Investing

Dividend Royalty: The Draw Of Undervalued Aristocrats – Amazon.com, Inc. (NASDAQ:AMZN)

Simple as it may sound at first blush, dividend investing has its foibles. Earlier this week, Barron’s led with this idea in an article titled “Dividend Investing: Beyond the Basics”:

“When it comes to dividend investing, sticking to the basics is often a sound strategy. But even basic strategies, including looking for higher yields or growing dividends, have their pitfalls.”

Sure Dividend, who’s become something of an income investing guru among dividend investors over the past three and a half years, would agree that dividend investing has its own unique complexities and nuances, and takes more care, research and creativity than some might think. As such, he’s created an entire website for dividend devotees that’s dedicated to the art and science of dividend investing, and in July, launched a Marketplace Service focused on high-quality, value dividend stocks called Undervalued Aristocrats.

We asked Sure Dividend to join us on the Marketplace Roundtable to talk about his specific criteria for dividend stocks (hint: it goes beyond basics like payout ratios and consistent dividend growth), his own income investing gaffes, his current favorite dividend ideas, and why he believes Target (NYSE:TGT) is a better investment than Amazon (NASDAQ:AMZN).

Seeking Alpha: You’re somewhat of a celebrity among dividend devotees. How’d you get started in dividend investing? Has your approach changed at all from day one to now?

Sure Dividend, author of Undervalued Aristocrats: Value investing was the first area of interest for me. My initial investing approach was focused on finding stocks that were trading at very low price-to-earnings ratios or other valuation ratios.

The idea of buying something worth $1.00 for $0.50 is the heart of value investing. This idea resonated with me, and still does to this day.

Over time I researched other market anomalies. By market anomalies, I mean factors that have either historically improved returns or reduced risk. A few are listed below:

  • The value effect: Stocks with low price-to-earnings ratios (or that are “cheap” based on a wide variety of metrics) tend to outperform
  • The quality effect: Stocks that score high on a “quality” scale (again, there are many ways to determine this) tend to outperform
  • The low volatility effect: Stocks with lower stock price volatilities tend to outperform with (obviously) lower volatilities. This may be related to the quality effect as well.
  • The shareholder yield effect: Stocks that offer investors greater dividend yields and share repurchase yields tend to outperform. This is related to the value effect.

I also looked into the pros and cons of different holding periods and the effect of portfolio turnover and frictional costs on returns.

This research pointed me in the general direction of purchasing high-quality stocks with shareholder-friendly managements trading at attractive valuations and holding for the long run. Interestingly, this approach is very similar to the approach Warren Buffett takes with the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) portfolio. Seeing that one of the greatest investors of all time invests in a similar fashion and that the historical record points to the efficacy of this approach, I felt that I was on the right track.

When analyzing the type of stocks mentioned above, I noticed that many had very long histories of paying rising dividends. It makes sense that a company that’s been able to pay rising dividends for a long period of time has a strong and durable competitive advantage and a shareholder-friendly management culture.

The Dividend Aristocrats List is a great place to find companies with long histories of rising dividends. It includes 51 S&P 500 stocks with 25+ years of rising dividends. The Dividend Aristocrats Index has outperformed the S&P 500 by about 2 percentage points a year over the last decade, with less volatility.

My investing strategy has not changed significantly from when I first started Sure Dividend around 3.5 years ago. I’ve slightly tweaked my ranking methodology in that time, but the focus has remained the same.

SA: What criteria do you use when evaluating dividend stocks? What are some of the risks you keep an eye out for?

SD: What I look for when evaluating dividend stocks is a mix of:

  • Long operating history
  • Long history of rising dividends
  • Low beta and standard deviation
  • Solid track record of earnings-per-share growth
  • High shareholder yield (dividends + share repurchases)
  • Low valuation relative to the stock’s historical average

In short, I’m looking for dividend growth stocks with strong competitive advantages trading at fair or better prices that are likely to generate better-than-average total returns over the long run.

The main risk I look out for is the chance the business will decline and not be able to increase dividends consistently. This is why a long operating and dividend history is preferred; it shows that a company has historically been able to grow through a wide variety of situations.

Declining earnings-per-share over several years are a tell-tale sign that a business is struggling to compete. All businesses go through short-term issues from time to time. When a company can’t grow its earnings per share over longer periods of time, that is a sign of trouble.

