Creating A Winning Large-Cap, High-Yielding Dividend Growth Portfolio: Consider Valero Energy

| About: Valero Energy (VLO)
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Summary

Presenting a formula that can be used to create a winning large-cap high-yielding dividend growth portfolio.

17 years back-test has given an average annual return of 7.40%, while the average annual return of the S&P 500 index during the same period was only 3.05%.

Highlights and a long-term buy recommendation for the first-ranked stock of the formula: Valero Energy.

I tried to create a large-cap high-yielding dividend growth portfolio that can outperform the market. The following screen shows such a promise. I have searched for S&P 500 companies that pay very rich dividends with a low payout ratio. Those stocks also would have to show a dividend growth in the last five years.

The screen's method that I use to build this portfolio requires all stocks to comply with all following demands:

1. The stock should be included in the S&P 500 index.

2. Market cap is greater than $500 million.

3. The dividend yield is greater than 4.0%.

4. The payout ratio is less than 100%.

5. Positive dividend growth in the last year.

6. Positive dividend growth in the last three years.

7. Positive dividend growth in the last five years.

8. The twenty stocks with the highest ranks according to the Dividend Factors ranking system among all the stocks that complied with the first seven demands.

The Dividend Factors ranking system is taking into account high dividend yield-35%, low payout ratio-35%, and high dividend growth-30%.

I used the Portfolio123's screener to perform the search and to run back-tests according to these conditions. After running this screen on June 14, 2016, I discovered the following twenty stocks, which are shown in table below. In this article, I will focus on the first ranked company Valero Energy (NYSE:VLO).

Valero Energy

Lower gasoline and distillate margins have impacted the financial results of U.S. refiners in the first quarter of 2016 and caused their shares to drop significantly. In fact, all the five U.S. leading refining companies' shares have shown a decline in the last 13 weeks between -9.9% for Phillips 66 (NYSE:PSX) and -30.7% for HollyFrontier (NYSE:HFC). Moreover, four companies have recorded a negative return (including dividend) in the last 52 weeks. Phillips 66 has shown the best performance among the leading refining companies with a positive return of 3.5% while HFC's negative return has been very high at -37.8%, as shown in the table below. Valero Energy, the world's largest independent petroleum refiner and marketer, has had a negative return of -10.8% in the last 52 weeks.

On May 3, Valero reported its first quarter financial results which missed adjusted earnings-per-share expectations by $0.06 (9.1%). The company posted revenue of $15.71 billion in the period, significantly surpassing Street forecasts. It was the first time that the company missed estimates after nine quarters of beating expectations, as shown in the table below.

Data: Yahoo Finance

The refining segment reported $695 million of adjusted operating income for the first quarter of 2016, compared to $1.6 billion for the first quarter of 2015. According to the company, the decline was primarily attributable to weaker distillate margins given high refining industry production levels and a warm winter. Other factors included narrower crude oil discounts relative to the Brent benchmark, reduced fuel oil and petrochemical product margins, and higher costs for renewable identification number credits. The company said that lower energy costs resulting from the continued growth in North American natural gas supply partly offset these factors. Valero's refineries achieved 96% throughput capacity utilization and averaged 2.9 million barrels per day of throughput volume in the first quarter of 2016, an increase of 169,000 barrels per day from the first quarter of 2015 attributable primarily to less maintenance activity in the first quarter of 2016.

In the report, Joe Gorder, Valero Chairman, President and Chief Executive Officer, said:

Our team's relentless pursuit of safe, reliable, low-cost operations delivered solid operating performance this quarter despite lower product margins. This strategy, combined with our system's flexibility and complex assets concentrated in the advantaged U.S. Gulf Coast region, are factors that allow us to succeed in this competitive global industry.

Looking forward, according to the company, it is optimistic about product demand. In the U.S., distillate inventories have shown favorable reductions recently, and the summer driving season is quickly approaching, which should support gasoline margins. Valero said that it also expects the strong export demand it experienced in the first quarter to continue.

Refining Margin

According to Howard Weil report from June 8, U.S. Gulf Coast's average crack spread thus far in the current quarter has been $11.41 per barrel, compared to $9.22 in the first quarter of 2016. U.S. Gulf Coast's throughput volume of 1.693 million barrels per day accounted for 58.8% of Valero's total throughput volumes of 2.879 million barrels per day in the first quarter of 2016. As such, we can expect better refining margin for the company in the current quarter along higher earnings.

