Investing requires one to have discretionary income.
You can’t invest what you don’t have.
However, I’d go so far as to say that investing is not a discretionary activity at all.
It’s a necessary one.
If one doesn’t save and invest, they’re going to put their future self at risk of destitution.
This world can be cold and cruel at times, and relying on the kindness of strangers in old age is not a good idea.
Living below your means and systematically investing your savings is a must.
And when investing your savings, consider the dividend growth investing strategy.
This is a long-term investment strategy whereby one buys and then indefinitely holds shares in high-quality businesses that pay safe, growing dividends to shareholders.
It’s such a powerful strategy, as it almost automatically filters out bad businesses (because bad businesses are typically unable to generate the ever-rising profit necessary to pay out ever-larger dividends).
For proof of this, take a look at the Dividend Champions, Contenders, and Challengers list, which lists the hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
You’re unlikely to find bad businesses on that list; to the contrary, many of these are world-class businesses.
This quality filter is one reason I’ve adopted the strategy for myself, using it as I’ve gone about building my FIRE Fund.
That’s my real-money portfolio, and it produces enough five-figure passive dividend income for me to live off of.
In fact, this dividend income unlocked financial freedom at a young age for me, even allowing me to retire in my early 30s.
My Early Retirement Blueprint shares how that went down.
Suffice it to say, the totally passive and growing dividend income that one can collect from great businesses is a fantastic aspect of this strategy.
However, one cannot blindly pursue investments.
Valuation at the time of investment is crucial.
That’s because price only represents what you pay, but value represents what you 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.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Putting your future self in a great financial position by living below your means and investing your savings into high-quality dividend growth stocks at attractive valuations is almost a no-brainer move in life.
Of course, being able to recognize undervaluation requires a basic understanding of valuation in the first place.
Well, that’s where Lesson 11: Valuation comes in.
Put together by fellow contributor Dave Van Knapp, it explains the whole concept of valuation using simple terminology and even provides a template you can use on your own.
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…
W. R. Berkley Corp. (WRB)
W. R. Berkley Corp. (WRB) is an American an insurance holding company that underwrites insurance and reinsurance on a global basis, focusing on commercial niche lines.
Founded in 1967, W. R. Berkley is now a $22 billion (by market cap) insurance player that employs more than 8,000 people.
The company operates through two segments: Insurance, 88% of FY 2024 net premiums written; and Reinsurance, 12%.
The insurance business model is a favorite of mine.
An insurer like W. R. Berkley can make money through two avenues.
First, there’s the core underwriting aspect of the business, where it assumes risk for premiums.
If a company can underwrite prudently, as W. R. Berkley does, this can lead to a nice profit.
But the insurance business model wraps this ingenious second money-making opportunity by way of the “float” – the capital that accrues to the business and accumulates over time because of the time delay between collecting premiums and paying out on claims.
This float can be conservatively invested and earn capital gains and income for the company alongside the core underwriting profit.
If an insurance company can get both correct, it can be an incredible compounding machine over time.
Well, that’s exactly what W. R. Berkley has been doing for years already (as I’ll reveal throughout this article), and I believe it’s fully capable of continuing that for many years to come.
That should result in higher revenue, more profit, and larger dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 23 consecutive years.
It’s quickly coming up on Dividend Aristocrat status.
Its 10-year dividend growth rate is 9.4%, which is solid and something that the company has been incredibly consistent with (almost every dividend increase over the last decade has been somewhere between 9% and 10%).
That said, as I’ll illustrate later, I think there’s room for an acceleration in the dividend growth rate over the coming years, which would be coming off of a great base.
Now, the downside here is the stock’s yield of 0.5%.
That’s well below what the broader market offers, but it is basically in line with its own five-year average.
However, this is only the headline yield – and it’s misleading.
The thing to understand here is, W. R. Berkley regularly declares special dividends.
It does so pretty much every year.
W. R. Berkley declared just over $1.08 in special dividends last year.
Those special dividends yielded 1.8% all on their own.
Added in with the regular dividends, we’re up to a respectable yield of 2.3%.