A high payout ratio is another sign of trouble when investing for dividends. The higher the payout ratio, the less margin for mistakes a business has before the dividend gets cut. A high level of debt relative to earnings power is another red flag.

SA: Why Undervalued Dividend Aristocrats? What’s the value in these types of stocks, and why should investors pay attention?

SD: We recently launched Undervalued Aristocrats on Seeking Alpha. Undervalued Aristocrats focuses specifically on finding undervalued Dividend Aristocrat stocks.

As mentioned in the first question of this interview, the Dividend Aristocrats Index has outperformed the market by over 2 percentage points a year over the last decade, with less volatility than the overall market.

To be a Dividend Aristocrat, a company must be in the S&P 500 and have paid rising dividends for 25+ consecutive years. The Dividend Aristocrats Index is filled with high-quality businesses that are shareholder friendly, and have, on average, significantly outperformed the market.

By limiting our universe to just the Dividend Aristocrats, we can reduce the chance of making costly investing mistakes. Yes, there will be opportunities outside of this universe, but by focusing on only the highest quality stocks, it helps us to minimize mistakes.

Not all Dividend Aristocrats make good investments all of the time. Valuation matters. The idea behind Undervalued Aristocrats is to invest only in Dividend Aristocrats when they are undervalued relative to their own historical averages.

This takes into account that a company like Medtronic (NYSE:MDT) is going to have a higher price-to-earnings ratio than AT&T (NYSE:T). That’s simply because Medtronic is expected to grow much faster than AT&T, so it commands a higher price-to-earnings multiple.

With the S&P 500 trading for a price-to-earnings ratio of around 24 versus its long-term historical average of 15.7, there are very few Dividend Aristocrats (or stocks in general) that are trading at a significant discount to their historical average valuation multiples. With that said, there are still several Dividend Aristocrats that are undervalued.

The big advantage to investing in Dividend Aristocrats while they are undervalued is that you avoid overpaying for great businesses. You are already avoiding investing in mediocre businesses without competitive advantages, businesses that aren’t shareholder friendly, and businesses that haven’t proven themselves.

By minimizing mistakes, Undervalued Aristocrats is likely to produce favorable risk-adjusted total returns over time.

The end benefit is building a portfolio of high-quality dividend growth stocks all purchased at favorable prices that is likely to generate rising dividend income over the long run.

SA: Without giving away too much of your “secret sauce,” how did you come up with the buy and sell rules for your Undervalued Dividend Aristocrats investing strategy? Have you ever had to break your own rules?

SD: The two sell rules for Undervalued Aristocrats are:

  1. Sell if a stock cuts or eliminates its dividend
  2. Sell if a stock trades above 150% of fair value

The underlying reason to purchase dividend growth stocks is to generate rising dividend income over time. When a company cuts or eliminates its dividend, it has violated the reason you bought the company.

Moreover, a dividend cut is likely (though there can be other reasons) a sign that the company is struggling and is losing or has lost its competitive advantage. It’s better not to stick around for the slow decline, and put the funds from the investment to work in a stock that is still paying rising dividends.

The second reason to sell is if a stock trades over 150% of its fair value. The 150% number is arbitrary, as are all cut off numbers. The idea is to not hold on when a stock becomes very overvalued. A high valuation level means that total returns going forward are likely to be depressed. It’s better to take advantage of overvaluation, harvest gains, and reinvest the proceeds into an undervalued Dividend Aristocrat. This way you take advantage of market mispricings both when a stock is undervalued (buy buying) and when it is overvalued (by selling).

With that said, selling is expected to occur rarely. Every time you sell, you incur frictional costs like brokerage fees, slippage, and capital gains tax (in taxable accounts, if the stock is up). Therefore it’s typically best to hold unless a stock is significantly overvalued, or if it is no longer paying rising dividends.

As far as breaking these rules goes, the valuation rule is slightly different for Undervalued Aristocrats than what we’ve used at Sure Dividend in the past. That rule hasn’t been broken and I don’t expect to in the future.

The one exception to this would be if a Dividend Aristocrat undergoes a massive change and its expected growth rate is much higher than it has been historically. This is unlikely, as Dividend Aristocrats are established companies.

