The market has been super bumpy over the last several weeks.
Volatility has picked up in a major way.
But here’s the thing: Volatility is a feature, not a bug.
Volatility allows those who have a long-term time horizon, a calm temperament, and an opportunistic mindset to acquire long-term wealth from those who lack what’s necessary to bear volatility.
It’s all about having the patience necessary to see through and withstand short-term volatility in order to come out the other side even better.
Warren Buffett said it best: “The stock market is a device for transferring money from the impatient to the patient.”
When others are selling their stocks at discounts so that they can escape volatility, that’s a patient person’s opportunity to buy on sale.
What makes this whole idea much more palatable is the dividend growth investing strategy.
This is a long-term investment strategy that involves buying and holding shares in high-quality businesses that shower their shareholders with reliable, rising dividends.
You can see many examples by perusing the Dividend Champions, Contenders, and Challengers list, which has compiled invaluable information on hundreds of US-listed stocks which have raised dividends each year for at least the last five consecutive years.
These reliable, rising dividends are funded by reliable, rising profits.
And it takes a great business to be able to consistently generate more and more profit.
By design, this strategy tends to funnel investors right into great businesses.
And those reliable, rising dividends are a comforting form of steady, increasing cash flow through a storm, making it much easier to maintain a sense of equanimity through the volatility.
In addition, the cheaper stocks get, the higher the yields become (all else equal) – meaning even more income to acquire and reinforce one’s composure.
I’ve been applying this strategy for the last 15 years, and it’s helped me to ignore short-term volatility as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of.
It’s been enough to live off of since I quit my full-time job and retired in my early 30s.
How I was able to do that is explained in my Early Retirement Blueprint.
Now, as I noted earlier, one of the best gifts of volatility is the ability to pick up those deals.
What I’m referring to is valuation.
Price is only what you pay, but value is 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.
Taking advantage of short-term volatility by picking up undervalued high-quality dividend growth stocks at lower prices and higher yields is a great way to follow through on Warren Buffett’s advice of taking money from the impatient.
Of course, all of this valuation talk assumes one already understands the basic ins and outs of the concept.
Just in case you’re not completely familiar with those ins and outs, Lesson 11: Valuation is a great read.
Written by fellow contributor Dave Van Knapp, it explains valuation using simple terminology and even provides an easy-to-use template that can quickly identify possible opportunities in the market.
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…
State Street Corp. (STT)
State Street Corp. (STT) is an American global financial services company.
Founded in 1792, State Street is now a $22 billion (by market cap) financial powerhouse that employs more than 50,000 people.
State Street is the second-oldest bank in the US, founded near the start of the United States as a country, but its banking presence is in the custody space (not retail banking).
The company has approximately $47 trillion in assets under custody and nearly $5 trillion in assets under management, making it one of the largest asset managers in the world.
State Street is truly global, operating in over 100 markets worldwide.
State Street has two primary businesses: Investment Servicing, and Investment Management.
The former provides a number of supportive services, including custody of assets, to a range of customers such as mutual funds and insurance companies; the latter is involved in managing financial assets.
Regarding custody, there are only a small handful of major global custody providers, meaning State Street is in an oligopoly.
Simultaneously, on the other side of the house, State Street’s ETF family is firmly ensconced among the “big three” (also including BlackRock and Vanguard), which combine to control ~75% of the market, placing the company in yet another oligopoly.
That’s two oligopolies for the price of one.
Also, this ETF exposure puts the company in the driver’s seat as it pertains to the shift from active to passive asset management.
What’s great about State Street is that its foundation is incredibly enduring, as evidenced by the fact that the company has been around for more than 230 years (nearly as long as the US itself).
For long-term investors who like a high degree of visibility, there are few institutions that can claim this kind of endurance.
The resilient nature of State Street can be traced, in part, to its structure – it is mostly a fee-based business model (with fees accounting for roughly 75% of revenue), avoiding the pitfalls of a traditional bank (such as credit exposure/risk).
