Sometimes investors think they need to choose between value and growth, you can have both.
However, in dividend investing, you often have to choose between value, yield and growth.
You want at least two of these three. Here are 5 stocks which offer both value and high growth.
Who doesn’t like a good deal?
Black Friday is just two weeks away. Every year, there seems to be a new viral video of shoppers going totally crazy on Black Friday.
Maybe this year will be different, with enforced social distancing and more people purchasing on line.
But can you really blame people for getting [a little too] excited at the idea of getting a deal?
Getting a bargain feels good. Retailmenot.com, a website which offers consumers deals, performed a survey on the psychology of bargains. They found that across the board, getting a bargain reduced the pain associated with expensive items, but that wasn’t it.
There is a bragging value associated with getting a deal, and I must say…I’m not immune to it. Of the respondents in the survey, 46% said they were proud of their deal hunting abilities and openly brag about them.
Shopping for bargains goes beyond buying new consumer goods. Investors also like bargains. Instead of calling it a sale, we call it value investing.
Value vs. growth
Value investing is appealing, not only because it is endorsed by the likes of Warren Buffett and Charlie Munger, but because it appeals to our desire to get a good deal.
But during the past 10 years, “value” as a theme hasn’t done great. Definitely not compared to “growth”.
The growth index has outperformed the value index big time. This has a few flaws. For one, The IWN defines value based on the Price to Book ratio, a mostly obsolete ratio. In a great article titled “Price to Book’s growing blind spot“, O’Shaughnessy Asset Management points out the multiple weaknesses of the ratio.
But this is not what I want to talk about.
There is a certain idea that you can either buy a “value” stock or you can buy a “growth” stock. This creates an idea that “growth” cannot be good value.
For dividend growth stocks, assuming ongoing safety of the dividend (and that’s a big assumption), we can use dividend growth as a proxy for the businesses underlying growth.
For instance, consider the Home Depot (HD).
The MAD Chart above takes all the dividend yields for HD over the past 10 years. It then charts the theoretical price at the maximum yield (bottom of the blue), minimum yield (top of the red), median yield (between the pink and the light blue), and the 25th percentile and 75th percentile marking the two remaining lines.
As we can see, while 10 years ago, a “fair value” (as defined between the theoretical 25th percentile and 75th percentile price) for HD 10 years ago would have been somewhere between $40 and $50. Today it would be between $243 and $288.
Invariably, HD has been a growth stock. But can anybody really argue that it wasn’t also a value stock when I bought HD at $186 in late March?
And there is a case for buying stocks which can have strong growth rates. I focus on dividends per share as a proxy, but you could of course use earnings or cashflows as well.
Consider the same chart, but for AT&T (T).
T’s fair range 10 years ago was between $27 and $32. Today it is between $34 and $40.
While HD’s fair value increased five fold, T’s increased by 25%.
So ignore low growth stocks and focus on high growth stocks, right?
Well, yes and no.
It is not quite as easy as that. The problem with the above, is that it excludes the effect of dividends.
Right now HD yields 2.1%. If you invest $10,000 today, and reinvest the dividends once per year for 10 years, and that the dividend continues to grow at 10% per annum, then in 10 years you can expect to receive $674 in dividends, of which $114 come from the reinvesting dividends. Assuming HD still yields 2.1% in 10 years’ time, the value of your investments will be $32,095.
On the other hand, if you invest $10,000 in AT&T today, that it continues to yield 7.2%, grows the dividend at 1% per annum, and you reinvest dividends once per year, then in 10 years you can expect annual income of $1,491, of which $692 comes from the reinvestment of dividends. The investment would be worth $20,708.
Of course, the holder of the HD stock could always sell and buy a higher yielding stock and reproduce similar income or superior income. I will discuss this concept of “yielding up” more in upcoming weeks.
Therefore there is no better or worse alternative. Both variations have different risks.
- Higher yield stocks often have a higher concern for dividend safety. The main risk comes from identifying a safe dividend.
- Lower yield high dividend growth stocks have a higher concern over future dividend growth. A 10% CAGR means the dividend per share will double about every 7 years. It is no easy task to keep this up for decades, and very few companies have succeeded.
All portfolios should have a certain balance of high yield and low yield stocks, with corresponding rates of potential dividend growth.
The role of the dividend investor is to pick dividend stocks which combine high and low yield stocks to have an overall profile which matches his time frame. Generally the more time you have, the more you want to bank on growth than on yield.
But this excludes the contribution of value.
If AT&T reverted to its median valuation of a 5.5% yield in that last year, your $20,700 position would become worth $26,900.
Valuation is related to expected growth. Therefore while we might consider HD to be undervalued when it yields 3%, we would consider AT&T extremely overvalued if it yielded less than 5%. Comparing a stock to its historical range of dividend yields as we do with the MAD Chart is one way to isolate company specific valuation.
Dividend investors should focus on the trifecta of value, growth and yield.
Value, Growth & Yield. These are the three contributors to your performance. A good investment opportunity will always have at least two of the three:
- If it has a high yield and is deeply undervalued, growth becomes secondary.
- If it has a high yield and high growth, then valuation becomes secondary.
- If it has high growth and is deeply undervalued, then yield becomes secondary.
Yield, provided it is safe is great because it gives that fire power for you to reinvest and compound your income. If you are already retired, it provides you with a larger amount of income.