Regarding the dividend cut rule, one exception we’ve made in the past in the Sure Dividend Newsletter is with ConocoPhillips (NYSE:COP) – which was a past recommendation. The company cut its dividend due to low oil prices. It is recommended as a sell, but only when oil prices return to around $55 to $60. The reason for the cut was solely because of low oil prices. It doesn’t make sense to sell the company at a depressed price. We have maintained a sell on ConocoPhillips, but only when oil prices are no longer depressed.

SA: Many dividend investors tout themselves as buy and holders, sometimes for life. You’re a seller when a stock cuts its dividend. Is that an absolute for you? Has there ever been a time when you just had to sell, other than a dividend cut, because the investment just wasn’t working out?

SD: I see myself as a buy and hold investor as well. In the ideal situation, I’m looking for dividend growth stocks to buy and never sell.

Yes, a dividend cut automatically triggers a sell. That sell may be delayed in some situations, as in the ConocoPhillips example above. The reason a dividend cut automatically triggers a sell is because – at the very least – it demonstrates that a company can’t sustain its dividend in all real-world market environments. The company can’t be counted on to provide dividend growth.

There have been two sell recommendations outside of ConocoPhillips since I started Sure Dividend in Spring of 2014. Those are Baxalta (BXLT) and Chubb (NYSE:CB). Both were the result of companies being acquired.

Baxalta was a stock I had recommended as it ranked very well using The 8 Rules of Dividend Investing. Within a few months, the company announced it would be acquired by Shire Plc (NASDAQ:SHPG). When the acquisition was announced, Baxalta stock was no longer a long-term dividend growth investment. It became a merger arbitrage play, which is not my area of expertise, so I recommended it as a sell.

A similar event occurred with Chubb. The “old” Chubb was one of (at the time) three insurance companies that were Dividend Aristocrats. ACE Limited (NYSE:ACE) announced it was acquiring Chubb. The new company would be renamed Chubb. Again, this made the “old” Chubb stock more of a merger arbitrage investment than a dividend growth investment, so I recommended it as a sell.

I haven’t yet had to sell because an investment isn’t working out but the dividend hadn’t been cut. While it’s possible this will happen in the future, I typically prefer to avoid selling too soon by speculating if a dividend cut will happen.

SA: What’s been your best dividend call to date? What sort of mistakes have you made in your dividend investing, and what lessons did you learn?

SD: Within dividend investing, perhaps the biggest mistake I’ve made so far is looking at energy stocks too much “by the numbers”. I didn’t factor in the effect of changing oil prices, which led to personally investing in Exxon Mobil (NYSE:XOM) and Helmerich & Payne (NYSE:HP) far sooner than I should have. When oil prices are high, energy stocks look very cheap based on earnings. Unfortunately, high oil prices overstate true earnings power for most energy sector stocks. I’ve since tweaked how I look at all stocks from this example.

My best investments personally over the last few years have been:

  • Cummins (NYSE:CMI) – Bought shares on 1/4/16 and 3/17/16 for $90.07 and $110.25, respectively. It’s currently trading for $152.10
  • Philip Morris (NYSE:PM) – Bought shares on 2/5/15 and 4/2/15 for $82.40 and $77.14, respectively. It’s currently trading for $114.80
  • McDonald’s (NYSE:MCD) – Bought shares on 5/30/14 for $101.36. It’s currently trading for $158.82

With dividend growth investing, you don’t often get the eye-popping 10x returns of growth investing, but you also minimize your chances for big losses. My worst performing investment personally since 2014 is Helmerich & Payne, which is down around 30%.

I closely follow the recommendations I make to Sure Dividend readers. There are a few great investments that I recommended that I personally missed out on. A few are below:

  • General Dynamics (NYSE:GD) – First recommended in March of 2016 for around $135/share. It’s currently at $199.05/share
  • Boeing (NYSE:BA) – First recommended in October of 2016 for around $135/share. It’s currently at $235.89/share
  • Becton Dickinson (NYSE:BDX) – First recommended in June of 2014 for around $118/share. It’s currently at $198.57/share.

