, TROW growing at 10% and trading at a 21 PE could deliver over 20% CAGR total returns over the next five years.

That's three to four times the market's likely returns, from a generously yielding Super SWAN aristocrat.

Energy Transfer is a nearly 10% yielding MLP whose ultra-high yield is both safe and likely to grow modestly over time.

That's courtesy of management's long-term guidance of $3-4 billion in annual growth project spending. Currently, ET is seeing mid-double-digit cash yields on investment. If ET enjoys 10% to 15% yields on investment over time, then 3% to 4% long-term cash flow growth is in store for what's effectively an energy utility.

Even during the great oil crash of 2014 to 2016, when crude fell 77%, Energy Transfer's long-term contracted and volume committed cash flow remained stable.

Buybacks that could begin next year (once the 4.0 to 4.5 leverage target is reached) could significantly accelerate cash flow/unit growth over time. How much? Currently, ET is paying out about 50% of distributable cash flow (equivalent to corporate FCF or REIT AFFO) to cover its nearly 10% yielding payout.

ET's current $5 billion growth backlog, most of which is coming online this year, could generate $2.6 billion in annual retained DCF by 2020. This can be split between modest payout growth in the future, but also repurchase its super undervalued stock, which is currently sporting a DCF yield of about 20%.

That means stock buybacks would be more profitable than actual growth investments, which ET expects to run about $17.5 billion over the next five years.

The market cap is $33 billion, meaning that buybacks could potentially repurchase up to 8% of units per year. This means I estimate this MLP's long-term cash flow growth potential at 3% 12%, depending on how aggressively it buys back stock in the future. I'm not the only one bullish on ET's long-term growth prospects.

  • YCharts long-term growth consensus: 11.2% CAGR
  • Reuters' long-term growth consensus: 16.5% CAGR
  • FactSet long-term growth consensus: 11.2% CAGR
  • Realistic growth range: 3% to 16.5%

Outside out of the current MLP bear market (worst in the industry's history and not supported by strong fundamentals), ET's fair value EBITDA multiple is between four and five. But to err on the side of conservatism, let's include the average 3 EBITDA multiple over the past four years in our total return estimates.

Even if Energy Transfer never buys back any stock, and grows 3% over time and merely reverts back to the MLP bear market average multiple, it could deliver 17% CAGR total returns that more than double your investment.

ET is so undervalued today that if it achieves the upper end of its realistic growth range and reverts back to its 5 times EBITDA normal valuation, it could deliver 45% CAGR total returns over the next five years. That would likely make it one of the best-performing stocks of any kind, in the entire world over the next half-decade.

British American Tobacco is a holding in three Dividend King model portfolios and my backup high-yield deep value high-yield choice should undervalued Super SWANs trade above my personal buy price (cost basis) in any given week.

Between 2018 and 2024, BTI hopes to increase its RRP (vaping and heat stick) users from 9 million to over 20 million.

4% revenue growth from rapidly growing reduced-risk products, combined with its stable premium cigarette revenues plus post-deleveraging buybacks is how management expects to deliver 7% to 9% long-term EPS and dividend growth.

Tobacco, in general, is trading at the lowest valuations in a decade which is why Dividend Kings and I have been steadily adding in the past few months, bringing our exposure (in two out of four portfolios plus my retirement portfolio) close to the 15% industry exposure risk limit.

Despite what the "vapocalypse" might have you believe, analysts remain bullish on BTI's ability to achieve its long-term growth guidance.

  • YCharts long-term growth consensus: 7% CAGR
  • Reuters' long-term growth consensus: 7% CAGR
  • FactSet long-term growth consensus: 8.4% CAGR (highest of any tobacco giant)
  • Realistic long-term growth range: 6% to 9% CAGR

Over the past 20 years, outside of bubbles and bear market periods, the market has valued BTI's earnings at 14 to 16 times. So, let's see what happens when we apply those historical, market-determined fair value multiples to a company that yields a safe 7.7% that's likely to grow 6% to 9% over time.

21% CAGR total returns are the conservative end of the total return potential range, courtesy of a nearly 8% yield and a PE that's about half the company's historical norm (while fundamentals remain firmly intact).

BTI is expected to grow 9% in 2020, 6% in 2021 and 11% in 2022 according to FactSet. 9% long-term growth is not unrealistic, just the high end of what's possible.

Applying that growth to a 16 PE generates 28% CAGR total return potential that would be four to five times what the S&P 500 is likely to deliver, and you'd enjoy a safe yield that's nearly four times as large while you wait for the market to stop ignoring objectively strong fundamentals.

While many investors don't want to own tobacco stocks for moral/regulatory risk reasons, 21% to 28% realistic return potential is why I personally am looking to make BTI 5% of my retirement portfolio and up to 5% of Dividend Kings' Deep Value and High-Yield Blue Chip Portfolios. My father has also invested 5% of his retirement portfolio in BTI based on my recommendations.

