Category Archives: Stock Selection

Duck Hunt with Aflac Insurance

In light of the recent market run-up since the beginning of the year, I’ve been focusing my attention on large-cap, dividend-paying (and yes somewhat boring) companies to invest in. My reasoning for this is that in the event of a significant market correction, the dividend will provide an income stream during the recovery and share prices of these large established companies don’t tend to get battered quite as badly as the small-cap growth stocks I usually pay attention to. Currently, my only exposure to the insurance industry is through my investment in EBIX, however this position will be closed out soon because the company is being bought out by a Goldman Sachs affiliate. Today I will be looking at another insurance company in terms of its suitability as an investment at present time, namely Aflac Inc. (AFL).

Aflac Inc.

While known for its cute advertising campaign featuring the “Duck” equally, if not more so than the actual services the company provides, Aflac is a provider of health and life insurance policies, headquartered in Columbus, Georgia. This company has grown at a 17% compounded rate since 1983, and has increased its dividends every year for the past 30. Despite being based in the US, Aflac does a significant portion of its business in Japan – seen as a risk to some and a benefit to others. Let’s take a look at some of the highlights in Aflac’s Q1 2013 report:

  • Owing to unfavorable yen/USD exchange rates, revenue was unchanged from the year-ago quarter at $6.2B, however EPS increased to $1.90 compared to $1.68 – a 13% increase.
  • Ignoring the currency exchange, revenue in Japan was up 9.7% and earnings up 10.7% in the first quarter. This includes an investment income increase of 7.3%.
  • The company is actively engaged in a share repurchase program, having purchased 3 million shares in the first quarter at a value of $150M. The company intends to repurchase a total of $400M – $600M worth of shares by year-end 2013.
  • Reiterated guidance of 4% – 7% earnings growth for 2013.

DDM analysis: As of Friday’s close, Aflac was trading at $55.69 and paid a dividend of $1.40, yielding 2.50%. Historically, the company has increased its dividend by over 19% annually over the past 10 years, but has only been averaging about 6-10% growth over the past 5 years. Using a dividend growth rate of 6.16% and a discount rate of 9% in the dividend discount model, I arrive at a valuation of $50/share.

EPS Growth analysis: My EPS growth method returned an intrinsic value of $69. Inputs to the analysis were a future EPS growth rate of 9%, a future PE equivalent to the 5-yr average 12.5, and a discount rate of 12% over a 5 year timeframe.

Valuation ratios: A look at current valuation ratios compared to historical numbers produced numbers ranging from $59 – $79 / share. These were arrived at based on an average 5-yr yield of 2.4%, avg. PE of 12.5, and an avg. PS of 1.14.

Graham Number: Plugging EPS of $6.33 and BVPS of $34.05 into the Graham equation, produces a fair valuation of $69.64.

Conclusion

It appears based on this analysis that AFL is undervalued, although cannot rely on the dividend alone to maintain current trading levels. My target price for Aflac is $65. I will be entering a position on Monday’s open.

Readers: What are your thoughts on Aflac? How much of a concern is the company’s exposure to Japan, and by extension its currency?

Evaluation of Canadian Banking Stocks

Being a Canadian, I try to allocate at least a portion of my portfolio towards Canadian companies. A very small part of me does this for reasons of patriotism, but more importantly I do it to at least partially avoid currency risk. Canadian investors who were fully invested in the US stock market during the past decade probably regret it being that the Canadian dollar increased in value from a low of $0.62 to par against the US dollar over that same time period. Specifically today I will be conducting an analysis of the major Canadian banks in an effort to select one as an investment candidate. The Canadian banking system is much more stable than that of the US due to tighter regulation among other things, generally pay healthy dividends, and the entire industry is in a period of growth as the Canadian economy strengthens and continues to recover from the financial crisis in 2009. Bob Johnson, a fellow Seeking Alpha author, offered an excellent summary outlining the strength and soundness of the Canadian banking industry which I encourage you to read.

