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The Case for Optimism – Top Dividend Growth Stocks Are Dirt Cheap

Anyone who had recently invested in real estate would most likely agree that the phrase “dirt cheap” carries a new and enhanced meaning today. In the same vein, we would argue that our top 25 dividend growth stocks based on the potential for five-year estimated annual total returns are dirt cheap. Consequently, we believe that most of the bad news is already priced in, and therefore, the opportunity to buy low is the best it’s been since 1997.

Negative Sentiment Focused on the Macro

Mainstream media, the markets, and it seems the entire world, are obsessively focused on numerous macro-oriented headwinds. This has led to extreme pessimism and fear-driven behavior on the part of investors. Moreover, this has caused some of the highest quality companies on the planet to become cheaper than they have been in decades, and more importantly, we would argue cheaper than they deserve to be. There certainly is a lot of bad news; on the other hand, there is always a lot of bad news for markets to deal with. This gives credibility to the old stock market adage: “The market climbs a wall of worry.”

Wall Street’s Walls of Worry During the 20th and 21st Centuries

Let’s take a brief journey down memory lane and highlight some of the most memorable crises during the 20th and 21st centuries. We will start with the panic of 1901 that caused the first stock market crash. Next was the 1907 Bankers’ Panic leading to numerous bank failures. Then the Sherman Antitrust Act brought us the panic of 1910 to 1911. Also, in 1910 the Shanghai China Rubber Market collapsed leading to numerous bank failures in China. And, of course, in 1929 we had the Great Depression and the catastrophic Stock Market Collapse.

Things were pretty benign for a while until 1973 brought us the oil crisis which caused the 1973 to 1974 market collapse that eventually spread to a banking crisis in the United Kingdom. Calendar year 1982 brought us the Mexican Weekend and the famed Latin American debt crisis that declared all of Latin American debt unmanageable. Then in 1983 Israel nationalized its four largest banks after they collapsed. Calendar year 1987 brought us Black Monday and the largest one-day percentage decline in stock market history. This was followed by the United States Saving & Loan crisis a few years later from 1989 to 1991. And in between then and 1990, the Japanese asset price bubble collapse made worldwide front page news.

Sweden and other Scandinavian countries followed suit with their own banking crisis during the early 1990s. Calendar years 1992 to 1993 brought us Black Wednesday where the British government was forced to remove the British sterling from the ERM (the European Exchange Rate Mechanism), which incidentally made currency speculator George Soros a billionaire by shorting the sterling. Then we had another Mexican crisis in 1994 and 1995 with the devaluation of the peso. But not to be outdone by Mexico we had the 1997 - 1998 Asian Financial Crisis that devalued their currencies and threatened banks all across Asia raising fears of an economic worldwide meltdown due to financial contagion. Then, and finally, the 20th century ended with the 1998 Russian financial crisis and the devaluing of the ruble and Russia defaulting on their debt.

This brought us into the 21st century where in early 2000 and 2001 we had the Turkish Crises and the Argentine Crises. But even more memorably, the 2001 U.S. recession brought us the dot-com collapse which abruptly ended the infamous irrational exuberant period that started in 1995. And, of course, we are still reeling from the 2007 to 2010 financial crisis which is easily the mother of today’s pessimism. And finally, we are now faced with the European sovereign debt crisis that we are all worried about today.

This has only been a brief listing and look at many of the crises of the 20th and 21st centuries. There were many more in previous centuries, and there will certainly be many more to come. However, through it all, the world and all the world economies have found ways to survive and even prosper. Perhaps most importantly of all, the one thing that each of these crises has in common is the creation of massive wealth and numerous millionaires and billionaires who had the courage and foresight to invest appropriately. We don’t believe it’s smart to bet against the indomitable human spirit.

As Napoleon Hill in his best-selling book "Think and Grow Rich" so aptly put it: “In every adversity lies the seed of a greater or equivalent benefit." With these words of wisdom in mind, we believe that a primary benefit resulting from today’s financial issues are cheap stock prices. Furthermore, we believe this especially applies to high-quality dividend growth stocks, many of which are currently selling at P/E ratios significantly below their historical norms. Low valuations on strong companies with attractive growth prospects, has always provided a reliable and safe opportunity for conservative investors to build long-term wealth.

25 Blue-Chip Dividend Growth Stocks with Attractive Prospects for Above-Average Total Returns

The following portfolio review lists our top 25 blue chip dividend growth stocks listed in order of highest potential future returns to the lowest. In order to make this list, each company had to possess several critical attributes. First they had to be available at current valuations that were significantly below their historical norms. And very importantly, each company had to have remained profitable through the great recession of 2008 and 2009.

