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Stocks  | April 17, 2019

Why Valuation ALWAYS Matters

Even the best companies can make terrible investments if you overpay. A Yale study looking at market returns from 1881 to 2016 found that starting P/E ratio had a significant effect on total returns out to 30 years. What's more, in the past few decades, valuation has explained about 45% of the market's forward 5-year returns.

In other words, buy-and-hold investors can't just blindly buy great companies at any price but need to remember Buffett's famous quote, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

The corollary to that quote is what I call "the Buffett rule," which is to never pay more than fair value for even the highest-quality companies. Doing so will lower your total returns, and since something great is always on sale, there is no reason to jump the gun on buying quality, low-risk dividend stocks.

After all, patience is the ultimate virtue of the long-term investor, because as Buffett also said, "the stock market is designed to transfer money from the active to the patient."

But there's another reason why valuation is always worth keeping in mind.

Value investing is one of the proven "alpha factors" that consistently beat the market over time. That includes January's rally (the strongest S&P returns in January in 32 years) when value stocks were the best alpha strategy of all.

Of course, value investing doesn't work all of the time - no investing strategy does.

Probability Of The Strategy Underperforming The S&P 500 Over Rolling Time Periods

But it's precisely because all investing strategies go through periods of underperformance that alpha factors keep working over decades. If any single approach could guarantee market-beating returns year in and year out, then everyone in the world would use it, and thus, the strategy would lose its edge.

Okay, so maybe value investing is great, and valuation is worth keeping in mind before buying any stock. But how does one find great companies trading at Buffett's mythical "fair value." Well, there are many approaches, but I personally consider four the most useful for long-term dividend growth investors.

Using these four valuation methods can tell us what are the best quality dividend growth stocks to buy at any given time, no matter how overvalued the broader market may become.

Discounted Cash Flow

Fundamentally, any company is worth the present value of all its future cash flow. That's as basic a valuation method as you can get. However, in reality, the future is uncertain, and the discount rate you use, as well as your growth assumptions, can make a DCF model say pretty much anything you want.

This is why I consider Morningstar's 100% long term, fundamentals-driven and conservative analysts to be a great source of DCF estimated fair values.

Those analysts generally assume slower growth than the analyst consensus and even sometimes management itself. As a result, Morningstar 4 and 5-star rated companies can be thought of as "strong buy" or "very strong buy" recommendations, respectively, from analysts whom I consider among the best in the business.

Above, you can see the top-rated companies that my Deep Value Dividend Growth portfolio owns. Every company presented here is one that my own long term, valuation-adjusted total return model (based on the one Brookfield Asset Management has been using for decades) expects to generate at least 13% long-term total returns (margin of error 20%).

Note that only the companies with "5-star prices" are ones that Morningstar has done a deep dive on. The "Q" rated companies are quantitative models and slightly less reliable.

Want a more quantitative approach to DCF? Well, here are my DVDGP holdings ranked by price/fair value, with each company at least 10% undervalued per Morningstar's estimate.

But DCF is far from the only valuation method you should consider.


Remember that Yale valuation study that looked at stocks based on P/E ratio? Well, the venerable P/E ratio is one of the most popular valuation approaches, and for good reason. While no valuation method is perfect, 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. Chuck's historical PE valuation approach has made him a legend on Seeking Alpha and, according to TipRanks, one of the best analysts in the country when it comes to making investors money.

Chuck usually compares companies to their historical P/E ratios, and he's ranked in the top 1.4% of all analysts tracked by TipRanks (based on the forward 12-month total returns of his recommendations). While 12 months is hardly "long term," the point is that Mr. Carnevale is a fantastic value investing analyst, and his historical valuation-driven approach is beating 98.6% of all bloggers/analysts, including 5,300 that work on Wall Street.

Here are DVDGP's portfolio holdings that have forward P/Es of 15 or less.

