I hope these 10 stocks are slightly different than those commonly mentioned on financial websites. Some of you may have read my recent articles regarding my macroeconomic views, which are admittedly bearish. While I do find equity multiples to be compressed, I believe this discounts the European crisis, an astonishing lack of political leadership and well-intentioned will, and a global theme of unsustainable debts. Given these views (and my age), I have largely been raising cash and have small holdings in gold and silver. I expect market multiples to remain compressed, and most sectors to experience a decline in earnings over the next couple of years. While some may say "be greedy when others are fearful," the reality is that the market is not currently very fearful.
My plan is to have enough meaningful cash to deploy into excellent, financially sound businesses with good economic fundamental outlooks, at seriously depressed stock prices. I typically look for companies with well above average usage of retained earnings, above average returns on equity, solid and improving profit margins, reasonable amounts of leverage (or none), growing and consistent owner (otherwise known as "look-through") earnings and cash flows, and, in this case, fantastic and sustainable dividend growth. If a firm's management buys back the company's shares below fair value, even better. Ideally, I'll feel most comfortable with stocks that have low institutional ownership (below 40%), little analyst and headline coverage, and so forth. These factors appear to lead to higher possibilties of beneficial market inefficiencies.
I completely understand, and, under normal circumstances, agree with the sentiment that investing based on macro predictions is often futile. For those who feel comfortable investing in these companies now, best of luck. Given their strong financial positions, good economics, and likely sustainable dividend growth, I think it'll be hard to lose. However, my personal circumstances and views allow me to wait a bit longer. I don't think I'll miss too much.
*All information sourced from annual reports, quarterly reports, Forbes, and Yahoo Finance unless otherwise linked.
Beckton, Dickinson and Company (BDX)
BDX's business is one that is classic and relatively easy to understand. The company engages in the development, production and sale of medical devices, systems, and reagents (chemical substances). Most of the firms revenues are derived from needles, syringes, insulin syringes, self-injection systems, auto-disposables and other medical products. In fiscal 2011, the company reported revenues of $2 billion from its surgical systems unit, $1 billion from pharma systems, and $800 million to diabetes related care. Overall, revenues totaled $7.8 billion, good for 6.2% growth over 2010. EPS growth from continuing operations topped 14%.
Earnings growth has been remarkably consistent and steady since 2007. Despite one of the worst economies in decades, BDX grew earnings, revenues, and their competitive position right through the recession. Capital expenditures, largely deployed by BDX to increase manufacturing capacity, have declined slightly since 2007, in contrast with excellent revenue growth. This implies improved efficiencies and strong economies of scale. As a result, cash flows and owner earnings are much easier to predict and discount back to the present, should you decide to employ a discounted cash flow model. I have not performed my own DCF on BDX as of yet, but will likely do so in the coming weeks.
Management is shareholder-oriented, and has done a wonderful job with share buybacks and profitable retention of earnings. Today, there are 30 million less shares outstanding than there were in 2007. Under the current plan, almost 20 million shares could still be purchased. I employed an earnings retention test for BDX. The company grew EPS by $2.39 since 2007, while it paid $6.56 in dividends. With the earnings that the company retained, they achieved a 36.43% return. This is very solid, in my view. If all of that had been paid out as a dividend to me, I doubt I would have been able to do any better, considering taxes and an equity collapse in 2009. Returns on equity have been acceptable, consistent, and improving. ROE in 2011 was 24.6%.
Dividend growth has been excellent. BDX is a member of David Fish's Dividend Champion List (link here, much thanks to you, David). YoY dividend increase was 10.8%, with a 15.7% 10-year average increase. Based on earnings, the payout ratio was 30%. Based on FCF (more important for payouts), the ratio was closer to 50%; still reasonably low, especially given the EPS growth. The current yield is 2.30%. The company trades at 14 times earnings, close to its EPS growth. This appears to be an extremely fair multiple for the long haul.
BDX has managed to continually innovate this decade. 8% of the company's 2011 revenues came from brand new products. Technological improvements are essential, considering the growing challenges regarding patient care and treatment. While most of BDX's product generation has come from within, the company recently completed its acquisition of Carmal Pharma, who is the producer of an advanced closed-system transfer device. Given the toxicity and dangers that many utilized chemical compounds pose to doctors and nurses, closed-systems are vital to maintaining their safety. As both drugs and diseases become more powerful, the market for safety-oriented products like these is going to expand.