The lessons I’ve learned from my investing successes and mistakes so far are:

  • Pay very close attention to valuation. Great businesses that are undervalued tend to perform very well.
  • Understand and use real earnings power, not GAAP earnings per share when valuing a company

SA: You wrote recently that Target is a better investment than Amazon. As a consumer, I personally shop at and love both, and source them for different items. To my mind, they’re very different retail experiences, one being a big box brick and mortar and the other being the Bezos-led online behemoth that seems in a constant state of evolution. What led you to this comparison, and why is TGT the frontrunner for you?

SD: I compared Target to Amazon because both are discount retailers, and because of the talk about Amazon “killing” retail. There’s been a lot of talk about Amazon versus Wal-Mart (NYSE:WMT), but less about Amazon’s effect on Target.

Target is a Dividend Aristocrat that appears deeply undervalued. It has a forward price-to-earnings ratio of just 12.5 and a 4.5% dividend yield. Target stock is trading near its all-time dividend yield high – and it has a long history of rising dividends. The company has paid increasing dividends for 46 consecutive years.

The reason Target is the front-runner comes down to valuation. Do I think Amazon will grow revenues faster than Target? I absolutely do. But so does everyone else; that growth is already more than priced into Amazon’s stock price. The company’s price-to-sales ratios are compared below:

  • Target has a price-to-sales ratio of 0.43
  • Amazon has a price-to-sales ratio of 3.05

Amazon’s price-to-sales ratio is 7 times that of Target’s. Worse yet for Amazon, the company has a much lower profit margin:

  • Target has a profit margin of 4.00%
  • Amazon has a profit margin of 1.30%

Target is the more profitable company. It pays rising dividends regularly, and it is very cheap. Amazon is the exact opposite. Amazon is priced for perfection. Target is priced to do little more than survive.

What’s even more interesting about this situation is that Amazon is betting big on brick and mortar retail. The company’s recent Whole Foods acquisition as well as building physical book stores are examples of Amazon’s “innovative new strategy” of having brick and mortar retail locations.

At the same time, Target is growing its digital sales rapidly.

Source: Company press releases

Target’s adjusted earnings per share declined 6.1% in its most recent quarter. But the company’s management has plans to return the company to long-term growth. A true “omni-channel” experience will help Target to continue growing its sales. Target is also renovating many of its stores, which should help return the company to growth.

The retail landscape is slowly changing, but Target remains highly profitable, and has plans to return to growth. The company’s steep price decline makes Target a compelling investment considering its long history of changing successfully with the discount industry.

Amazon, on the other hand, has a much shorter corporate history. It is expanding rapidly into a wide variety of industries. And it has very low margins. It’s yet to be seen if Amazon’s low margin business model will work in an era with rising and/or high interest rates. There’s risk at Amazon, but the stock price doesn’t reflect that. There’s risk with Target too, but the stock price certainly reflects that.

SA: What are one of your favorite dividend opportunities currently, and what’s the story?

SD: Target is one of them. The story with Target is that fears over “the end of retail” and Amazon have depressed the price to levels that make the company an excellent buy.

Another one of my favorite dividend opportunities right now is W.W. Grainger (NYSE:GWW). W.W. Grainger is the global leader in the maintenance, repair, and operation industry (MRO). The investment thesis is similar to that of Target’s. W.W. Grainger is a Dividend Aristocrat that’s seen its valuation multiple severely beaten down due to fears over Amazon stealing market share.

The company’s earnings per share have declined slightly as W.W. Grainger had margins and prices that weren’t competitive with the rest of the industry. The company ties into large customer’s inventory management systems, which helps W.W. Grainger to avoid price comparisons. This advantage has weakened some in recent years with easier price comparisons online.

However, W.W. Grainger is the leader in the industry, has shown phenomenal online sales growth, and has an excellent supply chain. The company has trimmed its margins some, but is poised for more years of growth ahead. You can see my full analysis of W.W. Grainger on Undervalued Aristocrats.

***

Thanks to Sure Dividend for sharing his dividend investing expertise. You can have a look at his work here, and if you’re interested in high-value dividend investing ideas, his Marketplace service, Undervalued Dividend Aristocrats, may help you take your income strategy to the next level.

Follow the Marketplace account to get all of our roundtables and interviews, and to stay up to date on all the news that’s fit to print in the Marketplace. We just hit some major milestones, and Marketplace shows no signs of slowing down as we head into fall. More good stuff to come, so stay tuned!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Sure Dividend is long TGT, WMT, CMI, MCD, PM, and GWW.

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