Recap from February’s Picks
On a price return basis, the Safest Dividend Yields Model Portfolio (-12.4%) underperformed the S&P 500 (-1.7%) by 10.7% from February 23, 2023 through March 20, 2023. On a total return basis, the Model Portfolio (-12.0%) underperformed the S&P 500 (-1.4%) by 10.6% over the same time. The best performing large-cap stock was down <1%, and the best performing small-cap stock was down <1%. Overall, five out of the 20 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from February 23, 2023 through March 20, 2023.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield greater than 3%. Companies with strong free cash flow (FCF) provide higher quality and safer dividend yields because strong FCF is proof they have the cash to support the dividend. I think this portfolio provides a uniquely well-screened group of stocks that can help clients outperform.
Featured Stock for February: Dow
DOW
Dow Inc. (DOW) is the featured stock in March’s Safest Dividend Yields Model Portfolio. I made Dow a Long Idea in September 2022, and the stock is up 15% while the S&P 500 is up 4% since then.
Since 2019, Dow has grown revenue by 10% compounded annually and net operating profit after tax (NOPAT) by 21% compounded annually. Dow’s NOPAT margin improved from 6% in 2019 to 8% in 2022, while invested capital turns improved from 0.7 to 1.0 over the same time. Rising NOPAT margins and invested capital turns drive the company’s return on invested capital (ROIC) from 4% in 2019 to 8% in 2022.
Figure 1: Dow’s Revenue & NOPAT Since 2019
Sources: New Constructs, LLC and company filings
Free Cash Flow Supports Regular Dividend Payments
Dow has increased its regular dividend from $2.10/share in 2019 to $2.80/share in 2022. The current quarterly dividend, when annualized, equals $2.80/share and provides a 5.2% dividend yield.
More importantly, Dow’s free cash flow (FCF) easily exceeds its regular dividend payments. From 2019 to 2022, Dow generated $20.9 billion (37% of current enterprise value) in FCF while paying $8.2 billion in dividends. See Figure 2.
Figure 2: Dow’s FCF vs. Regular Dividends Since 2019
Sources: New Constructs, LLC and company filings
As Figure 2 shows, Dow’s dividends are backed by a history of reliable cash flows. Dividends from companies with low or negative FCF are less dependable since the company may not be able to sustain paying dividends.
DOW Is Undervalued
At its current price of $54/share, Dow has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects Dow’s NOPAT to permanently fall 20% from its 2022 level. This expectation seems overly pessimistic given that Dow has grown NOPAT by 21% compounded annually since 2019.
Even if Dow only maintains its 2022 NOPAT margin of 8% and grows revenue by just 2% compounded annually for the next decade, the stock would be worth $80+/share today – a 48% upside. In this scenario, Dow’s NOPAT would grow 2% compounded annually from 2022 through 2032. Should the company’s NOPAT grow more in line with historical growth rates, the stock has even more upside.
Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology
Below are specifics on the adjustments I make based on Robo-Analyst findings in Dow’s 10-K:
Income Statement: I made $2.5 billion in adjustments with a net effect of removing $179 million in non-operating expenses (<1% of revenue).
Balance Sheet: I made $17.2 billion in adjustments to calculate invested capital with a net increase of $7.6 billion. The most notable adjustment was $7.1 billion (14% of reported net assets) in other comprehensive income.
Valuation: I made $26.0 billion in adjustments, with a net decrease of $18.3 billion decrease in value. Apart from total debt, one of the most notable adjustments to shareholder value was $3.8 billion in excess cash. This adjustment represents 10% of Dow’s market value.
Disclosure: David Trainer, Kyle Guske II, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.
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