Narrowing Down High-Quality Dividend Growth: Maybe It's Time For MarketAxess

DividendRodeo profile picture
DividendRodeo
471 Followers

Summary

  • High-quality dividend growth stocks are filtered and analyzed based on historical and Future Fair values plus analyst estimates.
  • Intel Corporation, Merck & Co, Expeditors International of Washington, MarketAxess, United Parcel Service, A. O. Smith, Visa, Mastercard, Qualcomm, Cisco, and Lam Research appear attractively priced.
  • MarketAxess is trading at 52-week lows, is well below historical valuations, and looks to have upside based on potential future growth.
  • I am changing my recommendation on MarketAxess from Hold to Weak Buy based on the current valuations, decline in price to this point, and upside based on potential future growth.

$1000 denomination US Savings Bonds

richcano

Introduction and Background

With the bulk of earnings season now past, I've had the opportunity to update valuations for many of the stocks that I track. There are not as many bargains as there were a month or so ago, but there are still a few candidates that look promising. As a reminder, I routinely track around 100 companies that I consider to be the highest quality, dividend growers. For this round, I decided to filter based on companies that have recently updated earnings, those that have a 5-year average Return on Invested Capital of over 12%, and those with earnings-based dividend payout ratios less than 60%. I realize these are somewhat arbitrary, but I have been casting a pretty broad net to fish for places to invest.

Using this first pass criteria, we will be looking at the following list of companies:

highest quality dividend growers

Finbox, Seeking Alpha, Author's Analysis

highest quality dividend growers

Finbox, Seeking Alpha, Author's Analysis

highest quality dividend growers

Finbox, Seeking Alpha, Author's Analysis

highest quality dividend growers

Finbox, Seeking Alpha, Author's Analysis

Fair Value Estimation

As I've described in previous articles, I like to calculate a fair value in two ways, using a Historical fair value estimation, and a future looking fair value estimation. The Historical Fair Value is simply based on historical valuations. I compare 5-year average: dividend yield, P/E ratio, Schiller P/E ratio, P/Book, and P/FCF to the current values and calculate a composite value based on the historical averages. This gives an estimate of the value assuming the stock continues to perform as it has historically. I also want to understand how the stock is likely to perform in the future so utilize the Finbox fair value calculated from their modeling, a Cap10 valuation model, FCF Payback Time valuation model, and 10-year earnings rate of return valuation model to determine a composite Future Fair Value estimate.

I also gather a composite target price from multiple analysts including Reuters, Morningstar, Value Line, Finbox, Morgan Stanley, and Argus. I like to see how the current price compares to analyst estimates as another data point, and as somewhat of a sanity check to my own estimates.

Plotting three variables on one plot is tricky but using a bubble plot allows us to visualize three variables by plotting the Historical fair value versus the Future Fair Value on a standard x-y chart, and then use bubbles to represent the size of discount relative to analyst estimates.

Historical and Future Fair Value calculations for high quality dividend growth stocks

Author calculation of Historical and Future Fair Value, analyst estimates

This chart is insightful once you understand how to interpret it. What we are looking for are stocks that are trading at a discount to both the Historical Fair Value and the Future Fair Value. So, those stocks that are farther to the left, and farther to the bottom, are potentially the stocks trading at the largest discount to fair value. This would be the bottom left quadrant of the graph. Additionally, those stocks with the biggest bubbles are the stocks that are trading at the largest discount to analyst estimates, so in theory, stocks in the lower left quadrant that also have large bubbles, should be decent candidates for investment.

Digging into this chart suggests that Intel Corporation (INTC), Merck & Co (MRK), and Expeditors International of Washington (EXPD) look to be attractively valued based on Historical and Future valuations and have decent upside to analyst estimates. I should also note that Intel is trading at 52-week lows. Additionally, MarketAxess Holdings (NASDAQ:MKTX), United Parcel Service (UPS), A. O. Smith Corporation (AOS), Visa (V), Mastercard (MA), Qualcomm (QCOM), and Cisco (CSCO) are attractively valued from a Historical perspective and are close to fair value based on the Future valuation. I will also point out that one of my favorites, Lam Research (LRCX) is close to fair value based on the Historical valuation but looks attractively valued based on the Future valuation. I need to do an update on Lam Research soon, but if you are interested in learning more of my thoughts, you can see my article from earlier this year here, which I still consider relevant.