Note that stewardship rating is Morningstar's estimate of the quality of the management team. P = poor (DVDGP's policy is to avoid all such companies), S = standard (average to good), and E = exemplary (very good to excellent).

The Deep Value "Fat Pitch" Dividend Blue-Chips

When it comes to putting my own money to work in my retirement portfolio, I base my decisions on a watchlist that takes every company I track and applies an 11-point quality score based on dividend safety, the business model, and management quality. All dividend stocks can be ranked 3-11, and my watchlist (117 companies and growing slowly over time) only includes those with quality scores of 7 and higher.

  • 7: "dirty value" buy at a deep discount and high margin of safety (like Vodafone (NASDAQ:VOD)) limit to 2.5% of your portfolio or less
  • 8: Blue-chip (buy a modest discount to fair value) limit to 5% to 10% of your portfolio
  • 9+: SWAN stock: buy with confidence at fair value or better, limit to 5% to 10% of your portfolio

I've programmed that watchlist to track prices and use the 52-week low as a means of estimating a target price at which a blue-chip or SWAN stock becomes a Buffett-style "fat pitch" investment. This means a blue-chip/SWAN stock is:

  • trading near its 52-week (or often multi-year) low
  • undervalued per dividend yield theory (more on this in a moment)
  • offers a high probability of achieving significant multiple expansion within 5 years and thus delivering 15+% long-term total returns over this time period

Basically "Fat Pitch" investing is about achieving high-risk style returns with low-risk stocks, by buying them when they are at their least popular ("be greedy when others are fearful".)

My Retirement Holdings Sorted By Unrealized Capital Gains

This "fat pitch" approach is what I've used in my retirement portfolio to buy quality dividend stocks at their least popular. The result is that 12/20 of my companies have delivered double-digit total returns (including dividends) over the past 6 to 12 months.

Note that "fat pitch" blue-chips/SWANs do NOT guarantee success and you want to make sure to use appropriate position size limits that fit with your personal risk profile.

All investing is purely probabilistic, and my goal is for 70% to 80% of "fat pitch" recommendations to deliver great returns, with the losers delivering flat to slightly negative returns that will be overwhelmed by the winners and dividend income.

My personal limit is 5% of my portfolio for all new holdings (previous overweight holdings will be diluted down to this limit over time). I also have 20% sector caps in place, which means that I am currently unable to buy more REITs or energy stocks (I'm overweight both sectors and diluting them down with other buys).

Dividend Yield Theory: Market-Beating Blue-Chip Returns Since 1966

This group of dividend growth blue-chips represents what I consider the best stocks you can buy today. They are presented in 5 categories, sorted by most undervalued (based on dividend yield theory using a 5-year average yield).

  • High yield (4+% yield)
  • Fast dividend growth
  • Dividend Aristocrats
  • Dividend Kings
  • My Bear Market Buy List (my master watchlist of quality dividend stocks worth owning)

The goal is to allow readers to know what are the best low-risk dividend growth stocks to buy at any given time. You can think of these as my "highest-conviction" recommendations for conservative income investors that represent what I consider to be the best opportunities for low-risk income investors available in the market today. Over time, a portfolio built based on these watchlists will be highly diversified, low-risk and a great source of safe and rising income over time.

The rankings are based on the discount to fair value. The valuations are determined by dividend yield theory, which Investment Quality Trends, or IQT, has proven works well for dividend stocks since 1966, generating market-crushing long-term returns with far less volatility.

That's because, for stable business income stocks, yields tend to mean-revert over time, meaning cycle around a relatively fixed value approximating fair value. If you buy a dividend stock when the yield is far above its historical average, then you'll likely outperform when its valuation returns to its normal level over time.

For the purposes of these valuation-adjusted total return potentials, I use the Gordon Dividend Growth Model, or GDGM (which is what Brookfield Asset Management (NYSE:BAM) uses). Since 1956, this has proven relatively accurate at modeling long-term total returns via the formula: Yield + Dividend growth. That's because, assuming no change in valuation, a stable business model (doesn't change much over time), and a constant payout ratio, dividend growth tracks cash flow growth.