Canada has six major players in its banking industry as follows:

  1. Bank of Montreal (BMO)
  2. Scotiabank (BNS)
  3. CIBC (CM)
  4. National Bank (NA)
  5. Royal Bank of Canada (RY)
  6. Toronto Dominion (TD)

All of these banks are listed on both the TSX and the NYSE, however all of the analysis that follows will be based on the TSX data/prices in Canadian dollars unless stated otherwise. First, let’s look at a quick snapshot of these companies. The following table highlights some of the fundamentals:

 

For each of the comparative criteria, green highlighting indicates the best, and yellow the second best. There is a large disparity in size between the largest bank (RBC) and the smallest (National), with market capitalizations of $86B and $12B respectively. All six banks pay a healthy dividend currently yielding greater than 4%, however BMO and CIBC are edging closer to 5%. Earnings growth over the past 5 years was dominated by TD at about 10.5% annually. Projected earnings growth over the next five years shows an edge for Scotiabank, however these are based on analyst consensus and all are relatively close together in the 6.5% – 8.5% range. From a valuation perspective, National Bank has both the lowest PE and PEG – significantly lower than the other companies. Finally, from a profitability standpoint, Scotiabank is head and shoulders above the rest from a profit & operating margin standpoint, while National Bank offers the best return on equity.

Looking at the above high level analysis Scotiabank seems to have an overall advantage from a growth and profitability standpoint, however National looks to be the best value while at the same time providing the best ROE.

Next let’s look at past stock performance over the past year:

 

As one would expect these stocks are highly correlated, however there are some observations that can be made. Notable, National and TD have lagged the other four over the past 12 months. Secondly, all banks are off of their recent highs achieved in late February by a significant margin, including a steep decline over the past week due to disappointing Canadian employment data.

Now let’s look at performance over the past five years:

 

Over the past five years, National was the clear winner, which could explain it’s lackluster performance recently as it may have been overbought. National is a smaller bank and as such is a bit more volatile. I am always interested in buying good value, so let’s use an additional valuation technique to determine whether any of these banks are over or underpriced at the moment. Specifically I am going to use the EPS growth capitalization method. The results are summarized in the following table:

 

For the above calculations I assumed a future PE of 12 for all companies and I used a discount rate of 9%. Current price, EPS (ttm), and analyst consensus estimated EPS growth rates from Yahoo Finance were used. It’s clear from the above table that National Bank appears to be quite undervalued at the moment. This is inline with the low PE ratio we noticed above. Scotiabank also looks to be slightly undervalued, while the other intrinsic values calculated are so close to today’s price that for all intensive purposes they can be treated as fairly valued. What’s interesting to note, is that these are the same two companies I identified above as being possible investment candidates.

Based on the above analysis, I will be looking to enter into a position in National Bank at or below current price levels within the next week. I will also be adding Scotiabank to my watch list with a target entry price representing a MOS of 15% below the intrinsic value I calculated above of $62.91. The represents an entry price of $47.18, which may be possible over the next few months based on the recent weakness due to unemployment.

Disclosure: I plan to take a long position in NA and BNS in the coming weeks.

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Is CAT a bargain right now?

I’ve been following Caterpillar (CAT) closely the past few months looking for a good opportunity to initiate a position. I’ve been searching for high quality dividend stocks to add to my portfolio to provide an income stream and reduce volatility. CAT has been beaten down from its recent high just shy of $100 in February to around $83 as of this morning’s trading. That’s a 17% drop, and I believe it opens the door to position entry. In fact, I initiated a position this morning at $83.37 on the dip at the open due to the lackluster US jobs report. Following are my reasons why.

Caterpillar is in the business of heavy mining & construction equipment, engines, and turbines. Visit virtually any industrial site and you’re virtually guaranteed to see some of their equipment in use. CAT is a $55B worldwide company, headquartered in the US but with a large focus on growth regions such as China more recently. General consensus is that the stock has underperformed as of late due primarily to uncertainties in some of the company’s key markets. With the price of gold plummeting, mining companies are becoming more cautious with their capital investments. Demand in China is showing signs of uncertainty as well. I prefer to look at the long term picture though rather than short term fluctuations. Long term there will be an ongoing demand for heavy machinery, and CAT is well positioned to supply that demand. For that reason I am treating this dip in share price as an opportunity rather than a cause for concern.

