A.O. Smith And Lazard: 2 Very Strong Blue Chip Buys I Just Added To My Retirement Portfolio – A. O. Smith Corporation (NYSE:AOS)

(Source: imgflip)

While many investors curse today’s trade war fear induced volatility, I take a more zen-like approach to my retirement portfolio. Given my goals of being able to live entirely off my dividend income, I am content to steadily keep buying blue-chip income growth stocks opportunistically, into the best opportunities the market provides that fit my individual needs/goals.

In other words, I enjoy following Buffett’s advice and being „greedy when others are fearful“ and thus any market freakout is a welcome opportunity to buy great companies at good to great prices.

That’s why, over the recent weeks I invested about 10% of my portfolio into seven undervalued blue-chips, including A.O. Smith (AOS), in a move that increased my position by about 25%.

  • May 16th (day of the short report crash): 60 shares at $43.71 ($0.36 commission with Interactive Brokers tiered pricing)

And most recently I also increased my position in Lazard (LAZ), the deeply undervalued boutique financial advisor/asset manager that could potentially double over the next five years from today’s extremely attractive levels, by 100%.

  • May 20th: 58 shares at $34.57 ($0.42 commission)

In fact, here are the valuation stats for the stocks I’ve bought over the past few weeks

  • weighted average forward PE 10.9 (S&P 500 forward PE hit 10.3 in March 2009 and bottomed at 14.3 in 2003 tech crash bear market)
  • Discount to fair value (Morningstar’s conservative DCF estimates): 24%
  • Yield: 4% (vs S&P 500’s 1.9%)

Basically, I’ve been putting all my excess savings to work into deeply undervalued high-yield blue-chips, which represent some of the best „coiled springs“ the market is offering income investors right now.

So let’s take a look at why Wall Street hates A.O. Smith and Lazard today, why those fears are likely overblown, and why now might be a great time for patient contrarian income investors to add one or both to their diversified dividend portfolios.

Because from today’s 25% (AOS) and 38% (LAZ) undervalued levels, both of these dividend blue-chips are very strong buys that offer not just safe and growing dividends but are very likely to deliver double-digit long-term total returns (10% to 21% CAGR) over the next five to 10 years.

A.O. Smith Is Facing A Perfect Storm Of Negativity…

There are three things that have combined to create a perfect storm battering this dividend aristocrat’s (25 consecutive years of rising dividends and no dividend cuts through at least 1983) share price.

The first is rising 12-month recession risk, which was near a 10-year high in April.

(Source: New York Federal Reserve)

As an industrial company, A.O. Smith’s business is naturally cyclical and sales and earnings can be expected to decline during a recession (during the Great Recession revenue declined 5%).

The second reason Wall Street is bearish on A.O right now is its exposure to China.

A.O. Smith entered China’s market over 20 years ago and has spent those decades building up a network of over 9,000 retailers that have allowed its business there to grow almost 20% annually over the past 10 years.

(Source: investor presentation)

However, the downside today is that, with 34% of sales from the middle kingdom, there are few companies as exposed to an escalating trade war as A.O. Smith.

(Source: BBC)

In Q1 2019 A.O. Smith’s China’s sales (local currency) were down 18% and despite expecting a better second half to the year, management still expects Chinese revenue to fall 6% to 8% in 2019. That (and lower India margins due to lack of sufficient scale) is expected to drive international segment margins down to 12%, about half the 23% it expects from its core North American business.

But the biggest reason for the recent crash (when I added to my position to the tune of 25%) was the recent short report published by J Capital Research on May 16th.

That report made some extremely damning but speculative claims including

  • channel stuffing is artificially inflating Chinese sales
  • use of an undisclosed distribution partner accounts for 75% of Chinese sales and artificially inflates margins
  • China sales will fall 21% in 2019, three times what management is currently guiding for
  • A.O. Smith’s cash, which is 84% held in China, is actually being used to make loans to distributors meaning its not actually available (accounting fraud)

The same day this very scary report came out analyst firm Spruce Point stated the company’s gross margins „are either being inflated by management with aggressive accounting or can’t be sustained as local competitors catch up.“

Spruce Point and J Capital say they think there is 40% to 60% downside to A.O. Smith’s short-term share price, explaining why J Capital is shorting the stock.

So there you have it, a perfect storm of fear, uncertainty, and doubt about one of the bluest of industrial blue-chips. But here’s why I consider these fears overblown and am willing to put my hard earned money at risk investing in this deeply beaten down dividend aristocrat (and you might want to consider doing the same).