Just based on the chart, MKTX does not look that much more interesting than some of the others, however, I would like to dig deeper into MKTX for two more personal reasons. First, it is currently trading at around 20% below where I last invested in it (around $307). The 20% number isn't magic but is a loose rule of thumb I use to take a deeper look at a stock to average down. Second, it is also trading at 52-week lows, which again, in itself, doesn't drive me to invest, but is another loose rule of thumb I use to trigger a deeper dive.

MarketAxess Analysis

Since I'm not trying to sell anything on Seeking Alpha (trust me, I don't do it for the money) but more to encourage me to dig deeper and be a better investor, I like to be as transparent as possible. I last wrote an article on MKTX at the end of 2021. Overall, I rated it as an interesting hold at that point, but also noted that I was looking for a target price around $330. It took it a few months, but I got lucky with an overnight price movement and had a limit order hit below where I had it set at $307. Since that time, it has generally continued to move lower. As I've shared previously, I try to buy when I believe stocks are fairly valued with some margin, but don't otherwise try to time the market. If the stock I buys continues to go down, I look for opportunities to buy more "on sale". That is the case with MKTX, so let's see if it should be a buy at this point.

I always like to start with the basics. MKTX has a 5-year average ROE of 30.2% however, it's most recent ROE is 23.9%. The 5-year average ROIC is 28.2% but it's most recent ROIC is 22.6%. In both cases, I like that ROE is so close to ROIC, since this suggests management isn't playing games with debt to increase the ROE, however, even though the numbers are still very good, there is some deterioration against the average that is a minor warning flag. The earnings-based dividend payout ratio of 44% and free-cash-flow-based dividend payout ratio of 39% are both excellent, though they are higher than the last article. They have paid a growing dividend for almost 13 years now, with the most recent raise of 6% being conservative and disappointing, because of the low yield. Morningstar still rates MKTX as wide moat, with exemplary capital management, and currently has a 4-star valuation rating.

Seeking Alpha makes available a summary of ratings, as well as factor grades. These make for another nice, first pass filter for investment timing.

Graphical user interface Description automatically generated

Seeking Alpha

Well, let's be honest, are some more warning flags. We see that SA Authors, Analysts and Quant analysis all suggest MKTX has problems. This could mean that it is still just the unpopular kid right now, or it could also suggest there are deeper problems. At a minimum, it suggests that market sentiment will not be our friend in this investment, and momentum is likely to be against us. This was the case the last time I evaluated this stock as well when it was trading much higher. Looking at the factor grades, we see further cause for concern. The valuation, growth and momentum are all negative. I am especially worried when I see a high valuation coupled with low growth. We definitely need to continue to think carefully about this investment. Sentiment has not turned with the lower stock prices.

MarketAxess Strategy

As I stated in the last article on MKTX, I am not necessarily afraid of stocks that are out of favor. As an active investor aggressively building my portfolio for the long term, I don't shy away from companies that are out of favor that I believe in. Dollar cost averaging has worked well for me over the years, and I have had several big wins buying unpopular stocks that are out of favor. Ultimately, as long as I believe in the company and in their strategy, I will continue to invest through thick and thin.

I did a deeper dive on the company strategy in the last article I wrote on MKTX late last year. If you'd like more details on the strategy or background on the company, I'd encourage you to read here.

To summarize how I think about MKTX - they are in the process of disrupting and automating the very manual debt-trading market. They were an early mover here, and there is still a lot of growth potential to implement electronic trading with a very large total addressable market. These factors fueled rapid growth, which led to high expectations, and historical valuations for MKTX. However, the growth story has been called into question as of late due to emerging competition, and some evidence that MKTX is not capturing as much of the growth potential as the competition now is. So, in my mind, this all does boil down to the question of growth. The only way MKTX continues to merit high valuations is if the growth story remains intact.

MarketAxess Historical Analysis

Before we dig deeper into the growth, I do like to look where things have been in the past. I think we realize that past performance can be somewhat indicative of the quality of the company. Obviously, it's important to understand the key drivers for that past performance, to see if you believe anything has changed that could impact that. So, let's start with how MKTX has performed for shareholders in the past:

MarketAxess 5-year total shareholder return

Seeking Alpha

Compared to the last time we took a look at this view, the story seems to continue on the same trajectory. First, up until recently, MKTX has drastically outperformed the S&P 500. Recently however, MKTX has given up all of its out-performance and is now under-performing. Of interest, Tradeweb is one of the key competitors we mentioned above. It has significantly outperformed the market as well as MKTX, however, it too has seen some correction. I still can't help but notice that some of MKTX's under-performance seems correlated to some of Tradeweb's outperformance, and this is one of the key foundations for the bear case - Tradeweb is taking a lot of that new and addressable market that MKTX is supposed to be getting. MKTX isn't growing because Tradeweb is taking market share.

