Investing is just like anything else in life.
It can be as easy or as difficult as you want to make it.
People have often drawn parallels between fiscal fitness and financial fitness.
Indeed, there are a lot of similarities.
To build wealth, you first need to spend less than you earn; to lose weight, you need to burn more calories than you ingest.
It’s basic math at its core.
But as someone who’s very interested and active in both investing and fitness, I notice further similarities: some people like to complicate things more than necessary.
For instance, my city has these gyms where people are basically using an indoor adult playground, complete with climbing apparatuses and heavy objects to throw around.
While that’s all fine and dandy, these gyms cost 10 times more than the local traditional gym that’s replete with treadmills, resistance machines, free weights, and everything else you could ever want/need to get very fit.
Likewise, the investing world is filled with expensive, complicated products that are totally unnecessary.
I long ago decided to forgo the superfluous in both the financial and fitness aspects of my life.
It’s a decision that’s treated me pretty well.
First, I can tell you that I’m working out at the traditional gym that’s a great value – and I’m in the best shape of my life right now.
And as a result of sticking to an investment strategy that is proven and straightforward, I’ve built a real-money, real-life six-figure stock portfolio that currently generates five-figure passive dividend income for me.
The strategy I used to get here?
Dividend growth investing.
It really can’t get any more simple than this.
I simply invest in wonderful businesses that have the great fundamentals and competitive advantages necessary to pay me growing dividends year in and year out, which is passive income I can use to cover my expenses and be financially free in life.
Very easy. Very straightforward.
And with the way brokerage fees are these days, it’s very cheap.
Many of the businesses I write about and personally invest in are blue-chip stocks.
These are proven winners.
Dividend payers and growers have been shown to outperform the broader market over longer periods of time (per Ned Davis research), which should be no surprise.
After all, wonderful businesses should do better than businesses that aren’t wonderful – or else they’re not very wonderful at all.
And one litmus test for how wonderful a businesses might be is its track record for paying growing dividends.
Since dividends are paid in cash from cash, they’re the ultimate form of “proof in the pudding”.
Growing dividends serve as proof that a company’s profit is also growing.
Don’t tell me how profitable you are; show me.
You can see what this looks like in real-life terms by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.
An incredible list of more than 800 US-listed stocks that have all paid increasing dividends for at least the last five consecutive years, it’s a manifestation of dividend growth investing in action.
But as great as this strategy is, and as great as many companies on Mr. Fish’s list are, it’s obviously not very prudent to buy random stocks at random prices.
The first thing you want to do is narrow down your potential investment ideas to companies that are within your circle of competence, and then one should make sure a company has high-quality fundamentals and durable competitive advantages.
Even then, though, a stock shouldn’t be bought if it’s vastly overpriced, as that will negatively affect the investment’s performance from the outset, perhaps to a significant degree.
Quite the opposite, one should aim to buy a high-quality dividend growth stock when it’s undervalued.
Undervaluation occurs when price is below value.
Price is only what something costs. Price is what you pay.
But value is what something is worth. Value is what you get.
And when you see how that dynamic plays out in everyday life, it only makes sense to avoid merchandise when that dynamic is disadvantageous to the buyer (i.e., when price is above value).
However, when that dynamic is advantageous (i.e., when price is below value), the benefits to the buyer can be immense.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.
This is all relative to what the same stock might offer if it were fairly valued or overvalued.
It’s easy to see how that works.
We must first consider that price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
So if a price drops significantly, with a stock going from overvalued to undervalued, the yield will rise in kind.
A higher yield means more current and ongoing income.
It also means greater long-term total return potential, as yield is one of two components of total return.
The other component is capital gain, and capital gain is also given a boost via the “upside” that would then exist between the lower price and higher value.
If that gap closes, it results in capital gain, which further boosts that long-term total return.
That’s on top of whatever natural upside an investor has to look forward to as the business becomes more profitable and more valuable.