Based on the regularity of these special dividends, that’s the kind of yield I’d actually keep in mind regarding this stock.
Distilling things back down into the regular dividends, the payout ratio is only 7.3%.
This is one of the lowest payout ratios I’ve run across.
The payout ratio is so low, W. R. Berkley either has to pay special dividends or meaningfully increase the size of the regular dividend (otherwise, the company risks a token dividend and questions around why a dividend is being paid at all).
And this extremely low payout ratio is part of the thesis regarding a possible acceleration in dividend growth (which I just touched on).
While this stock might not make sense for straight-up income investors, younger dividend growth investors who appreciate growth and the power of long-term compounding have a lot to like here.
Revenue and Earnings Growth
As much as there is to like, though, many of these numbers are based on what’s happened in the past.
However, investors must always be thinking about what may come to be in the future, as the capital of today gets risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be vital for the valuation process.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us the information we need to gauge where the business could be going from here.
W. R. Berkley grew its revenue from $7.2 billion in FY 2015 to $13.6 billion in FY 2024.
That’s a compound annual growth rate of 7.3%.
Very solid top-line growth, particularly from a mature business in a pretty staid industry.
Meantime, earnings per share increased from $1.15 to $4.36 over this period, which is a CAGR of 16%.
That is excellent bottom-line growth.
Very impressive stuff here.
Excess bottom-line growth was fueled by a combination of buybacks and profitability improvements.
Regarding the former, the company reduced its outstanding share count by approximately 8% over the last decade.
Looking forward, CFRA is forecasting a 13% CAGR in W. R. Berkley’s EPS over the next three years.
While that would be slightly lower than what transpired over the last decade, it would still be a great result.
On the other hand, W. R. Berkley recently reported results for the full FY 2024, showing a 29.4% YOY increase in EPS in a hard market for insurance.
The company showed healthy increases both in premiums written and investment income.
The latter stems from the company’s aforementioned “float”, which has resulted in the company accruing a ~$30 billion investment portfolio that’s mostly allocated to high-quality fixed-income instruments.
The company’s total fixed maturity securities had an average rating of AA-, so we can see that the company is conservatively invested.
This conservative investment portfolio generates steady income for the business, regardless of how well the core insurance business is doing.
However, the core insurance side of the house continues to do very well, with the company reporting a combined ratio (a measure of how profitable underwriting is, with lower being better) of 90.2%.
That’s not the lowest combined ratio out there, but the company consistently has a fairly low combined ratio (it was close to 90% in the previous year, also).
It’s really in the consistency that W. R. Berkley shines, in my view.
This company just gets it done, year after year.
It operates in a very clockwork-like manner.
I think a driving force behind this consistency is the management team.
This company is still run by the founding Berkley family.
William R. Berkley serves as Chairman, and W. Robert Berkley, Jr. is the CEO.
The family not only runs the business but also owns nearly 23% of the company.
In addition, there’s meaningful ownership among employees.
This family-led, ownership-based culture is a huge plus, and I just love this “skin in the game”.
Putting it all together, I think CFRA might be a bit cautious with their forecast.
I don’t see why the next decade can’t be just as good as the last one, which would set up W. R. Berkley for mid-teens annual EPS growth.
And since the payout ratio is so low, the dividend could grow at least that fast.
Plus, there’s plenty of room for special dividends to continue (which I’m sure the Berkley family enjoys).
This is all to say, this compounding machine looks ready to continue compounding at a high rate.
Financial Position
Moving over to the balance sheet, W. R Berkley has a rock-solid financial position.
The long-term debt/equity ratio is 0.4, and the interest coverage ratio is over 17.
Furthermore, the company carries a healthy cash balance that offsets about half of all long-term debt.
It senior long-term debt carries investment-grade credit ratings: BBB+, S&P; Baa1, Moody’s; and A+, Fitch.
It should come as no surprise that W. R. Berkley, as a risk manager, runs a pretty conservative balance sheet.
Profitability for the firm is strong (and improving).