CAT is currently trading just North of $83/share at a PE ratio of just under 10. The company pays an annual dividend of $2.08 which works out to a yield of around 2.4%. Better yet, CAT has increased dividends every year for the past 19 years and with a payout ratio of just 25%, looks capable of continuing this policy in the future. Stock performance itself has lagged the rest of the market due in part to the reasons I’ve outlined above, with share prices down nearly 20% from a year ago and 5% YTD. CAT has a debt/equity ratio currently of 1.58, and appears capable of meeting it’s near term obligations per it’s current ratio of 1.43.

I have used several valuation techniques in an attempt to ascertain what a reasonable price to pay for Caterpillar stock would be as follows:

  • EPS Growth Capitalization: Using a future PE of 13 and a projected EPS growth of 9.4% over the next five years, I arrived at an intrinsic value of $98.14 which is 17% above today’s trading price using a 12% discount rate.
  • Discounted Cash Flow (DCF): Using an initial revenue growth rate of 15%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of $105.34 which is 19.5% higher than today’s price.
  • Dividend Discount Model: Based on a current dividend of $2.08/yr, a long term dividend growth rate of 5.2% (3-yr avg.) and a 12% discount rate, fair value for CAT works out to be just $30.91 using the dividend discount model. Clearly what this is saying is that we must rely on capital appreciation in addition to dividend distributions if we are willing to pay today’s prices for this stock. Also dragging this number down was my choice to use the 3-yr average in an attempt to be conservative. The 1-yr and 5-yr dividend growth rates for example are circa 9% and would result in a fair value of $66 if used.
  • Graham Number: Based on earnings of $8.49 over the past 12 months, and a current BVPS of $26.86, the Graham Number equates to $71.63, or about 18% lower than today’s price.
  • Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be $155.18, $98.51, or $83.74 respectively.

Throwing away the two extremes (high and low), the fair value range for CAT looks to be between $71.63 and $105.34. The average valuation is $91.47 and the median is $89.80. Based on this, it would appear that Caterpillar is trading within it’s fair value range, but erring to the low side approximately 9% below the mean. As stated above, I am taking this opportunity to initiate a position despite the low margin of safety.

Disclosure: I am long CAT.

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Buying Chevron at current Price Levels

As I mentioned earlier this week, I am in the process of adding some long term dividend stocks to my portfolio in an effort to reduce the volatility arising from the growth stocks I own. After further analysis of the stocks in this list, I have decided to buy Chevron (CVX) despite the fact that it is near all-time highs. This may sound counterintuitive from a value standpoint, but based on my analysis, CVX is still reasonably priced, even at $118 / share.

Chevron is a multinational energy corporation operating in over 180 countries. The company’s primary focus is in the oil & gas industry (both upstream and downstream), but is also involved in geothermal, chemical manufacturing, and power generation. It is the 2nd largest oil company in the US, and employs over 62,000 people worldwide.

As of today, Chevron is trading at $118 / share and currently pays $3.60 in annual dividends which results in a 3.05% yield. The company has a solid history of increasing dividends every year for the past 25 years, and based on a current payout ratio of just 27% it would appear that this policy will continue for the foreseeable future.

Chevron has achieved earnings growth of 8.73% compounded over the past 5 years and revenue growth of 3.58% over the same period. Analysts forecast earnings growth 7.6% (source: Morningstar) over the next five years, which is inline with historical numbers.

CVX carried both short and long-term debt, with a debt/equity ratio of 0.09 as of last quarter. The company is in good shape to handle it’s current obligations as evidenced by a current ratio of 1.63. Chevron is currently involved in some ongoing legal issues in several countries, most notably in Ecuador. Un unfavorable outcome could negatively impact the company significantly in the future.