Paying much less than what a stock is worth also reduces one’s risk, as the maximum upside naturally means minimum downside.
While it might seem counterintuitive, one’s gains are the greatest precisely when risk is the lowest. And vice versa.
When a favorable gap between price and value is on the table, that means there’s a margin of safety present.
This margin of safety, or “buffer”, protects the investor in case anything goes wrong with the business.
Undervaluation is thus very appealing to the long-term investor, especially when talking about high-quality dividend growth stocks.
As such, I’m always on the hunt for an undervalued dividend growth stock.
And I believe I recently found one…
W.W. Grainger Inc. (GWW) is the largest global distributor of maintenance, repair, and operating (MRO) supplies and related products and supplies.
This company has a very rich corporate history, going back almost a century.
And they’ve become a world leader in their industry since then.
However, their industry is extremely fragmented, with W.W. Grainger laying claim to only about 3% of the global market share of MRO sales, which leaves plenty of room for further growth.
W.W. Grainger has more than 3.2 million customers, all of which rely on the company to provide routine products like gloves and ladders, along with direct services like inventory management. W.W. Grainger does this through a network of stores and distribution centers, where it uses its sales force to its advantage.
Because of the consumable nature of these products and the reliance on them being available, W.W. Grainger has competitive advantages built in via their existing relationships, distribution centers, physical stores, sales force, and online presence.
While the push to e-commerce is, overall, likely a negative for the business, more than 65% of the company’s orders originate online. Moreover, they’re the 10th-largest e-commerce retailer in North America. So the presence is already there.
This all bodes well for the company’s dividend growth, which itself has a rich history.
The company has paid an increasing dividend for 46 consecutive years.
That’s one of the longer dividend growth track records out there, and that represents about half the entire company’s corporate history. Said another way, W.W. Grainger has been paying an increasing dividend for about half the time it’s been a company.
And with a 10-year dividend growth rate of 15.8%, shareholders have seen their purchasing power increase pretty dramatically over time.
The major knock I see here is that the dividend growth has rapidly decelerated in recent years, with the most recent dividend increase coming in at less than 5%. This is something to keep an eye on.
But with a payout ratio of 52.4%, there’s still plenty of room for continued dividend growth, assuming underlying profit growth is at least modest.
In fact, that payout ratio is pretty close to what I consider a “perfect” harmony between retaining earnings and paying out shareholders. I consider a payout ratio of 50% to be that perfect balance.
Almost five decades of dividend growth. A payout ratio close to perfect. And dividend growth well into the double digits.
While that’s all pretty great, it gets better.
The stock currently offers a yield of 3.15%.
That’s much higher than what the broader market offers. In addition, it’s more than 130 basis points higher than the stock’s five-year average yield.
I discussed how undervaluation generally results in a higher yield. Well, here you go.
That yield is also very appealing when considering the backdrop of the rest of the dividend metrics.
So there’s just a lot to like about the dividend, pretty much across the board.
But we really need to take a look at the company’s underlying overall top-line and bottom-line growth over the long term in order to develop an idea of what kind of earnings power the company actually has, which will help us determine what kind of dividend growth is likely sustainable over the long run.
This will also help us value the business a little later.
We’ll look at not only what W.W. Grainger has done over the last 10 years (a pretty good proxy for the long term), but we’ll also consider a future near-term forecast for the company’s profit growth.
Combining that forecast with what the company has done over the last decade should give us a very good idea of W.W. Grainger’s overall growth profile.
The company’s revenue has increased from $6.418 billion to $10.137 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 5.21%.
That’s pretty solid. I usually like to look for mid-single-digit top-line growth from fairly mature companies. W.W. Grainger is right there.
Meanwhile, the company grew its earnings per share from $4.94 to $9.87 over this same period, which is a CAGR of 7.99%.
Again, solid. This is right about what I’d expect from a company like this.
That said, we can also see why dividend growth has slowed a bit. That 10-year dividend growth rate is just plain unsustainable when you look at what the bottom line is doing.