The valuation adjustment assumes that a stock's yield will revert to its historical norm within 10 years (over that time period, stock prices are purely a function of fundamentals). Thus, these valuation total return models are based on the formula: Yield + Projected 10-year dividend growth (analyst consensus, confirmed by historical growth rate) + 10-year yield reversion return boost.

For example, if a stock with a historical average yield of 2% is trading at 3%, then the yield is 50% above its historical yield. This implies the stock is (3% current yield - 2% historical yield)/3% current yield = 33% undervalued. If the stock mean-reverts over 10 years, then this means the price will rise by 50% over 10 years just to correct the undervaluation.

That represents a 4.1% annual total return just from valuation mean regression. If the stock grows its cash flow (and dividend) at 10% over this time, then the total return one would expect from this stock would be 3% yield + 10% dividend (and FCF/share) growth + 4.1% valuation boost = 17.1%.

The historical margin of error for this valuation-adjusted model is about 20% (the most accurate I've yet discovered).

Top 5 High-Yield Blue-Chips To Buy Today

Top 5 Fast-Growing Dividend Blue-Chips To Buy Today

Top 5 Dividend Aristocrats To Buy Today

Top 5 Dividend Kings To Buy Today

My Bear Market Buy List (AKA "Master Watchlist")

These are the blue-chips which I expect will generate 13+% total returns at their target yields. Note that all total return estimates are on a 10-year annualized basis. That's because total return models are most accurate over longer time frames (5+ years) when prices trade purely on fundamentals and not sentiment. This allows valuations to mean-revert and allows for relatively accurate (80% to 95%) modeling of returns.

The list itself is ranked by long-term CAGR total return potential from target yield. Stocks at their target yield or better (bolded) are good buys today.

This week, I added MSC Industrial (MSM), United Parcel Service (UPS), and United Health Group (UNH) to the watchlist.

Note that the bolded stocks are all at target yield or better, meaning it's a great time to either add them to your portfolio or add to an existing position.

Bottom Line: The Goldilocks Economy Continues But Never Overpay For Stocks

The good news is that in recent weeks, economic fundamentals have stabilized, and the probability of recession in 2020 appears to be fading.

Back in February, the New York Fed estimated the probability of a recession starting by early 2020 at 50%, the highest level in a decade. However, the Cleveland Fed's recession probability model puts the chances of a downturn beginning by March 2020 at about 33%.

With the yield curve currently at 12 basis points, we are currently on track for about 2% economic growth this year. That's "the Goldilocks zone" where inflation remains muted, the Fed doesn't have to hike, and there is little risk of financial excesses building up in the economy.

But just because no recession and bear market appears imminent doesn't mean investors should blindly chase the broader market higher. Current valuations are getting ahead of fundamentals.

In terms of putting new money to work, stay focused on top quality, undervalued blue-chip companies that have the greatest probability of sailing through a downturn with safe and growing dividends (and who generally fall less than the broader market).

This weekly watchlist series is designed to be a tool to give you solid investing ideas, so you can always know what's the best place to put your hard-earned money to work at any given time. Specifically, in companies with high margins of safety that have less to fall in a market correction or bear market, and which are all coiled springs that are likely to deliver outsized total returns if their valuations return to historical levels.

The addition of the "fat pitch" blue-chip watchlist this week is meant to highlight the valuation approach that I happen to be using with my retirement portfolio. By no means am I saying this is the best strategy to use. Rather like all the watchlists I present here, it's one of several reasonable approaches for generating good investing ideas at any given time.

The reason I've added it to this weekly series is to highlight the fact that, no matter how hot the market may get, quality blue-chips are almost always on sale.

This week I'm excited to be putting my "fat pitch" watchlist to work by buying an initial position in United Health, which is below my target price and about 26% undervalued according to Morningstar's DCF model.

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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