Analysis Of 'The U.S. Dividend Champions' Vs The S&P 500 Index On Main Street & Wall Street

| About: The Sherwin-Williams (SHW)
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Summary

Performs a quantitative analysis of the 'U.S. Dividend Champions' using some unique free cash flow ratios.

Compares the results to the S&P 500 Index and the S&P 500 equal weighted index.

Allows one to practice 'Capital Appreciation through Capital Preservation.'.

Recently a client (who is a big fan of dividend investing) sent me an email introducing me to a very interesting website, which he follows religiously. The website is called "The DRIP Investing Resource Center" and is run by fellow Seeking Alpha contributor Dave Fish. In his email my client asked me to analyze a portfolio (from that website) called the "US Dividend Champions" and to do so in a Seeking Alpha article. The "US Dividend Champions" for those who are unaware are U.S. companies with more than 25+ straight years of higher dividend growth.

Recently I wrote an article on Seeking Alpha called "How To Value Your Portfolio On Main Street Vs. Wall Street" that explains how our Friedrich algorithm can take any list of stocks, indices or specific portfolios and analyze each on Main Street and Wall Street, using some unique free cash flow ratios.

Friedrich is the name given to our algorithm for analyzing companies that trade on the global stock markets. In creating Friedrich we concentrated on analyzing each company's Main Street operations and compared those results to Wall Street's own valuation, as measured by market price. Through our Friedrich algorithm we can analyze ten years of Balance Sheet, Income Statement and Cash Flow Statement data for each company, all at once, and generate one our final result in seconds. Friedrich was designed to be ultra-conservative and thus will cut zero slack to any company under analysis and will do so with zero emotion. Companies must be exceptional in order to get an attractive valuation from Friedrich and the ideal investments according to our backtesting are the ones that have been consistent over time.

Our algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500 (NYSEARCA:SPY), an ETF, Mutual Fund or individual portfolio. Before I teach everyone how to do a similar analysis on one's own(using but a handful of the 66 ratios that are used in our algorithm) let us first define the roles that both Main Street and Wall Street play in the world of investing.

Main Street is where companies operate and Wall Street is where shares of those companies trade. The shares that one can purchase on Wall Street are in the public domain and each company has little control over how its share will trade. Companies are required to release earnings reports each quarter and from time to time also provides press releases to shareholders (and the general public) giving updates on how operations are doing on Main Street.

How well the management's of those companies perform on Main Street determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer, an internet connection and a brokerage account can buy or sell any stock at anytime, expertise is not a requirement in order to invest on Wall Street. This results in Wall Street being a very dangerous place to operate in as many investors tend to operate through emotion or tend to follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus we have the classic case of "greed vs. panic." By simply implementing the following ratios into one's own due diligence, we hope to help our readers avoid a similar fate when the next bear market shows up.

MAIN STREET AND WALL STREET ANALYSIS

One of the companies included in the "US Dividend Champions" list is Sherwin Williams (NYSE:SHW) and in order to teach everyone how our ratios work, I will do a Main Street vs. Wall Street analysis of it.

MAIN STREET ANALYSIS = FROIC

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it therefore has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street, that this news will eventually show up on Wall Street's radar.

Here is our FROIC analysis of Sherwin Williams:

Net Income per diluted share = $1,109,000,000/94,800,000 = $11.70

Depreciation per diluted share = $242,300,000/94,800,000 = $2.56

Capital Spending per diluted share = $-249,500,000/94,800,000= $-2.63

Revenue Growth Rate TTM = 2.98%

[(($11.70 + $2.56) (1+.0298%)) + ($-2.63)] =$12.05

Long-Term Debt = $1,909,700,000

Shareholders Equity = $1,597,800,000

Diluted Shares Outstanding = 94,800,000

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

$12.05/$36.99 = 32.58%

Now if one goes to my FRIEDRICH LEGEND (on what is considered a good or bad result) you will notice that our result of 32.58% is an excellent result and tells us that Sherwin Williams on Main Street generates $32.58 in forward free cash flow for every $100 it invests in total capital employed.

WALL STREET ANALYSIS = Price to Bernhard Buffett FCF

Many years ago, while reading the Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett entitled "Owner Earnings," or what we may consider to be Mr. Buffett's version of "Free Cash Flow." To my amazement, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

"[Owner earnings] represent (NYSE:A) reported earnings plus (NYSE:B) depreciation, depletion, amortization, and certain other non-cash charges…less (NYSE:C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

I have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line's sheets for my 60-year backtest of the DJIA from 1950-2009.

In the backtest that I mentioned above, I demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price to Free Cash Flow Ratio, that the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how each ratio below is calculated.

Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/(net income per share + depreciation per share) + (capital spending per diluted share)

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

To begin our analysis, we must first analyze Sherwin Williams Sherlock Debt Divisor and here is a more detailed definition of what that ratio is:

SHERLOCK DEBT DIVISOR = A major concern that I have these days in analyzing companies is the amount of debt each takes on relative to its operations and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what I have done to determine if a company's debt policy is beneficial or abusive, is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well, I take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, I reward it and punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used and the more leveraged a company is, the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for Sherwin Williams. TTM for those who don't know is "trailing 12 months" or as close to real time data as we can get, based on when each company reports.

