Recent Buy (16)
Purchases for my FI Portfolio have been few and far between the last few years. That's not for lack of opportunities or desire rather it had to do with our lives being on a roller coaster. However, there's a light at the end of the tunnel as our main goal for this year is to get rid of all non-mortgage debt and then refocus our energy towards building up the portfolio.
We aren't contributing fresh capital to our investments just yet as we're focused on getting rid of our non-mortgage debt. However, that doesn't mean that we're not able to make new purchases thanks to the dividends that keep rolling in from our other positions and some sales that we've made. Although I'm hopeful to start making at least one regular purchase each month starting in September!
One of my goals for my FI Portfolio for 2019 is to build up the positions rather than build out the number of positions. Essentially I want to increase my exposure to the companies that I own instead of many smaller positions that make it hard to be motivated to monitor the company. With the dividend growth strategy I still think it's fine since the bulk of the work is done upfront; however, I still think that in general the less the better.
While that's my plan, and overall I've stuck with it, I happened to find a new company that I believe is absolutely incredible.
On October 22nd I initiated a new position by purchasing 6 shares of Paychex (PAYX) at $84.00 per share. The total cost basis for this initial purchase was $504. Based on the most recent quarterly payout of $0.62 these shares carry a YOC of 2.95% and I can expect to receive $14.88 in dividends over the next year. Paychex is a Dividend Challenger with 9 consecutive years of dividend growth.
You can read my full business and valuation analysis of Paychex over on Seeking Alpha.
Due to this purchase my FI Portfolio's forward 12-month dividends increased to $7,653.39.
While Paychex's dividend growth streak is just 9 years old, they do have a lengthy streak of paying the same or higher dividend. Considering the somewhat recent pause in their dividend growth surrounded the financial crisis, I'm more tolerable of that decision.
As one of the leading payroll, HR and benefits outsourcing companies, it shouldn't come as a surprise that dividend growth goes as the economy does.
Of the 25 1-year periods since 1994, Paychex's dividend growth has ranged from 0.0% to 80.0% with an average of 19.3% and a median of 11.0%.
Expanding the time frame out to the 21 rolling 5-year periods annualized dividend growth is still quite volatile. Annualized dividend growth has ranged from 2.2% to 50.0% with an average of 18.6% and a median of 15.3%.
The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1994 can be found in the chart below.
One valuation method that I like to use is dividend yield theory. The idea behind dividend yield theory is that large, stable companies will see their dividend yields revert to their mean over time. So when the yield is higher than "average", shares are undervalued and when it's lower than "average", shares are overvalued.
The 5-year moving average dividend yield for Paychex currently sits at 3.17% while the YOC for my purchase is 2.95%. Based on dividend yield theory that suggests a fair price of $78.23 or roughly 7% lower than my purchase price.
The fair value range based on dividend yield theory corresponds with yields of 2.85% to 3.48%. Using the current annual payout of $2.48 gives share prices of $71 - $87. My purchase price at $84 is on the upper end of fair value.
Based on a quick and dirty Gordon Growth Model calculation Paychex needs to grow the dividend at 6.85% per year in order to generate 10% annual returns which I believe is easily achievable over the long term.
Looking at a multiples analysis the valuation isn't all that compelling. Based on estimates of $3.10 for FY 2020, the current year, and $3.34 for FY 2021 my purchase was made at a 27.1x and 25.1x P/E, respectively.
I've also started looking at multiples using enterprise value. The reason I like using enterprise value is that it encapsulates purchasing the entire business, both the equity and the debt, net of cash. I think this better encapsulates the true cost to buy the business.
Using EV/EBIT, Joel Greenblatt's Magic Formula valuation metric, Paychex is trading at a 22.2x EV/EBIT multiple or a 4.5% EBIT yield. Looking at EV/EBITDA it's 19.6x or a 5.1% EBITDA yield.
Paychex has been an excellent business to own. The sector is ripe for further consolidation with smaller payroll/HR outsourcing companies as well as businesses that handle it in house. Paychex's management estimates the total potential customers in the markets they currently serve to be 10 million. Compared to their current client base of just 670,000 there's huge potential here.
Couple the potential market size with the fact that Paychex regularly has free cash flow margins in the mid to upper 20's and a free cash flow ROIC in the low 40's and we have an extremely strong cash generating business.
Management is aggressive with their payout ratio by targeting an 80% net income payout. So I don't expect the dividend growth streak to remain in tact during the next recession, although I don't expect there to be a cut either.
I purposely kept the initial purchase small because the valuation isn't exactly the most attractive right now. However, at my $84 purchase price I do think that shares are on the upper end of fair value which is a reasonable place to add shares of a quality company.
The reason that I added shares now despite the so-so valuation is because I know myself all too well. I can't tell you how many times I've missed opportunities on some high quality businesses because I just didn't notice them when they occurred. However, now that I have a small stake in Paychex it will force me to pay more attention to how the share price is behaving in regards to what I believe the value of the business is.
I've started compiling the dividend history, growth rates and dividend yield theory for many dividend growth companies. Paychex's can be found here and the remaining companies that I've already gathered the data on can be found here. As new companies are added the list will be updated.
What do you think of my purchase of Paychex? Have you ever purchase a very small position with the intent to pay more attention for better buying opportunities?