So the stock market collapse that was supposed to happen with a Donald Trump election never happened.
This is why I “ignore the noise”.
All of the pundits out there are, collectively, noise.
Nobody knows what’s going to happen to stock prices today… tomorrow… or 10 years from now.
[ad#Google Adsense 336×280-IA]That includes yours truly.
This is exactly why I focus instead on high-quality dividend growth stocks, operational business fundamentals, and valuation.
The first part of that equation is made a lot easier when you’re using David Fish’s Dividend Champions, Contenders, and Challengers list as your stock “shopping list”.
Mr. Fish is an incredible contributor to the investor community, and has compiled information on more than 700 US-listed stocks with at least five consecutive years of dividend increases. Many of these stocks, however, have decades of dividend increases under their respective belts.
By focusing on these stocks, I’ve been able to personally build a six-figure portfolio that generates enough dividend income to cover the majority of my core personal expenses.
At 34 years old, I’m essentially financially free.
I love these stocks because, first of all, you’re typically working with great businesses.
After all, you can’t write out bigger and bigger dividend checks to your investors without generating the increasing cash flow needed to cash those checks. And you can’t generate increasing cash flow for years on end without doing a lot of things right.
Another major reason is because the growing dividend income these stocks generate on my behalf provides a great source of completely passive income.
Moreover, this dividend income is totally disconnected from the stock market.
I can ignore the noise because dividends don’t fluctuate like stock prices – and dividends are funded by business operations, not investor sentiment.
One simply has to make sure the operational business fundamentals (profit growth, indebtedness, margins, etc.) are such that growing dividend income is highly likely for at least the foreseeable future.
But it’s that last piece of the equation, valuation, that is just as important as anything else.
Stocks are like just about anything else in life in that they have a price and they have value.
But whereas price is simply what you pay, value is what you’re getting in return.
Value gives context to price. Value tells you whether or not the price paid is appropriate.
We internally value things pretty much every day. Every transaction that someone is involved in naturally triggers this mechanism where someone is trying to decipher whether the price they’re paying for something is appropriate or not.
Well, that’s perhaps never more important than when you’re buying stocks.
Specifically, one should aim to buy a high-quality dividend growth stock precisely when it appears to be undervalued.
Undervalued simply means the stock is priced less than it’s worth.
An undervalued dividend growth stock can offer many benefits to the long-term investor.
Think a higher yield, greater long-term total return prospects, and less risk.
That’s because price and yield are inversely correlated; all else equal, a lower price will equal a higher yield.
This higher yield means more income in the investor’s pocket both now and later.
And it also positively impacts one’s long-term total return prospects, since yield is one of two components to total return.
The other component, capital gain, is also positively impacted by virtue of the upside that exists between the lower price paid and the higher value of the stock. There’s a vacuum that exists there that, over time, is likely to be filled as investors realize how cheap the stock is. If that vacuum is filled, that’s capital gain (also known as profit).
Of course, paying less incurs less risk.
You’re risking less capital when you shell out less coin.
Furthermore, an undervalued stock should offer a margin of safety.
That means a company would have to do something wrong and permanently impair its value before your investment would start to look poor.
But since high-quality companies don’t typically do something like that very often, the odds are in your favor.
With all this said, it might seem like it’s difficult to know when a stock is undervalued.
But that’s not necessarily so.
For instance, fellow contributor Dave Van Knapp put together a series of lessons on dividend growth investing a while back, and one of these lessons pertains specifically to valuing dividend growth stocks.
If you haven’t already checked it out, it’s definitely worth a read.
Since I’m eating my own cooking here, I’m always on the lookout for a high-quality dividend growth stock on Mr. Fish’s CCC list that appears to be undervalued.
That way I can potentially boost my current and ongoing income, experience stronger long-term total return, and risk less.
Well, there appears to be a dividend growth stock that offers all of that right now…
United Technologies Corporation (UTX) is a diversified conglomerate that manufactures and markets a variety of products across the building systems and aerospace industries.
United Technologies is a terrific and super interesting company.
They’re diversified across disparate industries.
Their brands include Carrier HVAC systems, Otis elevators and escalators, and Pratt & Whitney aircraft engines.
In addition, the company manufactures a number of ancillary products, like landing gear, flight control systems, and security systems for residential and commercial buildings.
I say it’s a super interesting company not just because of its diverse products; the company is poised to capture a lot of growth from two huge global trends: urbanization and air travel.
From everything I’m reading, it seems highly likely that more people are going to be living in bigger cities in the future, which requires us to build up rather than out.
And it’s also likely that more people are going to continue taking advantage of air travel. This will not only be more attractive due to our global economy and increasing global population, but it’s also more accessible than ever before.
I say it’s a terrific company because of its longstanding track record of growing profit and sharing that wealth with shareholders in the form of growing dividends.
Indeed, the company has paid out growing dividends for 23 consecutive years.
So while a good chunk of the business is exposed to economic cycles, its diverse, conservative, and high-quality nature allows it to continue paying out bigger checks to shareholders year in and year out.