What if none of these stocks are right for your needs? That's where the rest of this article comes in, a step-by-step walkthrough of how to screen a watchlist of quality companies for reasonable to attractive 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 (CBS is 35% undervalued, not 51%), 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 Super SWAN dividend champion Cullen/Frost Bankers, despite being just 7% undervalued per Morningstar's estimate (14% undervalued according to Dividend Kings' model) is a four-star stock.

Morningstar's approach to star rating is similar to my own approach in which the quality of a company determines how undervalued it is before I call it a good, strong or very strong buy.

Quality Score (Out of 11)ExampleGood Buy Discount To Fair ValueStrong Buy DiscountVery Strong Buy Discount
7 (average quality)AT&T, IBM20%30%40%
8 above-average qualityWalgreens, CVS15%25%35%
9 blue chip qualityAltria, AbbVie10%20%30%
10 SWAN (sleep well at night) qualityPepsi, Dominion Energy5%15%25%
11 (Super SWAN) - as close to a perfect dividend stock as exists on Wall Street3M, JNJ, CAT, MSFT, LOW0%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:

CompanyMorningstar Fair ValueDividend Kings 2019 Historical Fair Value
3M (MMM)$188$188
Microsoft (MSFT)$155$100
Apple (AAPL)$200$165
Nike (NKE)$98$66
Home Depot (HD)$170$199
Simon Property Group (SPG)$195$206
UnitedHealth Group (UNH)$310$214 in 2019 about $240 in 2020
Merck (MRK)$97$76

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 PE 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 PE = Morningstar fair value (historical PE range 16 to 20)
  • UnitedHealth: 21 PE = Morningstar fair value (historical PE range 14 to 18)
  • Merck: 19.7 PE = Morningstar fair value (historical PE range 13 to 15)

Now, Merck's growth is expected to accelerate strongly in the coming years, courtesy of blockbuster cancer drug Keytruda. But Morningstar is claiming that almost 20 times earnings is fair value for a company that normally trades at 13 to 15, due to the patent cliff all drugs eventually face and high and persistent regulatory risk.

Even fast-growing pharma giants like AbbVie, which has grown at nearly 14% CAGR since 2013 trade at 14 to 16 times earnings. Modestly growing drug blue chips like JNJ average 15 PEs over time. Basically, with rare exceptions (like BMY which averages 20 times earnings) few drug makers achieve consistent multiples as high as Morningstar expects to be "the new normal" for Merck.

I should point out that Morningstar's valuation model is based on assumed $25 billion in peak Keytruda sales, which is the highest estimate I've seen.

  • $22.5 billion in 2025 sales according to GlobalData Research
  • $17 billion in 2024 sales according to EvaluatePharma
  • $10 billion in 2026 sales according to Fortune

Merck's market-determined fair value (long-term rolling averages) has never approached a 19.7 PE. That doesn't mean the stock hasn't ever traded at such lofty multiples.

The pink line represents Morningstar's 19.7 fair value PE. The only times this blue chip has ever traded at such levels was during the tech bubble, when it peaked at a dangerous 31 times earnings and then proceeded to crash 69% over the next five years. From a PE of 19.5 in October 2001 (about Morningstar's fair value PE), Merck went on to crash 55% through September of 2005.

It took six years to for Merck investors who paid 19.5 times earnings to break even on the stock, and only after it went into another bubble in 2007.

Drug stocks are naturally volatile and from Morningstar's approximate fair value multiple MRK investors saw basically zero total returns from 2001 to mid-2018. Does that mean that 10/11 quality SWAN stock Merck is a bad investment? Not if you buy it when it's most out of favor and trading at attractive levels.

If you bought MRK when the market hated it, rather than ignoring its complex risk profile like today, in 2005, then over 14 years, you've enjoyed a 10.3% CAGR total return. The S&P 500 delivered 7.5% CAGR total returns over that time.

From the 2009 lows, MRK has delivered 14.6% CAGR total returns, compared to the S&P 500's 13.2% CAGR.

Morningstar's claim that almost 20 times earnings on Merck is the "new normal" is likely akin to Yale professor Irving Fisher, who on Oct. 16, 1929, declared that stocks had reached “what looks like a permanently high plateau.”

The largest stock market crash in US history, which ultimately saw the market fall 90% before bottoming in 1932, began on October 29th, just 13 days after one of the nation's most respected economists predicted that stocks would never again suffer a significant decline.

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 forward P/Es of 15 or less 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.)

Super SWAN BlackRock (BLK) is a great example of how even a company with a PE of 15 can make an attractive income growth investment. I own it in my retirement portfolio and Dividend Kings owns it in our Fortress portfolio, which is 100% Super SWANs, 11/11 quality companies and basically the closest thing to perfect dividend stocks that exist on Wall Street.

  • Reuters' five-year growth consensus: 6.1% CAGR (possibly pricing in a recession)
  • FactSet long-term growth consensus: 11.1% CAGR
  • YCharts long-term growth consensus: 12.0% CAGR
  • Historical rolling growth rates: 8% to 19% CAGR
  • Realistic long-term growth potential: 8% to 12%

BlackRock normally trades at 17 to 22 times earnings, and so its current PE is below this historical range, despite its fundamentals being intact, and its historical growth rate expected to be maintained over time.

