Category: MP Market Reviews

It’s been a few months since we last reviewed our ‘Timely Ten’ dividend growth stocks. For those new to the blog, these are the ten most undervalued stocks on ‘The List,’ determined by one of our key valuation metrics, dividend yield theory.

This latest update of the ‘Timely Ten’ reveals a fascinating trend: a significant number of companies from ‘The List’ are signalling undervaluation. Fourteen stocks meet the criteria based on dividend yield theory—representing half of the companies on ‘The List.’ Even more encouraging, some of our highest-quality companies are now meeting our threshold, making our investment decisions even more straightforward.

Here’s a recap on how we select our ‘Timely Ten’:

Step three in our process involves monitoring our quality dividend growers regularly, which can become quite challenging depending on the number of companies we track. Fortunately, we rely on ‘The List’ instead of the vast array of stocks in the index, which streamlines our task. Nevertheless, we continually seek methods to enhance our efficiency. Through dividend yield theory, we’ve discovered an approach that has proven remarkably effective in aiding us with our efforts over the years.

Dividend yield theory is a simple and intuitive approach to valuing dividend growth stocks. It suggests that the dividend yield of quality dividend growth stocks tends to revert to the mean over time, assuming that the underlying business model remains stable. In practical terms, if a stock pays a dividend yield above its ten-year average annual yield, its price will likely increase to return the yield to its historical average. Knowing that price and yield go in opposite directions, this theory helps us find stocks poised for a positive price correction.

We have pre-screened our candidates using the criteria we initially laid out in building ‘The List’. This helps us considerably narrow the universe of investable stocks.

1. Dividend growth streak: 10 years or more.
2. Market cap: Minimum one billion dollars.
3. Diversification: Limit of five companies per sector, preferably two per industry.
4. Cyclicality: Exclude REITs and pure-play energy companies due to high cyclicality.

Next, we rank ‘The List’ by how significantly each stock is priced below its fair value (Low Price), as calculated using dividend yield theory. To determine fair value, divide the current dividend by what you consider to be the stock’s historically high yield.

All companies above the thin black line have a current price below fair value (sensibly priced). The stocks above the thick black line make up our ‘Timely Ten’.

Not every stock on ‘The List’ ends up in our dividend growth investing (DGI) portfolio. ‘The List’ is a teaching tool that screens for candidates based on a set criterion across the universe of dividend growth stocks in Canada. To end up in our portfolio a candidate would need to score high on ‘quality’ using our many quality indicators. Then and only then would we look at valuation.

Despite the superior quality of our dividend growers, we exercise caution and do not initiate or augment a position unless the stock is ‘sensibly priced.’ Here are the four methods we use to assess valuation. 

1. Historical Fundamentals
2. Dividend Yield Theory
3. CAPE Ratio
4. Graham Value 

In today’s post we will review the ‘historical fundamentals’ method of arriving at a sensible price using Fortis Inc. (FTS-T), one of the highest quality candidates on ‘The List’. 

Historical Fundamentals 

A company’s operating results will determine its stock price in the long run. Analyzing a company’s historical fundamentals provides insight into how the business has been valued over an extended period. Many of the stocks we invest in have a ‘narrow valuation corridor,’ meaning the stock price follows a path that rarely deviates from its historical trading range. A company’s P/E (Price to Adjusted Operating Earnings), OCF (Price to Operating Cash Flow), EBITDA (Price to Earnings Before Interest, Taxes, and Amortization), and Sales (Price to Sales) ranges tell us a lot about how a company has been traditionally valued.

Purchasing at the bottom of these ranges or selling at the top has helped us manage our entry and exit points to enhance returns.

We use the Fundamental Analyzer Software Tool (FASTgraphs) to visualize how a company has been historically valued. We like to see it trading within its typical ‘valuation corridor’ based on a ten-to-twelve-year timeline. This gives us a clearer picture of how the stock has traded in different economic cycles.

FASTgraphs – “FG” 

The following colours/lines on the “FG” chart shown below represent: 

• Black line: Price
• White line: Dividend
• Orange line: Graham average of usually 15 P/E (price/earnings) for most stocks
• Blue line: Normal P/E
• Dashed or dotted lines: Estimates only
• Green area: Earnings

Our strategy and the safety of our capital hinges on the growing income generated by a select group of quality companies. While stock prices may vary, our overall income consistently increases. The downside is the need for patience for this growth. What are we waiting for? The dividend, the income, the yield.

Our strategy and our safety depends upon the growing income from a few leading companies, not the market, not a fund, nor over-diversification.

A quick test I like to perform is our “7% in 10 Years” test. This test helps identify dividend growth stocks that are attractive investments today. If your income stream (without reinvesting dividends) is projected to grow to a yield of 7% in ten years, then it has the potential to be a good investment opportunity.

In monetary terms, if you invest $10,000 today, you can expect to receive $700 annually from dividends alone within ten years. How does an investment bought today generate a 7% return on dividends alone ten years from now? The answer is that the dividend grows!

