The Best Dividend Stocks To Buy During Earnings Season

by: Dividend Sensei

Last week, Netflix crashed 11% after missing subscriber growth guidance. This highlights the risks of buying red hot momentum stocks priced for perfection.

The S&P 500 is currently trading at a 17.0 forward PE, vs. a 25-year average of 16.2, and that is largely based on increasingly outlandish (and steadily falling) expectations.

If we don't get a trade deal soon, and the final China tariffs go up, double-digit EPS growth next year become highly unlikely.

Energy, industrials, and financials (the only sector reporting rising profitability) are the best choices for passive investors looking to put money to work in ETFs.

For the company focused investor this article provides not just many potentially attractive buying ideas, but also a guide about how to value companies, starting with the approach used by the Dividend Kings.

(Source: imgflip)

Due to reader requests, I've decided to break up my weekly "Best Dividend Stocks To Buy This Week" series into two parts.

One will be the weekly watchlist article (with the best ideas for new money at any given time). The other will be a portfolio update.

To also make those more digestible, I'm breaking out the intro for the weekly series into a revised introduction and reference article on the 3 rules for using margin safely and profitably (which will no longer be included in those future articles).

To minimize reader confusion, I will be providing portfolio updates on a rotating tri-weekly schedule. This means an update every three weeks on:

  • My retirement portfolio (where I keep 100% of my life savings)
  • The best dividend and aristocrats to buy now (the new, more useful format that tracks my model Bunker Dividend Growth Portfolio) - now including the best opportunistic buys of each week based on F.A.S.T. Graphs
  • My new "What I'm Buying Next" series, which explains what companies are on my immediate buy watchlist from which I make all weekly retirement portfolio buys.

I've also decided to remove the "Why Valuation ALWAYS Matters" intro to this series since that makes it more cumbersome to read for loyal followers of this series.

Earnings Season Is Famous For High Volatility, But Buying Quality Companies At Reasonable Valuations Is A Good Way To Minimize Short-Term Earnings Crashes

(Source: YCharts)

Last week, Netflix (NFLX) missed its subscriber growth expectations (badly), and the stock plummeted 11% the next day. That should have been no surprise to anyone.

(Source: F.A.S.T. Graphs)

The company has traded at a nose bleed average PE of 106 since its IPO, as investors were willing to overlook modest earnings in the early years and focus on subscriber growth (and ignore -$3 billion in FCF this year due to $8 billion in content costs). Netflix's rapidly rising debt (junk bond rated) means that it's in a race with the next recession (whenever it arrives) for its very survival.

Back in late June 2019, the stock was trading at an even loftier valuation of 121 PE and in mid-2018 it hit 200. When momentum stocks priced for perfection fail to deliver, sentiment shifts quickly and large crashes can result.

In the broader market, every sector except unloved financials (the second most undervalued sector relative to five and 10-year average PE) is reporting lower profit margins so far.

(Source: FactSet Research)

Granted, just 16% of the S&P 500 has reported, and 79% of companies have beaten EPS expectations (thanks to analysts massively lowering expectations for months). However, FactSet research is estimating that if the current trend holds, EPS growth for Q2 will be -1.9%, the second straight quarter of shrinking earnings.

An earnings recession is a bad time to buy overvalued companies, especially when the market is historically overvalued.

(Source: FactSet Research)

Analysts now expect Q3 to be another negative quarter for earnings growth and 2019's small increase depends on an increasingly questionable (and steadily shrinking) 5.4% EPS growth in Q4.

Meanwhile, the 17.0 forward PE (vs 16.2 25-year average) is likely being artificially inflated by rather bullish double-digit growth expectations for the first half of 2020. If we don't get a trade deal this year, it's very unlikely those will hold up, and the 10.9% EPS growth for full-year 2020 estimate (down from nearly 12% at the start of the year) is likely to keep shrinking.

(Source: FactSet Research)

One way to minimize the risk of a nasty earnings freakout is to invest in undervalued sectors such as energy (via the ETF (XLE)), Industrials (XLI) and Financials (XLF). Of if you are a stock picker like me, then buying quality companies at fair value or better is the way to go.

The Dividend Kings Approach To Valuing And Recommending Stocks

The Dividend Kings motto is quality first, valuation second and good risk management always.

This means, we don't recommend unsafe companies, with failing business models or unsafe dividends (value/yield traps). Similarly, while we love a bargain (who doesn't), we realize that many investors shouldn't be primarily focused on deep value. That's because deep value investing, while the strategy used by seven of the nine most successful investors in history, requires longer time frames and more patience than many investors (like retirees) have.