Even if a recession does occur and BLK grows at just 6.1% and trades at the low end of its historical PE range, investors can likely expect close to double-digit CAGR total returns over the next five years.

BlackRock's realistic best case scenario is achieving 12% growth and returning to the high end of its historical fair value range. Which could nearly triple your investment over the next five years.

The FactSet consensus growth rate of 11.1% CAGR applied to its mid-historical PE range shows BlackRock capable of nearly 20% CAGR long-term returns.

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 the 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 is why it's best to use the longest time period that corresponds to a company's expected growth rate. That will eliminate periods of short-term market insanity, such as when telecom tower REIT American Tower Corp. (AMT) traded at 86 times FFO in early 2000 (tech bubble). That stock fell 97% before bottoming in 2002 at a P/FFO of just 4, from which it then went on to deliver 29% CAGR total returns over the next 17 years.

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 as are industry-appropriate).

Here are all the companies on my watch list with price-to-cash flow of 15.0 or less.

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 rescued it and turned it into a great high-yield dividend growth stock, which justifies a much higher valuation (though it is about 7% overvalued today).

Similarly, Pfizer (PFE) has a bit of uncertainty surrounding whether the upcoming spin-off of its generic business will result in an effective dividend cut.

Pfizer is currently fairly valued (3% undervalued technically) and trades at 13 to 15 times free cash flow. The long-term and realistic growth range on Pfizer are between 3% and 6%, meaning that this 4% yielding blue chip offers 8% to 15% CAGR total return potential. Personally I would want to see PFE trade nearer $34, creating a 10% margin of safety that factors in its risk profile before buying it, but it is a reasonable buy for anyone who is confident that the spin-off's dividend will make them whole.

The point is you want to use several valuation metrics in concert to ensure that any false signals are eliminated (which is why DK uses up to 10).

PE/Growth Ratio (Growth At A Reasonable Price) And Putting It All Together

According to Chuck Carnevale, 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

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 PE/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 2.6-2.7 (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).

FedEx (FDX)is a great company, trading at a nice discount, which is why Dividend Kings Deep Value portfolio bought it. But it's PEG is not 0.36, which implies about 20% long-term growth (9% to 14% is realistic, possibly 6% CAGR over the next five years if we get a recession). Based on the analyst consensus of 14% per FactSet Research, and the blended PE of 9.2, FDX's PEG is 0.66, which is still incredibly low and makes it a fast-growing bargain worth considering.

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.

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, BTI clears nearly all these screens, making it a great deep value buy.

  • Dividend Kings Historical Discount To Fair Value: 32% (Strong Buy)
  • Morningstar's estimated discount to fair value: 41% (5 stars)
  • 2019 PE: 8.3 (vs. 14 to 16 historically)
  • 2020 PE: 8.1
  • Price-to-free cash flow: 9.4 for 2019, 8.4 for 2020 vs. 9 to 13 historical norm
  • PEG: 1.04 (based on management's mid-range 8% management guidance growth)
  • Forward PEG: 1.01

Like I said, British American Tobacco is one of my favorite high-yield dividend stocks right now, because any way you slice it, this stock is deeply undervalued.

When you see all these valuation methods lining up and saying the same thing, that's when you can "bend it like Buffett" and back up the truck on a quality dividend stocks. That's what I've been doing with tobacco stocks in recent weeks, buying BTI, Altria (MO), Imperial Brands (OTCQX:IMBBY) and Philip Morris International (PM) which collectively now make up about 13% of my portfolio and about 14% in two Dividend Kings Portfolios (15% is our risk cap on tobacco).

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 (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: Don't Let Interest Rate Uncertainty Keep Your From Making Reasonable And Prudent Investment That Serve Your Needs

I closely monitor the economic outlook, as well as interest rate and policy uncertainty in the Dividend Kings "Weekly Economic Update/What Companies We're Buying Now" articles.

While the bond market might be excessively optimistic about the probability of an October rate cut, I agree that one is likely, and more importantly, the reasonable and prudent action to take right now.

The time to stimulate the economy via rate cuts is before, not after, business and consumer confidence takes a dive before a recession. But I have confidence that the Fed will do the reasonable and prudent thing, which is looking at the data and make an appropriate decision about the Fed Funds rate.

In the meantime, I am personally still buying $1,000 per week of quality undervalued blue chips, and Dividend Kings continues to make reasonable opportunistic buys each week that fit our portfolio goals.

What happens in the next year isn't as important as a diversified and properly risk-managed portfolio that delivers generous, safe, and steadily rising income in all interest rate, economic and market conditions.

A revolutionary initiative is helping average Americans find quick and lasting stock market success.

275% in one week on XLF - an index fund for the financial sector. Even 583%, in 7 days on XHB… an ETF of homebuilding companies in the S&P 500. 

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