The firm is undergoing some management change. Vince Forlenza has taken over as CEO for Ed Ludwig, who will remain Chairman until the end of this year. As for potential risks, Obamacare will force the company to pay a 2.3% excise tax on products that comprise 80% of its revenues. I believe this has probably been priced in, but prospective investors should recognize the impact, while minor, this will have on net income going forward.
PPG Industries (PPG)
PPG is a nicely diversified chemical company. The firm manages six major segments:
- Performance, Industrial, and Architectural Coatings: These three segments (the last of which operates only in the EMEA) sell products like steel coils, refinishes to automobiles and industrial products, decorative and protective coatings, and the like. PPG has expanded heavily into vital markets like India. The company grew its joint venture with Asian Paints Ltd. in 2011, which granted it increased sales access to rapidly growing Asian markets.
- Opitcal and Specialty Materials: This segment includes transition lenses, high performance sun lenses, and opitcal lens materials.
- Commodity Chemicals: This segment sells chemicals like chlorine, hyrdochloric acid, etc. to manufactures operating within the chemical processing, rubber and plastics, water treatment industries.
- Glass: Operations in this segment include the production of flat glass and fiber glass. Major customers operate within the residential, wind energy, energy infrastructure, and electronics industries.
2011 was a blowout year for PPG. The company achieved record earnings per share of $6.87, up from $4.67 in 2010. As you may have been able to infer from the nature of PPG's business, the company's operating performance has generally been very sensitive to economic tides. If you take a look back to 2005, you'll see the following EPS numbers:
Steady? Not particularly. However, as you'll see on the historical income statements of almost every corporate cyclical, the visible lack of consistency is a result of the bubble economy of 2007, and the subsequent deep recession which bottomed in '09. On an organic level, earnings power has definitely been expanding.
A big driver of the owner EPS growth has been share repurchases. Here is where PPG separates itself from the pack. In 2008, when the company was trading at its (then) all-time high, management refrained from buying back shares. In late 2009, the company began aggressively buying back shares. These repurchases have continued without lapse, and a large majority of shares have been purchased in the upper $70 range. At that price, management was not only to purchase a significant amount of shares, but it was intelligently deploying capital and providing shareholder return. In 2011, the company purchased a massive 10 million shares. More than 2 million shares were purchased in the fourth quarter, probably at an average of $80. The share repurchase plan is on going.
Actual income growth has been strong as well, generally due to increased sales volume; pricing has been strong in specific segments as well. The company largely relies on volume, due to strong competition from companies like DuPont (DD) and BASF. This competition does not imply poor business economics. The company is a recognized leader within the industry, and customers are comfortable with PPG's high quality products. Additionally, though the company has large costs, mainly from natural gas, it has three major positives going for it right now. The first is that the company has had a relatively easy time passing on costs to its customers, given the nature of the business. The second is that management has done an excellent job reducing cost structure. The third is that natural gas prices have been particularly weak, and should remain depressed for the intermediate term. I believe the stock price does not reflect exceptionally low current input costs.
The firm has been around since 1883, and has an extremely strong franchise. This kind of long-term success and durability screams good fundamentals. Speaking of durability, PPG has increased its dividend for 40 years, and has been providing shareholders with dividends since 1899.
After reading PPG's 2010 annual report, I was very impressed by management's approach to taking on leverage. In November of 2010, the company completed an offering of about $1 billion in long term notes at exceptionally low rates of interest. The company has been using that cash to contribute to its pension assets, pay off loans with higher interest rates, and deploy back into the business (where the company has enjoyed a 15% ROIC). The company should be able to make an economic profit on its pension investments by utilizing the new cash to grow its pension assets (a profitable spread between the 3.6% notes and a presumed return on marketable securities in the ballpark of 6-8%), and reinvest in the business. Additionally, this sound approach to leverage allowed PPG to achieve a 31.32% return on equity in 2011. The firm has typically gotten a ROE closer to 20%.