…Which Is Why Today Is Potentially A Great Long-Term Buying Opportunity

First let’s address the scariest things that has investors so spooked, that short report and claims of accounting fraud and channel stuffing. Here’s management commenting on the J Capital report.

A. O. Smith, founded 145 years ago, has a long track record of operating with integrity across the world. A recent report by short seller J Capital Research makes inaccurate, unfounded and misleading allegations designed to negatively impact A. O. Smith’s share price for J Capital’s own benefit.“ A.O. Smith statement

While short sellers shouldn’t necessarily be dismissed outright (Enron’s accounting fraud was discovered by short-sellers) it’s 100% true that J Capital has a strong financial incentive to sow as much fear and doubt about this venerable blue-chip, and when trade war fears are at their peak.

As for J Capital’s specific claims about channel stuffing and accounting fraud, here’s A.O. Smith’s rebuttal

As is common for many companies who do similar business in China, we utilize a distribution channel where third-party supply-chain partners, such as Jiangsu UTP Supply Chain (UTP) and other supply chain partners, purchase product from us which they subsequently distribute to distributors and ultimate end-users. We understand our supply chain partners do similar services for other global companies with whom they work. All revenue associated with UTP and others was appropriately recognized in accordance with U. S. GAAP in our financial statements. Our financial statements and internal controls over financial reporting are annually audited by Ernst & Young LLP. While we value all of our distribution relationships, we do not have debt or equity interests in UTP and maintain appropriate independent commercial agreements. Given we have significant longstanding operations in China, a significant portion of our $633 million of cash, cash equivalents and marketable securities as of March 31, 2019 was held by our foreign subsidiaries, including $457 million of cash denominated in local currency in China, in A. O. Smith-owned, unencumbered bank accounts. We executed a $150 million dividend from China in 2018, and we expect to dividend approximately $150 million in the first half of 2019.“ – A.O. Smith statement (emphasis added)

Basically A.O. Smith, a company that has operated for almost 150 years and is known for its long-term, conservative focus, is saying that it’s done nothing wrong, its China sales are reported under the same audited standards as all US companies, and its Chinese cash is 100% available and steadily being brought back to fund growth, buybacks and dividends.

While the risk that A.O. Smith is another Enron is not zero, given the company’s pristine track record they certainly deserve the benefit of the doubt. Or to put another way, until J Capital’s statements prove true, their claims are merely scare tactics designed to elevate perceived risks about what could go wrong with the company’s fundamentals (the facts that ultimately determine a stock’s value).

So let’s look at the actual facts about A.O. Smith, which underpins the long-term investment thesis and is why I trust it with about 3% of my life savings. First, there’s dividend safety, which is the first thing I look at with any company I own or consider recommending to readers.

CompanyYieldTTM FCF Payout RatioSimply Safe Dividends Safety Score (Out of 100)Sensei Dividend Safety Score (Out of 5)Sensei Quality Score (Out of 11)
A.O. Smith2.0%40%99 (very safe)5 (very safe)11 (SWAN)
Safe Level (by industry)NA60% or less61 or higher4 or higher8 or higher

(Sources: Simply Safe Dividends)

A.O. Smith’s dividend is among the safest on Wall Street, and when combined with its strong business model (wide moat competitive advantages including local manufacturing that lets it avoid most threatened tariffs) and excellent management gives it a perfect 11/11 quality score. Or to put another way, A.O. Smith is one of the highest quality dividend stocks you can own.

CompanyNet Debt/EBITDAInterest Coverage RatioS&P Credit RatingAverage Interest CostReturn On Invested Capital
A.O. Smith0 (net cash)66.9NA3.2%26%
Safe Level3.0 or below8 or aboveBBB- or higherbelow ROIC8% or higher

(Sources: Simply Safe Dividends, F.A.S.T Graphs, Gurufocus, Morningstar)

That dividend safety is made abundantly clear by the fortress balance sheet which includes $349 million in net cash and a sky-high interest coverage ratio.

This is why despite not paying for a credit rating (which can run up to $500,000 per year per rating agency) bond investors are willing to lend to it at just 3.2%, almost nine times below its returns on invested capital or ROIC. ROIC is a proxy for management quality and A.O. Smith’s capital allocation is over three times the standard of a quality US company.

(Source: Ycharts)

You can use a company’s average interest rate to infer what effective credit rating the bond market is giving it. A.O. Smith’s average interest costs mean bond investors (who care primarily about minimizing risk and capital preservation) rate it between A and AAA.

