Spring 2016 Newsletter

The markets have rallied back up, and once against have fairly rich valuations. But there is considerable uncertainty in the market, and some high quality companies are trading at lower prices than they were a few months ago.

Here’s a list of three companies that I believe are reasonably valued, and that may become even more attractive if another market decline were to occur.

Magellan Midstream Partners LP (MMP)

I briefly mentioned Magellan in my December newsletter, and I certainly believe it deserves a more direct focus here. It’s a fairly conservative pick in the troubled pipeline industry, offering a decent yield and strong distribution growth. It’s my current preferred selection in the industry.

Unlike many other pipeline operators, Magellan primarily focuses on transporting refined products, and they’re the largest refined products pipeline company in the country. They have 9,500 miles of refined pipelines, 50+ terminals, and 40+ mm barrels of storage facilities, and access to about 50% of the country’s supply. To round that out, they also have 1,600 miles of crude products pipelines and 20+ mm barrels of crude storage facilities. Lastly, they have 5 marine storage facilities.

Their focus on refined products is what has largely protected them from the oil price crash. Their unit price has taken a big hit due to a reasonable valuation correction, but their actual operating numbers remain strong, and the distribribution remains very safe. This is because most of their volume is demand-based rather than supply-based. As long as U.S. consumers and businesses keep using large amounts of gasoline, diesel fuel, jet fuel, petrochemicals, lubricants, asphalt, and oil-based plastics, then Magellan should continue to do very well.

The company currently pays a distribution yield of about 4.5%, with double-digit distribution growth over the last decade and a half. The distribution growth from 2014-2015, straight through this crash of oil prices, was just over 15% for the year. MMP management expect 10% distribution growth in 2016 and at least 8% distribution growth in 2017.

They currently have over 1.3x distribution coverage, meaning they have over 30% more cash flow than they pay in distributions, which is much higher than most other MLPs. Magellan aims to keep this number above 1.1, so they’re far above their target and playing it safe. They also have a lower than average debt/EBITDA ratio of under 3, and one of the industries highest credit ratings at BBB+.

The partnership does face some headwinds from low commodity prices that affect about 15% of their business, and reductions in supply from some basins as well as the potential for defaults from some of their troubled customers that can affect Magellan’s performance to a degree.

A long term risk to Magellan is a reduction in the use of oil products. An example would be Tesla’s upcoming Model 3, or Chevrolet’s upcoming Bolt, which both aim to be roughly $30k all-electric vehicles with 200+ mile battery ranges between charges. The electric car industry is fragile, with little market penetration, reliances on federal subsidies, and a lack of charging infrastructure. But as lower priced electric vehicles with ranges that can comfortably fit any normal commute become commonplace, this could change. Overall though, industry estimates for the market growth of these kinds of vehicles aren’t large enough to materially affect Magellan through 2020 at least.

One of the strongest points in Magellan’s favor is the fact that they have no incentive distribution rights (IDRs) to pay. Many MLPs have to pay up to 50% of their cash flow to their general partners, but Magellan is 100% owned by the public. So, Magellan has all of the tax advantages of being an MLP, but doesn’t have to deal with the downside of IDRs. This effectively means they have a lower cost of capital than most of their peers. When IDRs cap out at 25% or so, like Brookfield Infrastructure Partners, then they’re not much of a drag on growth. But when IDR caps are as high as 50%, like many MLPs are, it can limit the types of investments that an MLP can profitably make while still increasing its per-unit distributions. Magellan is free of this problem entirely.

They also don’t currently rely on raising capital with equity. Many MLPs ran into trouble in 2015 when they relied on selling units to raise cash, but their unit prices were cut in half or worse, leading to that suddenly being a poor way to raise money. Magellan has the option to raise equity capital if a huge opportunity comes along, but they don’t need it for general growth and operating expenses, and haven’t increased their number of outstanding units in the last 5 years. They keep the distribution coverage high enough that they pay a growing distribution while using excess cash to internally fund investments for growth, and rely on conservative levels of debt financing.

Wrapping It Up Into a Valuation

Magellan’s most recent quarterly distribution was $0.785/unit, which is $3.14/unit annualized. This is a distribution yield of about 4.5%. Since inception, their distribution growth rate has averaged about 13% per year.

The performance, therefore, has been oustanding. A 4-5% distribution yield with a 10-15% distribution growth rate over a decade or more translates into market-crushing performance. So for the forward period, I’m not going to use those numbers. Instead, I’ll use more conservative estimates that assume Magellan must slow down, must face more headwinds, must deal with a more saturated pipeline industry, must face the rise of electric vehicles, and so forth.

Here’s a dividend discount model analysis of MMP, using 8% distribution growth for the next decade and 5% thereafter, and a 10% target rate of annualized return:


Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

The result is a valuation estimate of $83. In comparison, Morningstar currently has a fair value estimtae of $76, and Argus Research has a price target of $85.

The current price in the low $70’s places it about 15% below my fair value estimate, implying that expected returns going forward should be over 10%/year with a margin of safety. It’s not a very high hurdle to step over, and therefore I believe that Magellan is a great risk-adjusted opportunity.

If you want an even larger margin of safety than the current price offers, Magellan units have very attractive option premiums. You can sell a July 16, 2016 cash-secured put with a strike price of $65 for about three dollars. This means that during the next four months, if Magellan stock goes below $65, you may have to purchase it for $65, which counting the premium would give you a cost basis of about $62. Then, you’d have a great cost basis to hold it for the long-term. Or, if Magellan remains above $65, you would keep your three dollars per unit, which translates into a return of about 4.8% for just a four month period, and you could write another option at that point, and continue this strategy until you own it.

CSX Corporation (CSX)

I believe it’s time to buy the railroads, and it’s really a toss-up between CSX and UNP at this point, in my opinion. They’re the two largest remaining pure-play Class I railroads in the United States, and UNP operates in the western two-thirds of the country while CSX operates in the eastern third of the country.

UNP is, by many metrics, the slightly better company. Their long stretches of track along the lesser-populated region of the country are good alternatives to trucks, and they have access to Mexico for the transport of cars. But this comes with an earnings multiple that is about 2 higher than CSX, and a slightly lower dividend yield.

Mike recently published articles on both of them, and I think both are strong investments. An investor would likely do fine diversifying into both of them, if they want railroad holdings for the entire continental United States. For this article, I’ll focus on CSX.


The global crash in commodity prices has hurt the U.S. railroads. Coal in particular is down, both as a source of energy and as an ingredient in steel. Low natural gas prices have all but made coal obsolete as an energy source for new energy plants, especially considering that it’s one of the dirtier sources anyway. Export coal volumes are hurt by the strong U.S. dollar and a weak Chinese economy. Metallurgical coal used in steelmaking is down as well, also due to Chinese weakness and other global issues.

Many other goods in the economy have declining volume, and the massive reduction in diesel prices has made trucking more affordable, which can eat into railroads market share. As such, CSX has seen its stock price drop from about $37 to now around $25.

Despite the big stock price hit, the company is doing fine. Although revenue was down 13% for 2015 compared to the year prior, 2015 EPS was higher than 2014. Going into 2016, the company expects mild EPS declines compared to 2015, as continued volume weakness, especially from coal, is offset by reducing the number of engines and workers. Thanks to the the advances in automation technolgies over the last two decades, the railroads now have highly flexible business models that allow them to shrink and expand to meet cyclical demand, which is good for just about everyone except of course the rail workers. All in all, CSX deserved a price correction, but losing a third of the stock price puts it into oversold territory, in my opinion.

Analysists expect EPS in 2016 to be $1.86 compared to $2.00 in 2015. But with current information, they expect CSX’s 2017 EPS to be back up to over its 2015 figure. We’ll see what happens, but the point is, CSX adusts to changes in volume.

An Opportunity

A project is expected to be completed this year that will double the capacity of the Panama Canal, and increase the maximum size of ships that can pass through. This is expected to increase shipping volume between Asia and the east coast of the United States.

Currently, materials and products that ship between the eastern half of the United States and Asia are usually shipped between Asia and the west coast and then railed between the west coast and the eastern half. But with direct access to ports along the east coast with larger container ships thanks to the panama canal expansion, the two western U.S. railroads are expected by some analysists to lose market share to the two eastern U.S. railroads. Ports along the east coast are expanding to allow for these larger ships, in expectation of this increase. Some estimates are that the intermodal market share for CSX could increase from 20% to 25% over the next five years. When comparing CSX to UNP, that’s a factor to consider, especially with CSX consistently being at the lower valuation.

