Stock markets have melted up in recent weeks, erasing double-digit declines in a short time to show a positive gain for 2011. However, savvy investors know such rapid moves are not to be trusted but rather, only serve as further evidence of the market's volatility. In the face of such a schizophrenic investing environment, what are investors to do?
I have always emphasized cash returns, mainly in the form of dividends and catalyst-driven events such as buyouts. I simply cannot put much trust in other investors to deliver capital gains, especially since much market mentality is driven by relative value. Reasoning such as the market looks cheap based on its historical P/E ratio ignores the fact that earnings multiples can compress (or expand) regardless of economic fundamentals. Many investors seem to think we live in a "new normal" where the average earnings multiple cannot fall below 12-15x, when in fact many bear markets have laid low P/E ratios below 10 for the market as a whole. As such, I like to base my investment approach on absolute value, most commonly free cash flow and at times, net asset value where appropriate. I strongly prefer to see cash returns on my investment, which at the end of the day is the ultimate goal for any investment.
To this end, I ran a screen looking for the strongest dividend companies. To qualify, a company had to yield more 2% and show dividend growth in each of the last 5 years. This demonstrates some business durability given the recession that began in 2008 and gives us some assurance the dividend will continue to grow. In addition, payout ratios had to be no higher than 60% so the yield is sustainable. And finally, I added an ROA > 10% criteria to weed out names, leaving only the strongest companies. This screen spit out 29 names so I will split the results across two articles.
Readers can view my full financial summary, including my estimates for intrinsic value, in spreadsheet format here.
As might be expected, all of these companies are exceptional at generating free cash flow (FCF). With the exception of capital-intensive Chevron (CVX) and Kellog (K), all yielded double digit FCF returns on their asset base. Since dividend investing is much in favor and these stocks could be regarded as the cream of the crop in that regard, it is not surprising that all of them are trading close or above fair value with the exception of Life Partners Holdings (LPHI), which is being investigated by the SEC for possibly defrauding investors. Four other names stood out as trading below my estimated fair value but not yet cheap enough for sufficient margin of safety: Analog Devices (ADI), AstraZeneca (AZN), Johnson & Johnson (JNJ) and Lineary Technology (LLTC). No surprise that half of those names come from the pharmaceutical industry, which investors are shying away from despite outsized yields. Here is a summary of the entire list:
3M Company (MMM) is a diversified technology company with a presence in industrial and transportation; health care; display and graphics; consumer and office; safety, security and protection services, and electro and communications. 3M handily outperforms competitors as evidenced by ROE of 27% vs. 6% for peers and ROI 18% vs. 3%. The market has recognized 3M's business prowess, assigning it a EV/EBITDA multiple of 7.8. While shares are trading closer to the bottom of the 52 week range, investors are paying close to a fair price based on my FCF analysis.
Analog Devices, Inc. designs, manufactures and markets analog, mixed-signal and digital signal processing integrated circuits (ICs) used in all types of electronic equipment. Like most of the companies on this list, it beats its industry average, with 27% ROE and 22% ROI vs. 3% and 4%, respectively. I find the shares trading at fair value currently based solely on FCF but ADI also carries almost $9 net cash per share on its balance sheet.
AstraZeneca PLC is a global biopharmaceutical company. It discovers, develops and commercializes prescription medicines for six areas of healthcare: Cardiovascular, Gastrointestinal, Infection, Neuroscience, Oncology, and Respiratory and Inflammation. Returns 36% ROE and 21% ROI compare favorably industry averages of 6% ROE and 5% ROI. Based on its historic free cash flows, AZN is definitely undervalued but like many pharma companies, it faces a patent cliff that worries investors. It is difficult to accurately gauge the success of AZN's pipeline in replacing some of its big sellers coming off patent and thus AZN warrants a larger margin of safety. If shares revisited 52-week lows near $40 per share, I would take a harder look.
Becton, Dickinson and Company (BD) is a global medical technology company engaged in the development, manufacture and sale of medical devices, instrument systems and reagents used by healthcare institutions, life science researchers, clinical laboratories, the pharmaceutical industry and the general public. BD delivered 24% ROE and 15% ROI, topping industry averages of 13% and 10%, respectively. Like most of the names on this screen, BD normally trades at a premium due to its superior cash flow and business position. Despite being near 52-week lows, shares are not cheap enough for my value investing discipline.
Chevron Corporation operates in the energy industry via its upstream exploration segment, downstream (refining) and chemicals. It has delivered high returns vs.. its industry -- ROE: 21% vs. 13& and ROI: 15% vs. 9%. Chevron generates impressive free cash flow despite its intensive need for capital expenditure but I usually value commodity companies on net asset value. I value Chevron's energy reserves at $90, excluding its other operations such as refining. As the stock is trading above $100, CVX does not look as attractive as some other energy stocks, such as Devon Energy (DVN), which I wrote about here.