And as for the market’s fears that A.O. Smith is a flailing company who will be ravaged by the trade war? Well, that’s possible in the short-term. But as a long-term investor, I care not about 2019’s or 2020’s results, but how the company will do over the next five to 10 years. As Buffett famously said

If you aren’t willing to own a stock for ten years, don’t even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value.“ – Warren Buffett (emphasis added)

So let’s look at A.O. Smith’s historical results.

(Source: investor presentation)

The company’s sales, cash flow, and adjusted EPS have been soaring (and its EBITDA margins climbing higher), though admittedly that’s during the longest US economic expansion in history (as of July 1st, 2019). A.O. Smith is a cyclical company which means it’s likely to face periods of slower or even negative growth, such as during recessions.

(Source: earnings presentation)

However, despite the trade war headwinds A.O. Smith is guiding for 4.2% EPS growth this year. That’s 1% higher than what analysts expect the S&P 500 to deliver, according to Factset Research. In other words, A.O. Smith, despite all the risks Wall Street is focused on, claims it will be able to generate not just positive bottom line growth this year, but at a rate superior to the average US corporation’s.

The company made $46 million in share repurchases in Q1 (about 0.6% of shares outstanding) and the company’s strong net cash position will potentially allow it to buy back shares even more aggressively at these deeply beaten down prices.

(Source: earnings presentation)

In fact, management’s guidance calls for $200 million in buybacks this year, and that was before the short report beat the stock down on pure speculation, that management is adamantly denying.

Note also that for 2019 AOS is guiding for $428 million in free cash flow ($2.55 per share) which would be a 20% increase from 2018’s record levels. That bodes well for the dividend hike likely coming in two quarters, given that the FCF payout ratio would decline to 35% from 2018’s already safe 40% level. And that payout ratio was after two dividend hikes in 2018 totaling 57%.

In other words, despite what the short report might have you believe this 145-year-old dividend aristocrat isn’t dying but thriving. And with management guiding for impressive growth in earnings and FCF this year, that likely points to another big hike from a dividend aristocrat that is famous for some of the fastest payout growth of its peers, or any company on Wall Street for that matter.

(Source: Simply Safe Dividends)

Ok, so A.O. Smith says 2019 won’t be a horrible year, but what about 2020 and beyond?

CompanyYield5-Year Expected Earnings GrowthTotal Return Expected (No Valuation Change)Valuation-Adjusted Total Return Potential (5-10 Years CAGR)
A.O. Smith2.0%7.5%9.5%10.3% to 21.3%
S&P 5001.9%6.6%8.5%1% to 7%

(Source: Simply Safe Dividends, F.A.S.T Graphs, Morningstar, management guidance, Yardeni Research, Yahoo Finance, Multipl.com, Gordon Dividend Growth Model, Dividend Yield Theory, Moneychimp, analyst estimates)

Analysts, who are famous for overshooting to the downside on growth expectations for cyclical companies at times like these, still expect A.O. Smith to deliver 7.5% EPS and FCF growth over the next five year. And that’s likely baking in a future recession that is expected by 2024. Keep in mind that the median EPS growth rate for the S&P 500 over the past 20 years is 6.5%, so A.O. Smith is still expected to grow faster than most companies.

There is always a chance that A.O. Smith will beat those historically low growth expectations. For one thing, a crashing share price means buybacks become more accretive. And then there’s the booming India business.

(Source: investor presentation)

India sales are growing at 30% annually in local currency, indicating that AOS’s execution in that major market is going well. But let’s use those conservative analysts growth estimates just to err on the side of caution.

If A.O. Smith were to only grow earnings/cash flow and dividends at 7.5% CAGR over the next five years than at today’s yield, and assuming its valuation were to remain constant, that would still deliver about 9.5% CAGR total returns.

Not only is that superior to the market’s historical 9.1% CAGR total return, but it’s far better than the 1% to 7% CAGR total return that most asset managers expect the S&P 500 to generate over the next five to 10 years.

So basically, A.O. Smith is likely to outperform the market, and possibly by a wide margin, even if its valuation remains at today’s low levels.

(Source: Simply Safe Dividends)

That includes a yield that’s the highest it’s been since 2009 and a forward PE ratio that’s tied with December 24th’s lows (which was the lowest its been in a decade).

Or to put another way, A.O. Smith appears to be a coiled spring, whose share price returning to historical valuations could cause the price to vastly outperform its earnings/cash flow/dividend growth over time.