Both remain strong picks, in my view.

Dividend Growth

Estimating the actual volume growth or shrinkage of railroads over a long period of time is nearly impossible, due to how cyclical it all is. The good news is that unlike many other industries, you don’t need very accurate estimates; you just need to know how management intends to allocate their capital, assuming no fundamental changes radically reduce rail volume.

Revenue for CSX in 2016 is not much higher than it was in 2008, for example, and yet EPS has almost doubled during those eight years. Shareholder returns from railroads come mostly from dividends and sharebuybacks; not from core growth.

If over the next ten-year period, CSX has 0% net volume growth and 2% annual pricing growth in line with inflation, then revenue growth will average 2% per year. The dividend yield is about 2.8%, and the company historically buys back stock and reduces its share count by about 2-4% per year, which makes sense given that they have an earnings yield of about 7%, which mostly goes to dividends and buybacks.

Adding this together, if the dividend payout and debt/equity ratios stay relatively static, you can reasonably expect a 2.8% dividend yield and a forward dividend growth rate of about 4-6%, based on 2% annual price increases and 2-4% buybacks. That comes out to a total rate of return of about 6.8%-8.8% per year, with zero volume growth, from a boring railroad investment. Any volume growth would be in addition to that.

Rockwell Automation (ROK)

This is a good candidate to buy on dips. The company has excellent long-term growth prospects but the valuation is at the high end of what’s fair, with a current P/E ratio of about 18.

Rockwell is a provider of industrial automation products and services. This includes selling automation hardware and software to companies, and also includes experts that can implement those products for a company. Their products can cover both discrete and process solutions, and they have useful lifecycles of over ten years in most cases. Their software and hardware are unique, with high switching costs. Customers tend to be quite “sticky”, and therefore Rockwell has a durable competitive advantage.

I run the electrical engineering department of a small organization that I work for, and we’ve been using the same automation products from one of Rockwell’s competitors since I took the job, despite changing most other things over time. My predecessor used them, and I still use them, simply because they work well enough and the software engineers would have to change a lot of code to start working with a new system. I continue to buy tens of thousands of dollars of those systems, even as they increase the price regularly, because price isn’t our only decision point. I’ve examined other systems, and have never found a compelling reason to switch to a different one. In short, software switching costs can be high due to the need for re-integration and additional software writing and testing, and it creates a moat and pricing power.

Although Rockwell is in a low-growth period due to global economic issues, they’re a leader in an industry that has nowhere to go but up. Rockwell estimates that the global potential market for their products increased from $65 billion in 2010 to $90 billion in 2015.

Strong Cash Flow

Rockwell has had fairly unimpressive revenue growth over the last ten years, but they’ve enjoyed strong EPS growth, book value growth, and dividend growth. Their balance sheet is safe but not spectacular. What really shines is their free cash flow; they’re one of the uncommon companies that consistently generate more in free cash flow than they report as earnings. So, while the price to earnings ratio is currently 18, the price to free cash flow ratio is under 15. Suddenly the company looks a lot more attractively priced.

The company doesn’t waste it, either. Over the last five years, the company has increased its dividend by over 15% per year on average, while consistently reducing their outstanding share count. The current dividend yield is about 2.7%. Forward dividend growth should slow down as we enter a more difficult period for global growth, but Rockwell remains in a position to produce consistent dividend growth.

Wait For It…

Rockwell was at its high in 2014, at over $125/share at one point. In January of 2016, during the market correction, Rockwell stock traded nearly as low as $90/share. Now, it’s back up to $107. The market has been bipolar about it, constantly changing market price due to variances in global growth expectations.

Buying at $107 would be a solid purchase, in my opinion. But the stock is also a good candidate for selling puts, based on the price of the premiums, the stability of the company, and the volatility of the stock.

You can sell a July 2016 put for a strike price of $100 and earn a $4 premium. If the stock declines to under $100 in the next four months, then you’d buy it for a cost basis of $96, which is only 13x current FCF. If the company remained over $100 by expiration in mid July, you’d keep the premium anyway, and enjoy a return of over 4% in a period of a little over four months, and write another option. You can get paid like this to eventually buy at a very attractive cost basis.


Although overall market valuation remains fairly high at the moment, there are plenty of opportunities to establish long-term positions in cyclical industries. Railroads, best-of-breed pipelines, and industrials are all facing troubles at the moment, but their long-term potential remains optimistic and their valuations remain reasonable.

Winter 2015 Dividend Stock Newsletter

Several headwinds face stocks over the next few years, and I’m moderately bearish for fundamental value-oriented reasons. This article examines some of those headwinds and discusses several strategies to navigate them with decent risk-adjusted returns.

Headwind 1) High Market Valuations

According to broad valuation measures such as the Shiller P/E ratio (the price of the market divided by the ten year average inflation-adjusted earnings of the market, aka CAPE), the S&P 500 is at one of its highest earnings multiples in history. There were only three times in the last century that this valuation metric was higher: in 1929 shortly before the Great Depression, in 1999 shortly before the Dotcom Bubble Collapse, and in mid-2000’s shortly before the stock crash in 2008.

Here’s a fairly recent Shiller P/E chart:


The chat stops in August but the November figure is still above 26. The Shiller P/E is by no means a perfect metric, and unless interest rates get extremely high again it’s unlikely to see a long-term market staying near historical Shiller P/E averages. But it’s a useful one, and you can see the current market valuation problem yourself on an individual company basis by examining several defensive blue-chip stocks.

Coca Cola, Pepsico, Colgate Palmolive, McDonald’s, Automatic Data Processing, and other defensive brands currently trade for 20-25 times forward earnings. They’ll likely outperform the S&P 500 during a market correction, but their likelihood of providing future returns equal or better than past S&P 500 long term performance seems low. They remain strong for growing dividend income, especially when compared to how poor the returns are from bank accounts and bonds, and some of them are great for the defensive core holding part of your portfolio, but not particularly ideal for an overall high rate of return like they have historically offered investors.

Another useful metric is to compare total US market capitalization to GDP. The market recently went up to about 118%, which is historically significantly overvalued. This metric and the Shiller metric tend to correlate very well.

Jack Bogle, founder of Vanguard, said in October that he expects a 4% rate of return over the next decade for the S&P 500, which is less than half of the historical average. His estimate is based on a 2% average S&P 500 dividend yield, plus 5% average annual EPS growth for companies in the index, minus 3% per year for earnings multiple contraction, since earnings multiples are quite high. Tweaking these numbers for slightly better growth or slightly less earnings multiple contraction still leaves investors with returns that are less than the historical average.

I think holding most or all of your portfolio in dividend growth stocks, averaging a 3% yield with substantial dividend growth, and avoiding some of the highest valued companies, will probably outperform Bogle’s market prediction. But still, I think he’s largely correct about the overall state of the market and that it will negatively impact returns over the next several years.

Headwind 2) Interest Rates Will Likely Mildly Increase

The U.S. Federal Reserve has held interest rates at historically low levels for a historically long period of time due to the fragile economy. It’s been close to a decade since the Federal Reserve increased interest rates, and we’ve been at at near-zero rate for most of that time. This has been a decreasing trend that has extended through multiple market cycles.

Here’s a fairly current and historical Federal Funds Rate chart:


All else being equal, low interest rates push the stock market up. You can see the inverse correlation between interest rates and market valuations by comparing the charts for the Shiller P/E and the federal funds rate, but it’s also a conclusion that can be arrived at with reason. Low interest rates give companies easy access to cheap capital, meaning they can borrow large sums at low rates and use that money to expand or otherwise earn a rate of return that exceeds these negligible borrowing costs. People can access cheaper capital to start new businesses, and existing businesses can access cheaper capital to expand their operations. Even if a corporation simply borrows money by issuing low-interest bonds and uses that money to buy back its own stock, it pushes EPS growth and the stock price up at a faster rate than it would if borrowing costs were higher.

Low interest rates also drive people into stocks because other investment classes become less desirable. When bank savings accounts and bond yields are giving rates of return that don’t even keep pace with inflation, investors naturally seek out investments that provide better returns. This especially includes dividend-paying stocks, but also includes the broader stock market in general. People have flocked from other forms of investments into equities over the past several years as interest rates have been near-zero (and on a longer trend over the past few decades as interest rates have had a long-term decline), therefore inflating current equity valuations to historically high levels. Not quite into bubble territory, but certainly into danger territory.

