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Are Dividend Stocks Overvalued? Four Reasonable Blue-Chips to Consider

An observation from various articles I’ve been seeing in increasing frequency this past year, including on sites such as Morningstar or Seeking Alpha, has been that dividend stocks, in general, may be overvalued. The articles of course have a range of quality, with some of them going so far as to call dividend stocks a bubble, with others using more reserved and nuanced observations.

It’s certainly an observation worth considering. After all, the Shiller P/E of the S&P 500 remains above the historical average, and I wouldn’t call the market in general undervalued by any stretch.

Dividend stocks may be a particular target of capital, as they are often (but not always) defensive, blue-chip investments with reduced volatility. Plus, a key issue is that interest rates have been so low that even stocks with mediocre yields rival bonds in terms of income while simultaneously offering historically superior total returns.

There are a few ways to examine the question of overvalued dividend-payers.

A) How have dividend payers performed relative to the market as a whole?

B) How are dividend payers valued now compared to historically?

C) How are dividend payers valued based on more objective valuation models, such as the Dividend Discount Model?

A) Dividend Stocks vs. the Market

Comparing the Vanguard High Dividend Yield ETF (VYM), the Vanguard Dividend Appreciation ETF (VIG), and the Vanguard Total Stock Market ETF (VTI), shows that over a five year period, VIG mildly outperformed, VTI was in the middle, and VYM underperformed. Over the most recent year, VYM outperformed mildly, VTI was in the middle again, and VIG underperformed.

Over both a one-year and five-year period, the differences were mild. Over the longer scale of five years, companies that focus on dividend growth outpaced high-yielders and the stock market as a whole, whereas over the shorter term of the past year only, the trend reversed itself and high-yielders outperformed the market and the dividend growers.

The comparison doesn’t exactly lend itself to the thesis of dividend stocks being substantially overvalued.

B) Current Valuations vs. Historical Valuations

The second way is to compare several dividend stocks to how they were years ago. One article I read, from Barron’s, literally said dividend stocks were at “nosebleed valuations”. (But then later went on to indirectly define that as “20 to 25% overvalued”, and the article was reasonable). I’ve also seen some articles throw the word “bubble” around.

So where do dividend stocks stand today in terms of valuation?

Johnson and Johnson (JNJ) trades for over 21x earnings, which I think is on the high side, but much of this was due to recent decreases in EPS rather than large stock price expansion. Ten years ago, JNJ was trading at over 25x earnings.

Walmart (WMT) trades for a bit over 15x earnings after a large recent spike in price. Ten years ago, the valuation was approximately double, at around 30x earnings.

Procter and Gamble (PG) trades for over 21x earnings, which again I think is on the pricey side. Ten years ago, the valuation was a bit higher, at over 23x.

Southern Company (SO), listed by the Barron’s article as a poster child for the overvaluation of dividend stocks, is over 18x earnings, and in my recent analysis, I said it was moderately overvalued. Ten years ago, it was over 16x earnings. So it has gone up… a bit.

Coca Cola (KO) is rather expensive as well, at over 20x earnings. Ten years ago, the valuation was double that, at over 40x earnings.

I can only go through a limited number here, although I’ve purposely selected stocks that I’m not exactly buying at current prices. I think we can safely cross words like “bubble” or “nosebleed valuations” off of the list, and stick to the more nuanced questions like, “are dividend stocks moderately overvalued?” and “is the stock market in general a bit expensive at these prices?”

C) Objective Valuation Approaches to Dividend Stocks

My preferred method of stock valuation rests not on relative comparisons, but instead on absolute metrics. Discounted cash flow analysis relies not on any external comparisons, but instead determines the fair price of a stock based on the amount of cash flow it can produce.

The Dividend Discount Model (DDM) uses this method and is tailored specifically for dividend stocks.

Using it, we can find several companies that pay good dividends that are reasonably valued.

McDonald’s (MCD) currently trades for under 17x earnings, and is a robust and defensive name with three and a half decades of consecutive annual dividend increases. Earnings have grown by an average of 16% annually over the past seven years, while the dividend has grown by over 24% annually over the same period, although this must slow down. Based on the DDM, McDonald’s only needs to grow the dividend at 7% per year going forward (or alternatively, 11% per year for 10 years and 5% per year after that) in order to justify the current stock price of around $90/share with an expectation of 10% annual returns.