I don't usually look at price history, and am far from an expert on technical analysis, however I thought the MKTX chart was interesting.

10-Year MKTX Price history

Seeking Alpha

If you draw a rough regression line through the 10-year price history, it is interesting to see that MKTX is likely below the mean trend line, which could be indicative of under-valuation all things being equal. You could also argue as well that regression to the mean shouldn't happen for a growth company, so this is another point of evidence that the growth story is broken. An early investor in MKTX would likely still be very pleased with their results.

Let's now see if valuations have improved relative to history with the decline in price, or if we are seeing overall degradation. Let's reference P/E and yield for this.

MKTX P/E ratio

Finbox

MKTX dividend yield

Finbox

Maybe a positive note is forming with this view - the P/E is still relatively high, but compared to its historical valuation, is at a low compared to the 5-year average of 58.7. This suggests that the business has not degraded to the extent that the price has. Additionally, the yield is also at a 5-year high compared to the 5-year average of 0.7%. From this historical-based view, MKTX could be moving towards a more attractive valuation.

MKTX continues to do a nice job of maintaining shares outstanding, not letting shareholders get diluted, however, it doesn't look like share buy-backs should be counted on to add to future earnings per share growth. This could still suggest that they believe they have better ways to grow earnings for shareholders through strategic investment than just relying on share buy-backs, or could suggest they are preserving capital due to concerns about growth.

MKTX shares outstanding

Finbox

I still really love the revenue versus net debt story. MKTX is debt free and has a strong net cash position. This is not very common in today's day and age, and something I like seeing as a long-term investor counting on that compounding dividend growth far into the future. The net-debt position is trending up, which is something to keep an eye on, but the financials are strong. Revenue seems to be flattening, so another point of note for the growth story.

MKTX revenue and net debt

Finbox

MKTX has paid a growing dividend for over 12 years and has historically demonstrated very strong dividend growth. The growth is tapering recently. I look at this as an indirect indicator of management's confidence in future growth, so when I see dividend growth pulling back, it could indicate management is not convinced of their growth prospects. Likewise, it could also indicate that they have other plans in mind, such as strategic M&A or internal R&D, or it could just indicate that the high rate of growth in the early years was to get the dividend to a target level, and not that target level has been achieved, the growth will be more throttled by fundamentals (still tied to growth).

MKTX dividend growth

Finbox

The earnings and free cash flow-based payout ratios are still reasonable, however, even given the lower recent dividend growth, the ratios are increasing, and are at high levels compared to the past 5-years. This is also not a great sign.

MKTX payout ratio and free cash flow payout ratio

Finbox

MarketAxess Future Analysis

Moving on to our future looking analysis to really try to flesh out the growth question, it seems like the story hasn't changed a lot since we last looked at MKTX. The question still boils down to that future growth. Let's take a look at some of the future indicators to see if anything significant has changed in that story.

Let's start with projected earnings growth. This chart looks significantly different than the last time we looked at it. Next year looks pretty dismal, which makes sense in light of the challenges MKTX has seen. It is interesting to see that growth is projected to return to very healthy double digits into the future.

MKTX EPS growth forecast

Finbox

Recently, analysts have also been projecting lower long-term growth, as might be expected from the 2023 forecast above, but their estimates don't jive very well with the years after that. My own estimate that I derive from a combination of historical metrics and future looking metrics, is 12%, which is not much of a change from the 13% I was estimating at the end of last year. So, we're stuck with the mixed message of the near-term performance definitely suggesting risk to the growth story, however, longer-term the growth resuming. My own estimates suggest that the near-term concerns may be disconnected from reality, however, near-term business indicators are also showing some warning signs.

MKTX growth consensus

Finbox

For a dividend growth investor, understanding future dividend growth potential is also important, especially in as much as it is sustainable. Here are the long-term dividend growth projections for MKTX. The forecast growth looks very consistent, suggesting again, that growth may resume after the short-term speed bumps, however, I think it is important to think about the recent rate of change in growth, and factor that into our assessment - I think it is important to reflect on how confident management really feels about the growth based on the recent deceleration in dividend growth.

