20 Dividend Growth Stocks To Buy Today For Your ......2015/08/07 · 20 Dividend Growth Stocks To...

20 Dividend Growth Stocks To Buy Today For YourRetirement Portfolios: Part 1

August 7, 2015by Chuck Carnevaleof F.A.S.T. Graphs

Introduction

We are in the seventh year of a strong bull market, and stock valuations have generally become extended as measured bythe S&P 500. It is undeniable that the overall market’s valuation today is higher than it has been in years. However, eventhough that statement may be true in the general sense, it does not mean that every stock in the market is overvalued.Nevertheless, there are many investors unwilling to invest in any common stocks simply because they believe the marketis too high, even though there may be many individual stocks available at attractive valuations.

This all-stocks-are-too-high attitude is even more pervasive when it comes to dividend growth stocks. Many are arguingthat because interest rates are so low, investors desirous of income have driven up the valuations of all blue-chip dividendgrowth stocks to dangerously high levels. Although I will agree that this is in fact true for perhaps a majority of blue-chipdividend growth stocks, it is not true for all of them as I will illustrate later.

With this in mind, I conducted an extensive search of all prominent dividend growth stocks looking for value and attractivedividend yields. I went through the entire CCC lists of Champions, Contenders and Challengers presented by fellowSeeking Alpha author David Fish, and screened the entire universe of more than 20,000 companies in the F.A.S.T.Graphs™ research tool universe. My objective was to find 20 attractively-valued high-quality dividend growth stocks thatcould produce an average yield greater than 3% in the aggregate. Although attractive value and above-average yield wasadmittedly difficult to find, I was able to come up with my list of 20.

Principles of Sound Valuations on Common Stocks

Examining the same concept expressed in my introduction from a different perspective, rational investors recognize that allstocks do not move in tandem with the market. This is especially true over the longer run. In my experience I have anobserved and learned that there are two primary forces that generate long-term returns on an individual stock (business).The first and foremost driver of return is the level of operating success of the business behind the stock. The secondprimary driver is the price or valuation you pay to buy the stock relative to its operating business success.

A company’s operating success is typically reflected by its earnings growth rate per share over time. In the same vein,valuation is often measured as a function of the multiple of earnings you pay to buy the company’s operating success. Thecompany’s earnings multiple is expressed as a P/E ratio which is simply the company’s price divided by its earnings.

However, the more important aspect of the P/E ratio is that it also serves as a quick and simple measurement of the returnon your invested capital that a company’s total earnings provide when expressed as earnings yield. This is also a simplecalculation which is just the inverse of the P/E ratio. In order to determine a company’s earnings yield, you invert theformula and divide earnings by price (E/P = earnings yield). A quicker and easier way to calculate earnings yield is tosimply divide the number 1 by the P/E ratio. For example, if you divide the number 1 by a P/E ratio of 15, you get anearnings yield of 6.67% rounded (1/15=6.67).

Now, at this point it should be understood that calculating earnings yield does not simultaneously indicate that by investingas a shareholder/ partner in a company that you are entitled to all of its earnings. Instead, earnings yield is a usefulindication of whether or not the company’s earnings power is adequately compensating you for the risk you are taking incomparison to alternative investment options.

One method where this calculation becomes especially useful is as a measurement of the risk premium a stock offers inrelation to prevailing risk free rates. The most common risk free measurement is the 10-year T-bill. The current rate on a10-year T-bill is 2.23%. Therefore, rational investors would expect a company to offer a risk premium earnings yield that issignificantly higher than 2.23%. This same logic would equally apply to evaluating the valuation of an index like the S&P

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500 just as it does to an individual stock.

Another way to utilize the earnings yield in order to evaluate fair valuation is to compare it to the long-term average returnthat stocks have historically generated. Depending on the timeframe being measured, the long-term average return onstocks is somewhere in the range of 6% to 8%. Keep in mind that this is the average meaning that some stocks havehistorically done better and some stocks have done worse.

But more importantly, this indicates that it is no coincidence that the average P/E ratio of the S&P 500 has historically beenapproximately 15. Consequently, as a general rule of thumb, and depending on a given company’s earnings growthpotential and quality characteristics, a P/E ratio of 15 is a reasonable indication of fair or sound value. Although this is not aperfect indicator of fair value, I have learned to trust a P/E ratio of 15 to be an objective indicator of sound value for mostcompanies.