To adjust for historical valuations, I turn to my favorite blue-chip valuation method, dividend yield theory or DYT. This has been the only approach used by asset manager/newsletter publisher Investment Quality Trends since 1966. DYT, which compares a stock’s yield to its historical norm, has been the only approach IQT has used for 53 years, and only on blue-chips, to deliver market-beating returns with 10% lower volatility to boot.

(Source: Investment Quality Trends)

According to Hulbert Financial Digest, IQT’s 30-year risk-adjusted total returns are the best of any US investing newsletter. Basically, DYT is the most effective long-term valuation approach I’ve yet found, which is why it’s at the heart of my retirement portfolio’s strategy and drives many of my article recommendations.

DYT merely compares a company’s yield to its historical norm because, assuming the business model remains relatively stable over time, yields, like most valuation metrics, tend to revert to historical levels that approximate fair value.

I like to use DYT as one end of my valuation range with the other end provided by the conservative analysts at Morningstar.

CompanyYield5-Year Average YieldEstimated Discount To Fair ValueUpside To Fair Value5-10 Year Valuation Boost (CAGR)
A.O. Smith2.0%1.1%43%75%5.8% to 11.8%

(Sources: Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, F.A.S.T Graphs, management guidance, Moneychimp)

Today A.O. Smith’s yield is almost double its five-year average which implies it might be about 43% undervalued and could appreciate by 75% without becoming overpriced. But of course, this is a cyclical company, and the last five years have seen a strong economy, in the US, China and around the world.

So it’s very possible that DYT is overstating A.O. Smith’s discount to fair value. Which is why I also use Morningstar’s conservative long-term, three-stage discounted cash flow models. Morningstar is famous for using some of the lowest growth assumptions on the Street, sometimes even lower than official management guidance.

If Morningstar says a blue-chip is fair value, it might very well be undervalued. But at the very least under the Buffett rule of „it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price“ a Morningstar fair value price is still a good buy, especially for a dividend aristocrat.

CompanyCurrent PriceEstimated Fair ValueMoatManagement QualityDiscount To Fair ValueLong-Term Valuation Boost
A.O. Smith$44.60$48.11(uncertainty high)NarrowNA (Quantitative model)7%0.8% to 1.5%

(Source: Morningstar)

A.O. Smith isn’t covered by an analyst but has its fair value estimated using a quantitative DCF model. That model says the company is at least 7% undervalued, which admittedly disagrees significantly with DYT.

Because the truth of the company’s valuation is likely somewhere in between I take the average of these two estimates to conclude that A.O. Smith is about 25% undervalued which makes it a very strong buy under my personal valuation scale.

However, in case you are someone who seeks faster returns than my five to 10-year time horizon, there is a reason to expect that A.O. Smith might deliver exceptional returns within 12 months.

Dividend Aristocrat Forward 12 Month Returns Following 10+% Daily Crash

(Source: Ploutos Research)

Over the past decade, no less than 18 aristocrats have crashed 10+% in a single day. 80% of the time they were positive a year later, with an average total return of 32%. The median gain was 33%.

While the above data set isn’t technically statistically significant (thus no guarantee that A.O. Smith is going to rocket higher in the coming year) I point out this table to highlight that buying aristocrats on strong short-term crashes is a low-risk/high-probability strategy.

And given that Moody’s estimates a 60% chance that a trade deal will be reached by the end of June (possibly at the G20 summit on June 29th), and that the recent crash is based on allegations that are likely false, A.O. Smith has a very strong short-term catalyst that could potentially send it soaring to $58 (the 32% historical aristocrat 12 month gain) within a year.

But while A.O. Smith is a great opportunistic blue-chip buy today, Lazard is potentially an even better long-term income growth opportunity.

Why Lazard Is Trading Near 52-Week Lows…

There are likely two reasons that Lazard recently fell to within 3% of its December 24th low (which was itself due to 2019 recession fears). The first is that this is a high volatility company, historically about 50% more so than the S&P 500.

(Source: Ycharts)

That’s due to its business model, where about 50% of revenue comes from its investment advisory segment, and 50% from the higher margin but highly volatile asset management business.

Founded in 1848, Lazard is one of the most famous (at least on Wall Street) investment advisors, with clients ranging from corporations seeking advice on M&A to countries like Greece, who used it when it was going through its sovereign debt crisis.

(Source: investor presentation)

Right now Lazard is facing some weakness in its European advising arm, partially due to Brexit uncertainties but also due to the overall slowing global economy.