This is why we've built no less than four model portfolios, including one that's 100% Super SWANs (11/11 quality companies, as close to perfect dividend growth stocks as exist on Wall Street), and a $1 Million Retirement Portfolio that's 60% quality dividends stocks (including aristocrats), 30% bonds (of varying duration) and 10% preferred shares.

We just unveiled our Dividend Kings valuation/total return list, that tells subscribers the fair value and total return potential (a conservative range since the future is never certain) of all the dividend kings. In the coming weeks and months, we'll create lists covering

  • All dividend aristocrats
  • All safe MLPs
  • All the Super SWANs (40 companies that have historically beaten the market by 5% annually over the past 28 years and with less volatility to boot)
  • All 8/11 or higher quality companies (anytime I research a company, I run the model and add it to the database)

The idea is to combine the Kings' 134 years of investing experience and extensive watchlists of quality companies, with the power of objective historical valuation to let our members know, at any given time, what any company is worth, and what kind of realistic total returns are likely over the next five years.

How do we value companies? As Chuck Carnevale, SA's valuation guru, the founder of F.A.S.T. Graphs, and someone with 50 years of experience in asset management likes to say "valuation is a fact, not an opinion."

Over his half-century in learning to value companies, Mr. Carnevale has determined that Benjamin Graham (the father of value investing and Buffett's mentor) was correct in saying that, over the long term, the market correctly "weighs the substance of a company."

Another way of putting it is that a company is worth what the market will pay for it based on long-term fundamentals such as the quality of its assets, its competitive advantages, management track record, dividend safety, and growth record, and its fundamental growth rates (of earnings and cash flow).

This is why he built F.A.S.T. Graphs, to show the objective fact about how much real investors, using their hard-earned money, were willing to pay for a company.

But using a single metric can also be misleading at times, especially if you're looking at a shorter time frame. This is why I've discontinued the dividend yield theory section of these watchlist articles, in favor of this more comprehensive approach (which is 30% based on dividend yield theory but looking at three-time frames spanning five to 25 years).

Here is what our valuation model is built on.

  • 5-year average yield
  • 13-year median yield
  • 25-year average yield
  • 10-year average PE ratio
  • 10-year average P/Owner Earnings (Buffett's version of FCF)
  • 10-year average price/operating cash flow (FFO for REITs)
  • 10-year average price/free cash flow
  • 10-year average price/EBITDA
  • 10-year average price/EBIT
  • 10-year average Enterprise Value/EBITDA (factors in debt)

These metrics represent pretty much every company fundamental on which intrinsic value is based on. Not every company can be usefully analyzed by each one (for example, EPS is meaningless for REITs, MLPs, yieldCos, and most LPs). But the idea is that each industry appropriate metric will give you an objective idea of what people have been willing to pay for a company.

As long as the business model is stable over time (the wheels don't fall off the bus as they did at GE for example), then growth rates will be relatively stable as well, and share prices eventually revert to their historical norms. The average of four to 10 such historical fair values gives you a relatively objective and accurate idea of what a company is worth today.

For total return potentials, we use the Gordon Dividend Growth Model, which has proven highly effective since 1954. This simply states that, for stable companies (such as dividend blue chips), total returns = yield + long-term cash flow/dividend growth with valuations reverting to historical norms over 5+ years.

See my latest retirement portfolio update for three examples of how we build these conservative total return models, using three concrete examples (the last 3 stocks I bought for my retirement portfolio).

Here are five great investing ideas from our watchlists, created via the 10 metric historical valuation model and the realistic returns you could expect from today's valuations.

Great Investing Ideas From The Dividend Kings Watchlists

Investment Type Company Ticker Current Price Historical Fair Value Yield Discount To Historical Fair Value 5-Year F.A.S.T Graphs Estimated Total Return Potential
High-Yield MPLX (MPLX) $32 $50 8.5% 38% 14% to 17%
High-Yield (No K-1) British American Tobacco (BTI) $39 $50 6.9% 23% 22% to 25%
Dividend Aristocrat Caterpillar (CAT) $137 $172 3.0% 20% 18% to 26%
Dividend King 3M (MMM) $173 $188 3.3% 8% 11% to 16%
Super SWAN (11/11 Quality) Cullen/Frost Bankers (CFR) $92 $102 3.1% 9% 11% to 17%

(Sources: F.A.S.T. Graphs, Google Finance, Management Guidance, Analyst Consensus) - prices as of July 19th

Need more great investing ideas for quality companies trading at reasonable to great prices? That's what the rest of this article is for.