Aflac (AFL) is potentially a deep value pick at well under 9x earnings, with almost three decades of consecutive annual dividend growth. This insurance company’s core business remains incredibly strong, but they do have 5-6% of their portfolio in risky European debt. Over the past several years, they have realized losses on their balance sheet due to European debt exposure and have worked to contain and eliminate those risks. The dividend has grown by an average of 18% annually over the past seven years, as the payout ratio has increased but remained low. At the current rate of EPS growth, if Aflac grows the dividend by 15% per year over the next ten years, they’ll only have a 50% payout ratio. If after that point, they grow dividends by 6% per year, then the DDM reveals the current price of around $46 to offer potentially 12% long-term returns. There’s certainly risk here, but if you’re looking for stocks on the other end of the valuation spectrum, a quality company like Aflac is one of the better places to start.

Emerson Electric (EMR) sits near the top of the list of consecutive dividend-payers, with comfortably over 50 years of consecutive annual dividend increases. The company is a leading provider of automation, process management, network power (focusing on data centers and telecommunications providers, two areas I’m bullish on), and climate technologies. At under 16x earnings, the stock trades for a reasonable price. The dividend has grown by an average of over 9% over the past seven years, although it was a bit low during the recession. According to the DDM, Emerson only needs to grow the dividend by 7% going forward in order to produce 10% annual returns.

Republic Services (RSG) is the second largest trash collector in the United States. With a decent economic moat from its large ownership of landfills, and annuity-like cash flows, RSG barely has to grow at all in order to provide decent returns through dividends and stock buybacks. The company only has to grow the dividend at 6% or better for the long term to provide 9% long-term returns, based on discounted cash flow analysis via the Dividend Discount Model.

Conclusion

Although I do think the market as a whole is modestly expensive (via the Shiller P/E for an overview as well as inspection of individual securities), dividend stocks in general do not appear to be at dangerous valuations. Some areas do seem to be heated (conservative utilities, certain telecoms, some consumer products companies, in particular), but to balance those out, there are other areas of reasonable valuation (cyclical industrials, insurance, blue-chip tech, and even a few defensive names like McDonald’s).

There are some slightly more advanced tools to work with, such as selling cash-secured put options to get good returns while waiting for better prices, but overall, sticking to sound valuation principles still reveals some reasonable stock choices out there.

Full Disclosure: As of this writing, I am long JNJ, PG, KO, MCD, and EMR.
You can see my portfolio here.

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Millionaire Teacher Book Review

I’m joyed to be writing what is only my second book review on Dividend Monk.

The reason I don’t write many book reviews is, the investment strategies that I follow and showcase are rather straightforward, and there’s little reason to ever reinvent this wheel. But Andrew Hallam is a fellow blogger (and on my personal blogroll), and I’ve read his articles for a while now, so I knew his book would be a very worthwhile read, and was waiting to get a copy and write a review. I had the opportunity to get a book before, but I waited, and therefore I just sat around and waited some more for Amazon to get more in stock. (They had been sold out due to the success of the book.)

So without further delay, here’s a review of Andrew Hallam’s Millionaire Teacher.

Overview

Andrew Hallam is an English teacher who became a self-made millionaire in his 30′s. He achieved this by taking his teacher’s salary, frugally saving it, and diligently investing it, year after year, in index equity funds, index bond funds, and some rational individual stock selections. He’s living proof that almost everyone in the developed world can become a millionaire because he led by example.

Andrew’s a smart guy, but he didn’t have to apply some genius stock-picking approach, or take on huge risk to get a huge reward. He merely maintained a balanced portfolio of stocks and bonds, and once in a while he adjusted it to keep it balanced. So for instance, if he had a 65% stock and 35% bond portfolio, and stock prices were rising, he was selling shares while everyone else was buying, and instead was buying bonds to maintain his portfolio balance. Inversely, when stock prices were falling, and everyone was selling stock to buy bonds, he was selling bonds to buy stock at low prices to rebalance his portfolio. It didn’t require market timing, fancy math, or any sort of intellectually rigorous activity; just simple portfolio maintenance and the responsibility to maintain it. It only took him minutes per year. In addition, as a fun side portfolio, he applied fundamental principles of rational individual stock selection. In a noble fashion, he beat the market with his individual selections, but humbly points out that over the long run, it’ll become statistically less and less likely for him to maintain that claim, and that people should index rather than try to beat the market. It’s a rather solid case of wisdom and diligence being a winning combination.