I believe that the rewards outweigh the risks for CVX and will be initiating a position so long as the price is reasonable. In an attempt to determine a fair price to pay for Chevron I conducted several different valuation techniques as follows:

  1. EPS Growth Capitalization: Using a future PE of 9.3 and a projected EPS growth inline with analyst estimates of 7.6% over the next five years, I arrived at an intrinsic value of $101.38 which is 16% lower that today’s trading price using a 12% discount rate.
  2. Discounted Cash Flow (DCF): Using an initial revenue growth rate of 5%, declining to 3% over the forecast period, a terminal growth rate of 3%, and a 12% discount rate, my discounted cash flow analysis resulted in an intrinsic value of $149.22 which is 21% higher than today’s price.
  3. Dividend Discount Model: Based on a current dividend of $3.60/yr, a long term dividend growth rate of 9.2% (5-yr avg.) and a 12% discount rate, fair value for CVX works out to be $128.57 using the dividend discount model — about 8.7% higher than today’s price.
  4. Graham Number: Based on earnings of $13.32 over the past 12 months, and a current BVPS of $70.01, the Graham Number equates to $144.85, or a 19% premium to today’s price.
  5. Other multiples: Using historical PE analysis, PB analysis, and dividend yield analysis, fair value appears to be $123.69, $100.06, or $108.75 respectively.

In all, seven different valuation techniques were used, admittedly some more complex than others. Fair value for CVX appears to be in the range of $100.06 to $149.22. The average valuation is $122.36, and median is $123.69. Based on today’s trading price of $118, it would appear that CVX for all intensive purposes is within the fair value range, perhaps leaning towards being slightly undervalued.

Disclosure: I am long CVX.

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Combining Dividend Growth Investing with Value Strategies

hundred dollar billsDue to the relatively aggressive nature of my stock selection methods, I often tend to end up with my portfolio more heavily weighted towards small-cap, high-growth stocks. While the riskiness inherent to this class of securities is more often than not offset by above average share price appreciation (if bought at good value), it’s good to also have a portion of your portfolio allocated towards stocks that will exhibit less volatility and provide steady growth over the long term.

One way to accomplish this is to select a number of Dividend Growth stocks for inclusion in your portfolio. Dividend Growth stocks are those typically of older, large-cap, well-established companies that not only pay a dividend, but have also had a history of increasing the dividend annually over the past 10+ years. These stocks attract a different sort of audience from the investment community and provide the benefits of reduced volatility and an income stream even during times when the market is in a lull. More importantly however is the idea that because the company’s dividend increases every year, your yield-on-cost goes up every year as well. This means that buying a stock that yield’s just 2% today, might yield 10% on your cost to purchase the stock in the future. For this reason, dividend growth stocks are usually considered to be very long term investments, so that this benefit is maximized.

One of the best sources of information for dividend growth stocks is David Fish, who updates his list of Dividend Champions monthly. The list consists of all those stocks that have increased their dividend payments every year for the past 25 years or more. It also includes lists of those companies that have increase dividends between 10 – 25 years and also 5 – 9 years. The spreadsheet can be found on David’s DRiP Investing Resources website.

My goal is to identify those dividend growth stocks that meet the following criteria:

  • Current dividend yield of at least 2%
  • History of increasing dividends for at least the past 10 years
  • Payout ratio less than 50%
  • Positive EPS growth rate
  • Attractive valuation
  • Market capitalization of at least $5B

With these criteria in mind, I’ve selected ten stocks to add to the Stockodo watch list.

