There’s very little in this world that you can actually control.
Yet investors often seem intent on trying to control what they cannot.
You can’t control geopolitical events, interest rates, or how millions of other investors will react to news.
But I’ll tell you what you can control.
You can control which businesses you invest in and what you pay for those investments.
That might not seem like much.
But doing even just those two things right can have an immense impact on your long-term success as an investor.
Now, I’m not saying these are the only things you can control.
But if you focus on buying the right businesses at the right prices, you’ll likely do incredibly well.
I’d argue the right businesses are ones that produce reliable, rising profits and reward their shareholders with reliable, rising dividends.
That’s right.
I’m talking about high-quality dividend growth stocks.
You can find hundreds of these stocks on the Dividend Champions, Contenders, and Challengers list.
And this has resulted in the building of the FIRE Fund.
That’s my real-money stock portfolio, which produces enough five-figure passive dividend income for me to live off of.
Indeed, I do live off of dividends.
In fact, I started living off of dividends in my early 30s.
I was able to retire at a very early age in life, as I describe in my Early Retirement Blueprint.
But there’s another big factor at play here.
Valuation.
While price is what you pay, it’s value that you actually get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
It’s protection against the possible downside.
Getting the right businesses at the right valuations can, and almost certainly will, allow you to build significant wealth and passive dividend income over the long run.
With my beliefs on the right businesses out of the way, we now have to tackle valuation.
Fortunately, it’s not that hard.
Fellow contributor Dave Van Knapp put together Lesson 11: Valuation in order to make the valuation process much simpler.
One of many “lessons” he’s provided on dividend growth investing, it lays out a valuation guide that you can use to estimate the intrinsic value of almost any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Travelers Companies Inc. (TRV) is a holding company that, through its subsidiaries, provides commercial and personal property and casualty insurance products to individuals, businesses, government units, and associations.
Founded in 1853, Travelers is now a $40 billion (by market cap) insurance behemoth that employs over 30,000 people.
It’s the only P&C insurance company in the Dow Jones Industrial Average. This is truly a blue-chip company.
Net written premiums for FY 2021 break down across the following segments: Business Insurance, 50%; Personal Insurance, 39%; and Bond & Specialty Insurance, 11%.
As I’ve stated many times before, I love the insurance business model.
Whereas most business models make money by selling their products and/or services, the insurance business model makes money on top of this.
That’s due to the float.
The float is the capital that builds up as a natural course of doing business.
An insurance company charges premiums up front. And they later pay out claims against those premiums.
But the lag between these two events often leads to an insurance company sitting on a lot of cash – which is a low-cost and low-risk source of capital that earns returns all by itself. It’s somewhat similar to a bank deposit scheme.
For perspective on that, Travelers manages an investment portfolio with a carrying value of $84 billion (as of the end of 2020).
The investment portfolio is more than twice as large as the company’s entire market cap. And this kind of capital can produce a lot of income, even in a low-rate world.
For further perspective on just how powerful the float is, Travelers had net income of nearly $3.7 billion last fiscal year. The investment portfolio generated most of that, with net investment income coming in at $2.5 billion for the fiscal year.
The float is what makes the insurance business model so lucrative.
Whereas a lot of people might assume an insurance company makes most of its money by selling insurance, they actually tend to make most of their money by properly utilizing the float.
Warren Buffett recognized the power of the float decades ago, heavily investing in (and later buying out) insurance company GEICO. GEICO now forms a major pillar of his conglomerate, Berkshire Hathaway Inc.
Buffett took the inherent power of the float and supercharged it by virtue of his investing prowess, building a $300+ billion common stock portfolio in the process and becoming, arguably, the world’s all-time greatest investor.
If an insurance company can combine effective underwriting with a large float, they become a formidable company.
And that’s exactly what Travelers has done.
This positions them to continue growing their revenue, profit, and dividend for decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The company has already increased its dividend for 17 consecutive years.
And that growth is paired with a market-beating yield of 2.2%.
This yield is basically right in line with its own five-year average.
I suspect there’s plenty more growth in store for the dividend, as the payout ratio is only 24.7%.
Revenue and Earnings Growth
As good as these dividend metrics are, though, they’re largely looking at the past.
But investors risk today’s capital for tomorrow’s rewards.
And so I’ll now build out a forward-looking growth trajectory for the business, which will later help when it comes time to estimate the stock’s intrinsic value.
I’ll first show you what the company has done over the last decade in terms of top-line and bottom-line growth.