It’s likely that the Federal Reserve will begin slightly increasing rates at the end of 2015 or at least in 2016 according to statements they’ve made. But I’m not interested in making predictions here, since for long term investors the timing of interest rate changes doesn’t matter much. The fact is, interest rates are at rock bottom and don’t really have anywhere to go besides approximately sideways or up over time, which is the main message here.

It’s unlikely that interest rates would go very high like they used to be; they’ll likely remain at lower levels than historically. One of the reasons for the Fed to increase the interest rate is to keep inflation in check, but the inflation rate is already low and the US dollar is currently at extremely strong levels compared to foreign currencies such as the Euro and the Yen. So there’s little current incentive for the Fed to do anything more than mild and gradual rate increases.

These eventually rising interest rates wouldn’t necessarily be a cause for a bearish outlook if it weren’t for the previous headwind of high market valuations. Stock prices are already at a high valuation premium, and interest rates can mostly only go sideways or up, which puts pressure on those high stock prices.

Headwind 3) The Economy Remains Fragile

Although the average US citizen is in better financial shape than a few years ago, and the rate of loan delinquencies has decreased dramatically, and credit card debt has stabilized, there are numerous structural problems that remain.

Official unemployment levels in the U.S. are low at around 5% now, but unofficial levels remain high. This includes people that are underemployed compared to their level of education and experience, people that are not working as many hours as they’d prefer, and people that have given up looking for work altogether. And over 46 million Americans are on food stamps.

Although the total household net worth in the United States is at a record high of $85 trillion, the middle class is not very healthy. Existing student debt is extraordinarily high compared to prior decades, and the cost of saving for future college expenses of children is at historically high levels. Americans (both individuals and their employers) spend a larger amount of money on healthcare per capita than any other country in the world. Pensions for workers have been largely replaced by 401(k)s and most people have not proven to be good stewards of their retirement accounts, and the pension funds that still exist are expecting an average of 7% annual S&P 500 growth going forward for their investments, and would have problems if the S&P 500 has returns that are closer to Jack Bogle’s estimate. Average lifespans have lowered the ratio of the number of workers compared to the number of retirees, putting pressure on the financial health of social systems like Social Security and Medicare, eventually necessitating either additional cuts or taxes to fix them. Average personal savings rates are low, due to the cultural tendency towards consumerism but also due to the previously mentioned increasing costs of healthcare and education compared to historical norms. International trade agreements have not helped domestic manufacturing, and automation is increasingly putting pressure on low-skill jobs. All of this and more makes current and future disposable income for the working class and middle class appear not very strong.

Since consumer spending accounts for over two thirds of the US economy, the middle class is the core engine of growth, and so a fragile middle class does not bode well for the long-term health of the American economy, and would have a limiting effect on domestic corporate performance.

Other regions of the world are not currently in great shape either. Continental Europe has low growth and substantial sovereign debt, Canada has a very expensive housing market, Japan has long-term economic stagnation and the highest sovereign debt-to-GDP in the world, China’s growth is maturing and therefore slowing, Brazil is in a recession, and Russia’s economy is suffering from low energy prices.

Again, this wouldn’t necessarily be a problem for stock investors if stock valuations weren’t already so high. It all comes down to valuations, because if valuations were much lower, then these headwinds like eventual interest rate hikes or middle class fragility would already be factored in. The best investment opportunities generally arise during times of economic weakness, but in the current environment, there is global economic malaise mixed with historically exuberant stock valuations.

These three headwinds together should give a bearish outlook on equities, not for technical reasons of short term stock movements, but for fundamental reasons relating to future business performance and discounted cash flow analysis of the fair price of their shares compared to current prices.

If I were to pull out my crystal ball, I’d suggest that the next five years in the market will likely be choppy and sideways with occasional surges and corrections, rather than generally upwards as the last five years have been. Valuations have outpaced growth, and now growth needs to catch up with valuations a bit. But since I don’t have a crystal ball, all I can say with actual evidence is that reasonable expectations of future corporate earnings growth do not appear to fully support current stock valuations as determined by methods such as discounted cash flow analysis, at least if one expects to get anything approaching the historical S&P 500 rate of return. The markets are somewhere between fully valued and somewhat overvalued, though fortunately not irrationally overvalued.

The explanation for this situation, I believe, is that as mediocre as future equity returns are likely to be, most other asset classes offer even worse opportunities for returns due to low interest rates, which keeps people invested in equities anyway. Stock valuations are high and they’re not necessarily irrational or due for correction, since there aren’t many other good investment alternatives available.

A Few Stocks to Consider

All that being said, there are almost always reasonably priced opportunities to add to a portfolio. Some of these examples can benefit from some of those broad market headwinds rather than be hurt by them.

U.S. Bancorp (NYSE: USB)

Banks generally benefit from rising interest rates, unlike some other industries. They make a lot of their money by borrowing at short term low interest rates (like saving and checking accounts) and then lending at longer term higher interest rates (like mortgages, car loans, business loans, and personal loans). So when interest rates rise, they can generally enjoy a bigger gap between their borrowing and lending interest rates. When interest rates are low, their net interest margin gets squeezed, and when interest rates rise, their net interest rate margin expands noticeably.

I don’t think investors should invest in a stock just for the sake of expectations of changing interest rates, because interest rate increases will likely be mild, gradual, and partially unpredictable. But most banks are currently trading at reasonable valuations, pay decent dividends, and stand to benefit mildly from increasing interest rates while already being profitable in the current environment, and so they are are good all-around choices today. And I believe U.S. Bancorp is among the better bank investments at the moment.

US Bank, subsidiary of US Bancorp, is the fifth largest bank in the United States, although it’s only about a quarter the size of the fourth largest by assets, Wells Fargo. So US Bank is the largest of the mid-sized banks, but much smaller than the four “Big Banks” JP Morgan, Bank of America, Citigroup, and Wells Fargo.

US Bancorp currently pays a 2.3% dividend yield and the previous three annual dividend increases were 4.1% in 2015, 6.5% in 2014, and 18.0% in 2013. The payout ratio is about 30-35%. The company has a consistent history of annual dividend growth with the major exception of 2009/2010 when dividends were cut like most other banks.

US Bank held up better during the financial crisis than almost all other medium and large banks, with a lower percentage of net loan charge offs and a quicker recovery. The company did receive government funds, and was able to acquire weaker banks during the crisis, and quickly repaid those funds.

The credit quality of the bank is rated at the very top of its peer group of medium and large banks by all of the rating agencies, including above JP Morgan and Wells Fargo. And after a recent upgrade in October, US Bank currently is tied with the highest credit rating by Fitch of any bank in the world.

The bank has the highest return on equity and the highest return on assets in its peer group of medium and large banks. It also has the lowest efficiency ratio in the peer group, meaning the bank does a better job of controlling expenses than other banks. The net interest margin is about 3%, in line with the peer group, and the percentage of net charge offs is under 0.5%, also in line with the peer group. Higher interest rates could push the net interest margin to 3.5%-4% eventually, depending on how far interest rise and for how long. Small changes in net interest margin make a big difference for net profits.

Loan growth has been substantial over the past five years, increasing from $193 billion in 2010 to $241 billion in 2014, which is a growth rate of about 4.5% per year. The latest quarter in 2015 is up to a bit over $250 billion, so growth has been slower this year. Deposit growth has been more impressive, increasing from $184 billion in 2010 to $266 billion in 2014, which is a growth rate of about 10% per year. Growth through 2015 continues to be solid, at about $290 billion by the third quarter in the year.

The P/E ratio of US Bancorp is about 14, with a forward P/E of under 13, and the P/B ratio is about 1.9. So the bank is not at the lowest valuation in its peer group, but its at a reasonable price compared to the quantitative superiority it has over its peers.

The bank is also fairly conservative, with no investment banking arm. 42% of its revenue mix comes from consumer and small business banking. 30% comes from payment services, including credit card payment processing for both consumers and merchants. 17% comes from wholesale banking and commercial real estate, and the remaining 11% comes from wealth management. Nearly half of the revenue comes from fees rather than interest, including fees for credit card payment processing, wealth management, and so forth.

The economic moat of US Bancorp is substantial. First of all, like any major bank, there are significant switching costs for most of US Bank’s services. It’s a hassle to switch out assets from consumer bank accounts, wealth management accounts, merchant payment processing, and wholesale banking, and so customer turnover tends to be low. Second, because their credit rating high, their borrowing costs for long term corporate debt are lower than peers, and this small interest rate difference is a big deal for bank profitability. Third, they fully incorporate their acquisitions rather than keep them compartmentalized, and therefore keep everything on a single processing platform, which helps keep their efficiency ratio at the very top of its peer group.

