Finding Undervalued Dividend Aristocrats with the Graham Number

This is a guest post written by Ben Reynolds.  Reynolds runs Sure Dividend which is focused on finding high quality businesses trading at fair or better prices suitable for long-term holdings. Please note that this article utilizes the Graham Number, which is different from the formula provided by Benjamin Graham which is the basis of ModernGraham valuations.

The Dividend Aristocrats Index is comprised of over 50 businesses with 25+ years of consecutive dividend increases.  For a business to increase its dividend payments for 25 consecutive years, it must have a durable competitive advantage.

The Dividend Aristocrats Index has returned 10.7% a year over the last decade, versus 8.1% a year for the S&P 500 Index according to S&P.

Of course, not all stocks in the Dividend Aristocrats Index make excellent investments.  Some are overvalued at this time and should not be purchases.  On the other hand, some Dividend Aristocrats are trading at or below fair value.  This article applies the Graham Number to the Dividend Aristocrats Index.

Benjamin Graham & The Graham Number

Benjamin Graham returned nearly 20% a year  Over a 20 year period.  He has one of the best recorded long-term investment records in history.

Benjamin Graham’s most discussed investment technique is purchasing businesses trading at a discount to their net current asset value.

No Dividend Aristocrats are trading for anywhere near net current asset value.  High quality businesses with strong competitive advantages rarely (if ever) trade at liquidation value.

Fortunately, Benjamin Graham gave some guidelines to be applied to large, stable stocks to determine if they are undervalued, which investors over the years have considered as the Graham Number.  The Graham Number is below:

In the formula above, Price is the share price, EPS is earnings per share, and BPS is book value per share.

Applying the Graham Number to the Dividend Aristocrats Index will identify high quality businesses trading below fair value.

The Graham Number Applied to Dividend Aristocrats

Only 5 businesses out of the 53 businesses in the Dividend Aristocrats Index pass the Graham Number test.  The 5 businesses that do pass the test are listed below along with their discount to fair value as calculated by the Graham Number:

1. Chevron (CVX): 76% of fair value
2. AFLAC (AFL): 82% of fair value
3. Chubb Corporation (CB): 88% of fair value
4. Consolidated Edison (ED): 92% of fair value
5. HCP Inc. (HCP): 97% of fair value

Click this link to download a free excel spreadsheet of all 53 Dividend Aristocrats sorted by discount to fair value using the Graham Number.

The Graham Number favors asset rich companies. Asset light businesses like Colgate-Palmolive (CL), Clorox (CLX), and Kimberly-Clark do not rank highly using the Graham Number.

Of the 5 businesses that pass the Graham Number value test, the two insurers appear to be the best investments at this time.  Both AFLAC and Chubb Corporation rank in the Top 10 using The 8 Rules of Dividend Investing.

AFLAC & Chubb Corporation

Both AFLAC and Chubb have maintained combined ratios under 100% for over a decade.  The combined ratio is the sum of claims paid and expenses dividend by premium revenue received.  When an insurer has a combined ratio under 100%, it is running a profitable operations before accounting for investment gains from invested insurance float.

AFLAC and Chubb’s long streak of maintaining a combined ratio under 100% speaks to the conservative nature of these company’s managements.  Both companies simply refuse to write unprofitable insurance policies.

Both insurers have a potential catalyst that could push each company’s respective stock price higher.  The Federal Reserve is expected to raise interest rates later this year or in 2016.  When interest rates rise, Chubb & AFLAC stand to benefit.

Rising interest rates means both Chubb & AFLAC can invest new premium revenue into higher yielding securities.  Both company’s short-term debt holdings will also see increased interest rates. This will result in higher earnings-per-share for both companies which could potentially drive share prices higher.

Final Thoughts

The Dividend Aristocrats Index is an excellent resource to look for high quality dividend growth stocks.  Applying the Graham Number to the Dividend Aristocrats Index quickly finds high quality businesses trading at fair or better prices. AFLAC & Chubb in particular stand out as potential investments for long-term investors looking for both capital appreciation and dividend growth.

Disclaimer: The author held a long position in Aflac (AFL) but did not hold a position in any other company mentioned in the article at the time of publication and had no intention of changing that position within the next 72 hours.