Source: howardweil.com

Balance Sheet, Dividend and Share Repurchase

Valero ended the first quarter of 2016 with $7.3 billion of total debt and $3.8 billion of cash and cash equivalents. At the end of the first quarter, Valero's total debt to capital ratio was at 25.4%, down from 25.8% a year earlier. The company's debt is rated BBB stable by Standard & Poor's and Baa2 stable by Moody's.

On January 21, Valero announced a 20% increase in its quarterly common stock dividend from $0.50 per share to $0.60 per share. Valero paid $282 million in dividends and purchased 3.8 million shares of its common stock for $265 million, resulting in total cash returned to stockholders of $547 million in the first quarter of 2016. According to the company, it continues to target a payout ratio of 75% of net income in 2016. Valero defines payout ratio as the sum of dividends plus stock buybacks divided by adjusted net income from continuing operations attributable to Valero stockholders.

The annual dividend yield is high at 4.73% and the payout ratio only 26.6%. The current yield is historically high, which indicates that the stock is undervalued, according to some dividend assessment theories. The annual rate of dividend growth over the past three years was very high at 37.8%, over the past five years was also very high at 53.4%, and over the last ten years was high at 24.5%.

VLO Dividend Chart

VLO Dividend data by YCharts

Valuation

Since the beginning of the year, VLO's stock is down 28.2% while the S&P 500 Index has increased 1.5%, and the Nasdaq Composite Index has lost 3.3%. However, since the beginning of 2012, VLO's stock has gained 141.3%. In this period, the S&P 500 Index has increased 65%, and the Nasdaq Composite Index has risen 85.9%. Nevertheless, considering its compelling valuation and its healthy growth prospects, the recent drop in its price creates an excellent opportunity to buy the stock at an attractive price. According to TipRanks, the average target price of the top analysts is at $63.50, an upside of 25% from its June 14 close price, which appears reasonable, in my opinion.

VLO Daily Chart

VLO Weekly Chart

Charts: TradeStation Group, Inc.

Considering its compelling valuation metrics, VLO's stock, in my opinion, is considerably undervalued. The trailing P/E is extremely low at 7.16, its forward P/E is also very low at 7.41, and its price-to-sales ratio is exceptionally low at 0.29. Furthermore, its price-to-free-cash-flow ratio is very low at 9.94, its Enterprise Value/EBITDA ratio is also very low at 3.63, and the PEG ratio is at 1.49.

In addition, most VLO's Financial Strength and Return on Capital parameters have been much better than its industry median, its sector median and the S&P 500 median as shown in the tables below.

Source: Portfolio123

Summary

Valero missed analysts' estimates for the first time after nine quarters of beating expectations, mainly due to weaker distillate margins. However, looking forward, the company is optimistic about product demand. In the U.S., distillate inventories have shown favorable reductions recently, and the summer driving season is quickly approaching, which should support gasoline margins. Moreover, according to Howard Weil, U.S. Gulf Coast's average crack spread thus far in the current quarter has been $11.41 per barrel, compared to $9.22 in the first quarter of 2016. As such, we can expect better refining margin for the company in the current quarter along higher earnings. Considering its compelling valuation metrics, VLO's stock is extremely undervalued. The price-to-free-cash-flow ratio is very low at 9.94, its EV/EBITDA ratio is extremely low at 3.63. Also, the company generates strong free cash flow and returns substantial capital to its shareholders by stock buybacks and increasing dividend payments currently yielding 4.73%. In my view, the recent drop in its price creates an excellent opportunity to buy VLO's stock at an attractive price. The average target price of the top analysts is at $63.50, an upside of 25% from its June 14 close price, which appears reasonable, in my opinion.

Back-testing

In order to find out how such a screening formula would have performed during the last year and last seventeen years, I ran the back-tests, which are available by the Portfolio123's screener.

The back-test takes into account running the screen each four weeks and replacing the stocks that no longer comply with the screening requirement with other stocks that comply with the requirement. The theoretical return is calculated in comparison to the benchmark (S&P 500), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests results are shown in the charts and the tables below.

One year back-test

Seventeen years back-test

Summary

The dividend stocks screen has given much better returns during the last year, and the last seventeen years than the S&P 500 benchmark. The Sharpe ratio, which measures the ratio of reward to risk, was also much better in the two tests.

The one-year return of the screen was at 14.91%, while the return of the S&P 500 index during the same period was negative at -0.76%. The 17-year average annual return of the screen was at 7.40%, while the average annual return of the S&P 500 index during the same period was only 3.05%. The maximum drawdown of the screen was at 64.5%, while that of the S&P 500 was at 57%. In my opinion, the 17-year back-test's results are more reliable than those of the one-year results which could be coincidental.

Disclosure: I am/we are long VLO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.