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.
Continued from part one... Q1 hedge fund letters, conference, scoops etc Abrams and his team want to understand the fundamental economics of every opportunity because, "It is easy to tell what has been, and it is easy to tell what is today, but the biggest deal for the investor is to . . . SORRY! Read More
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 return calculator below indicates that Wal-Mart’s current price, or more precisely, valuation, is closer to 1997’s than it is to 1999. This company has not generated poor operating results. Illogical overvaluation is the only reason performance has not been good for the last decade. Today, Wal-Mart looks undervalued with a consensus estimated earnings growth rate by 31 analysts reporting to Capital IQ of 10% per annum.
Walgreen Co. (WAG)
“As of May 31, Walgreens operated 8171 locations in all 50 states, the District of Columbia, Puerto Rico and Guam. The company has 7715 drugstores nationally, including 131 medical facility pharmacies. Walgreens also operates worksite health and wellness centers, home care facilities and specialty and mail service pharmacies. It’s Take Care Health Systems subsidiary manages more than 700 in-store convenient care clinics and worksite health and wellness centers.”
Of the five companies covered in this article, Walgreen Co. (WAG) met all the criteria with the exception of beginning valuation. Nevertheless, it was included in the group because we felt it had a very important lesson on investing to offer. We contend that earnings growth is the major determinant of long-term shareholder returns. However, valuation holds the number two spot in importance. From the graph below we find that even though Walgreens started out richly valued at a PE ratio over 27, earnings growth compounding at 13.9% was able to overcome this headwind in the end.
The other lesson that we believe this example offers is how important it is to get valuation right. Very similar to the Wal-Mart story above, excessive overvaluation in the late 90s and into calendar years 2000 and 2001 crimped investor returns. In other words, Walgreens, the business, did fine, while Walgreens, the common stock, struggled with valuation issues. Furthermore, note that Walgreens’ earnings growth stayed positive through both the recession of 2001 and the great recession of 2008.
In spite of the overvaluation cited above, Walgreens did deliver shareholders a rate of return that was more than double the S&P 500. Dividends also grew each year, however, beginning overvaluation did cause total cash dividends to fall slightly behind the S&P 500 (note that due to rounding it shows that the dividend stayed the same from 2000 thru 2002 – the cash dividend column does show the moderate increases).
The consensus of 24 analysts reporting to Capital IQ expects Walgreens to continue to grow earnings in excess of 13% per annum. The biggest difference with Walgreens today versus Walgreens in early 1997 is better valuation. After being so overvalued for so many years, Walgreens’ consistent earnings generation capability coupled with today’s more reasonable valuation holds the promise for very attractive future returns and dividend growth.
General Dynamics Corp. (GD)
“General Dynamics, headquartered in Falls Church, Virginia, employs approximately 88,000 people worldwide. The company is a market leader in business aviation; land and expeditionary combat systems, armaments and munitions; shipbuilding and marine systems; and information systems and technologies. More information about the company is available on the Internet at www.generaldynamics.com.”
In early 1997 General Dynamics’ stock price was very reasonably valued in relation to its earnings justified value. Furthermore, stock price consistently tracked General Dynamics’ earnings growth with only a few bouts of volatility until the great recession of 2008. However, the great recession of 2008 generated a strong stock price overreaction, in our opinion. Consequently, the recession, coupled with fears of defense spending cuts, have created what appears to be a very attractive long-term buying opportunity at its current single-digit PE valuation.
General Dynamics’ strong and consistent record of earnings growth enabled them to reward shareholders at more than twice the rate of the S&P 500 since calendar year 1997. This is in spite of the fact that current undervaluation has dampened long-term shareholder returns, in our opinion.
The consensus of 25 analysts reporting to Capital IQ expects General Dynamics Corp. (GD) to grow earnings over the next five years at approximately 9% per annum. This is a significant discount to their historical norm of over 13% per annum which we feel reflects the potential impact of defense spending cuts. Nevertheless, a 9% above-average earnings growth rate should command a PE ratio at least in line with the S&P 500 PE of 12.7, or higher. General Dynamics Corp. has a strong balance sheet and generates cash flow in excess of earnings which protects the dividend and supports our view of a higher justified valuation.
