The stock market is off to a bumpy start this month.
The first four trading days of October have been extremely volatile.
What’s an investor to do?
Well, I think now is as good a time as any to brush up on some investment basics.
Volatile times like these should serve to remind us of something very important.
Successful long-term investors focus on the long term.
I’ve been investing in stocks for almost 10 years.
And I’ve never once found myself focusing on any particular day.
Instead, I focus on the long term.
I couldn’t tell you what the stock market did on a random Tuesday back in July of 2011.
And I’m willing to bet you’ll quickly forget about the start of October 2019.
The day-to-day movements of the stock market are just noise.
But ignoring this noise is easier said than done for most investors.
Especially in real-time, when everything is getting crazy.
Well, I’ve always found comfort in dividend growth investing.
This is the strategy I used to go from below broke at 27 years old to financially free at 33, as I lay out in my Early Retirement Blueprint.
While stock prices can swing wildly from one day to the next, growing dividends from high-quality dividend growth stocks tend to smoothly increase from one year to the next.
It’s a juxtaposition between volatility and stability.
My FIRE Fund, which is my real-money stock portfolio, generates the five-figure passive dividend income I live off of.
When you’re living off of dividend income, like me, the smooth nature of growing dividends makes it easy to ignore market volatility.
The thing that’s paying my bills isn’t volatile, so it’s not difficult to disregard volatile stock prices.
Check out the Dividend Champions, Contenders, and Challengers list.
More than 800 US-listed stocks are on that list. And all of them have raised dividends each year for at least the last five consecutive years.
Of course, dividend growth investing is more than buying high-quality dividend growth stocks for the long term and collecting your growing dividends.
Valuation at the time of investment is paramount.
Price is what you pay for a stock, but value is what you get for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Investment income is given a boost by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a company becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally reduce a company’s fair value. It’s protection against the possible downside.
These favorable attributes should obviously be sought by every long-term investor.
The good news is, these attributes aren’t difficult to find and take advantage of.
Fellow contributor Dave Van Knapp has made sure of that, via Lesson 11: Valuation.
Part of an overarching series of “lessons” on DGI, Lesson 11 provides a valuation process that can be applied to just about any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Albemarle Corp. (ALB)
Albemarle Corp. (ALB)Albemarle Corp. (ALB) is a global specialty chemicals company that has leading positions in lithium, bromine, and refining catalysts.
They operate across the following three business segments: Lithium, 36% of FY 2018 sales; Catalysts, 33%; and Bromine Specialties, 27%. All Other and Corporate account for an insignificant remainder of sales.
Albemarle is, at its core, a very solid chemicals company.
But in recent years, it’s reshaped itself into a futuristic business that’s perfectly positioned to capture growth from the rise in lithium demand.
Clean energy is one of the biggest global themes out there.
The world is changing quickly, and society is moving toward cleaner energy sources.
This is affecting everything from the way consumers and businesses consume energy to the type of cars people are buying.
Modern-day society has long required ubiquitious access to abundant, cheap, and reliable energy.
Well, you can now add clean to that list of requirements.
Whereas global energy production has long been heavily reliant on hydrocarbon resources, we’re shifting toward cleaner energy sources like wind, water, and solar.
A key component to this shift is the storage of energy.
That’s where lithium, in particular, comes in.
Most of the storage solutions that we now have (like batteries) require lithium. Large batteries (like those in electric cars) require a lot of it. But even smaller batteries (like those in mobile phones) are now everywhere.
Massive producers of lithium, operating at scale, are essential to this energy revolution.
As the #1 lithium producer, Albemarle has positioned itself perfectly.
And that’s not even to mention their exposure to a variety of other chemicals that are highly profitable and necessary.
Dividend Growth, Growth Rate, Payout Ratio and Yield
This is a highly diversified business beyond lithium, with exposure to industries ranging from pharmaceuticals to construction.
This is a great example of a juxtaposition between volatility and stability.
Albemarle’s stock price might change quite a bit from one day to the next.
But its operations and dividend do not.
The company continues to advance forward, increasing its profit and dividend like clockwork.
In fact, the company has increased its dividend for 25 consecutive years.
That track record dates back to well before they were a major lithium producer, which speaks to the solid nature of their chemicals businesses.
This is a time frame that stretches through multiple recessions, numerous wars, major changes in the world operates, and periods of economic and political turmoil.
The 10-year dividend growth rate stands at 10.7%.
Notably, the most recent dividend increase came in at just under 10%. That’s right in line with the long-term average.
And with a very low payout ratio of 20.6%, there’s almost certainly plenty more where that came from.
Meanwhile, the stock yields a very respectable 2.31% here.
That’s higher than the broader market.
It’s also more than 70 basis points higher than the stock’s own five-year average yield.
The dividend metrics are fantastic.
Revenue and Earnings Growth
But this is all looking at what Albemarle has already done.
Investors buy stock for where a business is going, not where it’s been.
As such, future expectations are of utmost relevance when determining the suitability and valuation of an investment.
I’ll build out some future growth expectations by first showing you what the company has done over the last decade, using that time frame as a proxy for the long term.
Then I’ll reveal a professional forecast for near-term profit growth.
Combining the known past with a future forecast like this should allow us to build a forward-looking growth trajectory.
The company grew its revenue from $2.005 billion to $3.375 billion from FY 2009 to FY 2018.
That’s a compound annual growth rate of 5.96%.