And because of the “stickiness” of these assets (i.e., it’s almost nonsensical to move around assets under custody), the fees are also quite sticky.
Not only that, but these fees have natural escalators built right in, as global assets are rising in price over time (which increases the absolute size of the base upon which State Street charges fees).
With custody a necessity for safekeeping, and with its ETF success placing it as one of the three majors, it’s position, which is nearly unassailable, makes it difficult to imagine any future in which State Street isn’t around and even larger than it is now.
And that’s why it should continue to reliably grow its revenue, profit, and dividend for decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has increased its dividend for 14 consecutive years.
Its 10-year dividend growth rate is 9.7%, which is strong.
Better yet, there’s been no slowing here.
State Street has been incredibly consistent with its dividend growth, reliably handing out dividend raises in the 9% to 10% area, year after year.
Its most recent dividend raise, which was announced last July and came in at 10.1%, is a perfect example of this.
And you get to layer that dividend growth on top of stock’s starting yield of 3.9%.
This yield is approaching utility territory, which is notable.
Another thing that’s notable about this yield?
It’s 90 basis points higher than its own five-year average.
The payout ratio here is only 37%, which provides plenty of leeway regarding future dividend raises.
I like every number here.
Nice yield, safe payout, plenty of growth.
These dividend metrics are really right in my wheelhouse.
Revenue and Earnings Growth
As much as there is to like here, though, these numbers above are looking backward.
However, investors must always be looking forward, as the capital of today gets risked for the rewards of tomorrow.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will be of great use when the time comes later to estimate intrinsic value.
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.
Blending the proven past with a future forecast in this way should give us enough information to judge where the business could be going from here.
State Street moved its revenue from $10.8 billion in FY 2015 to $22.1 billion in FY 2024.
That’s a compound annual growth rate of 8.3%.
This is really good.
I usually like to see a mid-single-digit (or better) top-line growth rate from a mature company like this, and State Street did far better than that.
Meanwhile, earnings per share increased from $4.47 to $8.21 over this period, which is a CAGR of 7%.
Its results can be a bit lumpy (due to the exposure to global capital markets), and one’s view of the company can be shaped by the starting and ending points used.
The pandemic and tech wreck of 2022 are included in this 10-year look, and that may skew things a bit negatively.
Still, I think we have pretty respectable growth here out of State Street, despite a suboptimal period.
Looking forward, CFRA is projecting a 10% CAGR for State Street’s EPS over the next three years.
This would be more in line with what I think State Street is truly capable of.
While what transpires over the next few years over at State Street will somewhat depend on the strength of global capital markets (which impacts the fee base) – and the spring of 2025 is not shaping up well – State Street has the pieces in place to prosper over time.
CFRA glowingly highlights some of these pieces, pointing to “…the strength of [State Street’s] custody franchise, which enjoys significant barriers to entry, while its large asset management business adds to earnings diversity. Sizeable operational deposits contribute to a robust liquidity profile complemented by a strong balance sheet with limited credit risk. We think its disciplined expense management supports earnings in any operating environment.”
That says it all.
It has the custody assets, which are very sticky, and State Street has built on top of that its large asset management business, which also has sticky assets and fees.
Business results may swing from year to year, depending on global capital markets, but the low payout ratio cushions this volatility and creates a smooth source of growing passive income for shareholders.
Reassuringly, it’s nigh impossible to imagine State Street actually experiencing some kind of operational/solvency issue.
No crisis heretofore has actually threatened State Street.
Backing up CFRA’s forecast is State Street’s Q4 FY 2024 results, which showed a 13% YOY fee revenue increase, $64 billion in net inflows, and record numbers nearly right across the board.
State Street is objectively as strong as it’s ever been.
With or without CFRA’s 10% projection being realized, I see the dividend continuing its ~10% growth path over the foreseeable future.
The low payout ratio and clear commitment to this by management is an “all clear” sign to me.
And that’s put on top of the near-4% yield.
It’s utility-like yield, except you’re also getting dividend growth well in excess of the average utility.