Overall, US Bancorp appears to be a reasonably priced and fairly conservative investment in an otherwise overvalued market. They’re increasing their asset base, paying growth dividends, are diversified, and stand to mildly benefit from rising interest rates.

If you want to diversify by investing in two or more banks without simply investing in all of them like an index fund, a factor to consider is the geographic footprint of those banks that you pick. For maximum diversification from minimum stocks, try to pick banks that have separate geographic footprints, so that they are not competing with each other and so that you have more geographic exposure.

Consider the geographic footprints of US Bank (top) and TD Bank (bottom) in the combined image below:


Their footprints fit together like perfect puzzle pieces. US Bank has a strong presence throughout the central United States and the west coast, while TD bank has a strong presence throughout Canada and the east cost of the United States. By investing in simply US Bank and TD, you can have broad geographic diversification across these two countries with zero physical overlap. This is a factor to consider when picking bank stocks for a portfolio, when balancing the desires for portfolio diversification and concentration.

Overall, US Bancorp appears well-positioned for risk adjusted returns at its current price of under $45.

Travelers Companies Inc. (NYSE: TRV)

Travelers Companies is one of the largest property casualty insurers in the United States. Total revenue is about $27 billion, with about $24 billion coming from insurance premiums and the other $3 billion coming from investment income and fees.

The insurance company business model is that they receive insurance premiums from a large number of clients, pay out benefits to a small number of them each year based on valid insurance claims, and hold a large revolving portfolio of money, which they can invest and keep the investment returns on. Most of their net income ends up coming from these investment returns.

About two thirds of the premiums from commercial insurance while the remaining third comes from personal insurance. Commercial insurance for Travelers includes worker’s compensation, multi-peril, automobile, property, and general liability. Personal insurance for Travelers is nearly evenly split between home insurance and auto insurance.

The company offers a fairly modest dividend yield of about 2.1%, but the dividend has grown by an average of about 10% per year over the past ten years.

The P/E of Traveler’s is just a little over 10, and the P/B is a little under 1.5. The company invests primarily in fixed income securities, especially municipal bonds, and the portfolio is very conservative with a focus on high credit rating investments. As such, Travelers itself has very high credit ratings from all rating agencies. The book value per share has grown at a rate of 9-10% per year over the past ten years.

A problem with insurance companies is that their economic moats are limited. Some of the largest insurers can be considered to have small moats due to the scale and diversification of their operations, which can give them slight cost advantages and brand recognition, but overall, it’s not an industry known for economic moats because insurance is so commodified. However, well-run large insurances companies can be quite stable blue chip companies despite this problem, and tend to trade for lower valuations than the general market. The double digit return on equity that Travelers earns in most years is evidence of at least a modest moat.

Travelers is not growing very much. Their insurance premiums have grown at a rate of under 2% per year for the last ten years, somewhere in line with inflation, but their investment income from their huge fixed income portfolio has decreased over time due to the low interest rates. This is another stock that can benefit from increasing interest rates over time rather than be hurt by them.

Revenue and net income have hardly increased at all in ten years, and yet Traveler’s EPS growth and stock performance have absolutely crushed the S&P 500 index over that timeframe. This is because Travelers uses virtually all of its profit to pay dividends and buy back its shares to reduce the outstanding share count. The number of shares has been cut in half over the last decade, so shareholders each own a larger and larger portion of the company. Therefore, while the company itself has not grown much, the value of each share has grown at market-beating rates.

Usually I have mixed opinions about share repurchases. Statistically, most management teams buy back more shares when stock prices are high and fewer shares when stock prices are low, which is not good. Just like how most investors are not very wise at buying at the right time, CEOs tend not to be wise at buying their own stock at the right time. But when performed at the right price, share repurchases can be a good use of profits and have tax advantages over dividends. Therefore, share repurchases are totally company-dependent, and dependent on whether you maximize your portfolio for current income or total long-term risk-adjusted tax-advantaged returns.

The insurance industry is the best industry for share repurchases, in my opinion. This is for a few reasons. The main reason is that insurance companies typically have very low P/E ratios, even for top companies, and so share repurchases can have an enormous impact on EPS growth because the company can buy back such a large chunk of its market capitalization each year. Travelers buys back in the ballpark of 8% of its whole market cap each year, while also paying a 2+% dividend yield. So it gives investors a double digit rate of return from dividends and share repurchases alone, without growing. Any gradual growth that occurs is on top of that rate of return.

The secondary reason for the share repurchases is that insurance companies, being generally commodified businesses, don’t necessarily benefit from growth. CEOs in any industry that pursue growth for the sake of growth are generally poor CEOs for shareholders. CEOs often have a problematic incentive to grow the company regardless of whether it benefits profitability, because CEO compensation is generally based on company size more than company profitability and performance. A CEO of a large company with mediocre performance is usually much better paid than an outstanding CEO of a market-beating small or medium company. A good CEO pursues long-term profitability regardless of company size. Sometimes this means focusing on growth to drive up scale and dig a moat for the long-term. Sometimes this means returning cash to shareholders in the form of dividends or share repurchases. Sometimes this even means divesting non-core parts of the business to streamline and focus on key strengths and higher margins. Insurance companies above a certain size no longer benefit from growth. They already have any benefits they’ll get from scale and won’t get more benefits from more scale. So, they should focus on profitability. And so, the top-performing insurance companies often buy back a lot of their own stock, since it offers good returns for shareholders that continue to hold onto their shares.

A great thing about this is that all else being equal, EPS and book value per share growth increase more quickly when the P/E is lower. The lower the share price, the more shares the company can buy with the same amount of money, and since most of the per-share growth is from these buybacks, the growth rate is heavily dependent on current stock P/E.

For example, a hypothetical insurance company that uses 100% of its earnings to buy back shares, and currently has a P/E of 10, can buy back 10% of its market cap per year and therefore can grow earnings and book value and dividends per share at a rate of 10% per year in addition to any mild growth they may have from increasing revenue. An identical company with a P/E of 15 can only buy back about 6.7% of its market cap each year, and therefore can only grow earnings and book value and dividends per share at a 6.7% yearly rate in addition to revenue growth. So, for insurance companies that buy back huge amounts of stock, the earnings multiple really matters, and you want it to be as low as possible, all else being equal. Travelers is a top notch insurer with a P/E in the range of about 10, pays 20-25% of its earnings as dividends, grows the revenue as a whole at a small rate about in line with inflation, buys back like 8% of its market cap per year, and so expected earnings, book value, and dividend growth per share can be expected to be around 10% per year with a 2% dividend yield.

When considering portfolio diversification, many people just consider the number of holdings and making sure they have adequate industry diversification. A sometimes overlooked factor is checking to make sure that your companies provide good returns in completely different ways and don’t all move in unison with market conditions. For example, most companies do better when economies are strong, but it’s also a good idea to own some stocks that do better when the economy is poor. Or, a company like Compass Minerals (NYSE: CMP) that sells road salt has much of its performance determined by snowy weather, not by the state of the economy. Travelers and other good quality property casualty companies offer good rates of return without even really growing. Profitability is mainly determined by underwriting quality and interest rates, with only mild reliance on economic strength of the regions they operate in. So, I always like to own at least one good quality insurer in my portfolio that gives low double digit returns entirely through dividends and share repurchases.

In conclusion, Travelers is one of the leading property casualty insurers, with a history of outperformance, trading at a low valuation, delivers most of its returns without even need to grow, and has the potential for mild tailwinds from rising interest rates going forward. It looks strong at the current price of under $115.

Brookfield Asset Management Inc. (NYSE: BAM)

I continue to view the Brookfield collection of stocks very favorably for long term outperformance potential. This includes Brookfield Asset Management (BAM), Brookfield Property Partners (BPY), Brookfield Infrastructure Partners (BIP), and Brookfield Renewable Energy (BEP). My preference is for BAM and BIP, personally.

Although the line of business is fairly straightforward, Brookfield Asset Management is one of the most complex publicly traded structures on the market. And it’s difficult to determine a fair value for due to the number of layers. But for all that, I believe the company has a high likelihood of substantially outperforming the market over the long run as it has already outperformed the market in the past due to unusually good management and a unique set of competitive advantages and growth opportunities.

BAM was originally known by different names and was in the hydroelectric power business, but transformed substantially over time. A young Bruce Flatt joined the company in 1990 in his 20’s and became CEO in 2000, when he was in his 30’s. A few years later, the company changed its name to Brookfield Asset Management and started dramatically expanding and changing its line of business, including partially spinning of multiple new publicly traded partnerships like BPY, BIP, and BEP. Flatt, now in his 50’s, continues to head BAM, and the company has significantly outperformed the market during his tenure. Flatt and other top executives own 20% of BAM, so their incentive is strongly aligned with shareholders.