However, just as it is with all rules of thumb, there are rational exceptions or adjustments that can be made. For example, itmight be rational to pay a modest premium for impeccable quality. Additionally, it might also be rational to accept amoderately higher valuation on a blue-chip dividend growth stock when its yield is attractive enough, coupled with a historyof raising its dividend every year. Furthermore, with interest rates as low as they are today, the spread between the riskpremium on stocks versus risk free 10-year T-bonds may also be high enough to indicate a willingness to pay a modestpremium valuation on stocks.

To summarize, a P/E ratio of 15 can serve as a reasonable valuation guide or reference. However, it is not perfect, andtherefore should not be thought of as an absolute. Instead, I contend that it be thought of as a fair valuation reference or afirst glance indication that fair valuation may be evident on a stock. With a P/E ratio of 15 serving as a valuation baseline,appropriate adjustments can and should be made based on many other factors, such as the ones I discussed above. Butmost importantly, the investor should be cognizant that a P/E ratio higher than 15 represents a lower earnings yield, andconsequently the potential for earning a lower future total rate of return. Of course, the opposite is also true.

The S&P 500 a Valuation Perspective

The blended P/E ratio of the S&P 500 Index is 17.6, therefore, clearly moderately higher than my baseline fair value P/Eratio of 15 previously discussed. This clearly indicates overvaluation; however, I would argue that this does not indicateespecially dangerous levels from a long-term perspective. On the other hand, this would indicate the potential for a short-term correction of 15% or greater if the market was to move back to a fair value P/E ratio of 15. This is vividly revealed andcalculated on the earnings and price correlated graph on the S&P 500 below.


However, if we take a slightly longer-term view out to calendar year-end 2017 and run a return calculation assuming anormal P/E ratio of 15 based on consensus analyst earnings estimates, we could see a positive total annual return inexcess of 4%. This is below the long-term average returns for the index, but it is at least positive.


Taking a slightly more optimistic view, if we applied a historical normal P/E ratio of 16 as reflected in the long-term graphabove, the S&P 500 index could generate a total annual rate of return of 6.83%. This would be consistent with the long-term average return of the index.


Regarding the accuracy of analysts’ earnings estimates on the S&P 500 index, the following analyst scorecard suggestswe have a better than 70% chance that they might get it right. The scorecard is based on analysts’ historical accuracyrecords when making forecasts one year forward and two years forward. There is a 10% accepted margin for error on theone year forward estimates, and a 20% accepted margin for error on the two years forward estimates.


Top 10 High-Quality Blue-Chip Dividend Growth Stocks with an Average Aggregate Yield of 3%

In this part 1 of this 2-part series I will present my top 10 blue-chip dividend growth stock research candidates in order ofthe highest S&P credit rating to the lowest. All but 2 of these top 10 blue chips are currently available at my fair valuationbaseline P/E ratio of 15 or lower. When I cover them individually I will argue that the two exceptions, Johnson & Johnsonand Procter & Gamble, could be considered worthy of a modest premium valuation.

The average current dividend yield of this top 10 list is slightly in excess of 3%. But more importantly, most of them areDividend Champions or Aristocrats with long histories of increasing their dividends every year. In each specific example, Iwill present calculations of potential future total returns on the same basis that I did with the S&P 500 index above.


Johnson & Johnson (JNJ)

Johnson & Johnson with its AAA credit rating and low debt-to-capital ratio is arguably the highest quality dividend growthstock on the planet. Although it’s blended P/E ratio at 16.5 is moderately above my baseline valuation reference, I believethe company is worthy of this modest premium especially considering its current yield of 3%.


On the other hand, when you pay a premium for quality, you must simultaneously be prepared to accept a lower rate ofreturn as a result. The following rate of return calculation based on consensus estimates would indicate a 5% annual totalreturn through investing in Johnson & Johnson out to 2017. It should be noted that the majority of this return would besupplied by Johnson & Johnson’s expected total cumulative dividends. Consequently, I offer Johnson & Johnson as a saferesearch candidate offering above-average yield.

Regarding analyst estimates, the following analyst scorecard indicates a perfect record on this bluest of blue-chips dividendgrowth stock. Consequently, I offer the expectations of the above calculated total annual return with high confidence.

Wal-Mart Stores Inc. (WMT)

High-quality dividend growth stock Wal-Mart Stores Inc. has fallen over 14% since the beginning of the year as a result ofrecent earnings weakness. This brings it comfortably down to my baseline fair valuation level.