I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past against a future forecast should give us a good idea as to where the business is going from here.
Travelers increased its revenue from $25.7 billion in FY 2012 to $34.8 billion in FY 2021.
That’s a compound annual growth rate of 3.4%.
It’s been a tough and competitive underwriting environment, but this is a solid result.
Meanwhile, earnings per share advanced from $6.30 to $13.94 over this period, which is a CAGR of 9.2%.
That EPS growth lines up pretty nicely with the 10-year dividend growth rate.
A major factor in the excess bottom-line growth has been buybacks.
Travelers reduced its outstanding share count by approximately 36% over the last decade. That is one of the more substantial buyback programs I know of.
Looking forward, CFRA is projecting that Travelers will compound its EPS at an annual rate of 10% over the next three years.
That would be pretty much in line with what the last decade has resulted in for the company.
One highlight that stands out from CFRA is them pointing out that Travelers has “a diversified mix of business and
sound capital management and underwriting practices.”
And in insurance, that’s pretty much the name of the game.
If you can underwrite with prudence and then manage capital intelligently, you’re going to do really, really well as an insurer.
Speaking on the underwriting, Travelers had an underlying combined ratio of 90.3% for FY 2021.
I think it’s important to point out that Travelers has put up some great numbers in a low-rate environment. But interest rates are set to rise this year. That would have a positive impact on the investment portfolio, which helps the company as a whole.
If Travelers can compound the bottom line at nearly 10% annually when rates are historically low, they stand to do a lot better when rates are higher.
Overall, I see CFRA’s EPS growth forecast as appropriate.
And that would allow Travelers to grow the dividend at a similar, or higher, rate, especially after factoring in the low payout ratio.
With a 2%+ starting yield, that kind of dividend growth is more than enough to make it a captivating long-term investment idea.
Financial Position
Moving over to the balance sheet, the company maintains a rock-solid financial position.
Since insurance companies are in the business of managing risk, they tend to have conservative balance sheets.
The long-term debt/equity ratio is 0.3, while the interest coverage ratio is over 15.
Their credit ratings are well into investment-grade territory.
The company’s senior debt has the following ratings: A, Standard & Poors; A2, Moody’s; A, Fitch.
Profitability is strong.
Over the last five years, the firm has averaged annual net margin of 8.5% and annual return on equity of 10.4%.
This blue-chip company is a well-run operation.
And they benefit from durable competitive advantages that include economies of scale and the float.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Competition is especially fierce in insurance.
There is natural disaster risk. Natural disasters are both very expensive and very difficult to predict.
The company’s investment portfolio is largely allocated to fixed-income instruments. The low-rate environment limits returns on these investments. And municipal bond holdings face risk from local government finances.
Travelers must remain disciplined with underwriting. There’s always a risk that future claims could reveal that prior underwriting policies weren’t appropriate.
I think it’s important to consider these risks, but Travelers still strikes me as a great insurance business that can make for an excellent long-term investment.
This is a rare stock that’s actually up in 2022 (by 8%), but the valuation still looks rather appealing right now…
Stock Price Valuation
The P/E ratio is 12.0.
That’s significantly lower than the broader market’s earnings multiple.
It’s also well off of the stock’s own five-year average P/E ratio of 14.1.
There’s also a disconnect in the P/CF ratio.
At 5.8, that’s much lower than its own five-year average of 7.5.
Meantime, the P/B ratio of 1.4 is right in line with its five-year average.
And the yield, as noted earlier, is basically right in line with its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 8%.
This dividend growth rate is as high as I go.
And maybe that looks aggressive at first glance.
But it is below the company’s demonstrated dividend growth and EPS growth over the last decade. It’s also below the near-term forecast for EPS growth. And the payout ratio is very low.
The last few dividend increases have admittedly been small.
But Travelers has the ability to easily grow the dividend at a high-single-digit rate, based on operating results.
With rates set to rise, their ability to do that only improves.
The DDM analysis gives me a fair value of $190.08.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
My analysis shows a stock that is severely discounted, even after running up this year.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates TRV as a 3-star stock, with a fair value estimate of $170.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates TRV as a 3-star “HOLD”, with a 12-month target price of $175.00.
I came out on the high end, but we all agree that the stock is worth more than it’s currently being priced at. Averaging the three numbers out gives us a final valuation of $178.36, which would indicate the stock is possibly 6% undervalued.
— Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from D&I: How safe is TRV’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 78. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, TRV’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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