One reason I use 7% as my numerical goal is that equities have historically provided around 7% returns over the last 100 years. Generating a return within a decade equal to the stock market’s historical total return from the dividend alone demonstrates the magic of dividend growth investing.

Another advantage of using at least a decade as your investment horizon is that the distance between your purchase and current prices is typically significant.

Let’s look at an example of growing yield and its effect on price using a company on ‘The List’:

As we approach the midpoint of 2024, it’s the perfect time to start scouting candidates for next year’s list. Monitoring potential additions closely allows us to evaluate how they compare to our existing list of members.

While we’re comfortable building a portfolio of quality dividend growers from our current list, we always keep an eye on potential future candidates. This forward-thinking approach has paid off in the past, as evidenced by our early additions of TFII-N and MFC-T before launching our public-facing model portfolio in 2022, both of which have proven excellent choices.

Identifying Potential Candidates

We’ve identified six companies on the TSX that will meet our first two criteria for inclusion on ‘The List’ in 2025:

Dividend Growth Streak: At least 10 years.

Market Cap: Minimum of one billion dollars.

I was recently invited to join a prestigious investment club founded in 1979. Reviewing the club’s history and bylaws, I realized I was being asked to join the ‘Growth Stock Crowd’. I had tried this approach before and found it challenging. This prompted me to compare the differences between growth stock investing and my preferred method of dividend growth investing for our readers.

The Growth Stock Crowd

Growth stock investors aim to buy stocks at the right time, focusing on companies with rapid growth potential. The goal is to sell these stocks for significant profits and repeat this process continually. Even the most brilliant investors experience both wins and losses, averaging about 7%-9% long-term returns. Perfect market timing and stock selection are unrealistic, as no one can consistently win. Over time, investors hope to improve their skills and achieve more wins than losses.

The Dividend Growth Crowd

In contrast, dividend growth investors like me take a different approach. With years of experience, I may not consider myself extraordinarily intelligent, but I know basic math, how to research earnings reports, and how to assess valuations. More importantly, I have the discipline and patience honed from running my own business for twenty-five years.

Dividend growth investors are passionate about a steady, predictable way to build a secure financial future. Our investment time horizon is indefinite, so we remain undistracted by short-term market fluctuations. We invest in quality companies that consistently pay and grow dividends. Daily share price changes, the broader economic picture, and other details are secondary to a company’s ability to increase its dividend payments. Historically, as dividends grow, so does the stock price. This combination of growing income and capital appreciation is the secret sauce in our strategy, with annualized long-term total returns in the 10%-12% range.

Key Differences Between Growth and Dividend Growth Investing

Growth stock investors juggle multiple factors: selecting the right stocks, assessing current prices, evaluating company products, and timing the perfect sale to make a profit. This process must be repeated continually with different companies.

On the other hand, dividend growth investors focus on ensuring that their chosen companies will continue to pay and increase dividends annually. Lists of companies that have increased dividends for over ten years, even during tough times, are readily available. We follow one such list on this blog every week.

While growth stock investors sell their stocks to realize profits, dividend growth investors rarely sell because doing so would reduce their growing income. This income can also be reinvested in sensibly priced dividend growth companies to increase our returns.

Wrap Up

I plan to attend the investment club’s next meeting to learn more. Life has taught me that personal growth comes from stepping out of your comfort zone occasionally. At the very least, I will meet some interesting people passionate about investing.

Last week, we shared our latest quarterly and second-year financial results for the MP Wealth Builder Model Portfolio (CDN). PAID Subscribers can access the full document in our ‘Premium Content’ section and receive DGI alerts whenever we buy or sell within the portfolio. Here are some highlights:

In the quarterly review, I reiterated our approach as DIY dividend growth investors:

This is about buying businesses, not just stocks.

Trusting Canada’s top companies, led by exceptional management teams and supported by thousands of dedicated employees, is key to achieving financial freedom.

We consider our portfolio an asset management business, with our assets being the many dividend growth companies we own. Our plan is to shift from working for our investments to managing our assets and growing our ownership in the investments that work for us.

Finding companies with a historical alignment between dividend growth and price growth and purchasing them when their current yields exceed historical averages is a straightforward strategy for successful dividend growth investing.

Metro Inc. serves as a prime example within our ‘Core’ category stocks. Let’s examine two crucial charts: dividend growth (DG) versus price growth (PG) alignment and the 10-year yield chart for this quality dividend grower.

Dividend Growth vs. Price Growth Alignment

Over the past decade, Metro Inc.’s stock price has closely mirrored its dividend growth. The price rarely stays out of alignment for long. Dividend growth stocks that behave this way are some of the highest-quality companies in your portfolio. In addition, recognizing and acting on this short-lived misalignment can lead to outperformance in your portfolio returns.

Last week, we identified the ‘Timely Ten’ companies on ‘The List’ that were reasonably priced based on dividend yield theory. This week, we will delve deeper into this group of stocks and explore what determines a quality company to see if there are any investable candidates. The stocks above the black line make up the ‘Timely Ten.’

With Q1 2024 earnings behind us now, it’s time to take another look at our ‘Timely Ten’ DGI stocks. These are the ten most undervalued stocks on ‘The List’ according to one of our valuation metrics, dividend yield theory.