(Source: Bloomberg)

Global manufacturing has been slowing to the point of near recession since late 2017, and that’s largely due to the trade war.

(Source: OECD)

The reason for that is that falling trade is hurting China, and China’s growth (via imports) is connected to many other regions.

(Source: OECD)

That includes Europe, whose main economic growth engine, Germany, is especially at risk from escalating tariffs on Beijing’s imports to the US.

(Source: Bloomberg)

The initial tariffs (which just went up to 25% on half of China’s imports) took a major toll on China’s manufacturing sector. Not surprisingly German’s economy also slowed considerably (it exports lots of high-end machinery to China) and today the EU is on the verge of a mild recession.

The 25% auto parts tariffs Trump is threatening to impose on the EU certainly wouldn’t help the situation, though those are now on hold for up to six months.

The fears that many have, including Moody’s Analytics, is that the probability of a worst case trade scenario is now rising (though still just 10% for now).

A much more serious, worst-case, and increasingly plausible scenario is that Trump engages in an all-out trade war, following through on most of what he has threatened to do. This includes putting a 25% tariff on all Chinese imports to the U.S., which comes to some $520 billion for the past year, about one-fifth of all imports into the country. In this dark scenario, Trump also goes all-in on the 25% tariffs on vehicle imports and parts (from Europe)The probability of this full-blown trade war scenario is 10%, and is the recipe for a U.S., Chinese and global recession later this year. – Moody’s Analytics (emphasis added)

The risk of a US and even possibly global recession could increase significantly because China is far from the only potential trade war the US is risking.

Moody’s estimates that the $300 billion final round on Chinese tariffs (which could go into effect in August/September) would alone cost the US 3 million jobs by the end of 2020, lower annual GDP growth by about 1.8% per year, and could cause a mild recession.

Morgan Stanley is warning its clients that a full-blown trade war could force the Fed to cut rates to zero by the spring of 2020. Bank of America warns that a 20% to 30% correction (technically a bear market) might occur should the US/China trade deal not arrive this year. That’s a scenario that BlackRock agrees is possible and is warning clients to use bonds as „portfolio ballast“ to smooth out potential short-term volatility.

Lipper Financial and Ed Yardeni (of Yardeni Research) both expect a market pullback of 5% to 9.9% even should a trade deal be reached soon, and say a 10% to 15% correction is possible should one not occur by June.

I personally expect that a deal will be reached this year, though not likely by June, which means that the effects on the economy will be slightly worse than Moody’s base case scenario (-0.5% GDP hit and 2% GDP growth in 2019).

As far as stocks go, I’m not a market timer, but a pullback does appear to be a high probability event right now (given that China has said it has no desire to talk trade deal while the US is targeting Chinese tech firms with parts embargoes) and a 10% to 15% correction by the end of the year is certainly plausible.

What does this have to do with Lazard’s ongoing bear market? Well other than the fact that broader market weakness tends to hurt most blue-chips, 50% of Lazard’s business is asset management, which actually accounts for about 60% of operating profits because it’s much more lucrative.

(Source: investor presentation)

Basically, that means that Lazard’s asset management fees, which are based mostly on AUM, could take a steep hit if the global stock market sells off, as it likely would in unison should the trade wars continue to escalate and threaten a global recession.

That’s especially true given that the fact that 83% of its assets under management are invested in equity funds, which are far more volatile than bonds or illiquid alternative assets.

(Source: monthly AUM report)

On final possible fear that Wall Street has is that the secular trend towards passive management (ETFs are expected to keep growing quickly for the foreseeable future) could potentially result in Lazard’s lucrative asset management fees declining over time.

(Source: BLK investor presentation)

Add it all up and like A.O. Smith, Lazard is facing a perfect storm of negativity that has the market hating it, and the shares trading at the most attractive levels ever (literally). Which is precisely why I’m back pounding the table on Lazard and just doubled my position in the company.

…And Why It’s Likely A Very Strong Buy

First, as always let’s make sure Lazard’s dividend is safe. After all, a high-yield stock that has to cut its dividend is likely to crash and such yield traps are to be avoided like the plague.

CompanyYieldTTM FCF Payout RatioSimply Safe Dividends Safety Score (Out of 100)Sensei Dividend Safety Score (Out of 5)Sensei Quality Score (Out of 11)
Lazard5.4%38%48 (borderline safe = average)4 (safe)8 (Blue-Chip)
Safe Level (by industry)NA60% or less61 or higher4 or higher8 or higher

(Sources: Simply Safe Dividends)

Lazard’s dividend isn’t as safe as A.O. Smith’s due to its business model, which naturally is more volatile and requires higher leverage. Here’s why Simply Safe Dividends (where I’m an analyst) calls Lazard’s dividend safety average.