BAM’s primary focus is to provide alternative investment opportunities to institutional investors, mostly in the areas of real estate, infrastructure, renewable energy, and private equity, collectively referred to as “real assets”, and they’re one of the largest and most established companies at what they do. So for example, when an insurance company or pension fund or sovereign wealth fund or a very high net worth individual wants to put perhaps 5-15% of its portfolio into alternative investments for increased diversification (other than stocks/bonds/treasuries/etc), they can go to BAM to invest in one of their private funds. BAM also invests its own capital in its own funds to inspire trust from its clients, so they make money both from fees they charge their clients for managing these investments, and from the performance of the investments themselves. Typical fees are 1-2% of the assets managed, depending on the complexity of the specific assets.

To get access to more capital, including permanent capital, BAM has spun off most of its holdings into several publicly traded partnerships, with the largest being Brookfield Propety Partners (BPY), the next largest being Brookfield Infrastructure Partners (BIP), and the third largest being Brookfield Renewable Energy (BEP). BAM holds the General Partners of these partnerships and a significant chunk of the limited partner units. Individual investors hold the rest of the limited partner units. BAM is entitled to an increasing percentage of profits from these partnerships, and also charges a management fee for running those partnerships.

So, investors have multiple ways to invest in these assets. If you want to have exposure to their property portfolio (including prime office real estate in New York and London and other top real estate), along with a 4.5-5% distribution yield and decent distribution growth, you can invest in units of BPY. If you want exposure to their global infrastructure portfolio (including shipping ports, coal terminals, toll roads, natural gas pipelines, and telecommunications infrastructure spread across numerous continents) and a high 5% distribution yield along with fairly high distribution growth, you can invest in BIP. If you want exposure to renewable energy (mostly hydroelectric power along with some wind farms), a 6% distribution yield, and decent distribution growth, you can invest in BEP. If you want exposure to all of it along with private equity as well, and are willing to accept a low 1-2% dividend yield but likely higher overall returns from growth, you can invest directly in BAM. If you’re extremely wealthy or you manage an institutional fund, you can invest in one of BAM’s private funds. All of them have different risk and reward opportunities.

All of the public partnerships are tax-advantaged but you’ll have to fill out a K1 form during tax season. In contrast, BAM itself is a corporation based in Canada, and its stock is like any other common stock with normal tax consequences of dividends and capital gains.

The assets within BAM and all of their partnerships all have very deep, very wide economic moats. Hydroelectric dams, toll roads, shipping ports, coal terminals, railways, telecommunications structures, and property in financial districts of New York and London, all have geographic moats because they’re either geographically limited or regulated, and they typically produce strong cash flows. They’re diversified globally into North America, South America, Europe, and Australia, and a bit into Asia. BAM as an asset manager has a moat in the form of scale, because they’re a leading provider of private infrastructure and property funds, and capital that investors provide is illiquid and committed for long periods of time, essentially meaning switching costs are high. The risk for BAM and all these assets doesn’t really come from competitors; it comes from the performance of the global economy and from how well the assets are managed. Shipping ports do poorly during recessions, dams do poorly when rainfall is low, and too much leverage can increase risk, for example. BAM’s performance also depends on to what extent institutional investors will continue to want to invest in real estate and infrastructure.

But since Flatt and other BAM executives stick to value-investing contrarian methods, they can also benefit from global weakness even as their own operations are negatively affected. During the 2008-2009 recession and onwards, they bought up high quality assets around the world, mostly assets owned by financially stressed organizations. They used their large scale and high liquidity to take advantage of financially troubled assets and companies, to buy them at cheap prices and stabilize them for growth, and this continues to be their strategy going forward. They also can build platforms out of their assets and expand internally, like buying railways and coal terminals in Australia that work together and then expanding that platform with organic expansion. Plus, when they buy assets in troubled places, the currency of those places is often low as well, so they often have currency advantages when they invest.

Investing in BAM stock:

The main things that drive BAM’s growth are: a) performance of its investments in all these asset classes and b) its overall amount of fee bearing capital. In other words, the more it can grow the amount of assets they manage via public partnerships or private funds, the more money they can make from fees on those assets. And the better their private funds and partnerships perform, since they’re directly invested in them along with clients and limited partners, the better BAM’s financial results will be.

BAM currently manages $225 billion in capital, and about $95 billion of that is fee-bearing capital. Fee-bearing capital has doubled over the last four years, from $47 billion to $95 billion, and at a smooth rate. 40% of the fee-bearing capital is in the form of private funds, 39% of it is in the form of the publicly listed partnerships, 14% is public markets, and 7% are transactions and advisory.

Unlike US Bancorp and Travelers, BAM is mildly negatively affected by rising interest rates. This is because most of their assets are real estate and heavy long-lived infrastructure, which means using considerable debt. So when interest rates go up, they have to pay more money to get the capital to buy their assets. However, there’s little reason to believe that interest rates will go very high, and it makes sense to have stock holdings that benefit from both low interest and high interest rate environments, so that you can remain largely indifferent to interest rates.

BAM, however, benefits from low interest rates and high equity valuations indirectly, which counterbalances the fact that their assets do better in low interest rate environments. The problems I described in the beginning of this article, like how equities are highly valued and how a long-term trend of low interest rates has made returns from fixed income securities barely keep up with inflation, are part of what helps BAM attract clients. Pension funds, insurance funds, sovereign wealth funds, and other institutional funds all want to conservatively earn decent returns. But with bond rates so low, and stocks often considered too volatile for these types of fund to hold much of, they have been turning a lot more towards alternative investments for a fraction of their portfolio. Alternative investments in the 1980’s were close to zero but now institutional funds typically hold around 10% of their portfolio in alternative investments. Private infrastructure and real estate funds can provide these institutional investors with access to stable, cash-generating assets with less volatility than publicly traded equities and are a very strong hedge against inflation. The downside is that liquidity is lower, since they have to commit long-term capital to these private funds, but since it’s only a fraction of a portfolio, that’s a fair trade from many managers’ points of view. If 5-15% of a portfolio is illiquid, it’s not a big deal, especially if they can get better returns from that part of the portfolio and can get protection from inflation.

BAM stock trades for about 15x FFO, which is the most useful profitability metric of the company. Under Flatt’s management, the stock has doubled the S&P 500 returns, and management currently expects to compound their invested capital at 12-15% per year going forward. The current price of under $35 appears very reasonable.

Investing in BIP units:

For investors that want a higher yield and a simpler structure, I think BIP is the most interesting of the publicly traded partnerships that BAM offers. It’s a good way to own a global portfolio of infrastructure that generates fairly stable and growing cash flows, and since it’s a partnership, it’s tax-advantaged.

The distribution yield is about 5.3%, and the distribution has smoothly grown at a 12% per year compounded rate since 2009. Management’s target is to grow distributions by 5-9% per year, and so far they’ve been at the high end or exceeded the target. The partnership often buys high quality infrastructure assets from financially troubled businesses and then either holds those assets or eventually sells them for much more than they paid.

The credit rating is BBB+, which is decent for an asset-heavy type of business, and BIP has plenty of liquidity, and can get more liquidity by issuing more units or by issuing bonds, and is supported by BAM. It’s definitely a good idea to keep an eye on their leverage and credit ratings over time, but so far all is good, and the history of the management is superb.

Because the distribution yield is high, BIP is an ideal candidate for using the Dividend Discount Model to determine a fair value for.

Using the past 12 months of distributions ($2.12), along with a conservative estimate of 6% distribution growth going forward (towards the bottom of their 5-9% expected distribution growth rate), and a target rate of return of 10% (higher than S&P 500 historical returns), the calculated fair value is $56.18.


Source: Dividend Monk Toolkit Excel Calculation Spreadsheet

The current price is under $40, well below this calculated fair value of $56.18, and even below the $44.52 calculated fair value if their future distribution growth is only 5%. If distribution growth ends up being at the higher end of their expected range, returns should be quite high.

Current uncertainty around their bid to acquire Asciano (assets in Australia, potentially threatened by regulators and now a rival bid) is currently weighing down their price a bit, I believe, which gives a good opening for long-term investors.