Return on equity has averaged 15.3% over the last five years, but this has been trending up around 20% in recent years (compared to a low-teens range a decade ago).
What I see is a high-quality, family-led niche insurer that’s been a great performer for years and should continue to perform extremely well.
And with economies of scale, deep industry expertise, an ownership culture, and its focus on specialty lines, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The insurance industry is especially competitive, and it’s heavily regulated.
Insurance products are essentially commodities from a customer’s point of view.
The business model is a risk unto itself, as W. R. Berkley is in the business of underwriting risk with a long risk “tail” (i.e., W. R. Berkley doesn’t know with certainty its cost of goods upfront, which can result in unknowingly underpricing policies in the present and facing consequences years down the road).
All insurance companies have exposure to catastrophic events, although W. R. Berkeley’s focus on specialty lines and niches does insulate the firm somewhat.
The insurance market is “hard” right now, which is a tailwind, but a transition into a softer market in the future would be a headwind and weigh on results.
The company has exposure to interest rates through its investment portfolio, and this portfolio must be managed intelligently to generate consistent income and avoid impairments.
Commercial insurance results in exposure to the broader economy, as an economic slowdown would likely reduce demand for commercial insurance.
A lot of these risks are pretty standard for an insurer, despite W. R. Berkley being a lot better than standard.
Yet, the valuation doesn’t seem to price in any kind of deserved premium…
Valuation
The stock is trading hands for a P/E ratio of 13.8.
This compares favorably to the stock’s own five-year average P/E ratio of of 16.8.
This is not expensive for an insurer.
It’s definitely not expensive for a high-quality business, in general.
For a business consistently growing at a mid-teens rate, you might expect a P/E ratio closer to (or above) 20.
On the other hand, if we go by book value, the P/B of 2.7 is trending above its own five-year average of 2.3.
That said, all of the stock’s various multiples are not demanding at all in absolute terms.
And the yield, as noted earlier, is 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 two-stage dividend discount model analysis.
I factored in a 10% discount rate, a 10-year dividend growth rate of 11%, and a long-term dividend growth rate of 8%.
I used a two-stage model to account for the high (and higher) growth over the near term (which cannot persist forever).
Notably, I did include the special dividends (something I don’t usually do), as these special dividends are so recurring as to be regular dividends anyway (and the valuation is hard to make sense of without them).
The 10-year dividend growth rate in the model is higher than the demonstrated 10-year dividend growth rate, but I think it’s clear by now that an acceleration in dividend growth is on the horizon.
With the 10-year EPS CAGR at 16%, and with the near-term EPS forecast at 13% (which I think is conservative), W. R. Berkley will almost have to increase the rate of dividend increases and keep them up with business growth (otherwise, the extremely low payout ratio starts to head to ~0%).
I actually believe that W. R. Berkley will grow the regular dividend even faster than this over the coming years, but this growth may be moderated by larger special dividends (which is, again, why I included them in this model).
The DDM analysis gives me a fair value of $97.48.
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.
In my view, this company’s excellence is not properly reflected in the stock’s pricing.
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 WRB as a 2-star stock, with a fair value estimate of $52.00.
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 WRB as a 4-star “BUY”, with a 12-month target price of $67.00.
Quite a spread here, although I’m out on a limb in an unusual way this time around. Averaging the three numbers out gives us a final valuation of $72.16, which would indicate the stock is possibly 16% undervalued.
Bottom line: W. R. Berkley Corp. (WRB) is a high-quality, family-led niche insurer with excellent fundamentals and a shareholder-friendly capital allocation policy. Underwriting is very prudent, and the “float” has resulted in a sizable investment portfolio that’s conservatively managed and generates consistent income for the firm. With a market-beating yield once special dividends are included, an extremely low payout ratio, high-single-digit dividend growth that’s likely to accelerate, more than 20 consecutive years of dividend increases, and the potential that shares are 16% undervalued, this is a fantastic long-term idea for dividend growth investors who appreciate great compounders.
-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 WRB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 98. 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, WRB’s dividend appears Very Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Disclosure: I have no position in WRB.