LAZ’s current net debt-to-capital ratio is 67%, which is on the high side for most companies and appears to leave LAZ with less flexibility to take on more debt should the need arise. On the other hand, LAZ’s net debt-to-EBITDA ratio, which measures how many years of earnings it would take to pay off the company’s debt, is at a healthy level of 2.25 (the lower, the better)… LAZ’s debt level looks okay for now, but the company could run into trouble if earnings fall substantially… Overall, LAZ’s dividend looks to be about as safe as the average company’s. While LAZ is likely a source of reliable dividend income, conservative investors often prefer to have most of their portfolios invested in companies whose dividends appear safer than average.“ – Simply Safe Dividends (emphasis added)

I’m less worried and consider the dividend safe (thus a 4/5 safety rating) due to several factors. The first is a strong balance sheet.

CompanyNet Debt/EBITDAInterest Coverage RatioMoody’s Credit RatingAverage Interest CostReturn On Invested Capital
Lazard2.39.2BBB- equivalent (positive outlook)3.6%18%
Safe Level3.0 or below8 or aboveBBB- or higherbelow ROIC8% or higher

(Sources: Simply Safe Dividends, F.A.S.T Graphs, Gurufocus, Morningstar)

Lazard’s leverage ratio is still below the safe level for most companies and this industry, and its interest coverage ratio is also at a level that doesn’t concern me or Moody’s, whose latest rating was for Baa3 (BBB- S&P equivalent) with a positive outlook. That means Moody’s expects to raise Lazard’s rating should current financial conditions hold.

However, the average interest rates the company is paying mean the bond market is effectively giving it a BBB+ rating. Morningstar’s Michael Wong similarly has little concern about Lazard even during a recession.

The company’s revenue and earnings are cyclical. However, Lazard has a strong restructuring business and little balance sheet risk, as its balance sheet isn’t highly leveraged. In addition, unlike other investment banks, Lazard doesn’t hold a significant amount of securities for trading on its balance sheet. As a result, it is one of the higher quality financials which gives us less concern in the event of a recession.“ Morningstar (emphasis added)

Ok, so maybe Lazard will survive the next economic/market downturn but what about the dividend? Might that not be cut? Not according to the company’s long-term capital allocation strategy that is based on steadily growing the regular dividend over time and supplementing it with annual special dividends ($0.50 to $1.5 per share in recent years) when it has excess cash flow available.

(Source: investor presentation)

What’s more Lazard’s dividend track record (for the regular dividend) is excellent, growing every year since its 2005 IPO, even during the Great Recession when financial firms were slashing or eliminating dividends left and right.

(Source: investor presentation)

As the saying goes „the safest dividend is the one that’s just been raised“ and Lazard raised its dividend 6.8% on April 25th.

(Source: investor presentation)

The company can do that because it’s a cash flow minting machine, posting 34% FCF margins in 2018.

Ok, so maybe a recession isn’t going to kill the company, or even likely cause a dividend cut (though it might be frozen if the recession were severe or long enough). But what about that shift towards passive management that threatens the growth prospects of all asset managers?

(Source: investor presentation)

Well, one-way asset managers adapt to that is through specialization and offering ever more new investment fund options to clients. Lazard has a good track record of doing just that, which is why its one of the few asset managers to consistently grow its assets under management organically in the last few years.

(Source: investor presentation)

Lazard, BlackRock (BLK) and dividend aristocrat T. Rowe Price (TROW) are my top three asset manager recommendations precisely because they either dominate passive management (BLK) or are so skilled at delivering great active fund returns that they continue to thrive even in the age of passive funds.

Ok, so maybe Lazard’s fund assets are still growing organically but what about its fees? Perhaps it’s locked in a race to the bottom and only gaining market share by slashing its average fund expense ratio?

(Source: investor presentation)

While that’s always a risk (what might go wrong with fundamentals) the fact is that over the past 14 years Lazard’s average fund fees have remained relatively stable. In fact, they were about 10% higher in the past 12 months then they were in 2005.

That’s not to say that Lazard isn’t going to face some potentially strong growth headwinds over the next five years, especially if a recession is indeed coming in 2020 or 2021.

