By Serkan Unal
Investors in pursuit of stocks with capacity for strong long-term total returns should examine undervalued stocks with consistently strong profitability. Sifting through stocks with forward earnings multiples below 15, debt-to-equity ratios below 50%, and positive earnings growth over the past five years along with a forecast long-term earnings growth above 5% per year, we selected five stocks with superb historical profitability as measured by the Return on Equity (ROE). Below is a closer look at stocks of five undervalued companies paying dividend yields above 2% that have proven their consistent capacity to earn amply on each dollar of invested equity capital. These stocks boast potential for strong total returns, including income from dividends, over the long run.
Illinois Tool Works Inc. (ITW), an industrial products and equipment maker, is an S&P Dividend Aristocrat with exactly 49 consecutive years of annual dividend increases. The company has a dividend yield of 2.5%, payout ratio of 36% of the current-year EPS estimate, and five-year annualized dividend growth of 7.4%. Over the past five years, ITW achieved a total return of 6.6% annually versus 4.9% for the S&P 500. The company has also achieved a remarkable ROE, which stood at 24.4% over the trailing twelve months and 18.7% over the past five years on average. For comparison, its peers have an average ROE of 9.7% over the trailing twelve months and 6.5% over the past five years. Illinois Tool Works recently reported an 8% year-over-year increase in adjusted EPS, despite a revenue decline. The company indicated improvements in capital goods orders and solid organic growth in the automotive OEM segment. However, it is still operating below long-term operational targets, including organic growth of at least 200 basis points above the rate of growth in global industrial production as well as both operating margins and ROIC above 20%. Last quarter, ITW was the largest positions in Relational Investors' portfolio (check out the hedge fund's top holdings here).
RPC Inc. (RES), an oilfield services and equipment company, also boasts solid long-term potential. It has a dividend yield of 2.8%, payout ratio of 40% of the current-year EPS estimate, and five-year annualized dividend growth of 36.4%. RES has achieved a total return of 17.7% per year over the past five years. Its trailing-twelve-month ROE is 33% and its five-year average ROE is 27.7%. For a comparison, its peers have an average ROE of 13% over the trailing twelve months and 13.8% over the past five years. Despite the shale oil and natural gas boom, the company has struggled with fierce competitive pricing pressures and the expiration of contracts in its pressure pumping segment, pushing the company into the spot market with greater price volatility. Moreover, the trends in rig counts, both U.S. domestic and unconventional, show extended declines last quarter, suggesting softer demand for RPC Inc.'s products and services. However, bidding activity has started to increase, reflecting higher capital spending. In terms of hedge fund interest, Mario Gabelli's GAMCO Investors held 6.7 million shares of RES last quarter (see GAMCO Investors' top picks here).
Coach Inc. (COH), "affordable luxury" apparel, footwear, and accessories maker, is another undervalued dividend-paying play on strong future growth. The stock pays a dividend yield of 2.4% on a payout ratio of 36% of the current-year EPS estimate. Its dividend has increased cumulatively by 350% since 2009. The stock has achieved a total annualized return of 11.1% over the past five years. Holding almost no long-term debt, Coach Inc. has attained a ROE of 50.9% over the trailing twelve months and 49.2% over the past five years on average. Its peers as a group have an average ROE of only 3.9% over the trailing twelve months and 19.5% over the past five years. Following its first quarterly miss in nearly three years in the fiscal second quarter, the company has came back with a robust financial performance in the fiscal third quarter. Its overall sales were up 7% year-over-year, with China revenues growing by 40% overall. The company's gross margin also expanded in the quarter (but operating margins shrank), despite worries that more intense competition and the need to boost sales through promotions would squeeze margins. The outlook is rosy on the emerging market expansion, given the rising propensity to spend of the mushrooming middle class in those markets. Last quarter, COH was popular with 'Tiger Cub' Rob Citrone and billionaire Steven Cohen.
Agrium Inc. (AGU) produces and sells agricultural nutrients and industrial products, ranging from seeds and fertilizers to herbicides and insecticides. The stock pays a dividend yield of 2.2% on a payout ratio of 21% of the current-year EPS estimate. Its five-year annualized dividend growth rate is a whopping 48.5%. AGU achieved a total return of 1.2% annually over the past five years, less than the S&P 500 index. However, AGU outperformed the S&P 500 by wide margins over both 10-year and 15-year horizons. AGU boasts a ROE of 22.4% over the trailing twelve months and 21.4% over the past five years on average. Its peer group has a ROE of 8.9% on a trailing-twelve-months basis and 18.2% on a five-year average basis. Agrium's growth record over the past few years has been impressive. Despite the challenging environment, the company earned record revenues in each of the past two years. It is well positioned to capitalize on the expected boom in demand for crop yield enhancers and protection as the growth in the world's population and incomes in emerging markets increase. Interestingly, the company is a target of activist hedge fund JANA Partners, which wants to spin-off Agrium's retail business.
Statoil ASA (STO), a Norway-based integrated oil and natural gas giant, is also an interesting highly-profitable value and income play. It has a dividend yield of 4.5% and a payout ratio of 36% of the current-year EPS estimate. Its dividend has increased cumulatively by 12.5% since 2009. While STO underperformed the S&P 500 index over a five-year period, realizing a total annualized return of -3.5%, the stock beat the index on a 10-year basis. Statoil has a strong ROE of 23% over the trailing twelve months and 21.3% over the past five years on average. These are about 3.8 times higher than the average ROEs for its peers. The company is implementing a production growth plan, aiming to achieve a total production of 2.5 mmboe per day in 2020. This will be achieved through production CAGR averaging 2%-to-3% through 2016 and 3%-to-4% between 2016 and 2020. The company realized a 9% increase in its earnings in 2012. It plans to increase dividends in line with growth in its long-term underlying earnings. Still, as with any ADR, foreign exchange risk is an added risk to investors holding foreign stocks/ADRs. Last quarter, Andrew Hall's Astenbeck Capital held STO as the largest position in its portfolio.