In other words, we wanted companies that were proven strong enough to withstand tough economic times. Although some of the companies on the list experienced minor profit drops during the great recession, they nevertheless remained profitable and viable enterprises. Consequently, most of them were able to increase their dividends right through the recession with only a few able to maintain their dividends and where none of the companies on the list cut their dividends.

The bottom line is that this list represents a group of strong companies that are currently on sale. Each of these companies can now be purchased at P/E ratios that are in many cases significantly below their earnings justified levels. This statement relates both to fair valuation on their current and actual earnings, as well as a fair valuation on their expected future earnings potential. Therefore, we believe this group of companies offers a three-pronged opportunity for above-average future total returns at below-average risk. We expect that each company will benefit in the future from a potential expansion in their P/E ratios coupled with future earnings growth and finally followed by dividend increases offering a return kicker.

Moving across the columns from left to right, the following table shows each company’s historical normal 15-year P/E ratio next to its current P/E ratio. This paints a clear picture of the low valuation we have been discussing. Then we find each company’s dividend yield followed by its estimated five-year EPS growth rate based on the consensus of leading analysts following the company. Next we show each company’s market capitalization. Finally, and most importantly, we list each company’s five-year estimated annual total return calculation.

This total annual return figure is conservatively based on each company achieving their estimated earnings growth and the market capitalizing their future earnings at only a stock market average PE ratio of 15. Consequently, we would strongly argue that these total annual return figures are based on conservative and achievable assumptions. Dividends are included in this calculation (but not reinvested) and are assumed to grow at each respective company’s estimated earnings growth rate. Therefore, these high return expectations are a function of a combination of modest expected earnings growth and significant current undervaluation.

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When Fear Is Not Supported by Fact - An Expanded View

To re-frame some famous words by Franklin D. Roosevelt, we believe that all we really have to fear is the fear that lies within ourselves. Regarding matters of investing, pessimism breeds fear and fear brings low stock prices. With low stock prices, we can find opportunities for above-average long-term gain at below-average risk. One of the hot topics breeding pessimism today relates to the failure of the "Super Committee" to reach a deal on spending, thereby prompting an automatic $1.2 trillion in spending cuts.

Although the Defense Department has vowed to fight any future cuts in defense spending, defense spending cuts are currently on the chopping block. Two of the companies on our list are blue-chip defense and aerospace companies, L3 Communications Holdings Inc. (LLL) and General Dynamics Corp. (GD). The following short video shows how both of these quality enterprises have seen their market values decimated, even though their earnings have remained strong.

View YouTube Video Here

Conclusions

There’s no denying that the world is currently faced with numerous problems and challenges. On the other hand, as we pointed out earlier, this is nothing new. The world has always faced trials and tribulations, and most certainly there are many new ones to come. But just as we have always been faced with these issues, we have always been able to meet them head on and overcome any and all obstacles that we have been faced with. But even more importantly, within each challenge there has also been accompanying opportunity. And in most cases, the opportunities tend to dwarf the risks.

The opportunities that we believe our recent challenges are bringing us are unnecessarily low valuations on some of our highest-quality companies. Yet, it is a fact that investors are flocking to bonds in droves at precisely a time when the risk of owning bonds is perhaps the greatest it has ever been. Interest rates are at historical lows and, therefore, bond prices are at historical highs. Conversely, dividend yields on good quality dividend growth stocks are at historical highs because their stock prices are at historical lows. Yet most investors want to defy the cardinal rule of investing — buy low, sell high.

Therefore, due to fear, we are concerned that investors are behaving exactly opposite of how they should be behaving in order to serve their best long-term interests. To be clear, we believe that investors are eschewing investing in stocks just when the opportunities for owning them are the best they’ve been in decades, while simultaneously, the long-term risks of owning them the lowest. There is a Warren Buffett quote from his Berkshire Hathaway 1994 annual report that we never get tired of sharing which eloquently speaks to what we see today:

We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen. 30 years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of the president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%. But surprise-none of these blockbuster events made even the slightest dent in Ben Graham’s investment principles. Nor did they render unsound the negotiated purchases of fine businesses at sensible prices. Imagine the cost to us, if we let a fear of unknowns cause us to defer or alter the deployment of capital. Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.


The names that we have presented in this article represent what we believe to be quality companies that can currently be bought at very attractive valuations. However, we do encourage prospective investors to conduct their own due diligence before investing in any of them. On the other hand, we will conclude this article with some additional final words of wisdom from the Oracle of Omaha — “be fearful when others are greedy, and greedy when others are fearful.”

Disclosure: Long CVX, RRD, AFL, ARLP, AVP, BDX, GD, HON, LLL, MSFT, ITW, INTC, XOM, WAG, ABT, MDT, HD, NVS, RSG, NEE, SYY, JNJ, MHP, PG, PEP at the time of writing.


Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

About the author:

Chuck Carnevale
Charles (Chuck) C. Carnevale is the creator of F.A.S.T. Graphs™. Chuck is also co-founder of an investment management firm. He has been working in the securities industry since 1970: he has been a partner with a private NYSE member firm, the President of a NASD firm, Vice President and Regional Marketing Director for a major AMEX listed company, and an Associate Vice President and Investment Consulting Services Coordinator for a major NYSE member firm.

Prior to forming his own investment firm, he was a partner in a 30-year-old established registered investment advisory in Tampa, Florida. Chuck holds a Bachelor of Science in Economics and Finance from the University of Tampa. Chuck is a sought-after public speaker who is very passionate about spreading the critical message of prudence in money management. Chuck is a Veteran of the Vietnam War and was awarded both the Bronze Star and the Vietnam Honor Medal.

Visit Chuck Carnevale's Website


Rating: 3.3/5 (26 votes)

Comments

The Science of Hitting
The Science of Hitting premium member - 2 years ago
Great article. In regards to PEP, when they beat that EPS assumption by a percent or two per annum, that annual return should look even better :)
superguru
Superguru - 2 years ago
Quite a few common stocks with Yacktman fund. Great minds think alike.

Also , hardly any financials?
Margin of Safety
Margin of Safety - 2 years ago


The truly great investors all have a healthy respect for history. Thanks for putting these 25 stocks into historical context, a wonderful article!
dealraker
Dealraker - 2 years ago
I can't help but wonder in hilarious disbelief why a site like gurufocus doesn't focus more on these type articles instad of 2 and 20 "Which hedge fund runner has milked the world or blown up?"

Somebody at guru, and I know you guys are very, very young, please remember that most people in the world and most investors need to gradually move ahead, minimizing fees sucked out of their limited portfolios, with guys like Chuck and Yacktman.

And there is no way, even with a very experienced investor like me, that anyone can live with what Bruce Berkowitz has done. Bruce went to the bar and found a commedian named Charlie and apparently tried to make the guy his "Charlie Munger." Bruce, no matter what, has some serious emotional issues. Bruce bought the manipulator a damn house with what what in effect his shareholders money? That, my friends, is exactly what has happened to America! We keep rewarding the wrong people for the wrong things. Bruce above all others should be lamblasted and - in my view - never re-employed by anyone.

Hurray for Chuck.

fkattan
Fkattan - 2 years ago
Chuck, thanks for the article. In the case of chevron, capitalizing the future earnings at a PE of 15 and taking the 18% EPS growth, what would you estimate the market cap could be 5 years from now?

Regards
Adib Motiwala
Adib Motiwala - 2 years ago
Chuck,

on RRD, do you worry about the amount of leverage they employ in the business?

thanks

superguru
Superguru - 2 years ago
Hi Chuck - I see you do not have financials (banks) in this list. Even Buffet (except for WFC) and Klarman seem to be avoiding banks despite claims by others that they are cheap.

Is it because Financials are outside your circle of competence?

Or you are finding "better risk reward" in these safer companies compared to financials which no one (except Bruce Berkowitz) seem to understand?

Or is it that you own financials but not part of this article's theme.

I am trying to understand why you would invest in these companies and not in say BAC, C or GS? (capital allocation decision)
vgm
Vgm - 2 years ago
Nice article Chuck. Thanks.

Dealraker, let's wait before pre-judging Berkowitz. He may still be proven the ultimate contrarian winner in a few years' time. There's more than one way to succeed in investing. There's wide diversity of approaches even among value investors. Your commentary on Berkowitz's partner is way below standard for GuruFocus. It's neither interesting nor true (nor even amusing) - especially for a self-proclaimed "experienced investor" like you.
fkattan
Fkattan - 2 years ago
I wouldn't call 'conservative' the expectation of Chevron's current market cap of 190bn to grow 4 times in five years.

Are you suggesting that this company can be valued at 760bn?
chuckc
Chuckc - 2 years ago


Fkattan,

First of all, I am not suggesting anything. The 18% forecast growth rate is a consensus number. Grow EPS by 18% and you get EPS of $26.29 by year end 2016. Multiply that by a 15 PE and you get the $394.35 number. Divide that by CVX’s approx $92-93 price and you get the 4 fold number. This is the simple math.

Thanks for asking,

Chuck

fkattan
Fkattan - 2 years ago
Chuck, suggesting or not, stating that a company with a market cap of 190 billion will be worth 760 billion five years from now doesn't seem to be conservative (you said that the figures are conservative and achievable assumptions). I respect your opinion but I strongly disagree.

Thanks again.

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