CompanyYield (Regular Dividend)5-Year Expected Earnings GrowthTotal Return Expected (No Valuation Change)Valuation-Adjusted Total Return Potential (5-10 Years CAGR)
Lazard5.4%2.7% to 4.2%8.1% to 9.6%12.6% to 20%
S&P 5001.9%6.6%8.5%1% to 7%

(Source: Simply Safe Dividends, F.A.S.T Graphs, Morningstar, management guidance, Yardeni Research, Yahoo Finance, Multipl.com, Gordon Dividend Growth Model, Dividend Yield Theory, Moneychimp, analyst estimates)

Analysts currently expect just 2.7% to 4.2% annualized EPS growth from the company, which I consider reasonable factoring in the possibility of a bear market and mild recession in the US or even globally. However, keep in mind that Lazard’s long-term growth also benefits from a low share price, due to buybacks.

The company has done $745 million worth of buybacks in last five quarters (reducing the share count 4.2%) while LAZ has been in a bear market with another $400 million in buybacks remaining under the existing authorization.

And unlike many company’s who repurchase stock regardless of price, Lazard’s buybacks are indeed masterful capital allocation. That’s due to the company’s historically low valuation.

(Source: Simply Safe Dividends)

Not just is the forward PE trading below its five-year average of 11.1, but the yield is now at an all-time high (due to the recent dividend hike).

(Source: Ycharts)

In other words, there has literally never been a better time for high-yield investors to buy this blue-chip. That’s also true if you look at the trailing PE ratio.

Time PeriodTTM PE Ratio
Today8.7
June 2016 (last big recession scare)8.9
September 2011 (19.6% market correction)14.1
February 2009 (near Great Recession market bottom)16.6

(Source: F.A.S.T Graphs)

Lazard’s current PE ratio is effectively at the lowest level its been since the 2005 IPO, including the worst market crash since the Great Depression. While another bear market might see it fall lower, ultimately there is only so cheap a quality company can trade and today is likely a great time to initiate or add to a position in a diversified and well-constructed portfolio.

CompanyYield5-Year Average YieldEstimated Discount To Fair ValueUpside To Fair Value5-10 Year Valuation Boost (CAGR)
Lazard5.4%3.5%36%55%4.5% to 9.2%

(Sources: Simply Safe Dividends, Dividend Yield Theory, Gordon Dividend Growth Model, F.A.S.T Graphs, management guidance, Moneychimp)

How undervalued might Lazard be, and what kind of long-term valuation boost might that create? Well, dividend yield theory estimates the company is trading at a 36% discount to historical fair value, creating 55% upside. Even if that takes five to 10 years to play out (yield returns to 3.5%) then that would result in shares outpacing earnings/cash flow and dividends by about 6% annually.

What if DYT is wrong and „this time is different“ for the asset management business? That’s always a risk which is why I turn to Morningstar’s industry expects to conservatively estimate the value of Lazard based on its future cash flow (and using some of the slowest growth assumptions on Wall Street).

CompanyCurrent PriceEstimated Fair ValueMoatManagement QualityDiscount To Fair ValueLong-Term Valuation Boost
Lazard$34.85$57 (high uncertainty)Narrow (stable trend)Standard (average, good)39% (4-star stock, very strong buy)5.1% to 10.4%

(Source: Morningstar)

In this case, Morningstar agrees with DYT and estimates Lazard is about 39% undervalued. Due to the high uncertainty around that estimate, Morningstar rates Lazard merely a 4 star, and not 5 star stock on valuation. But at below $34.2, Lazard becomes a 5-star, (very strong buy) under Morningstar’s valuation scale, even adjusting for uncertainty surrounding its near-term financial fundamentals (during a recession).

Again I average DYT and Morningstar to conclude the company is about 38% undervalued, making Lazard one of the most attractive blue-chips buys you can make right now.

Things To Consider

Lazard is a Bermuda domiciled corporation that has chosen to be taxed as a partnership. Thus its dividends are mostly return of capital (tax deferred until you sell) but it uses a K-1 tax form. If you hate K-1s, you should avoid Lazard.

Second, I must reiterate that I’m not a market timer, but a Zen style income investor, meaning I’m not seeking quick profits. That’s because, to paraphrase Yoda

Desire for quick profits leads to disappointment, disappointment leads to frustration, frustration leads to impatience, and impatience leads to costly mistakes and financial suffering.“ – Yoda paraphrase

My only goal is to maximize safe and exponentially growing income over time. Total returns will come naturally from that (since 1954 the Gordon Dividend Growth formula of yield + long-term cash flow/dividend growth = total returns has been relatively accurate).