Morningstar Is A Good (But Not Perfect) Place To Start Looking For Good Ideas

Morningstar is typically (though not always) a good starting location for blue-chip income investing ideas. That's because they are 100% focused on long-term fundamentals, rather than 12-month price targets like most sell-side analysts (the ones that issue "buy, sell, hold" recommendations). Most of their fair value estimates are reasonable (though not always, more on this in a moment). So, here are all my blue-chip watchlist stocks that Morningstar estimates are at least 20% undervalued.

(Source: Morningstar) data as of July 19th "q" = quantitative (non-analyst) model estimate

But you can't just look at any one analyst's fair value estimate and know if it's a good buy. That's because every company has its own risk profile, and differing business models mean that a 20% discount to fair value of a highly cyclical company (like commodity producers) isn't the same for one with very stable and recession-resistant cash flow (like a consumer staples company).

This is where looking at Morningstar's star ratings is a good next step. These ratings, which correspond to buy, strong buy, and very strong buy recommendations, factor in a company's risk profile, industry trends, management quality and Morningstar's definition of "Moatiness" (which I sometimes disagree with but are for the most part on the money when it comes to corporations).

Morningstar's moat definition is based on their belief that a company can maintain returns on invested capital above its weighted cost of capital (using their assumptions plugged into the CAPM model) for 20 years or longer (wide moat) and 10 years or more (narrow moat). I look for competitive advantages that allow returns on invested capital above the industry norm and above the cash cost of capital (what matters more to the ability to grow dividends over time).

Here are my watchlist companies that Morningstar consider 4 or 5 star buy and strong buy ratings.

(Source: Morningstar) data as of July 19th "q" = quantitative (non-analyst) model estimate

You'll note that there a lot more 4 and 5 star stocks than ones trading 20% or below Morningstar's estimates fair value. That's because Morningstar is adjusting for quality, safety, and overall cash flow stability (via their uncertainty ratings). This is why a Dominion Energy (D) is a 4-star buy recommendation despite being just 8% undervalued (per their estimate).

However, while a 4 or 5 star Morningstar stock is USUALLY a good long-term investment, it's important to remember that some of the company's recommendations can be far off the mark. Dividend Kings uses a 100% pure F.A.S.T. Graphs powered historical valuation method that only looks at historical and objective data and sometimes disagrees with Morningstar.

Typically, these disagreements are minor. Sometimes, they are not. Consider Microsoft (MSFT) which is actually a Fortress holding. While we own the company for its dominant position in cloud computing, we also realize that it is overvalued (historical fair value $100) and will need trimming in the future (quarterly rebalancing) if it continues its red hot run (our cut off for rebalancing is 33% historically overvalued or more).

In contrast, Morningstar's Dan Romanoff estimates Microsoft's fair value at $155 (raised after great earnings) indicating he thinks it's 13% undervalued at its current $137 price (as I write this). Why the big disconnect in fair value estimates?

Our fair value estimate for Microsoft is $155 per share, which implies a fiscal 2021 enterprise value/sales multiple of 8 times, adjusted price/earnings multiple of 29 times, and a 4% free cash flow yield... We model total revenue growth slowing from 11% in fiscal 2020 to 9% in fiscal 2029, representing a 10-year compound annual growth rate, or CAGR, of approximately 10%, ahead of the 6% CAGR Microsoft generated over the previous 10-year period...We also model operating margins increasing steadily from 35% in fiscal 2020 toward 40% in fiscal 2029, driven largely by an approximately 300 basis point improvement in gross margin as Azure continues to scale, and more than 200 basis points of scale-related reductions in operating expenses." - Morningstar (emphasis added)

Basically, Morningstar is saying that faster earnings growth at Microsoft, courtesy of strong top-line cloud growth and margin expansion, will justify the PE ratio expanding from its historical 21 to 29 (a 40% increase).

Is that necessarily wrong? No, it just requires Microsoft's EPS growth to accelerate from its historical 10% to 14% (analyst consensus is 12.3% CAGR over the next five years).

(Source: F.A.S.T. Graphs)

As you can see over the past 20 years, despite the major slowdown in growth during the Ballmer years, MSFT has managed nearly double-digit growth, earning it a 21.3 average PE.

To justify a 29 PE would require sustained 14% growth, which, while possible (it's expected in 2021 and possibly several years beyond), is far from guaranteed, given the company's massive size and already large cloud market share.

So, what does this mean for total returns?