Step three in our process involves monitoring our quality dividend growers regularily, which can become quite challenging depending on the number of companies we track. Fortunately, we rely on ‘The List’ instead of the vast array of stocks in the index, which streamlines our task. Nevertheless, we continually seek methods to enhance our efficiency. Through dividend yield theory, we’ve discovered an approach that has proven remarkably effective over the years in aiding us with our efforts.

Dividend yield theory is a simple and intuitive approach to valuing dividend growth stocks. It suggests that the dividend yield of quality dividend growth stocks tends to revert to the mean over time, assuming that the underlying business model remains stable. In practical terms, if a stock pays a dividend yield above its ten-year average annual yield, its price will likely increase to return the yield to its historical average. Knowing that price and yield go in opposite directions, this theory helps us find stocks that are poised for a positive price correction.

We have already pre-screened our candidates using the criteria we laid out in building ‘The List’ initially. This helps us considerably narrow the universe of investable stocks.

1. Dividend growth streak: 10 years or more.
2. Market cap: Minimum one billion dollars.
3. Diversification: Limit of five companies per sector, preferably two per industry.
4. Cyclicality: Exclude REITs and pure-play energy companies due to high cyclicality.

Next, we rank ‘The List’ by how significantly each stock is priced below its fair value (Low Price), as calculated using dividend yield theory. The stocks that are currently trading below this threshold form our ‘Timely Ten’.

If you were given a choice between receiving an immediate cash payment of one million dollars or a magical penny that doubles in value every day for 30 days, which option would you choose? At first glance, the million dollars might seem like the clear winner. However, a closer examination reveals a startling outcome. If you take a moment to do the math—doubling a single penny each day for 30 days—you’ll discover that on the 30th day, that humble penny would have grown to over $5 million.

This scenario serves as a powerful illustration of the power of compounding, an essential concept for anyone new to investing. It shows how small, seemingly insignificant amounts can exponentially grow over time, yielding astonishing returns.

However, one crucial question remains: How can you achieve consistent, reliable returns on your investments year after year to truly harness the magic of compounding? By leveraging the right investment strategy, you can transform the theoretical promise of compounding into real, tangible wealth.

Dividend growth investing is a strategy that focuses on buying stocks of companies that not only pay dividends but also consistently increase them over time. This approach combines the immediate benefit of receiving regular income from dividends with the potential for capital appreciation and the powerful effect of compounding. Here, we’ll explore how dividend growth investing works and why it might be a beneficial strategy for long-term wealth creation.

Understanding Dividend Growth Investing

Dividend growth investing targets companies with a track record of increasing their dividend payouts. These companies are typically well-established, with stable earnings and strong business models, which enable them to progressively increase dividends. Investors who adopt this strategy look for companies with a “dividend growth streak,” meaning they have increased their dividends for a number of consecutive years.

The appeal of dividend growth investing lies in its dual return mechanism. Firstly, investors receive regular dividend payments that can be used as income or reinvested. Secondly, if the dividends are consistently growing, the yield on the original investment cost can rise over time, potentially outpacing inflation and increasing the investor’s purchasing power.

The Power of Compounding

Compounding occurs when the earnings from an investment are reinvested to generate their own earnings. In the context of dividend growth investing, compounding amplifies returns over time as dividends are reinvested to purchase additional shares of stock. This increases the total dividend income because more shares accumulate more dividends, which can then be reinvested again.

For example, if you invest in a company that pays a $1 dividend per share annually and increases this dividend by 10% each year, your dividend payment in the first year on 100 shares would be $100. By reinvesting these dividends, you could buy more shares. Assuming the stock price remains constant, in the second year, you would not only receive the increased dividend on your original shares but also dividends on the additional shares purchased with your first year’s dividends.

The Impact of Long-Term Investing

The effectiveness of dividend growth investing becomes most apparent when practiced over long periods. This strategy is less about speculating on stock prices and more about being patient, allowing the power of dividend growth and compounding to play out over time. Over the decades, reinvested dividends that grow can contribute to exponential growth in the value of the investment portfolio.

Starting with Dividend Growth Investing

To begin with dividend growth investing, it’s essential to identify companies with potential for long-term growth in dividends. Look for companies with low payout ratios, strong balance sheets, and a history of earnings growth. Tools like dividend yield, payout ratio, and the dividend growth rate are fundamental metrics to assess the suitability of a stock for dividend growth investing.

Conclusion

Dividend growth investing offers an attractive combination of regular income, potential for increasing returns through rising dividends, and the powerful effect of compounding. This strategy requires patience, a focus on long-term rewards, and a disciplined approach to reinvesting dividends. By carefully selecting stocks and committing to a long-term strategy, dividend growth investing can be a cornerstone of building sustainable wealth.

If you have time this week, please review the SAMPLE-DGI Business Plan on our site to see the effects of dividend growth and compounding in action. Pay close attention to the article’s ‘Income Target’ section and see how quickly your income and capital compound using our process. It’s never too late to get started.