Value is great because when a company reverts to median valuations (like we saw with HD above) you get gains. You can then exploit these gains to increase your income.
Dividend Growth is great, because it increases your income, and the value of your position.
Of course these things don’t happen automatically, and sometimes there can be opportunities in which you can get bargain valuations and high yields in stocks with high growth potential. This is when we find a really great opportunity.
This article, however, focuses on value and growth. These are stocks which I believe are cheap now, and are incredibly cheap when you look at the growth they could exhibit 5 years down the line.
Huntington Ingalls (HII)
Not many stocks have had it as bad as Huntington Ingalls. While the stock is in a defensive sector, has a monopolistic position, and has been growing its dividend at a very high rate with no signs of slowing down, its valuation still lingers way below what it historically has been.
In my article “Huntington Ingalls is in freefall yet you should still buy it now“, the company has a massive backlog of orders, a moat within the ship building space, and the power to increase dividends aggressively for the next 5 years. The dividend was increased by 10.7% following my article, less than I had previously anticipated, but still a nice large bump given the insanely low valuation.
A reversal to HII’s normal range of yields would imply 100% returns from current prices. Given the stability of the sector, and the strong implications of a potential vaccine on shipyard attendance, I believe HII has limited downside now with consequential upside.
I will be increasing my position in HII in upcoming days.
Snap on (SNA)
One of my favorite industrial stocks, Snap On is run by an extremely shareholder friendly management.
The stock is up 15% since we added it to the All Weather Dividends portfolio in early October. However, it remains significantly undervalued in the wake of its historical range of yields. While a normal range for SNA has been anywhere between 1.57% to 2.29%, it still yields 2.54%. A reversal to the normal valuation range implies upside of anywhere from 10% to 60%, with approximately 20%-25% being my target for the next year.
In the meantime, SNA has been growing its dividend at a 13.7% CAGR for the past 10 years. This past year the company increased its dividend by exactly that amount.
In September, the stock had a golden cross, where the 50 day SMA crossed the 200 day SMA.
Since then the stock has been trading upwards with gusto. I wouldn’t be surprised to see the valuation gap close within the next 2 months.
Abbvie is one of those stocks which ticks every single box:
- It is significantly undervalued.
- It has a high yield.
- It has high dividend growth potential.
The chart above doesn’t show the whole picture. The dividend was recently raised another 10% to $1.3 per quarter, implying a 5.3% dividend yield. ABBV’s normal range has been between 3.19% and 4.53%, quite a large range, reflecting the stock’s inherent volatility. I believe ABBV will likely increase another 15% to 20%. The company has had trouble recovering from its fall from its 2017 highs.
In the meantime, you can own shares of a high quality dividend company, which increases its EPS faster than it increases its dividend, ensuring dividend safety for years to come.
Nexstar Media (NXST)
This mostly unknown dividend stock is a high quality pick. It holds a dominating position in local news TV, and has been able to increase its dividends at a breakneck 24% CAGR these last 5 years. It must be pointed out that the dividend only requires 20% of earnings and 10% of operating cashflow, which suggests that this explosive dividend growth could continue for a long time.
The company’s recovery from its March low is still incomplete, for no fundamental reason. In late October, I dubbed the stock the “US Election winner” regardless of the outcome of the election. The stock has jumped 10% since then, but I believe 20% returns could be in the books for the upcoming year, as the stock resumes its reversal to more normal values. The company beat on earnings and revenues this quarter, and I expect this superior company to continue generating growth in upcoming years.
Tyson foods (TSN).
I owned TSN in the past, and at one point I switched it for Hormel Foods (HRL). Then in June, I decided to sell HRL, maybe somewhat prematurely.
Regardless, my attention on TSN foods returned recently when it appeared in one of my stock screeners. During the past 10 years, TSN has grown its dividend at a mind blowing 26.5% CAGR. During the past 5 years, at a 33% CAGR. Last year, only 12% CAGR.
In the process, the stock’s dividend yield changed greatly.
During the first half of the decade, TSN was a low yielding dividend stock, yielding less than 1%. Then in the second half, the dividend spent more time between 1% and 1.5%. Its yield of 2.75% is now way below its historical range.
I don’t believe TSN will ever return to a range of 0.8% -1.2%. Those days are over. However a range of 2% to 2.5% is warranted given that the stock still only pays out 22% of its free cashflow in dividends, ensuring years of double digit growth ahead.
For a more detailed analysis of TSN, read Chuck Waltson’s excellent article. The most important point he highlights, is TSN’s 25% international sales growth. This is fundamental to the company’s continued growth. It recently announced new facilities in China and Thailand, which will add over 100,000 metric tons of cooked poultry capacity to TSN’s operations.
As incomes in the world increase, they tend to consume more meat. TSN is positioning itself to profit from this, fueling growth for upcoming years. Get in now while the price is still cheap.
I am initiating a position as soon as I finish writing this article.
As a dividend investor, you get an extra tool to help you pick stocks: yield. By incorporating yield into a trifecta of value, growth and yield, you can identify attractive investment opportunities, protect your downside, and profit when the market agrees with you.
I always wanted to eat my cake and have it too. Looking for growth and value rather than one or the other increases the amount of tests a stock needs to pass. This makes you a more diligent investor, and will in turn boost the safety and performance of your portfolio.
One last word…
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