The pickings are pretty slim right now.
There’s no shortage of claims out there of an imminent stock market collapse, but we have yet to see one. Rather, the S&P 500 is up more than 3% over the last month as it approaches 2,000 points. Meanwhile, the Dow Jones Industrial Average is nearing 17,000 points.
With that said, I don’t really care about these numbers. They make for an interesting context, but in the end I’m still investing in individual high-quality businesses for the next few decades of my life. As such, I do my due diligence on businesses, not the stock market.
But a big part of me does long for a broader market pullback of some sort so that many individual stocks are pulled into the storm and find themselves battered and cheaper when the skies clear. However, in the meantime, I’ll just continue allocating capital as best as I possibly can. And the two stocks I’m going to discuss below are where I’m looking to allocate fresh capital over the course of the coming weeks.
Two “Stage 3″ Stocks
Visa Inc. (V)
Visa Inc. is a global payments technology company, connecting consumers, businesses, banks, and governments in more than 200 countries by enabling them to use digital currency instead of cash and checks.
I recently discussed the three stages of stocks that a dividend growth investor can look at, and I also pointed out that I was missing some exposure to what I called “Stage 3″ stocks. Investing in a business like Visa would definitely give me some exposure to a business that has managed explosive growth over the last five years in all aspects, albeit at a slightly high valuation.
They’ve only been publicly traded since 2008, so the data doesn’t go back very far. But the numbers they’ve posted since going public paints a picture of very impressive growth. Earnings per share increased from $3.10 in 2009 to $6.39 in 2013 – a compound annual growth rate of 19.82%. That’s obviously very impressive. Revenue has grown in likewise fashion, up from $6.911 billion to $11.778 billion over this same time frame. That’s a CAGR of 14.26%. And apparently this juggernaut is showing no signs of slowing down. S&P Capital IQ predicts earnings to compound at an 18% rate over the next three years.
The dividend has grown in even more spectacular fashion. The five-year dividend growth rate for this stock is 45.9%. And with a low payout ratio of just 18.9%, there is no reason that massive dividend growth shouldn’t continue for the foreseeable future. Of course, not is all peachy with this stock. That low payout ratio comes at the expense of a low yield, as the stock currently has a yield of just 0.76%. Visa management prefers share buybacks to dividends for rewarding shareholders, although both should be aggressive for the foreseeable future.
I really like Visa here. The balance sheet is flawless, and their competitive advantages are obvious. And for all their size, they still have a ton of opportunity in many emerging markets where cash transactions are still dominant. Of course, there are risks in investing in a company like Visa as technology can change how people access mobile payments. However, I’m highly considering investing in this company in July even though the yield is so low.
The valuation appears a bit rich here with a P/E ratio 24.78, but considering the growth this company has experienced and is likely to continue experiencing I view this ratio as very reasonable. Especially so when many companies with much lower growth rates are trading for ratios near 20 or even slightly above. I valued shares using a dividend discount model analysis with a 10% discount rate, but two stages of dividend growth: 20% for years 1-10 and 8% as a terminal rate. This growth is aggressive, but I think it’s fairly reasonable based on what they’ve been able to post thus far. This gives me a fair value on shares at $232.89, which is a bit above where the stock trades at now.
International Business Machines Corp. (IBM)
International Business Machines Corp. is an information technology company. They provide integrated solutions for clients through a broad range of product and service offerings, designed to solve business problems using data and technology.
I initially invested in IBM back in August 2013, and the stock hasn’t really budged since then. As such, I remain interested in adding to my position here as I still think it’s undervalued. It’s especially interesting that the stock hasn’t really gone anywhere considering the broader stock market has been breaking new records seemingly daily. But I remain happy that this is the case as the stock remains low-hanging fruit for me. Plus, this is another Stage 3 stock I can get my hands on.
Growth in IBM’s business paints a mixed picture. EPS is up from $4.94 in 2004 to $14.94 by the end of 2013. That’s good for a CAGR of 13.08%, fueled by the company’s aggressive buybacks. Revenue, however, is mostly flat. Total company revenue stood at $96.293 billion in 2004, and ended at $99.751 billion in 2013. That’s a CAGR of just 0.39% over the last decade. The lack of revenue growth is why there’s a large base of investors that aren’t a fan of the stock, but even with little organic revenue growth the company throws off very healthy cash flow which they send shareholders’ way via aggressive buybacks and growth in the dividend. S&P Capital IQ predicts EPS to grow at a compounded annual rate of 6% over the next three years.
Dividend growth has been very strong, although this isn’t the primary way IBM rewards shareholders. The company has a 10-year dividend growth rate 19.4%, which is very, very healthy. The yield right now isn’t lighting the world on fire at 2.42%, but this is near the all-time high for this stock. And the payout ratio remains very moderate at just 30%. Overall, I predict strong dividend growth to continue.
IBM is an interesting holding for me. I’m not a big fan of tech companies in general, and this remains my only pure play in technology. As such, I’ve been content to keep it a small holding. However, the clear value in shares here has presented a scenario where I can see myself adding to my position. Although there are risks with investing in any tech company because technology is so inherently fickle, IBM has fairly stable revenue thanks to the integration of its platforms.
Shares are trading hands for a P/E ratio of just 12.43, which is well below where the market’s at. I valued shares using the DDM analysis with a 10% discount rate and an 8% long-term growth rate. This growth rate seems more than feasible considering the historic growth in earnings and dividends, along with the company’s model of rewarding shareholders via buybacks and dividends. This gives me a fair value on shares of $237.60, which is approximately 30% higher than where shares are priced at right now.
I view shares in both of these companies as reasonably priced considering their growth histories and the likely growth still yet ahead. The yield for each respective company isn’t particularly impressive, but the payout ratios are low, which when combined with continued earnings growth means dividend growth well above average should persist for the foreseeable future. I think IBM is the better value of the two, but I also anticipate V will grow much more quickly. I’m likely going to purchase shares in one of these two businesses in July, assuming prices remain relatively similar to where they’re at right now.
Full Disclosure: Long IBM.
How about you? A fan of either of these businesses at today’s price?
Thanks for reading.