Other High Yield Partnerships like BIP
If you’re looking for other strong high-yielding partnerships, particularly ones that lack significant commodity price exposure, then I also suggest taking a look at Magellan Midstream Partners LP (NYSE: MMP) and Spectra Energy Partners LP (NYSE: SEP). They offer yields of about 5% and 6.5% respectfully, with strong dividend growth. Both of them have negligible commodity price exposure, and yet both of their stocks have fallen from their highs along with the energy crisis sell-off. Magellan is mostly involved in the transport of refined oil, and Spectra is mostly involved with the transportation of natural gas to customers, so they have some distance from the gathering side of the energy business. I have bullish long-term views on both of them, as both are in a position to fairly conservatively provide double digit total returns for the foreseeable future with fairly high yields and growth. Magellan in particular is strong because it doesn’t have to pay incentive distribution rights to anyone and they have among the strongest balance sheets in the industry. They’ve been able to shrug off this energy price drop as though it didn’t happen.

I’ve recently revised my investment thesis from six months ago on Kinder Morgan and Oneok. Both of these companies, especially Kinder Morgan, have offered investors high dividend yields, big dividend growth, and market outperformance for a very long time. But oil and gas have hit their lowest prices in a decade, both with their prices cut in half from 2014 levels. In recent months, it has become clear that these two companies were unprepared for such a large drop, and so they’ve significantly underperformed their targets. Both have become highly leveraged, and dividend cuts appear likely.

For Kinder Morgan in particular, they’ve not been managing the downturn in a way that investors are happy with. They partnered with Brookfield to buy out another company, but that company has a lot of debt. This is fine for Brookfield, as they are in a strong financial position and can make deep value investments like this, but Kinder Morgan is in a crisis with an over-leveraged balance sheet and very high debt interest. Richard Kinder appears to be going “all in” during this downturn, which may prove to be the right move years from now, but at the current time, there’s a ton of risk here. I no longer consider Kinder Morgan or Oneok to be dividend growth investments. They’re now in either “deep value” or “value trap” territory depending on what their outcomes are, rather than companies that are in a position to reliably produce growing dividend/distribution income with conservative risk.

So, if you’re an investor that allocates a part of your portfolio to publicly traded partnerships, like I do, then some of the companies with lower commodity risk and strong balance sheets are the preferable choice now compared to these higher risk, deeper value picks, assuming you’re a dividend growth investor rather than a deep value investor or speculator.

This was a situation that emphasizes the importance of diversification; anyone that had too much exposure in the industry or in certain companies in particular, likely was hit hard by this. I personally sold my KMI position at a loss at around $30/share because it was no longer in line with my investment thesis, but the overall impact to my portfolio was minimal because of proper diversification.

The Case for Selling Put Options in Today’s Market

In addition to investing in the previously mentioned reasonably priced stocks (USB, TRV, BAM, BIP, MMP, SEP), the current market with high valuations is great for selling long term cash secured put options that expire in 6-14 months.

Selling put options allow long-term investors to buy stock at a lower cost basis than the prices that shares are currently trading for. It’s like getting paid to place a long-term limit order, and is a slightly more conservative strategy than buying shares at current market prices. This has been a part of my investment strategy in 2015 due to the aforementioned problems about overvalued stock valuations in many industries.

For those that are unfamiliar with them, I’ll give a brief overview of put options.

When an investor sells one or more put options (which I’m advocating), it means they sell the potential obligation to buy a certain number of shares at a certain strike price in the future, and are neutral or bullish on the stock. The reason to do so is either to make money from the premium, or to buy the stock at a lower cost basis than what is currently available when the purchase price and premium are considered together. When an investor buys a put option (which I’m not advocating), they buy the right to sell a certain number of shares at a certain strike price in the future, and are generally neutral or bearish on the stock. The reason to do so is to have some insurance for investors that are averse to volatility or risk, or to short a stock because they expect it to decline in value.

For the put option seller, you can make money in a flat or mildly downward market, and you can potentially buy stock at a lower cost basis in the future. It mildly shifts the risk/reward profile downward, because you typically commit to a lower cost basis than what shares are currently trading for. It’s a good strategy in highly valued markets. It allows you to take advantage of volatile markets, and do fundamental analysis on a company, determine a fair value, and then commit money to that fair value even if the current price is higher than that.

If you normally keep a part of your portfolio in cash or bonds as dry powder to use during market drops, or if you’re having trouble finding good stocks at good prices today, then using put options can be a good strategy for part of your portfolio.

Selling these put options keeps risks lower than buying the stock right now, but overall risk depends on what stocks you’re doing it for. It’s generally not a good idea to do this for extremely defensive companies like KO or ADP, because volatility is so low and premiums are therefore low. It’s better to do it for solid companies in industries that are cyclical (industrial, energy, etc) or even just standard medium-volatility companies like medium/large banks or blue chip tech companies. Premiums for the most cyclical can be very high (annualized returns of 10-20% per year for slightly out-of-the-money long term puts), premiums for medium cyclical companies can be moderately high (annualized returns of 5-10% per year for slightly out-of-the-money long term puts), and premiums for extremely defensive companies will generally give less than 5%.

Here’s a moderate example:

USB 1/20/2017 $42 Put

If you feel that US Bancorp is a good investment, but want to commit to a lower cost basis to get a higher margin of safety, then selling a put option for a strike price of $42 that expires on January 20th, 2017 can do just that. To make it cash-secured means you have to put $42/share aside for if that option is excised. Each option contract is for 100 shares, so the amount of money you need to put aside is in multiples of $4,200.

The current price of USB stock is about $44 per share. If you write this put option, you’ll be paid a premium of $3.15 per share now, and then on or before 1/20/2017, the holder of the put option can obligate you to buy shares at a price of $42/share, which is lower than the current price. She would only do this if the market share price at that time is under $42. Otherwise she’ll simply let the option expire.

What this means for you, the seller, is that one of two outcomes will occur within the next 13 months until expiration.

The first potential outcome is that USB’s stock will be above $42 at the time of option expiration, which means the option will expire without you buying the stock. You’ll have gotten paid $3.15 per share, which you get to keep. The rate of return on your secured cash is about 8% over a 13 month period, or slightly less than that when calculated on an annualized basis. This means your investment can grow in value regardless of whether the stock price goes up, remains flat, or even goes mildly downward.

The other potential outcome is that USB’s stock will be below $42 at the time of option expiration. You still get to keep the $3.15 per share. But you’ll have to buy the shares at $42, regardless of what price they are at that time. For example, they’re $40/share at that time, you still have to pay $42. Your cost basis would be $38.85, which is the strike price of $42 that you’d be buying at minus the $3.15 premium you received per share. So, you’d be buying the shares at a significant discount to today’s stock price.

As a long-term investor, the key is to plan for and be satisfied with both potential outcomes. Your ultimate goal in this investment strategy would be to get a good rate of return on your cash if stocks remain flat or go up, or to buy the shares of a great company at a low cost basis if the stock price goes down.

Your overall risk profile is similar to simply buying the stock today, except a bit more conservative because you’re committed to a lower cost basis than today’s price. Your risk and reward over the next 13 months are shifted downward a bit. Someone selling put options like this will typically underperform during periods where the market goes up a lot and will outperform during periods where the market is flat or down.

If there are some otherwise blue chip energy companies you’re interested in investing in during this commodity price downturn, but want a bigger margin of safety, then selling put options to keep your cost basis low can help achieve that goal with higher premiums.

Adding It All Up

With historically high average stock valuations that do not give much of a margin of safety for the mixed aspects of today’s global economy, investors in the broad markets might not be satisfied with their expected future returns.

But by focusing on buying well-diversified stocks at good prices, especially ones with dividend yield and growth, opportunities do exist for stock performance that should outperform the market while providing solid growing income. And by using put options for a portion of your portfolio to earn income while waiting for entry points into a lower cost basis, you can moderately adjust your risk and reward profile a bit downward compared to the market, meaning you can still potentially earn good returns in a market that doesn’t perform very well over a medium or long term.

Autumn 2015 Dividend Stock Newsletter

This has been an interesting time for markets. China’s market crashed, and global markets around the world responded with milder crashes and volatile rides.

And yet the US still has a highly valued market.

According to historical valuation assessments of the broad market, such as the Shiller P/E, the U.S. stock market is still valued at a premium compared to its historical mean. This is probably partially the result of the unusually long stretch of low interest rates. And when discounted cash flow analysis, or other versions of that like the dividend discount model, are performed on individual stocks, many of them have been valued at a premium lately.