Some of that excess bottom-line growth can be explained via share repurchases: W.W. Grainger reduced its outstanding share count by approximately 28% over the last decade.
Furthermore, the company’s board has authorized up to $3 billion in share repurchases to occur over the next three years, which is about 1/3 of the company’s market cap.
This ongoing activity should help buoy or even propel bottom-line growth going forward.
However, some of that repurchasing is going to be offset by margin compression. As e-commerce sales increase, pricing competition intensifies, which limits the company’s margin potential.
Looking forward, CFRA believes that W.W. Grainger will compound its EPS at an annual rate of 8% over the next three years, which would be right in line with what we see above. That seems fairly reasonable to me, although further margin compression (which has started to occur over the last few years) could inhibit this.
If the company’s able to continue growing at approximately 8%, that would allow for dividend growth in kind. With a moderate payout ratio, assuming no expansion of it, dividend growth in that upper-single-digit area is certainly plausible.
Fundamentally, the company is fairly solid across the board, which shows up on the balance sheet.
Long-term debt and shareholders’ equity are roughly equal, meaning the long-term debt/equity ratio is approximately 1.0. The interest coverage ratio is just over 16, which is pretty strong.
The company’s profitability has historically been a strong suit, although pricing competition has shrunk margins of late.
But the five-year averages still indicate strength.
Over the last five years, W.W. Grainger has averaged net margin of 7.58% and return on equity of 26.73%.
For what’s essentially a distributor, that net margin is mighty impressive. FY 2016, however, showed net margin of just under 6%. Further compression is problematic, but I think the business can sustain some of that and continue humming along.
Overall, the company offers a lot to like.
They’re the global leader in a very fractured industry, which leaves room for growth and consolidation. They’ve moved in front of industry changes, not letting the e-commerce movement take them by surprise. They’re entrenched with customers. And their distribution and store base leaves them well positioned going forward.
The fundamentals are really solid across the board. And the dividend metrics are right in that “sweet spot”, with a great payout ratio, appealing yield, and outstanding track record for dividend increases.
A continued move to e-commerce is, in my view, a negative for the company. Competitors are growing. And this only means more price competition.
However, the stock is down ~30% this year, which has led to a potential opportunity.
The stock looks undervalued at this point…
With a P/E ratio of 16.59, the stock is priced at a multiple that’s well below the broader market. And compared to the stock’s five-year average P/E ratio of 21.5, it looks downright cheap. While some valuation compression seems warranted, this is a strong move down. Investors are also paying much less for the company’s cash flow than they’ve been willing to pay over the last three years. And the yield, as noted earlier, is substantially higher than its recent historical average.
So there’s clearly a discount here, but how much? What might the stock be worth? What’s a reasonable estimate of its intrinsic value?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
That growth rate seems realistic when you look at the demonstrated long-term dividend growth rate, moderate payout ratio, historical earnings growth rate, and forecast for earnings growth moving forward.
The DDM analysis gives me a fair value of $182.61.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
My analysis concludes that the stock is undervalued here, but my perspective is but one of many. That’s why I like to compare my conclusion with what professional analysts come up with. This adds further value and perspective to the piece.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates GWW as a 3-star stock, with a fair value estimate of $202.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates GWW as a 3-star “HOLD”, with a fair value calculation of $178.60.
I came out somewhere in the middle there, but we can see a clear gap between the stock’s current price and its estimated intrinsic value. Averaging these three numbers out gives us a final valuation of $187.74, which would indicate the stock is possibly 16% undervalued.
Bottom line: W.W. Grainger Inc. (GWW) is a high-quality firm, with a rich corporate history that extends to its dividend growth legacy. It’s a leader in its industry, firmly entrenched with its store base, distribution centers, sales force, and e-commerce presence. With the potential for 16% upside on top of a yield well above its recent historical average, this appears to be a strong long-term dividend growth investment opportunity.
— Jason Fieber
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