Wal-Mart’s earnings are expected to recover next year and the following two years thereafter. Assuming a fair value P/Eratio of 15 based on consensus earnings estimates out to 2017 indicates a total annual rate of return in excess of 7%.

The analyst scorecard on Wal-Mart is almost as impressive as what we saw with Johnson & Johnson. However, it shouldbe noted that the only miss that analysts recorded since calendar year 2000 was for the last fiscal year when earningswere slightly down.


Cisco Systems, Inc. (CSCO)

Cisco Systems Inc has only paid a dividend since fiscal year 2011. However, its dividend growth rate has been impressive.With a current P/E ratio of 13 and a dividend yield of 3%, I believe Cisco represents an excellent value at these levels.

It should be noted that Cisco has only commanded a historical normal P/E ratio of 14 since fiscal year 2007. This is clearlybelow my fair value baseline P/E ratio of 15. However, even if you only assume that Cisco’s stock price moves to a P/Eratio of 14 by fiscal year-end July 2018, and further assume that analysts estimates are correct, this research candidateoffers the potential for double digit returns in excess of 12% per annum.


It was not a surprise to see that the analysts scorecard on Cisco was not perfect. After all, this is a tech stock andtherefore, prone to moderate cyclicality. Nevertheless, the company’s low valuation and 3% dividend yield indicate that AA-rated Cisco is attractive at current levels.


International Business Machine (IBM)

IBM, once considered one of the bluest of blue chips, has been recently maligned due to earnings weakness. However, Ibelieve that IBM’s extremely low valuation and high dividend yield warrant consideration.

When calculating the potential future return on IBM out to fiscal year-end 2017, I chose to utilize a conservative P/E ratiovaluation only moving to 12.8. Although analysts expect only moderate growth for the next couple of years, today’s currentlow valuation would indicate high double digit return potential.


Considering that future growth expectations are rather low, coupled with a reasonably high scorecard, I have confidencethat IBM represents an attractive long-term opportunity. To be clear, I believe that much of the risk associated withinvesting in IBM is already reflected in its low valuation.


The Procter & Gamble Company (PG)

Procter & Gamble is a blue-chip dividend growth stock that has historically commanded a premium valuation. Recentsoftness in earnings’ performance has driven the stock down approximately 10% since the beginning of the year. Althoughthis blue chip offers little in the form of growth, its dividend yield of 3.5% is worthy of consideration.


Utilizing the company’s historical normal P/E ratio of 17.8 as a target, Procter & Gamble offers the potential to generateannual returns in excess of 7% out to fiscal year-end June 2018. However, it should be noted that more than half of thatreturn is expected to come from dividends.

The most comforting aspect of the analyst scorecard on Procter & Gamble is the 2-year forward forecast record.Consequently, this gives me confidence that Procter & Gamble might deliver on analysts’ expectations over the nextcouple of years.

Royal Bank of Canada (RY)

Royal Bank of Canada is considered one of the best Canadian banks. I found this research candidate interesting becauseit is a dual-listed security. The following earnings and price correlated FAST Graph looks at Royal Bank as it’s listed on theNew York Stock Exchange. Consequently, this is the graph that would be best utilized by US residents. Note that all data ispresented in US dollars (USD). Low valuation and high current yield is the primary attraction.

Once again, utilizing a discounted historical normal P/E ratio of only 12.3 would indicate the potential for double digitreturns out to fiscal year-end October 2017 in excess of 12% per annum. High dividend yield and low valuation is theattraction here.


The analyst scorecard on Royal Bank of Canada has been exceptional. Consequently, I have confidence that futureearnings forecasts are reasonable.

For those investors domiciled in Canada, the Royal Bank presents a more consistent historical record of earnings anddividend growth. The following earnings and price correlated graph illustrates Royal Bank on the Toronto Stock Exchange(TSX) and all data is presented in Canadian dollars (CAD).

Devoid of potential currency exchange headwinds, the Canadian version of Royal Bank is more consistent than what wesaw on the New York Stock Exchange version. Nevertheless, the return potential for both US and Canadian citizens aresimilar.


S&P Capital IQ only provides analyst scorecard data on one year forward estimates for the TSX listing. Nevertheless,analysts have been accurate with their forecasts.


