Yesterday, I published the first half of a stock screen focusing on only the strongest dividend growers based on the following criteria:
- Yield > 2%
- Dividend growth in each of the last 5 years
- Sustainable payout ratio < 60%
- ROA > 10%
In the face of volatile markets, investors have embraced dividend stocks as something of a safe haven, especially considering the paltry yield offered by U.S. Treasuries. Since this list comprises of mostly the strongest dividend stocks available, it is no surprise almost all of them trade at some premium to the market. As these companies are exceptionally strong businesses with copious cash flows, they perhaps deserve to trade more dearly than the average stock. Nevertheless, Mr. Market does funny things from time to time and may offer some top-class names for a bargain price at a later date. In the meantime, here is the 2nd half of the list:
(Click to enlarge)
Four names stood out as possible opportunities: Medtronic (MDT), Microsoft (MSFT), Span-America (SPAN) and Xilinx (XLNX). As with yesterday's list, the medical industry accounts for half the names. Out-of-favor "old" tech accounted for the other half. It's somewhat ironic that in a screen looking for the safest of dividend stocks, the most attractive name turned up is perhaps the least safe -- Span-America. A tiny micro-cap with illiquid shares, SPAN seems very attractive from a 10,000 ft view and may warrant a closer look.
McCormick & Company, Incorporated (MKC) manufactures, markets and distributes spices, seasonings, specialty foods and flavorings to the food industry. Its return on equity of 24% has bettered the industry average at 20% but return on investment lagged at 13% vs. 15%. Averaging 8% free cash flow on its asset base over the last 5 years, MKC is more of a slow-and-steady earner as is typical with consumer staple companies. With the market being concerned about slowing growth, recession resistant names are an overcrowded trade at this point and MKC looks unattractive based on my FCF evaluation.
McDonald's Corporation (MCD) franchises and operates McDonald's restaurants in the global restaurant industry. One of the strongest brands in the world, McDonald's handily outperforms peers with ROE of 37% vs. 13% and ROI of 19% vs. 11%. While the company is a proven performer, it is priced to match, with enterprise value (which takes debt into account) to EBITDA multiple over 11. Opportunities to buy world-class franchises for cheap are rare and with MCD trading near 52-week highs, investors seem content to pay a fair or perhaps slightly dear price to own a piece of the golden arches.
The McGraw-Hill Companies, Inc. is a global information services provider serving the financial, education and business information markets. Despite its role in the housing and credit debacle (via Standard & Poor's), MHP's returns look impressive with ROE at 42% vs. 17% for its competitors and ROI of 22% easily topping the industry's 13%. MHP is an interesting case. Trading roughly around my estimated fair value, the company has announced a tax-free spin-off by year-end 2012, with the company splitting into two parts: McGraw-Hill Markets and McGraw-Hill Education . Spin-offs often create an "unwanted stepchild" company which is then undervalued by the market for a time. Perhaps McGraw-Hill will offer such an opportunity next year.
Medtronic, Inc. is a medical technology company engaged in research, design, manufacture and sale of products to alleviate pain, restore health and extend life. It manufactures and sells device-based medical therapies. In a low return industry that averages 6% ROE and 5% ROI, Medtronic has outperformed with 20% ROE and 13% ROI. It is one of the few stocks in this screen that is selling at a discount to fair value without being embroiled in some sort of scandal. Perhaps the market is punishing the stock due to its 23% revenue exposure to Medicare reimbursements. Whatever the case may be, I would become very interested if shares were to revisit the 52-week low of $30.
Microsoft Corporation develops, licenses and supports a range of software products and services. It also designs and sells hardware, and delivers online advertising to the customers. Historically, MSFT is a veritable cash cow as evident in its 45% ROE and 33% ROI vs. 23% and 19%, respectively, for the industry. Based on its recent FCF run rate around $25B, the shares would be worth $40 excluding net cash of $5 per share. However, the market harbors some doubt as to whether Microsoft can successfully navigate the transition into the post-PC world of tablets and smart phones. Nevertheless, MSFT performed admirably as a safe harbor during the recent market swoon, dropping far less than the market while still generating a nice return for investors via its decent dividend that's assured to grow.