  1. ACE Limited (ACE) – An insurance holding company currently yielding 2.2% with a track record of increasing dividends annually for the past 20 years. With a payout ratio of just 25%, positive earnings growth, and a compounded dividend growth rate of 13% over the past 5 years, it meets our criteria. Despite trading at near 10-year highs, it’s currently trading at a PE ratio of 11.
  2. Chevron (CVX) – An oil & gas company worth $230B sporting a current dividend yield of 3%. Chevron has increased dividends for each of the last 25 years, yet has a payout ratio of just 27%. The company has grown dividends at a rate of 9% over the last 5 years, and CVX trades at a PE multiple of just 8.9 today.
  3. C.H. Robinson Worldwide (CHRW) – A $10B logistics company with a current dividend yield of 2.35% and a history of dividend increases over the past 16 years. Payout ratio is currently 38% and dividend growth has been 13% over the past 5 years. CHRW is currently trading at a PE ratio of 16.
  4. Cardinal Health (CAH) – A $16B healthcare services company with a current dividend yield of 2.6%. CAH has increased dividends for each of the past 17 years and has a current payout ratio of 33%. Dividends have grown at a rate of 24% over the past five years, but has slowed down to just 10% last year. Cardinal Health currently trades at a PE of 12.
  5. Caterpillar (CAT) – A manufacturer of heavy mining/construction equipment with a market cap of $57B and dividend increases in each of the last 19 years. CAT currently yields 2.4% and has a payout ratio of 25%. Dividends have grown at 8% over the past 5 years and CAT currently trades at a PE multiple of just 10.
  6. Deere & Company (DE) – Manufacturer of John Deere farm equipment, currently valued at $33B and yielding 2.4%. Deere has increased dividends for the past 10 years and has a payout ratio of 26%. Dividends are growing at a rate of 8% per year and DE trades at a PE ratio of 15 currently.
  7. 3M (MMM) – A conglomerate currently valued at $73B and yielding 2.4%. 3M has increased dividends for the past 55 years and has a payout ratio of 40%. Dividends are growing at a rate of only 5-7% per year and 3M trades at a PE multiple of 17.
  8. Praxair (PX) – A specialty chemical company with a market capitalization of $33B and a dividend yield of 2.1%. PX has increased dividends for the past 20 years and achieves a dividend growth rate of 12% per year. Praxair’s payout and PE ratios are currently 43% and 20 respectively.
  9. Teva Pharmaceutical (TEVA) – An Israeli pharmaceutical manufacturing company with a focus on generic drugs. TEVA is currently valued at $34B, yields 2.6%, and has increased dividends for the past 13 years. Dividend growth rate has ranged between 15% and 22% over the past five years and TEVA trades at a PE multiple of 18 currently.
  10. Walgreen Company (WAG) – A retail drugstore chain with a market capitalization of $45B and a dividend yield of 2.3%. Walgreen has been growing dividends for the past 37 years and at a high rate in the recent past. Dividends have been growing at a 23% rate compounded over the last 5 years. WAG currently trades at a PE ratio of 21.
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Stock Screen for Predictable Growth & Low Debt

Stock Screen for Predictable Growth & Low DebtIn the previous article we developed a value investing stock selection criteria based on companies that exhibit predictable growth in earnings, sales, and equity, and have low or no debt. This is called the PGLD criteria and we will now use a stock screener to see what stocks are able to meet it.

We will use the Finviz stock screener for this exercise, as it’s free and offers the ability to screen against virtually any fundamental, technical, or descriptive criteria possible. The only exception is BVPS growth which we will have to handle manually or with another tool. Continue reading

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Stock Selection Criteria: Predictable Growth & Low Debt

Question mark in spray paint

Defining a suitable stock selection criteria is step #1 in our value investing workflow. It’s critical that we select only those stocks that will allow us to calculate a valuation with an accuracy we’re sufficiently confident in to enable proper execution of our value investment strategy.

Selected stocks firstly must be highly predictable. A highly predictable company will allow us to determine an intrinsic value with a high degree of confidence.

Secondly, we are looking for high quality stocks. Quality ties in closely with predictability and is defined by the company’s ability to meet a number of criteria with respect to consistent growth and return on capital. This stock selection criteria will seek to choose only the highest quality companies with a stellar record of consistently high growth across a number of metrics.

Finally, we will seek to limit our selection only to those sectors and industries within which we have at least a cursory understanding of the business. This will allow us to further screen our stock selection against possible red flags or opportunities that may not be present in the numbers themselves. Continue reading

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