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Dividend Champions a Rare Undervalued Opportunity

2012-01-06

We believe that based on earnings, 2012 is starting out with the stock market undervalued. We believe in the long-term ownership of great businesses purchased at sound and attractive valuations. Consequently, we view the stock market as merely the store that we shop at in order to buy the businesses we want to own.

Furthermore, we do not rely on the market to set the price at which we are willing to buy or sell. Instead, we prefer to calculate the intrinsic value of the business based on the company’s earnings power. If the market price is at or below that level of valuation we will be a buyer, if not, we either look elsewhere or patiently wait for the True Worth™ valuation to manifest.

Conversely, if the market significantly overprices a company, even one that we like very much, we will sell to avoid long-term risk. Based on years of research and reviewing the earnings and price relationship on thousands of companies, we are confident that the proper value will inevitably be applied to a business by the market; it’s only a matter of time.

Shares of stock represent ownership in the business. In the long run, business success and shareholder returns will inevitably correlate. However, it is also an undeniable fact that the stock market can and will temporarily either over-price or under-price a business. And, it is also an undeniable fact that a company (business) derives its true value from its earnings power, in other words, the amount of cash flow it is capable of generating on its shareholders’ behalf.

Therefore, contrary to what many people are willing to accept, is the indisputable reality that the business results of the company behind the common stock you own is far more important to wealth creation, than what the stock market may be mispricing it at over a short period of time.

Mispricing happens when emotions erode rational thinking thereby manifesting either greed or fear. It is important that investors maintain a reasoned and rational approach and avoid the emotional response at all costs.

When reviewing the broader stock market in the context of market price versus intrinsic value, we emphatically state that the stock market is significantly undervaluing many best-of-breed American corporations. We believe this is primarily due to extreme pessimism that has been promulgated by the masters of the media.

Currently, when you review America’s best of breed companies from the perspective of operating results, i.e., earnings power, you will discover that in the aggregate, there are a large number of businesses that have performed extremely well in calendar year 2011.

Stated more simply, there are numerous businesses that grew at above-average rates during 2011, but alas, the stock market did not reward that growth according to what it should have. Therefore, based on price action, many of America’s best businesses had a down year. However, when you measure earnings power, the same companies generated significant business growth. In time, we contend that it is inevitable that these fine businesses will be rewarded according to their business achievements. Once again, it’s only a matter of time.

Even more importantly, we further contend that best-of-breed companies trading at such unrealistically low valuations, at least in our opinion, offer the best combination of low risk and future growth possible. The opportunity to invest in and own best-of-breed companies trading at unjustified low valuations is very rare. Common sense would dictate that it can only come when pessimism about our future is at its lowest.

Furthermore, we are also very confident that the majority of these companies are going to continue to generate above-average future earnings growth. As a result, we see a potential double-barreled explosion in the future stock price of many of these fine businesses.

First, we expect a PE expansion as the market inevitably values these companies at more normal PE ratios. Second, we expect that the majority of these companies will continue to grow their businesses (earnings) at above-average rates over the next several years.

The combination of these two factors could generate significant future rewards at low levels of risk. We feel that risk is reduced when valuations are too low to be reasonable, and could be reduced further with the proper level of diversification.

The Case for a Positive View of Stocks

The following list is comprised of Dividend Champion companies that are trading at historically low PE ratios based almost exclusively on negative investor sentiment. Our list is comprised exclusively from David Fish’s current list of 102 Dividend Champions, companies that have increased their dividends every year for at least 25 years. Amazingly, of the 102 names on this list, 43 of them were available at below normal, and therefore we feel, attractive valuations.

To be clear, there were another 45 or so names out of the 102 Dividend Champions that could have been included based on reasonable or fair valuation. Names like McCormick & Co. (MKC), McDonald’s Corp. (MCD), Hormel Foods Corp. (HRL), Sherwin Williams Co. (SHW), and RPM International (RPM) represent just a few of the high profile names that were excluded due to our strictest definition of intrinsic value. In other words, these names were not necessarily overvalued but just fully valued. Of the entire Dividend Champions list, we only rejected five that we considered either excessively overvalued or poor investments based on weak fundamentals.

43 Dividend Champions On Sale

We have organized this list in order from the highest five-year estimated annual total return to the lowest, based on the combination of consensus analyst estimates for growth and valuation. The first four columns in the table compare the current PE to the historically normal 15-year PE and the 15-year historical EPS growth rate to the 5-year estimated EPS growth rate. Then the current dividend yield is listed, and finally, the 5-year estimated annual total return calculation. The 5-year estimated annual total return is a calculation based on the company achieving the estimated EPS growth rate and then the stock trading at its earnings justified valuation.

More Reasons to be Positive About the Market

On top of low valuations, there are additional insights supporting a positive view for our economy and the stock market. John Bodnar, a financial planner/registered investment advisor in Florham Park, New Jersey, sent a letter to his clients, and with his permission we offer a few excerpts. What fascinated us was the following paragraph referencing an article in TIME magazine in 1992 that is eerily similar to even almost identical to the doom and gloom promoted by the media today:

“The U.S. economy remains almost comatose… the economy is staggering under many structural burdens, as opposed to familiar cyclical problems… The structural faults represent once in a lifetime dislocations that will take years to work out. Among them: job drought, debt hangover, the banking collapse, the real estate depression, the healthcare cost explosion, and the runaway federal deficit.”

