It’s no secret that Warren Buffett is a fan of dividend stocks. The Oracle of Omaha owns many of them, including Bank of New York Mellon (BK).

Approximately 0.7% of Buffett’s $148 billion stock portfolio is comprised of Bank of New York Mellon stock.

Bank of New York Mellon is a diversified financial services company. It serves its clients in 35 countries, and 100 markets.

Now that interest rates are on the rise again, the bank’s growth is picking up.

This is allowing it to return more cash to shareholders. Bank of New York Mellon raised its dividend payout last year, for the first time since 2014.

It still has a long way to go before it becomes a Dividend Achiever, a group of 272 stocks with 10+ years of consecutive dividend increases.

You can see the full Dividend Achievers List here.

That being said, Bank of New York Mellon has a strong balance sheet, competitive advantages, and multiple catalysts for growth.

Bank of New York Mellon could raise its dividend by 10% or more per year moving forward.

This article will discuss why Bank of New York Mellon could be one of the highest dividend growth stocks in the financial sector.

Business Overview – Bank of New York Mellon Corp (BK)

Berkshire Hathaway owns approximately $1 billion worth of Bank of New York Mellon. But why?

The answer most likely has to do with consistency.

To say that Bank of New York Mellon has stood the test of time would be an understatement. It was founded by Alexander Hamilton all the way back in 1784. It is America’s longest-running bank.

2016 was a successful year for Bank of New York Mellon, on a number of fronts. The company reported adjusted earnings-per-share of $3.17, up 11% from 2015.

Bank of New York Mellon Corp (BK)

Source: 4Q Earnings Presentation, page 12

Contributors to this growth included 2% growth in investment service fees, and 4% growth in net interest revenue.

In addition, Bank of New York Mellon realized a 180-basis point expansion of pre-tax operating profit margin last year.

The company generated a healthy 10% return on common equity last year.

Going forward, continued growth is within reach, thanks to a number of potential catalysts.

Growth Prospects

Bank stocks have risen significantly over the past several months. The rally in the financial sector is due in large part, to expectations for rising interest rates up ahead.

The Fed raised rates in 2016, and expectations are for another three rate hikes in 2017.

This is a tailwind for Bank of New York Mellon.

Bank of New York Mellon Corp (BK)

Source: 4Q Earnings Presentation, page 15

Fourth-quarter net interest revenue increased 9% from the same quarter the previous year. Future interest rate hikes would help Bank of New York Mellon grow its interest income even more.

Banks benefit from higher rates because it widens the spread between interest earned on long-term loans, compared with interest paid on short-term deposits.

Separately, Bank of New York Mellon should benefit from its investments in new technologies and servicing platforms.

One specific example is the NEXEN initiative, its next-generation technology platform. NEXEN helps clients utilize one secure, powerful platform. It can allow the bank to respond more quickly to evolutions in financial technology.

In an age of mobile banking, Bank of New York Mellon has responded by divesting itself of unnecessary real estate square footage, to reduce its physical footprint.

By transitioning its services to better meet customer demands, Bank of New York Mellon could continue to see growth in assets under management and service fees.

Competitive Advantages & Recession Performance

In the financial services industry, reputation is everything. Consumers need to know they can trust their financial institution with their hard-earned money.

Consequently, an operating history stretching over 200 years, gives Bank of New York Mellon a great deal of brand equity.

Bank of New York Mellon has stood the test of time, going back more than two centuries.

This gives it a significant competitive advantage, which is a relatively ‘sticky’ industry position. It is not likely a start-up bank would successfully pry away Bank of New York Mellon’s customer base.

These qualities served the company well during the Great Recession of 2007-2009:

  • 2007 earnings-per-share of $2.18
  • 2008 earnings-per-share of $1.20
  • 2009 earnings-per-share of $1.07
  • 2010 earnings-per-share of $2.14

While Bank of New York Mellon’s earnings-per-share declined significantly during the Great Recession, it enjoyed a sharp rebound once the recession ended.

Valuation & Balance Sheet

Bank of New York Mellon has a price-to-earnings ratio of 14.8. The S&P 500 Index has an average price-to-earnings ratio of 26.

Given Bank of New York Mellon’s solid earnings growth, the stock appears to be undervalued.

In addition to an expanding valuation, the stock should generate satisfactory returns from future earnings growth and dividends.

One downside of investing in Bank of New York Mellon is that it has a relatively low dividend yield, of 1.6%. The S&P 500 Index on average has a 2% dividend yield.

Bank of New York Mellon should continue growing its dividend regularly. To that end, it helps that Bank of New York Mellon has a strong balance sheet.

It receives an A and A1 credit rating from Standard & Poor’s and Moody’s.

And, last year, Bank of New York Mellon generated a Common Equity Tier 1 Ratio of 12.3%, up 80 basis points from the same quarter last year.

Bank of New York Mellon Corp (BK)

Source: 4Q Earnings Presentation, page 17

As a systemically-important financial institution, Bank of New York Mellon is subject to the Federal Reserve’s annual stress tests. Fortunately, its strong business model and high-quality balance sheet allow the bank to routinely pass with flying colors.

This is important, because banks need to pass the Fed’s stress test in order to return cash to shareholders.

After the 2016 stress test concluded, Bank of New York Mellon announced a $2.7 billion share repurchase, and a 12% dividend increase.

Double-digit dividend increases could easily continue over the next several years. The current $0.76 per share annual dividend represents just 24% of Bank of New York Mellon’s 2016 earnings-per-share.

Final Thoughts

Warren Buffett famously looks for stocks trading at a discount to their intrinsic value. Buffett subscribes to the belief that the stock market is a voting machine in the short-term, and a weighing machine in the long-term.

What this means is that, eventually, a company’s intrinsic value is realized.

Bank stocks languished over the past few years, due to general uncertainty over regulation and monetary policy.

However, Bank of New York Mellon seems undervalued, due to its low valuation, and future growth catalysts.

It could be a very rewarding dividend growth stock over the next several years.

Article by Bob Ciura, Sure Dividend