I recently read a report written in 2012 by Robert Arnott and Dennis Chaves on value, growth and dividend investing and the results were astounding.
The duo took an international sample of stocks from 23 developed nations in which they selected the top 1,000 stocks by market capitalization from 1963 excluding, only the companies that lack book value data, and divided them into two portfolios: 50 percent by market capitalization are assigned to the value portfolio and the remaining 50 percent to the growth portfolio with each portfolio rebalanced every year (to take into account, for example, new issues, acquisitions or reaching of "fair" value). "Value" in this study was defined as larger cap companies that were discounted by the market with higher dividend yields, while "growth" was defined as smaller cap companies with higher valuations and little or no dividend yield.
Contradicting the conventional wisdom that growth stocks experience stronger increases in fundamentals, the study revealed that the value strategy outgrew the growth strategy by 89 basis points per year, every year, over the past 48 years. What was even more astounding was that the study found the "value" stocks portfolio saw larger dividend growth than the "growth" stocks and portfolio. In other words, not only were these companies beating growth stocks over very long periods by a very wide spread on asset returns (89 basis points per year leads to thousands of percentage points with the effects of compounding), but those same stocks were beating growth stocks in the very game that they were supposed to be winning; dividend growth. The growth strategy underperforms in precisely the return component where it presumably should hold a comparative advantage, and the value strategy outperforms the growth portfolio (and the market) on virtually every metric by a substantial margin.
How can this observation be applied?
This brings me to Deere and Co. (NYSE:DE), a global large cap heavyweight that, according to yours truly, is one of the most undervalued companies on the Russell 1000 and S&P 500 indices and fits precisely into a value-oriented portfolio.
Mathematically speaking, Deere is a very easy case. Let's look at the facts: Over the past decade, DE has had an annual dividend growth rate of 16.30%, a 21.30% average increase in annual EPS, a payout ratio under 30% and on May 28th, it increased the quarterly amount 18% to $0.60 per share. A 16% growth in distributions translates into the doubling every seven years on average. If we check the dividend history, going as far back as 1989, we could see that Deere has actually managed to double dividends every eight years on average. Enterprise Value/EBITDA ratio is low at 10.27. The PEG ratio is low at 1.33, and the price-to-sales ratio is very low at 0.89 also compared to its historical values. Furthermore, this company is not only an earnings powerhouse but one of the most shareholder friendly companies on the NYSE. In the first two quarters of fiscal 2014, the company repurchased $1.1 billion of its shares, and in 2013, it repurchased $1.5 billion of its shares.
Moreover, almost anyone can estimate its fair value via a range of equity models. For example, using the DDM with DE's current dividend of $2.40 (annualized), an 8% dividend growth for five years (very conservative), followed by a terminal dividend growth of 5%, and an assumption of a terminal payout ratio of 70%, one can calculate fair value for the stock at roughly $125.49. The DDM valuation is a conservative method of valuing a stock, and almost always comes in below any DCF calculation.
All of this data is a reflection of the quality of DE's business. Last year, the company had $35 billion in sales, of which $29.1 billion was related to its Agriculture division. The remainder was from the Construction, Forestry and Financing divisions. Continued growth in global food production alone should result in Deere being able to report $50 billion in sales by the mid-cycle of 2018 (through management projections, which have historically been very conservative). Currently, reported operating margins of 12% are seen as normalized margins throughout the cycle. ROE in its most recent quarter is over 37% and growth in retained earnings over the past four quarters is at a remarkable 14.80%, which is a leading indicator of sustained total organic growth. There aren't many $30 bn+ companies attaining that level of growth in retained earnings.
Let's not forget Deere is a formidable financial institution. With an impressive $36.8 billion portfolio, Deere's loan portfolio generated net earnings of $469 million for the past year while write-downs were a miniscule 0.03%. That kind of write-down level is virtually impossible for a major bank with that kind of asset base and its earnings power is more than double the fiscal year-end earnings of Canadian Western Bank, a high growth Canadian bank in Western Canada whose stock price has grown at an annualized rate of 30% the past ten years.
Clearly, DE is a unique issue: not only classified as a traditional value stock but its metrics also reveal it to be a quasi-growth stock with incredible potential. It is no wonder bigger cap value stocks like DE are the types of businesses that can (and do) beat your typical growth stocks by a significant spread over the long term, leading to incredible wealth creation.
But why is DE so cheap?
Part of it is the market discounting its prospects. According to the company, Deere's worldwide sales of agriculture and turf equipment (84% of FY13 revenue) are forecast to decrease by about 7 percent for fiscal-year 2014, including a negative currency-translation effect of about 1 percent. The company explains that although the agricultural economy remains in a relatively healthy condition, farm income is forecast to be lower than last year. The decline is putting pressure on demand for farm equipment, especially for larger models. All of this however, should be seen as a gift and reason for a depressed price. Not many businesses in today's market are seen as "on sale" and DE is certainly one of them.
I believe that the long-term prospects of the company are brighter since simple agricultural economics are on the company's side. An increasing world population should continue to exert pressure on food supplies, limited farm land (cannot grow new lands) and inflation will presumably increase farming income in addition to the values of crop yields relative to today's levels. This could raise the demand for new efficient farm machinery, reinvestment in new agricultural technology and would certainly bolster its loan portfolio. These are all quite simple long term trends in addition to the growth of its global Construction and Forestry business.
Furthermore I don't seem to be the only one who holds this view. The company's largest shareholder is none other than a little known company called Cascade Investments LLC, which is the holding company that holds the investment portfolio of Bill Gates, and has roughly $80 billion in total capital. At the helm of this portfolio is Michael Larson, one of most successful value investors outside the state of Nebraska. Smart money and smart managers recognize the true value of this company over the long term and thus you should take a close look at the green machine that is Deere.
Disclosure: The author is long DE. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.