As a teacher, he has witnessed first hand how dismal the financial education is for most students. They learn how to work with quadratic equations, and learn the difference between eukaryotic and prokaryotic cells, but they don’t learn to manage their own money. Recalling my own education, I can literally say that not a single teacher taught me a single thing about investing, valuing a company, corporate structure, or stock indices, except for the simple chapter in a mathematics class regarding the power of compound interest. That was it. Andrew has sought to correct this by educating teachers, educating family members, giving talks, blogging, and now, writing a successful book.

The book is organized as a series of his “Nine Rules of Wealth”.

The Good

The book is excellent, as I expected.

-The organization of the book is well thought-out. He covers the basics, makes arguments, reinforces those arguments, but never becomes tiring or overly repetitive. This is in contrast to the famous book, The Millionaire Next Door, which contains a similar message, but after 50 pages of that book, the reader is like “OK I get it already! You don’t have to say the same thing ten times!” Andrew avoids that problem by providing enough reinforcement of his ideas without tiring them out.

-His set of arguments for index funds over actively managed funds is flawless. He really puts the nail in the coffin of actively managed funds. Not only does he make extremely effective arguments backed up by statistics, history, and reasoning, he even counters the expected counterarguments made by people who wish to sell you those funds anyway. His devastating arguments against the enormous self-serving financial services industry should be clear to any rational mind.

-His final section on individual stock selection uses intelligent principles, and covers a lot of the investment basics. In a few parts of the book, he covers topics of how corporations work, why shares go up in value, differences in company value, and more.

-He gives a definition of “wealthy” that I very much agree with. It’s very straightforward, and in my opinion it’s also accurate. Perhaps just as importantly, it’s reasonably attainable on a regular income with diligent saving/investing habits.

-Andrew is a Canadian teacher that currently lives and teaches in Singapore. So he’s sensitive to global differences, and takes an international approach. There’s a whole section devoted to international indexing. So it doesn’t matter what country you’re from; the truths in this book remain valid.

-The 184 page book is an elegant read. Remember, this isn’t a financial guru writing a book; it’s a self-made millionaire English teacher. It can be read in a weekend, is easily accessible to a multitude of different types of readers, and the nine rules break it up into easily read chunks. He artfully blends personal stories, humor, facts, and images to create a rather effortless reading experience.

-I found myself being unable to put the book down, and finished reading much earlier than I had planned. “Well, I’ll read one more of these rules for now…”, I kept telling myself, until I had read through all of them. It’s not because the book is overly short; it’s because it flows elegantly, and gives the information needed without providing any distracting extras. Andrew’s investment approach is simple, as any effective investment approach should be.

Any Downsides?

Any good review includes some constructive criticism. In this case, it’s not criticism of what he said, or of his arguments; it’s an observation of what he didn’t say, and what most people don’t say.

At one point, when Andrew is explaining how a corporation works (his reminder to readers that indexes are built on real companies, and are not just little lines on a graph that go up and down), he uses the following example: He discusses Willy Wonka starting a public company to raise more capital, talks about the shareholder relationship, talks about growth and dividends, and says that the board of directors is voted in by the shareholders.

All of this is true, and yet with index funds, that’s not what really happens in practice. With index funds, shareholders don’t vote for the board of directors. Instead, they own hundreds or thousands of companies, and can’t pay attention to what those boards are doing. Index investors give their right to vote to the owner of the fund. When Vanguard, for instance, votes on behalf of the millions of investors that gave up their right to vote by buying their index funds, Vanguard sets a very low bar for whether they will vote for a given board member, and they abstain from voting with regard to 94% of shareholder proposals that are related to corporate or social policy.

One can’t really blame Vanguard; they have fiduciary duty to their customers to promote good returns, and they can’t predict how millions of would-be shareholders would want to vote their shares. So they largely stay neutral and abstain from much of the process. I think pointing out the loss of shareholding voting that comes with index funds (as well as actively managed funds), would have been a fair addition in the book.