And what’s really wonderful is that these dividend increases aren’t just pittance; shareholders are getting really solid “pay raises” that are definitely well in excess of inflation, which increases one’s purchasing power.
Over the last decade, the company has increased its dividend at a compound annual rate of 11.3%.
On top of that, the stock currently offers a yield of 2.44%.
While not monstrous, that’s a very appealing yield when you think about it.
It’s higher than the broader market, and it’s also almost 20 basis points higher than the stock’s own five-year average yield. Plus, combining a yield like that with double-digit growth tends to lead to really strong gains in both income and wealth over the long run.
The company is expecting to earn between $6.30 and $6.60 per share this fiscal year (2016). At the midpoint of that guidance, the payout ratio is just 41%, so there’s plenty of room for the company to continue handing out sizable dividend increases for the foreseeable future.
But in order to really get a feel for what kind of dividend growth to expect moving forward, we need to know what kind of underlying growth the business is generating.
So we’ll first take a look at what United Technologies has done over the last decade. And then we’ll compare that to a near-term forecast, which should help us come up with a reasonable expectation moving forward.
This will help us to not only determine what kind of dividend growth to expect, but it will also help us later value the business and its stock.
United Technologies has grown its revenue from $47.829 billion to $56.098 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 1.79%.
This isn’t great revenue growth, although some of it can be explained quite simply.
The company sold its Sikorsky helicopter business to Lockheed Martin Corporation (LMT) for $9 billion in FY 2014.
This business accounted for approximately 11% of FY 2014 revenue, so the top line took a hefty dip as a result.
However, I think the sale was a great idea. It didn’t generate great margins for the company, and it didn’t seem to fit into anything else they were doing. It also reduced their exposure to the US government.
The proceeds of that transaction have mostly been directed toward share buybacks, which help reduce the overall shock of the revenue loss, and we see that already showing up on the bottom line.
United Technologies has increased its earnings per share from $3.71 to $6.30 (adjusted) over this same time frame, which is a CAGR of 6.30%.
A lower outstanding share count explains much of this excess growth (shares have been reduced by ~12% over the last 10 years), but there’s also been a noticeable uptick in the company’s overall profitability, which is why I believe the Sikorsky move was the right call.
However, while much greater than the top-line growth, the EPS growth still trailed the dividend growth by a large measure.
As such, it would seem likely that dividend growth might moderate a bit unless the company can start to accelerate its EPS growth from here. We see this moderation a bit with the most recent dividend increase of just ~3%.
But it’s important to have an idea as to whether there will be any acceleration.
For that, we’ll take a look at a near-term forecast for future EPS growth.
S&P Capital IQ believes United Technologies will be able to compound its EPS at an annual rate of 10% over the next three years, citing accelerating air travel growth and a strong residential construction market.
This kind of underlying growth improvement could portend larger dividend increases, especially considering the otherwise modest payout ratio.
The rest of the company’s fundamentals are fairly high quality.
One example is the balance sheet.
With a long-term debt/equity ratio of 0.71 and an interest coverage ratio of almost 8, there are no real issues here. Probably some room for improvement, but nothing concerning.
Profitability, which was arguably a weak spot for the company years prior, has really improved after the aforementioned sale of Sikorsky.
Over the last five years, United Technologies has averaged net margin of 8.68% and return on equity of 19.63%. Both metrics are definitely moving in the right direction, and in a big way.
All in all, I think there’s a lot to like with this business.
If you’re interested in growing dividend income, this strikes me as one of the safest long-term bets around.
Such a great business like this could be trading for a premium, but I’d argue it’s actually available at a discount right now.
Using midpoint guidance for this fiscal year (which is almost over), the stock is available for a P/E ratio of 16.75. That’s certainly a discount to the broader market. Meanwhile, the stock’s yield is also currently higher than its five-year average, as noted earlier. The yield is also higher than the broader market. So you’re getting a stock at a cheaper price with a higher yield.
So what is the stock likely worth? What’s its estimated intrinsic value?
I valued the stock using a dividend discount model analysis. I factored in a 10% discount rate. I then assumed a long-term dividend growth rate of 7.5%. This looks to be a fair assumption to me, as it’s much lower than the stock’s long-term proven dividend growth. A modest payout ratio and an acceleration of underlying EPS growth could provide for a lot of surprise to the upside here. The DDM analysis gives me a fair value of $113.52.
[ad#Google Adsense 336×280-IA]The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
My analysis (which is arguably quite conservative) concludes that the stock is at least modestly undervalued, but am I alone in that evaluation? Let’s find out.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates UTX as a 4-star stock, with a fair value estimate of $122.00.
S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
S&P Capital IQ rates UTX as a 4-star “BUY”, with a fair value calculation of $110.90.
Well, looks like I’m not alone here. If we average these three valuations out, we get a final number of $115.47. That would mean this stock is potentially 7% undervalued right now.
Bottom line: United Technologies Corporation (UTX) is a premier dividend growth stock, and it’s rewarded patient long-term investors with growing dividend income for decades. I find that likely to continue for years to come. A high-quality dividend growth stock like this available with the possibility of 7% upside when the broader market is at an all-time high is a pretty good proposition.
— Jason Fieber
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