Compass Minerals International, Inc. (CMP) is a producer of minerals, including salt, sulfate of potash specialty fertilizer and magnesium chloride. As of December 31, 2010, Compass Minerals operated 11 production and packaging facilities. It generated 44% ROE vs.. the industry's 6% and 16% ROI vs. 4% for its peers. CMP is a favorite of Barron's Roundtable member, Meryl Witmer ( watch a video of her discussing the stock). Not being familiar with the salt production industry, I valued CMP based on free cash flow and derived a value below its current trading price.
Flowers Foods, Inc. (FLO) is a producer and marketer of bakery products in the United States, with two segments: direct-store-delivery (DSD) and warehouse delivery. One of the few stocks in our screen to underperform its industry, returns of 17% ROE and 11% ROI lag the average of 20% and 15%. Despite this lag, FLO trades at 10x EV/EBITDA, one of the more expensive names based on that metric. On FCF analysis, I concluded shares are currently trading near fair value.
Graco Inc. (GGG) designs, manufactures and sells equipment that pumps, meters, mixes, dispenses and sprays a variety of fluids and semi-solids, primarily to contractors and original equipment manufacturers. Graco delivered eye-popping returns 46% ROE and 27% ROI, far above the industry's 11% and 9% returns. With its stellar free cash flow generation and solid balance sheet, investors have paid a premium to own GGG, which sports an EV/EBITDA ratio over 10.
Intel Corporation (INTC) is a semiconductor chip maker company and develops advanced integrated digital technology products, primarily integrated circuits, for industries, such as computing and communications. As the undisputed leader in its industry, its 26% ROE and 23% ROI handily outpaces the 3% ROE and 4% ROI averaged by the industry. Its large cash horde may partially explain the company's 5.3x EV/EBITDA valuation but some investors are also concerned about Intel's ability to cope in a post-PC world as consumers move from computers and laptops to smart phones and tablets. I find INTC to be trading near fair value around $24.
Johnson & Johnson is engaged in the research and development, manufacture and sale of a range of products in the health care field via more than 250 operating companies conducting business worldwide. Returns against the industry look impressive: 20% ROE vs. 11% and 14% ROI vs. 8%. For investors looking for a safe haven in volatile times, JNJ may be a top pick. Slightly undervalued at current levels, JNJ is the model of consistency and while investors may not see outsized capital gains, they can expect to see little capital loss over the long term.
Kellogg Company is engaged in the manufacture and marketing of ready-to-eat cereal and convenience foods. The contrast between Kellog's high 51% ROE (vs. 20% industry) below average 14% ROI (vs. 15% industry) illustrates the company's relatively high debt load. At 2.5x debt-to-EBITDA, Kellog had the most leveraged balance sheet by far of all the stocks in this list. I also found its FCF generation too small to warrant its current trading price.
Lancaster Colony Corporation (LANC) is a diversified manufacturer and marketer of consumer products focusing primarily on specialty foods for the retail and foodservice markets. It also manufactures and markets candles for the food, drug and mass markets. I am completely unaware of any of these company's products but my ignorance has not prevented LANC from generating nice returns of 21% ROE and 20% ROI vs. industry averages of 20% and 15%. These stellar returns are bolstered by zero debt and roughly $5 net cash per share on the balance sheet. Combined with a decent dividend, LANC is one of the few stocks in my screen to be trading near 52 week highs, which unfortunately takes it out of my buy range.
Life Partners Holdings, Inc. is a financial services company engaged in the secondary market for life insurance known generally as life settlements. LPI facilitates the sale of life settlements between sellers and purchasers, historically generating massive returns of 46% ROE and ROI vs. 8% ROE and 0% ROI industry average. This is the only stock in our list which is trading well below fair value based on historic free cash flows but there is a good reason: the company is currently under investigation by the SEC. A Wall Street Journal article may have shed light on how LPHI generated such outsized returns -- by misleading its clients. These allegations have decimated share prices and perhaps its future business prospects, even if the firm should survive the SEC's wrath.
Linear Technology Corporation designs, manufactures and markets a broad line of standard high performance linear integrated circuits. Its returns seem virtually unreal with 213% ROE vs. 3% for the industry and 47% ROI vs. 4%. The firm averages an outstanding 31% FCF yield on its asset and carries a reasonable debt load at under 1x debt-to-EBITDA. Shares are modestly undervalued but if LLTC should revisit 52 week lows below $25, I will take a hard look at the stock.
Watch for part 2 of the stock screen coming tomorrow.