(Source: F.A.S.T. Graphs)

If Microsoft grows as analysts expect (10% to 14% growth is a reasonable expectation given the company's strengths), then mean reversion to its historical PE could mean investors would see about 6% CAGR total returns.

If it achieves slightly slower growth than expected (10% is the conservative estimates DK is using), then it would do rather poorly.

(Source: F.A.S.T. Graphs)

If Microsoft grows at 10% over time, it's likely the PE reverts back to the historical level, and it might generate just 3% CAGR total returns over the next five years.

(Source: F.A.S.T Graphs)

Morningstar's estimate of about 14% long-term growth and a 29 long-term PE MIGHT happen, though it represents the realistic best-case scenario. If it happens then MSFT could deliver 12% CAGR total returns, which is why the analyst firm rates MSFT a fair buy today.

Dividend Kings only assumes 10% to 12.3% long-term growth on MSFT and a reversion to the historical PE which is why our long-term return potential on the company is currently 3% to 6% (and why it will be part of the quarterly Fortress rebalancing should it continue trading at above $133).

How can you tell whether or not Morningstar's valuation estimates and star ratings are reasonable or totally off the mark (other than becoming a Dividend King member and looking at our exclusive company valuation/total return potential lists)? One good way is to look at objective valuation metrics, which is where we turn to next.

Price-To-Earnings Vs. Historical Norm

While no single valuation method is perfect (which is why DK uses 10 of them), a good rule of thumb (from Chuck Carnevale, the SA king of value investing and founder of F.A.S.T. Graphs) is to try not to pay more than 15 times forward earnings for a company.

This is because PE ratios are the most commonly used valuation metric on Wall Street and 15.0 PE being a reasonable price for quality companies is based on Mr. Carnevale's 50 years of experience in asset management valuing companies. He bases that on an earnings yield of 6.7% (inverse of a 15 PE) being roughly equal to the 200-year return of the stock market.

Chuck's historical P/E valuation approach has made him a legend on Seeking Alpha and, according to TipRanks, one of the best analysts in the country when it comes to making investors money (Brad Thomas and I are both at 69% success rates by the way).

(Source: TipRanks) - data as of July 19th, note the stock market's historical 1-year return is 9.1% and 60% is considered a good success rate for analysts.

Chuck usually compares companies to their historical valuation ratios, and he's ranked in the top 1.5% of all analysts tracked by TipRanks (based on the forward 12-month total returns of his recommendations). While 12 months is hardly "long term," the point is that Mr. Carnevale is a fantastic value investing analyst, and his historical valuation-driven approach is beating 98.5% of all bloggers/analysts, including 5,200 that work on Wall Street.

Here are dozens of blue-chip companies with forward P/Es of 15 or less. Note that some industries are naturally prone to lower multiples (such as financials) due to more cyclical earnings. Which is why you want to compare their current PEs to their historical norms (Morningstar offers 5-year average PEs, but 10 years is better for factoring in industry/sector downturns).

Also, P/E ratios for MLPs, REITs, and YieldCos are not a good indication of value since high depreciation results in lower EPS. Price/cash flow is the better approach with such pass-through stocks.

(Source: Morningstar) - data as of July 19th

But as I just said, PE is not appropriate for some stocks, such as REITs, YielCos, MLPs, and LPs. This is where you want to check price to cash flow, which can give you a rough idea (though also not perfect) whether a pass-through stock is trading at a reasonable valuation.

Price/Cash Flow Vs Historical Norm

While earnings are usually what Wall Street obsesses over, it's actually cash flow that companies run on and use to pay a dividend, repurchase shares, and pay down debt. Thus, the price/cash flow ratio can be considered a similar metric to the P/E ratio but a more accurate representation of a company's value. Chuck Carnevale also considers a 15.0 or smaller price/cash flow ratio to be a good rule of thumb for buying quality companies at a fair price. Buying a quality company at a modest to great cash flow multiple is a very high probability long-term strategy.

Again, comparing a company's price to cash flow against its historical norm can tell you whether it's actually undervalued. Dividend Kings uses 10-year average cash flows and Morningstar only offers 5-year averages. For cyclical companies, sometimes, that can cause skewed results (which is why we use longer time periods and as many of our 10 valuation metrics as are industry-appropriate).

Here are all the companies on my watchlist with price/cash flow of 15.0 or less.

(Source: Morningstar) - data as of July 19th

You want to use several valuation metrics in concert to ensure that any false signals are eliminated. Dividend Kings uses 10 whenever appropriate and, if needed, standardizes them by excluding any obvious outliers (such as ones that show Broadcom's (NASDAQ:AVGO) fair value at over $700).