MKTX dividend

Finbox

With the return to growth forecast, it shouldn't come as a surprise that the earnings-based dividend payout ratio is projected to drop. This is comforting and consistent with the other projections.

MKTX payout ratio forecast

Finbox

Tying out the story, revenue is also projected to grow at a healthy rate moving forward.

MKTX revenue forecast

Finbox

The Seeking Alpha Dividend Grades still are at the head of the class compared to other financials. Yield is more aligned to a growth company, but otherwise, MKTX appears to continue to be a solid dividend growth candidate.

MKTX dividend grade

Seeking Alpha

MarketAxess Risk Considerations

Let's end our journey with a brief discussion on risk. At this point, I think it is clear the risk is that MKTX is done growing and could even start to decline. If the total addressable market isn't what it has been sold as, or MKTX is not successful in competing against emerging competition, and at least gaining their share of the market growth, the stock is likely still too highly valued. However, if the challenges are short-term, and the deceleration in growth is temporary, or we believe the market potential is big enough for everyone to share the growth, this could be a good point to buy, while it is as 52-week lows.

MarketAxess risks

Seeking Alpha

Let's look at two items that could help us answer our concerns with an investment now in MKTX. First, the short interest is low. You would think if this was truly a falling knife, there would be higher short interest. Second, another indicator of financial health is the Altman Z Score. Anything under 3 could signal financial distress. With a score of 17.8 and the net debt position we saw earlier, this is a healthy company. They do not currently have a credit rating, however Value Line gives them Financial Strength rating of A.

Summary

I will admit to being torn on my recommendation. On the one hand, there are many indications that the valuation is attractive, the growth story is bumpy, but intact, and this could be a great time to invest some more - 20% below my first entry point. Trading at 52-week lows, and below what looks like the historical regression is also potentially positive. On the other hand, I do worry about the momentum, sentiment, and what catalyst is needed to turn the trajectory around - not to mention what is happening at the macro level in the markets. At the end of the day, this is a high-quality company, that has performed very well historically, and is very financially sound. It is never easy to invest in a company that is out of favor, but I like to remind myself that quality is never out of style for too long. I also must believe that a company that is a significant player in the piping of the debt markets will likely continue to do well in the uncertain interest rate, inflationary, and volatile markets. I do not know how MKTX is likely to track with the market if the total market continues to decline. On the one hand, it has already come down a lot from its highs. On the other hand, the valuation is still fairly rich compared to the broader market. I plan to update my rating on MKTX to a weak buy and will likely add some more holdings to my portfolio at these levels ($245 is 20% below my last investment point).

The initial analysis for this article also identified several other good candidates for further consideration. Intel Corporation, Merck & Co, and Expeditors International of Washington look to be attractively valued based on Historical and Future valuations and have decent upside to analyst estimates. Additionally, United Parcel Service, A. O. Smith Corporation, Visa, Master Card, Qualcomm, and Cisco are attractively valued from a Historical perspective and are close to fair value based on the Future valuation. Lam Research is close to fair value based on the Historical valuation but looks attractively valued based on the Future valuation.

This article was written by

DividendRodeo profile picture
471 Followers
Why DividendRodeo? It's not the wild ride that investing sometimes provides that I'm addicted to, it's that rush that an ever-increasing flow of passive income provides. I do not have a financial background - my background is actually engineering - but I have been a self-directed investor for over 20 years.My investing approach is pretty simple. I believe in prudent living - striving to live an upstanding life of meaning well within my means, prudent working - working hard in my career to maximize value to my employer, and my opportunities for career progression, and prudent investing - investing in high quality instruments at reasonable valuations for the long term.Dividend growth investing fits me very well. I believe I can identify high quality companies at reasonable valuations that I am comfortable holding for the long term. The passive income from the dividends helps me hold through troubled times. Employing automatic dividend reinvestment helps me dollar-cost-average, and the double compounding I get from growth, as well as reinvestment, helps me see the tangible outcome of my efforts.Hang on and enjoy the ride!

Disclosure: I/we have a beneficial long position in the shares of AAPL, BLK, CSCO, GD, INTC, LRCX, MKTX, MRK, MSFT, QCOM, SNA, TXN, UNP, UPS, UNH, V either through stock ownership, options, or other derivatives. 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.

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