All of these worries, which reflect almost perfectly the exact worries we face today, were offered by TIME magazine just prior to one of the longest and strongest stock market advances in recorded history – 1992 to 2007. Similarly, with stock valuations as they are today, we believe that we are sitting on the threshold of extraordinary future returns from owning high-quality common stocks that can be bought at such low valuations. Billions upon billions of dollars have been fleeing the stock market as panicked investors seek the refuge of so-called safer alternatives such as bonds and other fixed income instruments.

However, we would caution you that interest rates are currently at all-time lows which imply that the future price of bonds could be just as volatile and fall just as far as stock prices did in 2008 when interest rates return to more normal levels. Moreover, the rates on these so-called safer investments are so low today as to almost guarantee the potential for loss given any level of future inflation.

It is comforting to know that we are not alone regarding a positive view of the future. Most of us have heard or read Warren Buffett’s famous refrain: “Be fearful when others are greedy and greedy when others are fearful.”

With stock market fears at such a heightened state, and with billions of dollars on the sideline, it only seems logical that investors faced with few alternative viable choices for an adequate return at reasonable risk levels might someday soon become once again attracted to blue-chip stocks.

This would especially apply to blue-chip dividend paying stocks with long histories of increasing their dividends every year. As the list above depicted, there are so many blue-chip names like Procter & Gamble (PG), PepsiCo (PEP), Abbott Labs (ABT), Johnson & Johnson (JNJ), Medtronic (MDT), and others that offer an attractive and growing dividend rate, that can be bought today at historically low values.

The following excerpt from the concluding remarks from John Bodnar’s piece referenced above summarizes our views:

“Ready to wrap this up? Let’s return to the 1992 Time cover story. Sounds eerily like the headlines we read today. And yet, the decade of the 1990s turned out to be a boom for investors. Odd considering all the negative headwinds reported in the Time article. I suggest we resurrect the American spirit and align ourselves with the economic realities instead of the political headlines. American businesses are doing well. They are well capitalized, sitting on loads of cash, increasing their dividends, and buying back their own stock. It is a great time to be an investor in some of the greatest companies in the world…… Significant market bottoms, when they finally occur, have less to do with fundamental economic and financial shifts than with crescendos of public panic. On this you can rely: the stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.”

A link to an article we posted on our blog includes John Bodner’s entire letter can be followed here.

Low Valuation: A Significant Long-term Opportunity

We remain very frustrated by the low, and what we consider to be ridiculous, valuations that the market is applying to many great businesses. It is inconceivable to us that strongly above-average franchise names such as Hewlett-Packard (HPQ), Aflac (AFL), or Teva (TEVA), the world’s leading generic pharmaceutical company, could be trading at single-digit PE ratios when the more than 150-year-old historical normal PE ratio for the S&P 500 has been 15, as it is today.

To be clear, many average companies with significantly lesser earnings power are trading at earnings multiples approaching 2 to 3 times greater than many above-average companies are trading at. This makes no logical sense, and therefore, we believe it represents a rare and significant opportunity for those investors with the foresight to consider earnings power over what is often a very fickle stock market. We believe that these low prices simply mean that many stocks are currently illiquid, and not that they are poor or bad investments. In this context, we are suggesting they are illiquid because they cannot be currently sold for what they are truly worth based on fundamentals. Selling a stock, or any asset for that matter, for less than it is worth is not a wise decision, in our opinion.

Three High Profile Examples of Extreme Undervaluation

Notice how the black monthly closing stock price lines are uncharacteristically and significantly below the orange earnings justified valuation line on the following earnings and price correlated F.A.S.T. Graphs™. This vividly illustrates how undervalued these companies really are:

Hewlett-Packard Co. (HPQ)

AFLAC Inc. (AFL)

TEVA Pharmaceutical (TEVA)

The above are just three examples of many that we could show.

Conclusions

To be fair, many undervalued holdings have experienced moderate to even minor issues that spooked investors. After being traumatized by the 2008 market crash, investors remain fearful. Therefore, even the slightest bit of negative news can result in panic, even when it’s mostly unjustified. We believe the reactions with the three examples featured in this article have been extreme. Consequently, we further believe that the opportunity that these reactions have created represent an incredible long-term opportunity. The above emotional reactions do not reflect the fundamental strengths and future potential of those fine businesses.

Speculating in the stock market can be fraught with risk. At any moment in time the market can become disconnected from economic reality. We believe the key is not to react to market volatility, and we have certainly had lots of that recently. If you invested in a business that you like, and the business continues to perform well as an operating entity, short-term market variations should mean little to you. After all, if you were not planning to sell your investment today why should you care what someone is willing to offer you. This especially applies to dividend growth investors that have invested in businesses that they believe can continue to provide them a growing income stream.

Disclosure: Long MKC, MCD, AFL, ITW, WAG, MDT, ABT, BCR, SYY, MHP, JNJ, PG, KMB, PEP, GPC at the time of writing.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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