Cummings Inc. (CMI)

Cummings Inc has a moderately cyclical record of earnings growth. However, its record of dividend growth has beenconsistent and strong. The company’s recent earnings and revenue beat seems inconsistent with its recent weak priceaction. Consequently, its low P/E ratio and above-average dividend yield appear attractive.

Leading analysts reporting on Cummins appear to be very upbeat about their earnings over the next couple of years.Consequently, this A+ rated dividend growth stock with a low debt-to-capital ratio and a dividend yield over 3% appearsquite attractive in today’s overvalued environment.


However, due to the cyclical nature of this company’s operating history, the analyst scorecard has not been as accurate aswe’ve seen with other companies. Therefore, prospective investors should monitor future earnings reports closely. On theother hand, current low valuation and dividend yield might mitigate some of that potential risk.


Qualcomm Incorporated (QCOM)

Qualcomm’s current low valuation is somewhat justifiable based on its recent earnings reports. Nevertheless, the companyappears attractively-valued with a dividend yield above 3% and a consistent record of dividend increases since theyinitiated one in 2002.


If we assume that Qualcomm trades at its historical normal P/E ratio of 18 by fiscal year-end September 2017, the futurereturn potential is extraordinary. A quick glance at the historical earnings and price correlated graph would indicate that thisis not the first time that Qualcomm experienced a moderate earnings drop.

The 1 and 2 year forward analyst scorecard on Qualcomm does indicate some caution. Nevertheless, low valuation andhigh dividend yield indicate this candidate as an attractive opportunity.


Archer Daniels Midland Company (ADM)

The primary attraction motivating me to include Archer Daniels Midland was its fair valuation P/E ratio and prospects for areturn to growth next fiscal year. Additionally, in spite of a moderately cyclical record of earnings, this Dividend Championhas consistently increased its dividend for 40 consecutive years.

In spite of leading analysts expecting a flattening of earnings in fiscal year 2017, Archer Daniels Midland still calculates outto a total annual rate of return in excess of 7%. The real attraction to this dividend candidate is its long history of dividendincreases.

The analysts’ record of forecasting future earnings is positive, but not as consistent as we saw with other companies on thelist. Nevertheless, the real story with Archer Daniels Midland is reasonable valuation and a long record of increasing itsdividend.


AFLAC Incorporated (AFL)

Aflac is a financial that has suffered with low valuation since the Great Recession of 2008. Additionally, earnings growthhas been weak over the past several years. Nevertheless, Aflac is a Dividend Champion that has consecutively increasedits dividend for 32 straight years.

Even when you assume that Aflac will continue to trade at a discounted P/E ratio to the market average, the company stilloffers the opportunity for average total returns. However, even in spite of low future earnings growth expectations, if thecompany were to once again be valued at a market multiple P/E ratio of 15, the annualized total return would exceed 23%per annum. Consequently, I consider this an attractive long-term opportunity for the patient dividend growth investor.


A strong analyst scorecard contributes to my confidence in analysts’ forecasts on Aflac. Consequently, I see a lowdownside potential with a possibility of significant long-term upside.


Summary & Conclusions

In this part 1 of a 2-part series I presented the first 10 of 20 attractively-valued high-quality dividend growth stocks with anaverage aggregate current yield exceeding 3%. In part 2, I will present 10 additional fairly valued dividend growth stocks,some of which offer higher dividend yields as I move down the quality chain. The fairly valued research candidates I willpresent in part 2 will offer an average aggregate current dividend yield exceeding 4.3%.

Assuming an equal investment in each of the 20 research candidates provides an average aggregate dividend yield of3.66%. Although each candidate was primarily suggested based on the merit of fair or attractive valuation, the 10 researchcandidates in this article was primarily focused on quality. In part 2, the 10 candidates presented were focused primarily oneither yield or total return.

Consequently, the primary objective behind both articles is that there are fairly valued common stock opportunities even intoday’s moderately overvalued market. Admittedly, it is getting very difficult to find attractive valuation at any quality level.Nevertheless, I believe that the research candidates presented in this series are worthy of consideration for those retiredinvestors primarily focused on income. However, thanks to fair valuation, I believe this group of 20 dividend growth stocksalso offers a reasonable opportunity for capital appreciation. Given the current high valuation of the S&P 500, I believe thisgroup of stocks also provides the opportunity for market-beating future total returns as well.

(c) FAST Graphshttp://www.fastgraphs.com


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