Moreover, I see State Street’s safety and resilience from an operational/solvency point of view as being just as good as any utility in the world.
Financial Position
Moving over to the balance sheet, the company has a rock-solid financial position.
The long-term debt/equity ratio is 0.9.
State Street has a CET1 ratio of 10.9%.
Its senior debt at the corporation level has credit ratings that are well into investment-grade territory: AA-, Fitch; Aa3, Moody’s; and A, Standard & Poor’s.
In addition, the lack of credit risk relative to a traditional bank involved in lending should give investors more confidence in the financial position and the bank’s resiliency.
Profitability is fairly robust and competitive.
Return on equity has averaged 10.2% over the last five years, while return on assets has averaged 0.8%.
Notably, ROE came in at over 11% last fiscal year, which was one of its best showings in years.
This is a a well-run bank that has been around for centuries, and it’s positioned to last centuries more.
And with economies of scale, “sticky” assets across both major businesses, oligopolistic markets, its ETF leadership in an era favoring passive asset management, and brand recognition, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
While competition is somewhat limited, owing to State Street’s oligopolistic positioning across its major business lines, the competitors that do exist are fierce and trying to take market share away from State Street.
Due to banks being under the thumb of the US Federal Reserve, regulation is an outsized risk for State Street (relative to many other business models), although this regulation serves as a barrier to entry which can scare off new entrants.
The company’s exposure to global capital markets is a risk, and this exposure creates volatility in its results from quarter to quarter and year to year.
The fee-based business model is attractive and offsets some volatility from the markets, but fees in the industry are under constant pressure to head lower.
Its global footprint exposes it to geopolitics and currency exchange rates.
Although it’s not a “bank” in the traditional sense, State Street would still get hurt by any kind of economic slowdown (which would negatively impact markets and fees).
The risk profile here for State Street lines up pretty well with any custody bank, but its lack of retail banking is reassuring.
And the valuation, which seems to price in a high risk profile after a recent 20%+ drop in the stock’s price, appears to add a nice margin of safety…
Valuation
The stock is carrying a P/E ratio of 9.6.
That is low in both absolute and relative terms.
It’s well below the broader market’s earnings multiple, and it’s also below the stock’s own five-year average P/E ratio of 11.6.
This represents a PEG ratio of barely over 1.
Also, the P/B ratio of 1 is on the low end of what banks tend to command (with P/B ratios usually ranging from 1 to 2), and this is below its own five-year average of 1.1.
And the yield, as noted earlier, is significantly higher than 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 7%.
This dividend growth rate is probably on the low side of what State Street is capable of and will do over the coming years.
I say that because the payout ratio is very low, the company is growing faster than 7%/year, and the demonstrated dividend growth rate over the last decade is nearly 10%.
However, this is a financial institution facing pressure on fees and looking at extreme volatility in the capital markets.
I think it makes sense to err on the side of caution and set oneself up with a one-foot bar they can easily clear.
The DDM analysis gives me a fair value of $108.43.
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.
Even with what I think was a cautious model, the stock looks materially undervalued.
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 STT as a 4-star stock, with a fair value estimate of $90.00.
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 STT as a 4-star “BUY”, with a 12-month target price of $113.00.
We’re all in the same neighborhood here. Averaging the three numbers out gives us a final valuation of $103.81, which would indicate the stock is possibly 24% undervalued.
Bottom line: State Street Corp. (STT) is one of the US’s oldest and most storied financial institutions, built to last centuries. Its resiliency revolves around fees, “sticky” assets, and oligopolistic positioning in both of its major business lines. With a market-smashing yield, high-single-digit dividend growth, a low payout ratio, nearly 15 consecutive years of dividend increases, and the potential that shares are 24% undervalued, long-term dividend growth investors interested in taking advantage of market volatility and wanting to pick up a deal on a high-quality company should take this idea seriously.
-Jason Fieber
Note from D&I: How safe is STT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, STT’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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.
Disclosure: I’m long STT.