Buying my stocks at bargain basement prices is another way to boost total returns. According to my valuation-adjusted total return model (based on what Brookfield Asset Management has used for decades) and purely using Morningstar’s conservative DCF estimates, my long-term total returns should be 11% to 18% CAGR (including 20% historical margin of error for this model).

Thus I am not shocked, horrified or disappointed if any of my holdings declines for long stretches of time. Should my stocks go up (UNH up 10% in 5 weeks) then I’m satisfied to be proven right.

If they fall, like LAZ and AOS recently did, then I’m content to buy more ($2,000 buy each and every week as long as my retirement portfolio’s recession protocol isn’t in effect).

Either way, I’m likely to win in the long-term. If my stocks go up immediately (I catch the bottom) then I enjoy capital gains now. If they languish or fall further, I build up a big position at an even lower cost basis and maximize my yield on cost and boost my already substantial portfolio income.

(Source: Simply Safe Dividends)

Income that is growing at a rapid pace over the last decade, including at a double-digit compound rate even during the Great Recession.

(Source: Simply Safe Dividends)

Will I be wrong on some of my stocks? You bet because as even the legendary Peter Lynch (29% CAGR total returns from 1977 to 1990, the second best investor behind Buffett) points out „in this business if you’re good, you’re right six times out of ten.

Risk management is how you ensure winners overcome losers, and your wealth grows over time.

Right now Lazard is about 2% of my portfolio and A.O. Smith about 3%. I’m willing to take each to 5% before I focus on other undervalued blue-chips (something great is always on sale).

I also have a recession plan in place, to allow me to not just sleep well at night during the next economic downturn and bear market, but actually, profit from it. That plan involves zero selling of what I already own, since my dividends are safe and growing, which is why I bought everything in my portfolio.

Anyone who is considering buying any of my recommendations needs to remember to also use appropriate risk management rules and asset allocation.

I am 100% in stocks because of my unique personal situation (such as $15,000 per month in income from 32 sources and $10,000 per month in investable income). I am also 32, have a 50+ year time horizon, and have invested through 3 separate 50+% market/sector crashes. Volatility doesn’t bother me, because I prefer to invest at lower valuations and higher yields.

Most of my readers have far lower risk tolerance which is why asset allocation, in addition to a properly diversified portfolio, is so crucial. The mix of stocks/bonds (including cash equivalents) that’s optimal for you will depend on how much you need to ensure meeting expenses during corrections/bear markets without having to sell stocks.

40% to 60% is a good rule of thumb for most people that balances the long-term return power of stocks with the low volatility and countercyclical nature of bonds.

Let me make very clear that the historical data is definitive on this, diversification/asset allocation is how to protect your wealth during corrections/bear markets NOT MARKET TIMING. JPMorgan is the 4th largest asset manager on earth. They crunched the numbers and found their average investor, mostly due to terrible market timing, saw 1.9% CAGR total returns over the past 20 years.

A 40/60 stock/bond portfolio (ultra conservative and recommended for 80+-year-old retirees) did 2.5 times better, and nearly matched a pure S&P 500 portfolio but with about 50% less annual volatility.

As Peter Lynch explains, time in the market is far more important than timing the market.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

Bottom Line: Short-Term Volatility Is The Best Friend Of Patient, Value-Focused Dividend Investors

Don’t get me wrong, I’m not saying that deep value dividend investing is right for everyone. It requires nerves of steel and the patience of a monk. As Peter Lynch (the second greatest investor in history behind Buffett) pointed out, even great long-term investments can take up to four years just to break even.

There is no way to tell what the market will do in the short-term. Trade war volatility is likely to continue, as it appears no final deal is likely coming soon. Thus it’s possible that a broader market correction could cause A.O. Smith and Lazard to fall even lower.

But what I do know for sure is that both of these niche industry leaders are high-quality companies, with safe and growing dividends, and skilled management teams that should deliver solid long-term cash flow and income growth.

From today’s deeply undervalued levels, which in some cases are already pricing in a recessionary bear market, both of these blue-chips represent low-risk/high probability long-term investments. Ones that should easily deliver double-digit total returns for any investor who is patient enough to wait out the market’s short-term bearishness.

Just remember that even deep value blue-chips can fall during corrections/bear markets, so always practice good risk management and the right asset allocation for your needs. All of my stock recommendations are purely meant for the equity portion of your portfolio and never as bond alternatives.

Disclosure: I am/we are long AOS, LAZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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