The stock currently yields 2.50%. The dividend has been growing at a 3.6% clip over the past five years. Some investors may see both the initial yield and growth rate to be insufficient for this investment strategy. However, I see a company that has a FCF payout ratio below 30%, that is also growing earnings at an excellent rate. This implies that PPG sees some of growth ahead, and thinks they can deploy the capital wisely. Earnings retention has resulted in 21% return since 2006. This is average. While PPG should be rewarding shareholders with slightly more distributions, I agree with their desire to maintain a strong financial position. Additionally, PPG noted in its fourth quarter report that they are going to aggressively aim to create shareholder return in 2012, as they'd like to see a cash balance below $1 billion. This is very promising.
For a company that his been around for 175 years, Tompkins Financial is a rather interesting investment opportunity.
Tompkins Financial (TMP) is a holding company based in Ithaca, New York. The firm fully owns the Bank of Castile, the Mahopac National Bank, and AM&M financial services.
The main businesses of TMP are as follows:
- Commercial and Consumer Banking
- Trust and Investment Management
- Financial Planning
- Credit Cards
- Brokerage Services
Tompkins Financial encompasses the very best aspects of regional banking. The name has been around for 175 years, and has built up an exceptionally strong brand, which generates further growth with customer referrals.
Think about the durable economics of this company for a moment. The company has strong relationships with its clients because it has the resources that too big to fail banks don't have. Huge institutions generally have poor customer service, a bunch of hidden fees, and very little flexibility. There are some exceptions, but well-run localized banks clearly have an advantage when it comes to customer satisfaction. Furthermore, it would be extremely difficult for a new banking institution to steal business away from TMP.
For example, let's say Citigroup, Bank of America, or another regional bank opens up a new branch in Brewster, NY, where TMP already has a Bank of Mahopac branch. To attract customers, this new bank offers a few products with teaser rates, or other incentives. You are a small-business owner, If you've happily been getting financing, tax and accounting, and investment help with the Bank of Mahopac for 15 years, are you going to switch over your business to the new guy? These kind of services require in-depth relationships between the lender and the customer. It's difficult to run your business when your in the midst of changing the way you get your short-term capital, or how you manage your books. Sure, if the Bank of Mahopac starts getting on your nerves, this new competitor may start to look like a good alternative. However, after talking to some customers of both the Bank of Mahopac and the Bank of Castile (TMP operates near where I live), it's clear that the managers of TMP's subsidiary's branches do an incredible job, and customers stick with them for as long as they need their variety of services.
Tompkins Financial recently announced that it is acquiring VIST Financial (VIST). VIST operates in Southeastern Pennsylvania, a fresh region for TMP. The company believes that the region's demographics are very similar to those that they already work with in New York, so it won't be an entirely new experience.
This acquisition appears to be very solid for TMP. VIST was purchased at a surprising 7/10ths of book value, and roughly at tangible book. VIST has $1.4 billion in assets, $1.2 billion in deposits, and $960 million in outstanding loans. TMP expects the transaction to be accretive to earnings in the first fiscal year. VIST will operate as a fully owned subsidiary of TMP. The new affiliation will allow TMP to integrate some of its financial services into VIST's business. The last time TMP made this type of transaction (for Mahopac National Bank) the results were stellar. The deal will be paid for with TMP shares. VIST shareholders will likely receive about one third of a TMP share for every VIST share they own.
In 2006, TMP earned $2.52 per share, had a book value per share of $17.49, and paid $1.04 in dividends per share. Today, the company earns $3.20 per share, has a book value per share of $26.76, and pays $1.44 per share, even as the payout ratio has remained steady at roughly 40%. This performance results in annual increases of 5.4%, 10.6%, and 7.6%, respectively.
The stock currently yields 3.50%, with the dividend growing at roughly 8%. TMP has raised dividends for 25 straight years, and has a payout ratio of only 44%. Combining annual earnings growth with the current yield, investors are attaining underlying returns of 9%. As the dividend grows and yield on cost substantially improves, overall returns should prove to be excellent. In ten years, TMP should be paying about $3.11 per share, for a YOC of 7.6%. Over time, investors should be easily outperforming broader market gains. Using a DRIP will speed up and magnify returns even more.
TMP trades at 12.75 times trailing earnings, and 1.5 times book. The stock has a whopping 10% short interest, mostly due to arbitrage hedges as a result of the pending acquisition. Only 30% of the float is held by institutions -- this is a reasonably small portion, though I wish it was even smaller. Additionally, 15% of the company is held by insiders.
TMP is a classic well-run, economically durable business that dividend investors should heavily consider.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I will be initiating a position in TMP and PPG, not including the next 72 hours.