PE/Growth Ratio

According to Benjamin Graham, Buffett's mentor and the father of value investing, a company with stable cash flow but zero growth prospects is fairly valued at a PE of about 8. If you just go off the PE ratio alone, you may actually not be getting a good deal, because companies with fast growth are naturally worth higher multiples. This is where the PE/Growth or PEG ratio comes in.

While this method is limited by what growth assumptions you use, it's a quick and dirty way to screen for potentially attractive dividend growth investments, when used in conjunction with other methods. The S&P 500's PEG ratio is currently 2.8. A PEG of 1.0 or less is generally excellent, but 2.0 or less is likely to deliver good returns IF you're buying a quality company with a stable business model. Here are my watchlist stocks with PEGs of 2.0 or less, as estimated by Morningstar's forward growth forecast.

(Source: Morningstar) - data as of July 19th

PEG is a good way to strive for "growth at a reasonable price" or GARP. However, the obvious flaw is that it's based on forward projections that can be wrong. All valuation metrics have their limitations, which is why you shouldn't rely on just one.

Quality Stocks At 52-Week Lows Are Great Screening Candidates

(Source: Google Sheets) data as of July 19th, bolded companies are within 5% of 52-week lows

I maintain a watchlist that takes every company I track and applies an 11-point quality score based on dividend safety, the business model, and management quality. All dividend stocks can be ranked 3-11, and my watchlist (about 200 companies) only includes those with quality scores of 8 and higher.

  • 8: quality company, seek 15% discount to fair value or better, limit to 5% to 10% of invested capital,
  • 9: Blue-Chip company, limit to 5% to 10% of invested capital and seek 10% discount to fair value
  • 10: SWAN stock: buy with confidence at 5% or greater discount to fair value or better, limit to 5% to 10% of invested capital
  • 11: Super SWAN (as close to an ideal dividend stock as you can find on Wall Street), fair value or better, limit to 5% to 10% of your invested capital

I've programmed that watchlist to track prices and use the 52-week low as a means of knowing when a blue-chip or SWAN stock is within 5% of its 52-week low and potentially a Buffett-style "fat pitch" investment. This means a quality company is:

  • Trading near its 52-week (or often multi-year) low.
  • Undervalued per other valuation methods
  • Offers a high probability of achieving significant multiple expansion within 5 to 10 years and thus delivering double-digit long-term total returns over this time period.

Another method you can use is to target blue chips trading in protracted bear markets, such as sharp discounts to their 5-year highs. Buying a company at multi-year lows is another way to reduce the risk of overpaying and boost long-term total return potential.

(Source: Morningstar) - data as of July 19th

Basically, "Fat Pitch" investing is about achieving high-risk style returns with low-risk stocks, by buying them when they are at their least popular ("be greedy when others are fearful.")

Mind you, it can take a long time for coiled springs like these deep value blue-chips to pop, but as long as their business models remain intact and they keep growing cash flow and dividends, they eventually will which is why seven of the nine best investors in history have been value investors.

Bottom Line: Overvalued Companies Are Priced For Perfection And Most Likely To Suffer Major Earnings Miss Crashes...While Undervalued Companies Are Pricing In Low Expectations That Are Much Easier To Beat

I don't concern myself with earnings crashes, other than to use them as opportunistic buying opportunities. That's what I've done no less than four times in the last five months, to load up on Walgreens (WBA), 3M, Lowe's (LOW) and Broadcom.

But while I may revel in double-digit daily declines, most investors prefer to avoid them. While there is no way to avoid earnings crashes entirely, avoiding buying companies trading far above their historical norms is a great way to minimize earnings season drama.

While there is no perfect way to value a company, the multi-metric approach I've outlined here, (which the Dividend Kings have been using for decades between the three of us, to great effect) is the best way to find great companies trading at reasonable, or downright undervalued levels.

Coiled spring blue chips, who are pricing in very low expectations, are the most likely to reward investors with joy-inducing rallies following earnings beats (Philip Morris International (NYSE:PM) just soared 8% after beating pessimistic expectations and slightly raising 2019 guidance).

But if you aren't comfortable with deep value investing (most people aren't), then merely buying top quality companies, such as Caterpillar, 3M or Cullen/Frost Bankers (each that has raised its dividend for at least 26 consecutive years) at modest discounts to historical fair value is a great way to put new money to work today.

Disclosure: I am/we are long MPLX, BTI, CAT, MMM, CFR, LOW, WBA, AVGO, MSFT. 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.