This is the fourth in a series of articles designed to counter a pervasive attitude that common stocks are expensive today. Furthermore, we would agree with those that contend that we have been in a stealth bull market for the last 18 months or more. However, would also contend that stocks were so cheap prior to this stealth bull-run that even though they have risen, there are still many stocks that remain fairly priced and even many that are undervalued. Blue-chip Dividend Aristocrats represent one of the best examples of our thesis.
A second, but very important additional theme of this series of articles focuses on the reality that it is, in truth, a market of stocks and not a stock market. Therefore, we argue that investors and their portfolios are best served by focusing on specific companies they may be interested in investing in, in lieu of worrying about the general levels of broad markets and/or the economy, etc. Links to our previous articles can be found here: Part 1 , Part 2 and Part 3.
Blue-Chip Dividend Aristocrats – Many Attractive Buying Opportunities
The equity asset class that many believe is overvalued is the high-quality dividend growth stock. This perception has been created in part because many of these stocks have performed well lately. However, as we will illustrate later, many in this group were so undervalued that even after their prices rose they have only become fairly valued, while some still remain undervalued.
The prestigious Standard & Poor’s Dividend Aristocrat list is comprised of 50 companies that have increased their dividends for 25 or more years in a row. Thanks to the almost effortless efficiency of the F.A.S.T. Graphs™ fundamentals analyzer software tool, it has been an easy task to run through this list of 50 quality dividend growth stocks one at a time. Therefore, a clear perspective of the valuation on each constituent was easily and quickly accomplished. We believe this is far superior to relying on a vague idea about valuations based on notions of the markets at large, or pre-judgments about a large group.
This exercise empowered us to organize the Standard & Poor’s Dividend Aristocrat list into four simple groups based on valuation. With so many investors perceiving stocks as generally overvalued, the results were quite gratifying. Of the 50 Blue-chip Dividend Aristocrats, we found 23 that were fairly valued to undervalued, 16 that were moderately overvalued, only 8 that we felt were dangerously overvalued, and finally, 3 that we felt had fundamental issues. The following tables and individual examples will be presented in reverse order, starting with the most overvalued and moving on to where we see the best valuations.
Dangerously Overvalued Dividend Aristocrats
The label “dangerous overvaluation” refers to Dividend Aristocrats whose prices have risen far enough above rational earnings justified valuations that short to intermediate-term price movements could result in temporary losses of 20% or greater. However, because of the quality of these names and their long-term consistent records of earnings and dividend growth, each of these eight names are still expected to generate positive long-term total returns in spite of today’s overvaluation.
Therefore, the real message here is that we believe investors would be best advised to wait patiently for what we believe will be inevitable corrections, representing better entry points. In concert, this would also imply that current owners might want to consider either lightening up on these positions or even outright sales of the total position. Moreover, the reader should recognize that this is primarily a valuation recommendation, because most of the companies on this list are superb businesses with great long-term operating records. In other words, we like the stocks, but not their current prices.
The following table lists the eight dangerously overvalued Dividend Aristocrat constituents by order of highest expected future return to the lowest. As a valuation measurement, we believe the highlighted column “EPS Yld%” provides important insight into valuation. A preponderance of historical evidence has led us to conclude that a minimum earnings yield of 6.5% to 7% is required for fair value to be present. Therefore, the reader will notice that all of the names on this list possess earnings yields below 5%. In other words, this suggests that the company’s earnings and cash flows do not adequately compensate investors for taking the risk of owning the equity.
A quick glance at the following earnings and correlated F.A.S.T. Graphs™ on Sherwin-Williams Company (NYSE:SHW) vividly displays how the company’s stock price has currently deviated from its intrinsic value. Moreover, it is clear that this is completely unsupported by historical precedent. Furthermore, it’s important that we focus on the fact that Sherwin-Williams was very reasonably priced at the beginning of 2004, and essentially stayed that way until inexplicably price started deviating in late 2011.
We believe the Sherwin-Williams’ example illustrates one of the great dangers of relying on statistical data when looking for investment candidates. The 10-year track record of this high-quality dividend aristocrat that has produced a compounded annual return in excess of 19% per annum could easily entice investors into believing that it is an excellent investment choice. However, we would argue that the proper view would be that Sherwin-Williams was an excellent investment choice in 2004. On the other hand, we believe the picture above clearly illustrates that this company is dangerously overvalued today.
Even looking to the future, and acknowledging that Sherwin-Williams is expected to have accelerated earnings growth in excess of 15%, still does not justify today’s high valuation. Consequently, we feel that now would be an excellent time to lighten up on, or even completely sellout of, this high-quality Dividend Aristocrat. We believe it would even be prudent to hold the cash with a parentheses around it that says “this money is earmarked to be returned to Sherwin-Williams when its valuation inevitably comes back in alignment with earnings.” However, there are not many investors that possess this kind of discipline or rational thought.
Moderately Overvalued Dividend Aristocrats
When we examine the 16 moderately overvalued Dividend Aristocrat constituents, we are presented with an interesting challenge. Even though past and present operating results play an important role in the valuation decision, we believe that the greatest weight should be given to the forecasts of the future operating potential of each company. The challenge that this presents rests with the accuracy of the forecasts. For example, if the estimated future earnings growth is too low, then these companies may not be overvalued after all, and vice versa.
Nevertheless, looking at an earnings and price correlated F.A.S.T. Graphs™ provides a great deal of information and insight that can be useful in regards to making this kind of determination. Furthermore, if we accept the consensus forecasts provided by leading analysts, we discover that our earnings yield, although below are 6.5% to 7% threshold, is closer to fair