There are a lot of long term problematic trends. Trends that are decades in the making, larger than individual bull and bear cycles in the market. The U.S. has a weak middle class along with increasing political polarization and public debt, Europe has ongoing problems with their shared currency, debt levels, and unemployment, Russia’s economy is in shambles due to their concentration in the energy sector and the fallen energy prices, China’s stock bubble just burst, and Japan has an aging, shrinking population and the world’s highest national debt level as measured by the debt to GDP ratio. These large drivers of the global economy all have substantial long-term problems. And yet U.S. stock market valuations are historically high.

Needless to say, I’m not surprised to see a market correction, and wouldn’t be surprised to see a bigger one on the way. We’re certainly due for one. And yet, I’ll still be putting money into the market. This season’s newsletter will focus on how to build a dividend portfolio to weather economic storms, including some stock ideas I think look reasonably valued at the moment.

Keys to Defensive, Successful Investing

Investing is simple, but not easy. Many investors buy and sell on emotion, as evidenced by the fact that large cash flows into the market are observed to occur at market peaks, and large cash flows out of the market are observed to occur towards market bottoms. I think that readers of dividend sites like this one tend to do better, fortunately. I’m preaching to the choir a bit in this section.

The healthiest, longest lived populations in the world, such as those living in Okinawa Japan or Icaria Greece, tend to have the simplest, most obvious diets and lifestyles. And most of the world doesn’t follow them, despite their simplicity and pleasure. In places like that, the people eat whole fresh food like wild fish and legumes, plenty of vegetables and fruits and herbs and spices, socialize with family and friends as a cultural priority, drink tea or wine in moderation, get plenty of slow exercise from walking to and from their jobs and neighbors homes and doing manual work, and don’t rush or experience much stress. And many of them are dancing and hiking and laughing and staying mentally sharp into their 90’s and 100’s, while spending a fraction of what we do on health care. It’s not complicated for them.

Successful investing is a lot like that. Simple, but rare. Obvious, yet rarely followed.

Check your Balance
This is a good time to check your asset balance. Do you have the ratio of stocks, bonds, cash, and other investments that you target?

Having a diversified portfolio reduces volatility because by ocassionally rebalancing, you’ll naturally shift money from bonds/cash to stocks when stocks are cheaper, and shift money from stocks to bonds/cash when stocks are expensive, simply due to returning to your target balance from time to time.

Invest Over time
If you determine the suitability of an investment by calculating a fair intrinsic value, don’t worry too much about trying to predict the future. If the price is reasonable now, a few months from now might be even better. Or it might be worse. Neither of us know. By putting money into attractively priced investments on a regular basis, you even out your chances.

There are plenty of people I know that dabble in investing as a hobby rather than as a consistent means of building wealth. What this means is that they maintain a little portfolio of some hot stocks, and enjoy discussing performance with colleagues and friends. Five years later, their portfolios are still small, because individual stock performance is a lot less important than shoveling money into a portfolio month after month.

Stock, Country, and Sector Concentration
Consider how much money you’d be willing to lose in a single investment, and then invest accordingly.

Regardless of how prudent we may be, an investment could go sour. We don’t have access to all the current information, nor do we have the ability to see the future. Plus, a shared event could bring down all stock prices in a sector, such as a reduction in the price of a barrel of oil, or a housing bubble. And a single country could have poor governance or economic stagnation. It’s often a good idea to maintain diversification among companies, sectors, and countries.

As long term investors, we don’t really care about stock prices themselves, because all else being equal, low stock prices just mean more buying opportunities. But we do care about tangible financial damage to a company including things that could lead to dividend cuts, so diversification is important.

Concentration into a few companies, or a major sector, could lead to outperformance compared to a diversified portfolio. But it could also lead to disaster, wiping away a decade of portfolio growth. Deep concentration sometimes makes sense for professional investors, but rarely is ideal for casual investors who are building wealth for their families.

Four Stocks to Consider

Texas Instruments (TXN)
Texas Instruments has fallen from a high of nearly $60 down to under $50 per share, and I believe it may be a solid investment at this price level.

Over the last decade, the company has not had any revenue growth, and a big reason was that they completely exited the wireless market to focus on analog and embedded chips, which was a transition they completed in 2013. Despite the lack of revenue growth, the company has increased free cash flow margins and reduced their share count substantially from share repurchases, resulting in 13% free cash flow per share growth over the last decade. They’ve also increased their dividend for eleven consecutive years now. All of their free cash flow goes to dividends and share repurchases, and only 4% of revenue has to be invested back into the company for capital expenditures.

Looking forward, with no major transitions ahead, Texas Instruments is the largest analog chipmaker in the world and should be set to finally grow. In addition, their transition from 200mm to 300mm wafers should cut their costs significantly, further increasing their profit margin. As they continue giving all the free cash flows back to shareholders, investors should do well.

An issue that some dividend portfolios face is that they lack much investment in the technology sector. Dividend growth companies are rare in the sector, and as an investing demographic, we tend to prefer stability. A company like Coca Cola will be selling pretty much the same products ten years from now as they do now, but Apple will be selling absolutely nothing of what they currently sell in ten years. A company that has to continually reinvent itself is harder to predict for the long holding periods that dividend investors tend to prefer.

But a handful of tech companies are blue chip companies with decent dividend payouts, and Texas Instruments is one of them. The dividend yield is currently 2.8% with a high dividend growth rate, and the overall shareholder yield is over 7%. Analog chips, which measure things like temperature and pressure and convert them into digital information, are hard to design, have very long product lifecycles (years, and sometimes decades), and as a result offer high profit margins for the designers. Embedded systems, like microcontrollers, also have long lifecycles and similar profitability levels. If there’s a tech stock out there that’s good enough for a dividend portfolio, the world’s largest analog maker is a top contender.

Chipmakers exist in a cyclical industry, and competition is significant, so Texas Instruments is not without risk.

Using the last twelve months of dividends ($1.36), along with a conservative estimate of 7% dividend growth going forward (quite low, compared to their 13% free cash flow growth per share over the past decade and their high recent dividend growth rate), and lastly a slightly market beating 10% target rate of return (discount rate), we can arrive at an estimate of fair value:


For investors that use options, Texas Instruments is also a decent stock to write a long term covered put for. If you want to pick up shares of the company at a lower cost basis than what is currently available, you can write puts at a strike price you desire, and get paid to wait. For example, you can write January 2017 puts at a strike price of $47, and receive about $6 per share as a premium for doing so. If, in the next 16.5 months, Texas Instruments goes below $47/share, you’ll have to buy at $47/share, and your actual cost basis would be about $41. On the other hand, if Texas Instruments stays above $47, you’ll have been paid a fairly high rate of return simply to wait, without buying, and then you can use your capital elsewhere, or write another put.

Chevron Corporation (CVX)
Chevron stock was absolutely slammed and has since rebounded a bit.

In my previous newsletter from three months ago, I stated that Chevron stock was fairly valued. Not overvalued or undervalued, but fair. A couple months after I wrote that, crude oil prices dropped like a rock from $60/barrel to $40/barrel, which naturally brought oil stocks down, including Chevron. This is an example of where not putting too much money into one stock, and having a habit of investing money every month, helps ease things a bit. Recently, crude went back up to about $50, easing Chevron’s problems.

Chevron is in a particularly vulnerable state, because they have a high dividend payout for the industry, and they’re right in the middle of an investment cycle where they are spending a lot of money on investments and waiting for large LNG projects to fully come online and start producing major revenue. Having oil prices fall and their profit cut away, is a major blow to the company.

The big question for dividend investors is whether or not the dividend is safe. The company has raised its dividend for 27 consecutive years and now is being looked at as a potential dividend cut. After this stock price drop, the dividend yield is at a lofty 5.3%.

The official position of the company, based on their most recent investor presentation and words from their chief financial officer during the last earnings announcement, is that their number one priority is to cover the dividend with free cash flow by 2017. This is because their major LNG investments are coming online, and capital expenditures are expected to fall dramatically when their period of massive investment will be finished, and the fruits will be harvested. The next year and a half though, until 2017, will be rough. At these oil prices, free cash flow won’t cover the dividend, and so the company is issuing debt to pay for it. Obviously that’s not sustainable.

The company currently has about $30 billion in long term debt, and shareholder equity minus goodwill of about $150 billion. This is a LT debt-to-equality ratio of about 20%, which is a very strong balance sheet. The company currently pays out about $8 billion per year in dividends, so if the company uses debt to fund the dividend for 18 months, that would require about $12 billion. This would boost long term debt to $42 billion for the dividend alone, resulting in a LT debt-to-equity ratio of around 30%, which is still a very strong balance sheet. As a comparison, Conoco Phillips currently has a LT debt-to-equity ratio of about 50%. So, Chevron could fuel its dividend with debt until its LNG operations help it fully cover its dividend with free cash flow in 2017, and still have a stronger balance sheet than Conoco Phillips.

