By: Chuck Carnevale, F.A.S.T. Graphs, Inc.
For many people these are troubled times where fears about our economy and the stock market are at a heightened state. Stock price volatility is higher than we've ever seen it, which only adds to investor nervousness. Therefore, we searched for a safe place for conservative investors to invest. Our due diligence identified five dividend growth stocks that possess stringent quality characteristics, while at the same time have produced strong above-average historical total returns. But more importantly, each candidate had to have future consensus earnings estimated growth rates greater than the S&P 500.
Impeccable Quality and Growth Characteristics
In order to make our list, there were several hurdles that each company had to overcome. The first hurdles were quality hurdles. We used the Value Line Investment Survey rankings where each company had a safety ranking of one, the highest. Also, each company's financial strength rating had to be A+ or A++, and had a debt to equity ratio below 50% of capital. Since many investors consider volatility to be risk, each company also had to have a beta below one.
Additionally, each company had to have a ranking for earnings persistence of at least 90%, but preferably 100%. But even more importantly, each company had to show earnings growth prior, during and after the great recession of 2008. And, each selection had to have achieved 15-year historical EPS growth which was at least double the S&P 500. Each company also had to have increased their dividend each year and paid total cumulative dividends that preferably exceeded, or at the very least, closely matched the S&P 500’s dividends for the 15-year period.
Once a company met our quality characteristics they had to meet strict valuation and performance hurdles. Each company had to have a historical 15-year annualized percentage rate of performance (total return) that was, at a minimum, double the S&P 500. Finally there were two valuation hurdles, beginning and ending, that each company had to meet. Each company had to be trading within a reasonable range of fair value based on earnings at the beginning of 1997, and was required to be currently undervalued based on earnings today.
Summarizing Our Selections
We summarize what we were seeking as follows: We wanted to see if we could find companies of impeccable quality, with below-average volatility and superior track records encompassing both capital appreciation and above-average dividend growth. But, in addition to good historical records, we wanted to offer readers a group of companies that were worthy of further due diligence based on expectations for superior future performance. Finding companies with above-average quality, lower price volatility while simultaneously generating above-average returns represented the “Holy Grail” we sought.
There were several other potential candidates that met most of our requirements that were eliminated usually because they only failed to meet one or two. Procter & Gamble (PG) was overvalued in 1997, as were PepsiCo (PEP), Medtronic (MDT), Coca-Cola (KO) and Johnson & Johnson (JNJ). Generally, it was only due to this beginning overvaluation that caused these companies to fall short of historical performance that was double the S&P 500. Otherwise, the above-mentioned represent additional examples of companies that could be considered for further due diligence based on current low earnings justified valuation.
The following portfolio review highlights five companies that were able to meet our strict and high standards. We have highlighted the annualized performance column in yellow to focus on each of these companies’ superior annualized performance since 1997.
The S&P 500 Benchmark
The following earnings and price correlated graph of the S&P 500 shows how average companies were affected by the recession of 2001 and the great recession of 2008. The average company experienced sharp earnings declines during each of these weak economic periods which led to severe bear markets. Also, episodes of overvaluation coupled with cyclical and erratic earnings results led to volatile, and as we will soon see, anemic results. The orange line on the graphs represents earnings justified valuation. When the black price line is significantly above the orange line, overvaluation is manifest.
The following associated performance results of the above graph tell several stories about the general state of the stock market in recent times. The cyclicality of the earnings of the average company caused the index to cut their dividend three times (shaded red). Overvaluation against an average earnings growth rate of 6% generated anemic capital appreciation of only 3.3%. Although dividends improved the results somewhat, the 4.8% total return, including dividends, was still disappointing for many investors. But these graphs represent the average company, and not the superior companies that we will be reviewing later in this article.
5 Dividend Growth Stocks for Capital Appreciation and Growth of Income
A brief description of each company will be quoted from their respective corporate press releases. A series of F.A.S.T. Graphs™ and a brief commentary on each will be provided to illustrate the historical superiority of each of these selections and illuminate their future potential. Although these "essential fundamentals at a glance" speak volumes about the quality and opportunity that each of these selections offer, they only represent the beginning of a recommended more comprehensive research effort. On the other hand, we believe it is apparent that each of these selections represents excellent investment opportunities, assuming they meet the investor’s goals, objectives and income requirements.
TJX Cos. Inc. (TJX)
“The TJX Companies, Inc. is the leading off-price retailer of apparel and home fashions in the US and worldwide. The company operates 971 T.J. Maxx, 880 Marshall’s, and 369 HomeGoods stores in the United States, 213 Winners, 85 HomeSense, 6 Marshalls and 3 STYLESENSE stores in Canada, and 323 T.K. Maxx and 24 HomeSense stores in Europe.”
The earnings and price of this above-average growing retailer is highly correlated up through August of calendar year 2008. Although earnings flattened, they held up remarkably well during the great recession. Nevertheless, their stock price was almost cut in half creating an extraordinary opportunity to invest. Although current yield might not be high enough for many, strong cash flows and consistent earnings coupled with low debt indicate a well protected dividend with room to grow.
At the beginning of 1997, TJX Companies Inc. (TJX) could have been purchased at its intrinsic value. Even though the entry yield of .8% was low, their yield on cost has expanded rapidly consistent with their above-average earnings growth. This also led to their total cumulative dividends exceeding the S&P 500 and capital appreciation of 16.8% per annum which is more than five times average. Clearly, the stock market and the general state of the economy had little to do with long-term shareholder performance. Superior results were generated by superior operating results.
Although the consensus of 25 analysts reporting to Capital IQ expects earnings growth to average 12%, or one third less than their historical average, this is still more than twice the expectation for the S&P 500 at 5.5% (see Est EPS Growth column on portfolio review above). If these estimates were to come to pass, investors could be rewarded with a double-digit rate of return over the next five years (see calculated 5 yr. Est Tot. Ret at top right of each selection’s Estimated Earnings and Return Calculator).
Wal-Mart stores Inc. (WMT)
"Wal-Mart Stores, Inc. (NYSE: WMT) serves customers and members more than 200 million times per week at 9,667 retail units under 69 different banners in 28 countries. With fiscal year 2011 sales of $419 billion, Walmart employs more than 2 million associates worldwide."
Wal-Mart (WMT) was very fairly valued at the beginning of 1997 before experiencing a three-year period of rapidly rising stock price far in excess of its earnings justified level (orange line). However, even though earnings continued to advance at a steady double-digit rate, Wal-Mart’s stock price had nowhere to go but sideways or down. Therefore, it went first sideways and then drifted down for more than a decade, even though their earnings growth and dividend growth was consistently above average.
The associated performance report on Wal-Mart (WMT) since 1997, shows that shareholders were rewarded with an acceptable and highly above-average rate of return. The dividend was increased every year rewarding shareholders relying on income with a raise each year. However, after the three years 1997, 1998 and 1999, capital appreciation has actually been negative. It's also important to note that Wal-Mart's earnings growth was very recession-resistant and remained very strong through both the recession of 2001 and 2008.
One can only surmise that investors were unwilling to sell this king of all retailers. But, if you bought the stock in 1997, your long-term returns were very attractive. Yet, if you bought the same company with the same impeccable earnings and dividend record three years later, you would have received a negative rate of return. Wal-Mart represents a great lesson on the importance of valuation.
The estimated earnings and