I believe responsible portfolio management includes treating shares as an owner would, and voting accordingly with regards to board member elections, management compensation, and review of shareholder proposals. It’s the one area where my investing philosophy seems to differ from the book.

Conclusion

Millionaire Teacher is an excellent, easy-to-read book. In my opinion, this should be on the reading list for every high school student in the world. In addition, I suggest that everyone who currently invests in actively managed funds should read this, since I couldn’t agree more that index funds in almost every case are far more rational to invest in than actively managed funds. I offered to let a co-worker of mine borrow my copy of the book after he started talking to me about his mutual funds. Andrew’s arguments are solid, the book is a delight to read, and after having seen him blog for a while now, he certainly is a genuine and honest person.

Click below to have a look at the book.

Disclosure: The book image link is an affiliate link to Amazon, and I only use affiliate links for products I highly recommend.

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The Downside of Upside

If you haven’t noticed, the US stock indices have performed fairly well in aggregate over the past few months. Including several of my holdings.

What a bummer!

That’s probably not the reaction that you’d expect, but it’s rather common among long-term investors. When stock market prices go up, the paper value of a portfolio increases, but finding solid investments for currently invested capital becomes more difficult. My brother, an executive at one of the largest US defense contractors and a husband and father to a wife and three kids, is joyed to see his indexed portfolio replenished, and I can’t really blame him, but I’m disappointed to see some values lessen! I’m glad to see people get to work; I’m not disappointed about economic improvement. It’s strictly the stock valuations that can be suboptimal.

In a market with lower valuations, fresh capital can result in producing better returns, and reinvested dividends and company share repurchases result in better rates of return as well. Markets with higher valuations result in reinvested capital going to lower-return investments.

To illustrate this point, here’s an example. Company A has a P/E of 12, solid cash flow and a good balance sheet, pays out 75% of its EPS as regular growing dividends, and grows EPS by 6% per year. Company B is identical in every way, but has a P/E of 18. For simplicity, these valuations stay constant for 10 years, and dividends are pooled and reinvested once per year. I could have done this chart in multiple ways, such as making stock prices equal and having the two companies with different EPS (to reflect the differences in valuation), or I could have made EPS the same, and make the stock prices different. I choose the first approach so that we can start with the same amount of shares at the same price per share. This link shows a PDF of the charts and outcomes.

As can be seen, since both companies have the same payout ratio but company A is at a lower valuation (and therefore a larger dividend yield), investing in company A results in a larger initial amount of dividend income for the same invested value. In addition, over the next 10 years, since the valuation is lower and the yield is therefore higher, reinvesting the dividend purchases more shares, which grows the investment and the income at a quicker rate.

An investor in company A turned $12,000 into $39,403, which is an annualized return of 12.6% over this 10 year example. Meanwhile, an investor in company B turned $12,060 into $32,486, which is an annualized return of 10.4% over this 10 year example. The total dividend income growth rate matches the total return for each respective investment.

So, two identical companies had significantly different returns based simply on their valuation over that period. This is because dividends can buy more dividends when the valuation is lower (and this applies to share repurchases by the company as well). Of course, over any realistic time period, the valuation will rise and fall, but the point is, that at any given time, it’s preferable in the eyes of the long-term investor (net buyer) for the valuation to be low. Any time that’s spent with her dividend stocks at higher valuation, is money lost. Now, there are some times of course when a spike in valuation could be profitable, such as if a stock goes up to an overvalued state and the investor sells, looking for a better stock, or if the valuation increases just when a person retires and cashes out part of her stock portfolio. But for most long-term investors, especially net buyers that aren’t retiring any time soon, it’s low-valued markets that provide the better long-term returns.

Now, one could point out that valuations are directly linked to growth expectations. In other words, when the stock market changes, it’s because investors are increasing or decreasing their expectations. The example chart that I provided only remains true if fundamental growth is unchanged by the changing valuation; it assumes the differences in valuation of those two identical companies are strictly irrational rather than due to legitimate differences in expectation. But one can look at any long term graph of stock price and annual EPS for a given set of blue-chip stocks, and see irrationality in the stock price.

Buy low, look for good combinations of dividend growth and dividend yield, solid balance sheets, strong cash flows, economic moats, and hope it stays low for a while to let those shares accumulate.

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