MOCON, Inc. (MOCO) operates primarily in the measurement and analytical instrument and services markets. A tiny company with only 78M market cap, it delivers outsized returns: 18% ROE vs. 11% peer average and 18% ROI vs. 9%. With no debt, the company's cash holdings is more than 10% of its market capitalization. However, sometimes size matters and that holds especially true in the corporate world. I deem shares to be trading around fair value currently and would demand an adequate margin of safety as well as a thorough understanding of the business and its prospects before investing in this stock.
Questar Corporation (STR) is a Rockies-based integrated natural gas holding company, operating through its wholly owned subsidiaries: Wexpro Company (Wexpro), Questar Pipeline Company (Questar Pipeline) and Questar Gas Company (Questar Gas). It delivered returns of 19% ROE and 8% ROI. The company is a hybrid exploration/midstream/utility company so it's tough to gauge which industry category STR should be compared against. Its shares indicate investors treat STR as an utility stock as the 52 week trading range is relatively narrow between $16 - $20. Questar's integrated business model makes comparisons and valuation less straightforward than a simple FCF analysis but my back-of-the-envelope calculations based on its natural gas reserves and a very conservative multiple on its other operations suggest the stock is too dearly priced for investment.
Span-America Medical Systems, Inc. manufactures and distributes a variety of therapeutic support surfaces and related products utilizing polyurethane and other foam products for the medical, consumer and industrial markets. The Company operates in two segments: medical and custom products. The company generated impressive returns compared to competitors: 18% ROE vs. 12% and 18% ROI vs. 10%. Trading around $14, shares look a bit underpriced, especially considering the 3% yield, no debt, over $2 net cash per share and a strong insider base with 28% ownership. However, with a $41M market cap, Span-America is the smallest stock in our screen which takes some sheen off my assessment. Businesses can derive competitive advantages due to scale, which SPAN would seem to lack judging from its market capitalization and shares are highly illiquid to boot, with average volume of only 2,000 shares (that's thousand, not thousand thousand's). Nevertheless, SPAN is an attractive prospect for further research.
Strayer Education, Inc. (STRA) provides post-secondary education services via a range of academic programs through its wholly owned subsidiary Strayer University, Inc. (the University), both in classroom courses and online via the Internet. Its eye-popping returns put even Microsoft to shame with ROE at 94%(!) vs. 9% for peers and 64% ROI vs. 7%. However, there is controversy brewing around the for-profit university industry and its propensity to generate delinquent student loans. My experience via those who have attended similar institutions leaves me less than impressed with anything other than the company's ability to make money hand-over-fist. It wouldn't surprise me if those profits were generated through nefarious means however and am taking a pass on this stock.
Sysco Corporation (SYY) is a North American distributor of food and related products primarily to the foodservice or food-away-from-home industry. Returns look good with ROE of 27% and ROI at 15% vs. industry averages of 8% and 6%, respectively, but like most of the stocks on this list, shares are priced at a premium relative to free cash flows.
T. Rowe Price Group, Inc. (TROW) is a financial services holding company which provides investment advisory services to individual and institutional investors in the sponsored T. Rowe Price mutual funds and other investment portfolios. Like most of the companies in our screen, TROW delivers strong results with 24% ROE and ROI beating the industry averages of 8% and 6%. Asset managers are usually valued based on a percentage of their assets under management, not free cash flow but on either metric, I find TROW to be too expensive for my portfolio.
Xilinx, Inc. (XLNX) designs, develops and markets programmable platforms. In a mostly commodified tech industry, Xilinx's returns look quite impressive: 29% ROE and 18% ROI vs. 3% and 4% for competitors. XLNX basically operates in a duopoly with its closest competitor, Altera (ALTR). While Xilinx is the larger of the two, Altera has gained market share recently and both stocks have seen their share prices drop. While XLNX has a much better yield (2.5% vs. 1% for ALTR), further research is needed to determine if XLNX is indeed the better investment over ALTR. If not, I would not pass over the better bargain for the sake of yield.
YUM! Brands, Inc. (YUM) is a quick service restaurant company with five concepts: KFC, Pizza Hut, Taco Bell, Long John Silver's and A&W. It numbers more than 37,000 units operating in over 110 countries and territories. YUM! generates high returns of 70% ROE and 21% ROI compared to 13% and 11% and the company's burgeoning growth in China is well known to investors. YUM is valued at a premium, trading over 10x EV/EBITDA and 20x earnings. Like MCD, it's hard to envision shares trading at a low enough price for my portfolio in the near future.
