Hitting to the Power Alley

At the intersection of Value Investing Drive and Income Investing Lane is a little corner known as dividend growth investing. The concept combines Benjamin Graham's margin of safety with the dividend discount model valuation calculations favored by valuation pioneer Myron J. Gordon. By pulling the concepts of the two masters together, investors can often find themselves hitting in the power alley and beating the market over time. For investors looking for both the deep bench that comes from investing in solid companies at discount prices and the opportunity to get paid to invest, this is a chance to find those few companies with the best of both worlds.

Math made easy
Gordon penned an equation to determine the value of a company with steady and consistently rising dividends. Rearrange his work to solve for "R," the investor's required (or expected) rate of return on a company, and the whole mess simplifies to R = Y + G. In plain English, according to this classic model, an investor's long-run expected return on a company is really little more than the sum of its current yield and its long-run expected dividend growth rate. If a company has a 4% yield and is expected to grow its dividend at 6% a year essentially forever, then the investor could reasonably expect a 10% annual return (4% current yield plus 6% dividend growth) over time, as long as the company's performance holds true to its expectations. There are no guarantees in the stock market, of course, and the companies involved must be able to perform over time for this technique to work.

Every investor determines his or her own expected return rate (the "R" value) for a company. I use 12% for my baseline expected return when screening for opportunities, and then I'll add a fudge factor to that level if a company passes that screen but seems especially risky.

The power
To find the power alley, an investor must wait for the market to lob a softball pitch. The investor should first look for a company where the stock's current yield plus its expected long-run dividend growth rate is greater than that investor's required rate of return for that firm. For the math-inclined out there, if Y + G > R, then the investor has found a company with power-alley potential. By putting the company on sale, it allows the investor to generate returns in excess of his or her expected levels. And because Graham's margin of safety is at work along with Gordon's valuation, the investor is expecting to generate those returns with less risk than would otherwise be expected. It sounds like a winning combination to me.

Putting it to work
Because of that combination of potentially higher returns with lower risk, very few companies trade in the power alley for very long, and an investor must be prepared to swing for the fences when the opportunity comes along. For example, Coca-Cola (NYSE:KO) was recently recommended by Motley Fool Inside Value advisor Philip Durell. While it hasn't declared a dividend since his recommendation, the company has been raising its dividend at a rate a bit better than 9.8% over the past decade, and it's due to announce a new dividend later this month. Presuming Coke raises its dividend a comparable growth rate to recent history, and adding in its 2.4% current yield, it becomes a potential power-alley firm.

In late October 2003, banking giant Bank of America (NYSE:BAC) found itself in the power alley. Following the announcement of its intent to purchase Fleet Boston, the company closed at a split-adjusted $36.79. At a recent price of $46.68, along with total split-adjusted dividends of $2.10 per current share (up 12.5% annualized since that time), investors have seen a 32.6% total return since that announcement. Compared with a 17.6% total return in the Spyders (AMEX:SPY), an exchange-traded fund that tracks the S&P 500, over the same period, investors have done quite well putting their money in the bank's stock.

More recently, while looking for companies in the power alley, I literally stumbled across Talx Corporation (NASDAQ:TALX), an employment and income verification service company. On Dec. 29, 2004, I paid $25.70 per share for a stake in this firm, estimating its intrinsic value closer to $30.00. Following a stellar quarterly report and an announcement of a pending stock split, the company's shares simply skyrocketed, charging past my intrinsic value estimates. It recently closed at $34.84, up a whopping 35.6% in just over a month. During the same period, those pesky Spyders have dropped 2%. Such a quick run-up is the exception, definitely not the rule and, with such a move, the value proposition looks to have vanished. It certainly shows how fleeting the opportunity can be to hit a stock to the power alley.

The one that got away
In early 2003, I was attracted to motorcycle icon Harley-Davidson (NYSE:HDI). The company had built a solid recent history of raising its dividend, and its stock price had slipped to as low as $35.95 in March of that year. What scared me away was a fear that 2003 would be a unique banner year, due to the company's 100-year celebration and the special promotions and products that accompanied the milestone. As I feared the results would be a fluke, I elected not to invest. As it turns out, Harley has capitalized on its successful centennial and has performed well. Recently trading at $60.74, its stock price performance alone has trumped the market. And yes, Harley's dividends have continued to grow over time, as well.

What goes around comes around
While searching for companies to hit to the power alley may not help investors find the next Microsoft, the current Microsoft is starting to look interesting. By replacing its stock options program with an actual stock ownership plan, it signaled its willingness to better align its employees' interests with those of its external shareholders. Additionally, its conversion to a dividend paying stock, the raise in its regular dividend since that conversion, and the massive special dividend it paid out late last year make it appear as though it is willing to directly reward shareholders for the financial risks of investing. [Are you listening, Cisco Systems (NASDAQ:CSCO)? Or would you prefer to remain among the carnage of the dot-com disaster?] While Microsoft's current price is still a bit high for my value-focused tastes, its strong balance sheet, dominant market position, and new focus on shareholder friendliness has placed it prominently on my power-alley watch list.

In the end, what really matters to investors is their risk-adjusted total return over time -- what does an investor expect to end up with, and how much risk did it take to get there? By building a portfolio with the right kind of companies, investors can take advantage of both the value wisdom of Graham and the valuation lessons of Gordon. With batting coaches like that, it just might be possible to maximize those risk-adjusted total returns and hit to the power alley.

Looking for companies that are trading cheaply enough that they might be hit to your power alley? A free trial of Inside Value is just a click away.

Fool contributor Chuck Saletta owns shares of Bank of America and Talx Corporation. The Motley Fool has a disclosure policy.