Seeking Alpha
Profile| Send Message|
( followers)  

The profitability of the industrial producers is directly correlated

with that of other sectors. These companies play an essential role in the development of the new technologies as well as services. Consequently, the performance of the large-cap industrials is a solid indicator of the strength of the U.S. economy. In the last 5 years, the average EPS growth of industrial companies was 7.02%, whereas the average EPS growth estimate for the next 5 years is 14.66%. While the year-to-date performance of 1.38% is disappointing, one year performance of 23.25% is promising.

As of June 13, the average yield of industrial companies was 1.81%. Some large caps offer substantial dividends, whereas some have no dividend policy yet. This article, the fourth in series, offers a unique dividend selection model for the next 5 years in this sector based on strong evidence from the last 5 years.

Review of O-Metrix

O-Metrix is a simple grading technique based on the stock's dividend yield, future expectations, and current valuation.

O-Metrix = [(Dividend Yield + EPS Growth) / (P/E Ratio)] * 5

Dividend Yield: Higher is better.
EPS Growth: Higher is better.
P/E Ratio: Lower is better.

I multiplied the original formula by 5 to get a scale over 10. The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as 5 years.

The following table shows a back-test of this technique's predictive power using the data for large-cap industrial companies: (data from finviz/morningstar)

Company Name

Ticker

2006 P/E

2006 Yield

5-Year EPS growth

O-metrix

Annualized Return

[A] Average:

23.87%

Cummins

CMI

8.3

1.12%

13.92%

9.06

29.78%

Goodrich

GR

12.0

1.76%

16.19%

7.48

17.95%

[B] Average:

8.93%

Raytheon Co.

RTN

21.5

1.82%

20.51%

5.19

4.43%

Lockheed Martin

LMT

15.9

1.36%

14.13%

4.87

4.17%

ITT Corporation

ITT

21.3

0.77%

17.62%

4.32

3.06%

General D.

GD

17.7

1.20%

13.53%

4.16

4.55%

Emerson Electric

EMR

19.1

2.11%

10.81%

3.38

8.12%

Deere & Co.

DE

15.4

1.69%

8.19%

3.21

16.90%

Precision C.

PCP

20.9

0.15%

22.23%

5.35

21.26%

[C] Average:

6.97%

Dover Corp.

DOV

16.7

1.45%

8.16%

2.88

6.69%

3M Co.

MMM

15.4

2.36%

6.44%

2.86

4.58%

Honeywel Int.

HON

18.0

2.01%

5.95%

2.21

9.64%

[D] Average:

5.59%

Fluor Corp.

FLR

27.7

0.98%

8.61%

1.73

9.41%

Illinois Tool W.

ITW

15.3

1.62%

3.11%

1.55

4.56%

Boeing Co.

BA

31.2

1.35%

6.82%

1.31

0.00%

Rockwell

ROK

17.0

1.58%

2.26%

1.13

5.66%

Eaton Corp.

ETN

12.6

1.97%

0.86%

1.12

8.43%

Republic Services

RSG

19.6

1.48%

2.50%

1.02

5.50%

[F] Average:

6.69%

Caterpillar Inc.

CAT

11.9

1.79%

0.54%

0.98

9.14%

Waste Man.

WM

17.5

2.39%

-1.08%

0.37

4.23%

As can be seen from the table above, the back-testing of the O-Metrix on large-cap industrial stocks works pretty well. Take Cummins and Goodrich, each of which were fairly priced for a growth of 8.3% and 12% in 2006. However, these companies enjoyed EPS growth rates of 13.92% and 16.19%, respectively. The higher-than market-priced growth rates resulted in 29.78% annualized return for Cummins and 17.95% annualized return for Goodrich.

I also decided to include letter grades, as it will make things easier to understand. Below i've included the relationship between the O-Metrix score and the letter grades:

O-Metrix Score

Letter Grade

O-Metrix > 10

A+

10 > O-Metrix > 8

A

8 > O-Metrix > 6

B

6 > O-Metrix > 4

C

4 > O-Metrix > 2

D

2 > O-Metrix > 0

F

0 > O-Metrix

Sub-F

If the regression above is too complicated for you, just go with the letter grades. The following graph shows the 5-year annualized return of the stocks based on their O-Metrix scores:


As shown in the graph above, the O-Metrix grade explains almost half of the variation in the returns. Given the unpredictable nature of the stock markets, this is a remarkable success. According to the equation above, for each point increase in the O-Metrix score, the annual return is expected to get higher by 2%. There are three ways to achieve higher returns:

1) Higher Growth

2) Higher Yield

3) Cheap Valuation (Low P/E ratio)

Note that the past performance does not guarantee future returns. While Cummins and Goodrich have outperformed in the past 5 years, the future expectations are different. Based on trailing P/E ratios, dividend yields, and analyst estimates of 5-year EPS growth expectations, here is the current ranking:

Company

Ticker

P/E

Dividend Yield

EPS next 5 years

O-Metrix

Caterpillar

CAT

17.22

1.90%

21.20%

6.71

Dover Corp.

DOV

14.95

1.81%

16.40%

6.09

General D.

GD

10.01

2.71%

9.45%

6.07

Raytheon Co.

RTN

10.29

3.56%

8.61%

5.91

Lockheed Martin

LMT

10.53

3.88%

8.29%

5.78

Eaton Corp.

ETN

14.78

2.97%

12.68%

5.29

Illinois Tool W.

ITW

14.81

2.49%

13.16%

5.28

Emerson Electric

EMR

17.9

2.69%

14.37%

4.77

3M Co.

MMM

15.56

2.42%

12.17%

4.69

Honeywell Int.

HON

19.42

2.40%

15.34%

4.57

Republic S.

RSG

19.15

2.68%

14.77%

4.56

Rockwell A.

ROK

19.99

2.18%

15.00%

4.30

Deere & Co.

DE

14.05

2.00%

10.04%

4.28

Cummins Inc.

CMI

14.79

1.13%

11.48%

4.26

Boeing Co.

BA

16.05

2.31%

10.20%

3.90

Waste M.

WM

18.36

3.72%

10.33%

3.83

Goodrich Corp.

GR

16.86

1.33%

11.56%

3.82

ITT Corp.

ITT

16.1

1.82%

9.33%

3.46

Precision C.

PCP

21.17

0.08%

11.32%

2.69

Fluor Corp.

FLR

30.98

0.81%

12.80%

2.20

If the analyst estimates hold, Caterpillar, Dover Corp, and General Dynamics have the potential to beat the market returns with a large margin. While the first two companies seem to be over-priced, higher growth expectations justify the current valuation.

Dividend investors should consider making these estimations themselves, and use O-Metrix as an additional tool to other fair value estimation techniques.

Disclaimer: The article is a back-testing article which shows that by the year 2011, stocks with higher O-Metrix scores in 2006 outperformed other stocks. I cross-checked the data from a variety of sources, but no data is perfect. Things get particularly complicated when there are mergers / break-ups involved. I am not a registered advisor [yet]. You should always do your own diligence before making any investment decision.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Selecting the Best Industrial Dividends for the Next 5 Years