Becton Dickinson & Co. (BDX)
“BD is a leading global medical technology company that develops, manufactures and sells medical devices, instrument systems and reagents. The Company is dedicated to improving people’s health throughout the world. BD is focused on improving drug delivery, enhancing the quality and speed of diagnosing infectious diseases and cancers, and advancing research, discovery and production of new drugs and vaccines. BD’s capabilities are instrumental in combating many of the world’s most pressing diseases. Founded in 1897 and headquartered in Franklin Lakes, New Jersey, BD employs approximately 29,000 associates in more than 50 countries throughout the world. The Company serves healthcare institutions, life science researchers, clinical laboratories, the pharmaceutical industry and the general public. For more information, please visit www.bd.com.”
Becton Dickinson & Co. (BDX) has produced a very consistent record of an above-average earnings growth rate of 11.9% since calendar year 1997. From the graph below we can see that the market has traditionally valued this quality healthcare company in line with earnings plus dividends (dividends represented by the light blue shaded area). However, today Becton Dickinson shares can be purchased slightly below their earnings justified valuation (orange line), which in effect offers the dividend kicker for free.
This opportunity has only occurred a few times since calendar year 1997, during most of calendar year 2000, and then again in the latter part of 2002. From that earnings and price correlated graph, both of these time frames represented an excellent opportunity to purchase shares of this high-quality above-average growing business.
Becton Dickinson & Co. shareholders earned a total return since 1997 that was more than twice the S&P 500. Also, their consistent record of dividend increases has expanded their yield on cost over six-fold. Furthermore, their payout ratio below 30% provides an opportunity for continued dividend expansion in the future.
Becton Dickinson (BDX) is a high-quality healthcare company with a significant demographic opportunity in front of them. Consequently, the consensus of 21 analysts reporting to Capital IQ expects them to continue to grow earnings at double-digit rates over the next five years. With their current valuation among the lowest it’s been in decades, a long-term opportunity to invest in this quality business appears very attractive.
Summary and Conclusions
One of the primary objectives of this article was to illustrate that above-average returns were capable of being achieved without sacrificing either quality or safety. In this same vein, the companies highlighted in this article have proven to be much less volatile than the average company as represented by the S&P 500, while simultaneously producing significantly greater long-term returns. In other words, as conservative as these companies are relative to stocks of companies in general, they were still capable of racking up superior long-term returns.
Investors don’t need to expose themselves to excessive levels of risk in order to outperform. The best way to accomplish outperformance, in addition to focusing on quality characteristics, is to get valuation right. The earnings and price correlated graphs above show that an investor can overpay for even the best of companies. When you overpay, the company can provide all the operating success and excellence that you could ever dream of, and you could still lose money at worst, or earn very poor returns at best.
The secondary objectives of this article were to provide factual insights into the great debate between the so-called “dividend growth zealots” versus the “total return zealots.” In essence, we believe this article provides evidence that investors can have their cake and eat it too. Above-average long-term total returns can be achieved without sacrificing dividend income. In essence, it all boils down to getting the equation between earnings and intrinsic value correctly calculated. But finally, and perhaps even most importantly, it’s all about making decisions one stock at a time in contrast to vague notions about stock markets or economies in general.
In closing, we ask that the reader consider how each of these carefully selected companies was capable of performing on an operating basis during very aberrant times and conditions. Most companies since late 1997 suffered from excessive overvaluation which severely limited their ability to generate strong shareholder returns. Not so for our five selections; for whatever reasons each of them was reasonably priced in 1997.
But perhaps the most telling point of all is how recession-resistant each of these companies proved themselves capable of being. Each of these great businesses went through a period of irrational exuberance followed by two recessions while continuing to prosper and grow their businesses through it all. Therefore, we believe the moral of the story is for investors to make their selections carefully, and for goodness sake, pay attention to the principles of sound valuation.
Disclosure: Long TJX, WAG at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.