Price-to-Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor/ [(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding)

Sherwin Williams

Market Price Per Share = $309.71 (at time of analysis)

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $3,708,200,000

Total Current Liabilities = $2,515,800,000

Working Capital = $1,192,000,000

Long-Term Debt = $1,909,700,000

Diluted Shares Outstanding = 94,800,000

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

Sherlock Debt Divisor = $309.71 - (($1,192,000,000 - $1,909,700,000)/94,800,000))

Sherlock Debt Divisor = $309.71 - $-7.57 = $316.57

Since Sherwin Williams has more Long-Term Debt vs. Working Capital, we therefore must punish it and use the $316.57 result as the new numerator in all our calculations.

Price-to-Bernhard Buffett Ratio = Sherlock Debt Divisor/ (net income per share + depreciation per share) + (capital spending per diluted share)

Sherlock Debt Divisor = $316.57

Net Income per diluted share = $1,109,900,000/94,800,000= $11.70

Depreciation per diluted share = $242,300,000/94,800,000= $2.56

Capital Spending per diluted share = $-249,500,000/94,800,000= $-2.63

$11.70 + $2.56 + ($-2.63) = $11.63

Price-to-Bernhard Buffett Free Cash Flow Ratio = $316.57/$11.64 = 27.19

In viewing our Friedrich Legend again, we will notice that our result of 27.19 is an average result.

We last ran our Datafile for Sherwin Williams on February 9, 2017, and our Friedrich Algorithm gave a recommendation to our subscribers to hold it as our Algorithm's sell price is $443.

So on Main Street Sherwin Williams is doing great, but Wall Street has noticed this fact and has been buying up its shares, which has it approaching our overbought level for this ratio of 30.

Since the subject of dividend investing is of great interest here on Seeking Alpha, we will thus proceed and analyze the "US Dividend Champions" using the same exact methodology outlined in our Sherwin Williams analysis above. We will provide numerous individual company results for both Main Street and Wall Street and then provide the final result for the combined list as well. Once that is done, we will compare those combined results to the S&P 500 Index and the S&P 500 Equal Weighted Index (NYSEARCA:RSP).

Here is our analysis of the "US Dividend Champions"

Our analysis shows that the "US Dividend Champions" generated the following combined average results, using an equally weighted portfolio analysis.

FROIC = 12% (Main Street)

Price to Bernhard Buffett FCF = 34.89 (Wall Street)

For FROIC, we consider any result above 20% to be excellent and any result above 10% to be good, so the "US Dividend Champions" having a FROIC of 12%, can be considered good and tells us (that as a group on Main Street) the components on that list are doing well.

The problem is that Wall Street has "overbought" the list, giving it a score of 34.89 for our Price to Bernhard Buffett FCF ratio. That ratio considers a stock a bargain when it trades under 15 times and overbought when it trades over 30 times. Therefore, the list is 4.89 points or about 16% in "overbought" territory.

If one compares the "US Dividend Champions" results to those of the S&P 500 Index, it has a similar FROIC of 12% on Main Street, but is much more attractive then that index on a Price to Bernhard Buffett FCF ratio front on Wall Street, as the S&P 500 Index came in with a result of 38.34. Since the S&P 500 Index is not equally weighted, we therefore re-analyzed it again with our Friedrich Algorithm and this time used the S&P 500 Equally Weighted Index and here are those results.

FROIC = 10% (Main Street)

Price to Bernhard Buffett FCF = 42.67 (Wall Street)

Clearly when one analyzes the S&P 500 Index from an equally weighted point of view, that index looks quite scary and shows how overbought the markets really are currently, for on Wall Street that index's result is some 42% higher than what we consider overbought.

Therefore when investing these days, one is basically doing so in an environment of "overbought conditions" on Wall Street. So whether you are a dividend investor or a growth or value investor, any purchases made these days are being done with a greater degree of relative risk compared to any future rewards in which one can expect. The "US Dividend Champions" clearly are more conservative, but nevertheless as a group are still overbought on Wall Street. The ones on the list with outstanding FROIC results, unfortunately have high Price to Bernhard Buffett FCF results as well. So in our opinion the smart move to make right now is to build up one's cash position, in preparation for the next correction and weed out those holdings in your portfolio that have weak FROIC scores, as well as high Price to Bernhard Buffett FCF results.

If President Trump's "Rhetoric" actually turns into "Reality", and he is able to drop corporate taxes down to 15-20%, then markets will erupt and since corporate taxes will go down dramatically, at the same time company FROIC scores will erupt as well. Therefore if one believes that President Trump will succeed, then I would suggest concentrating your attention on those companies in the "US Dividend Champions" list that have the highest FROIC scores.

Going Forward, if you want to duplicate this same analysis for your own portfolio, it will require some effort on your part, in order to calculate the FROIC and Price to Bernhard Buffett ratio for each holding. But once you have done that, then you simply weigh each holding in your portfolio and then multiply that weighting result by each holding's FROIC result and then by each holding's Price to Bernhard Buffett result. Then sum each column's results and that will give you the final results for both ratios for your portfolio. Then you can act based on how your portfolio stacks up on Main Street vs. Wall Street and can also easily compare it to any index. For those who don't want to do the leg work on your own we offer a service where we have done the calculations for 4000 US stocks and soon to be 16,000 global stocks from 27 countries.

In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor tool box in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below and don't forget to hit the "Follow" button after our Friedrich Research username on top as now that we are able to analyze entire lists or portfolios, we will then proceed to analyze ETFs, Mutual Funds and certain popular portfolio managers' (gurus) portfolios in a series of articles here on Seeking Alpha.

Disclosure: I am/we are long SHW.

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.

Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.