Does Chevron have to cut its dividend? Absolutely not. Will they? Who knows. In a world without dividend champion lists, and investors that rely on dividends for income, cutting the dividend for a year or two and then restarting it at a higher rate when they are in a better position, would be financially prudent. But when reputation matters, the executives seem as though they want to hold onto it.

The way I see Chevron currently, is that gas prices won’t stay this low forever, and five years from now, Chevron at $80/share or Exxon Mobile at $75/share will be seen as steals. But in the near term, a dividend cut is not out of the question, especially for Chevron. I wouldn’t rely on Chevron for current income, but I’d look at it as a potential bargain stock for the long haul.

Toronto-Dominion Bank (TD)
The Canadian housing market is highly priced, and Canadians have record levels of household debt relative to disposable income, at over 160%. This is higher than US household debt levels right before the housing crash in the mid 2000’s, when we were at 130% on average, down to under 110% now after some household deleveraging.

Vancouver is a particularly interesting case, because much of the demand for housing comes from outside their local labor market. A significant chunk of luxury property in the city is purchased by people from mainland China, and many Chinese people just lost a lot of wealth on paper from their stock market crash.

Plus, oil prices have fallen far, and Canada’s economy has a lot of concentration in this sector. If there’s something that could cause a housing bubble to burst, something like this might do it.

Needless to say, some investors are shorting companies that have exposure to the Canadian housing market. I can see why. And yet, I don’t think investors necessarily have to avoid this industry. TD in particular is in a decent position.

The Canadian banking system works in a fundamentally different way than the US banking system. In Canada, it’s a lot harder to simply walk away from a mortgage when the price of a house drops. As a result, even before the U.S. housing crash, Canadians have had a much lower rate of mortgage delinquency than Americans. In addition, many residential mortgages held by Canadian banks are insured by the government, limiting their own losses.

Toronto Dominion bank is one of the largest banks in Canada, and is the sixth largest bank in North America. Their business model involves borrowing money mainly from depositors and lending that money at higher interest rates to customers for mortgages, auto loans, and other types of loans. The bank has expanded strongly into the United States along the east coast, resulting in the bank having 15 million Canadian customers and 8 million American customers and growing. The bank’s focus is on retail banking, aiming to offer top quality customer service compared to competitors. At a time when banking is starting to shift from physical to online banking, TD is going against that trend by focusing on expanding their physical footprint and offering longer banking hours than competitors.

Compared to their peers, TD has a larger portion of their Canadian mortgages insured. Slightly over 2/3rds of their Canadian residential mortgages are insured. For that other third, the average mortgage-to-value of the loans is 70%, meaning that a fairly large housing correction would have to occur before those mortgages would be underwater. Unfortunately by some estimates, the Canadian housing market may indeed be that far overvalued, with that far to fall. Overall though, it can be said that TD is in a stronger position than American banks were before the US housing crisis, and is also in a stronger position than many of the other large banks in Canada. The credit agencies currently assign TD bank with high credit ratings (Aa1, AA-, and AA respectively by Moody’s, S&P, and DBRS), and those credit agencies are taking into account the risks embedded in the current Canadian housing market.

Historically, TD’s performance has been excellent. The company has had 12% average dividend growth over the past 20 years, and currently has a solid 3.8% dividend yield. Over the past 10 years, the bank’s revenue has climbed from under 12 billion CAD to over 30 billion CAD, while EPS has grown at a similar rate, despite some share dilution.

Their most recent investor presentation states that the bank expects to increase adjusted EPS by 7-10% per year over the medium term. In combination with a nearly 4% dividend yield, this is a good potential investment. However, given the state of household debt and housing prices in Canada, I’ll use a more conservative growth estimate in my dividend growth expectation.

Here’s the estimated fair value, in CAD, using a 6% long term dividend growth rate and a 10% discount rate:


That’s in CAD on the TSE, not in USD on the NYSE. Currently, the price is about equal to the estimated fair value. And that’s using a dividend growth rate that is below the low end of the company’s estimated EPS growth rate; 6% compared to 7-10%, because I’d prefer to be pessimistic on this. If you believe the company will hit its estimates, or if you’re willing to settle for a lower 8% or 9% rate of return, the fair value to you would be substantially higher than the current price.

Overall, I believe TD represents a fair buy at this time. There are risks in the Canadian housing market, but the stock is trading at a price that seems to take that into account. TD has protection in the form insurance for a majority of its residential mortgage portfolio as well as diversification into the US lending market.

Aflac Incorporated (AFL)
Aflac sells supplemental health insurance in the United States and Japan. While primary health insurance companies will cover various specific procedures, usually by paying the health care provider rather than the policyholder, Aflac’s main business model instead is to pay cash to policyholders that file claims for certain health problems, like cancer. This way, when customers face income loss or other financial problems due to a health problem, Aflac provides them with cash to get through those difficult times while their primary health insurance company covers the actual medical expenses.

The company experienced strong top line growth between 2005 and 2012, climbing from $14.3 billion in revenue to $25.3 billion in revenue. During that time, the dollar was weakening compared to the yen, giving the company a strong tailwind. Then, from 2012 to now, the revenue has fallen from that height of $25.3 billion to $21.7 billion, this time due to the dollar strengthening compared to the yen, giving the company a major headwind. EPS has followed a similar pattern over that period of time.

So, this has been a tough few years for Aflac. The positive part of the story, however, is that their core business is doing very well when exchange rates are excluded. Between 2005 and 2014, the amount of premiums they have generated in Japan has increased every single year, from about 1 trillion yen in 2005 to about 1.6 trillion yen in 2014. The story is similar for their US business; premiums have increased from $3.7 billion to over $5.6 billion during that period, and every single year saw an increase in premiums compared to the previous year.

Japan has an aging population, and the universal health care system is conservative in its payouts. Japan has the longest life expectancy in the world and pays considerably less than half of what the US pays per capita on health care each year. This gives Aflac plenty of room for continued growth for the forseeable future, because their role as a supplemental insurer should only grow stronger.

The long-term bearishness of Japan’s economy, along with their very high national debt, is a risk to be aware of. However, Japan’s debt is held in its own currency to its own citizens, giving the country considerable flexibility in avoiding default in most foreseeable scenarios.

Although predicting exchange rates is not something I care to do, the fact that the dollar has already had a four-year surge relative to the yen (going from fewer than 80 yen per dollar in 2012 to over 120 yen per dollar currently in late 2015), and the dollar has surged relative to foreign currencies in general, implies that the company probably doesn’t have too much to worry about from continued currency headwinds over the long term, at least. I believe the worst of their currency troubles are probably behind them, and if not, the company is doing fine anyway, albeit with reduced profitability, and they can safely ride out the currency problems.

Aflack stock currently trades for a P/E of just under 10. They have raised their dividend for 32 consecutive years, but their payout ratio is on the low side, and the dividend yield is about 2.7%. They also repurchase a lot of shares, and between 2005 and the current quarter, their total share count has fallen from 508 million to 444 million. This is a business model I like; a large portion of the returns comes from the dividend and from the company reducing its share count by buying cheap shares, while also enjoying moderate premium growth and a growing customer base in two countries.

Aflac’s dividend has historically risen at a double-digit rate, but during the recent problem with currency exchange rates, Aflac’s dividend growth rate has fallen below 6%. In 2015, the company expects to repurchase $1.3 billion worth of stock, which is 5% of the market cap. The board of directors this past month increased the authorization for the amount that the company can repurchase, up to 56 million shares, or over 12% of the existing number of shares outstanding. Repurchasing the shares is one way to accelerate dividend growth, because reducing the share count allows the company to continue to pay out more and more per share. With shares so cheap, the company gets a good rate of return on their purchases, although I’d like to see a moderately higher dividend payout ratio, personally.

Given historical dividend growth rates, recent growth rates, share repurchase rates, core company performance, and an assumption of reducing currency problems over the next 5 years, I’ll use 7% dividend growth as an estimate for the long term. The estimated fair value ends up being around $55:


As you can see, with the fairly low yield, the estimated fair value is very sensitive to adjustments in the estimated dividend growth rate and the discount rate. Overall, with a low P/E, a long history of dividend growth, a modest current dividend yield, and a fairly safe business, I believe Aflac represents a decent purchase at these prices levels, especially with many other stocks being valued at much higher earnings multiples.