Pretty solid top-line growth here; however, not all of it was organic.
Albemarle acquired Rockwood Holdings, Inc. in 2015 for $6.2 billion.
This move instantly transformed the company into the major lithium player it now is. It was a prescient move by Albemarle, which should serve its shareholders well for many years to come.
Meanwhile, earnings per share increased from $1.94 to $4.98 over this period, which is a CAGR of 11.04%.
I factored out a $1.36 gain from Q2 2018, related to the sale of the polyolefin catalysts and components business for $416 million, which artificially skewed FY 2019 EPS. Sale proceeds were partially used to initiate a $250 million accelerated share repurchase program.
Even after factoring out a one-time gain, we can see accretive growth show up on the bottom line.
EPS growth started to materially accelerate after the Rockwood acquisition closed.
Interestingly, the company’s outstanding share count is not materially higher today than it was a decade ago.
In my view, the company is far stronger and more attractive than it was 10 years ago.
And it was already a very solid business back then.
Looking forward, CFRA is predicting that Albemarle will compound its EPS at an annual rate of 10% over the next three years.
CFRA cites continued strong growth in lithium volumes being partially offset by slowing growth in lithium prices.
Strong demand for batteries is expected, but there’s also more supply coming online.
Growth in all segments is expected, but there are some headwinds coming in from higher production and raw material costs.
I think much of their future growth potential does hinge around lithium, though.
Well, the company is taking the future of lithium very seriously.
If the Rockwood Holdings, Inc. acquisition wasn’t enough proof of that, the company has more recently shored up its assets in this space.
In late 2018, the company agreed to buy a 50% stake in an Australian lithium mine for $1.15 billion. Australia is quickly becoming a major source of lithium, competing aggressively with Chile.
In the meantime, the company heavily relies on the Salar de Atacama mine in Chile (the largest salt flat in Chile), which offers a very low cost of production due to a high concentration of lithium in the salt.
Supporting CFRA’s outlook is Albemarle’s own guidance for FY 2019.
The current guidance calls for 13% to 21% YOY adjusted diluted EPS growth.
A 10% EPS growth rate forecast could prove to be conservative. But it would be roughly in line with what’s transpired over the last decade.
Well, what’s transpired over the last decade is fantastic.
That sets shareholders up very nicely for double-digit dividend growth for the foreseeable future.
You have a base of 10% dividend growth supported by like EPS growth.
Furthermore, the very low payout ratio has plenty of room for expansion.
Even if the payout ratio isn’t expanded, 10% dividend growth on top of a 2%+ yield is plenty.
Assuming a static valuation, the sum of yield and growth should equate to total return. So you’re quite possibly looking at 12% annualized returns here, before factoring in the low valuation that has plenty of room for expansion in and of itself.
Financial Position
Moving over to the balance sheet, the company maintains a rock-solid financial position.
Even with major moves in lithium, the company has deftly managed to avoid imperiling the future of the business with a heavy debt load.
The long-term debt/equity ratio is 0.39, while the interest coverage ratio is over 16.
Moreover, the company’s cash position is great.
I sometimes see asset-heavy businesses like this carry around terrible balance sheets.
Albemarle, however, is a high-quality business.
That quality extends over to profitability.
Over the last five years, they’ve averaged annual net margin of 12.20% and annual return on equity of 12.46%.
One-off events have negatively skewed the averages.
Nonetheless, the profitability picture is clearly one of strength and improvement.
Overall, I view Albemarle as a high-quality company that is on the leading edge of a global megatrend.
And while the lithium exposure is obviously great, and worthy of investment all by itself, investors who buy this stock are also getting a very solid underlying chemicals business.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks for any business.
There are also unique geopolitical risks here, due to the company’s exposure to Chile.
Swings in raw material costs can shift profitability dramatically.
And any drop in lithium battery demand, or a wholesale change in battery technology, would have a material effect on the company’s revenue and profit.
Lastly, elevated capital expenditures have recently created a severe drag on free cash flow. This is something to keep an eye on.
Stock Price Valuation
Even with these risks, though, Albemarle looks awfully appealing as a long-term investment.
What’s particularly appealing right now is the valuation…
The P/E ratio is sitting at 10.36.
That earnings multiple is about half of where the broader market is sitting at.
It’s also less than 1/3 that of the stock’s own five-year average P/E ratio.
Most valuation metrics are well off of their respective averages.
For instance, the P/CF ratio, at 13.0, is almost half that of the stock’s three year average P/CF ratio of 24.2.
And the stock’s current yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a two-stage dividend discount model analysis (to account for the low yield and high growth).
I factored in a 10% discount rate.
Then I assumed a dividend growth rate of 12% for the next decade, followed by a long-term dividend growth rate of 8%.
I’m basically assuming low-double-digit dividend growth for the foreseeable future.
Results back my thesis.
The company has a low-double-digit EPS and dividend growth rate over the last decade.
With the very low payout ratio and forecast for 10% EPS growth moving forward, I think a 12% dividend growth rate is more than reasonable.
I’m then assuming that starts to flatten out as the lithium business matures and the payout ratio expands a bit.
If anything, Albemarle has the capability to do much better than this.
But I’d rather err on the side of caution, particularly considering the recent weakness in FCF.
The DDM analysis gives me a fair value of $111.31.
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.
Even with a pretty cautious look at intrinsic value, the stock looks extremely cheap.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 ALB as a 5-star stock, with a fair value estimate of $130.00.
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 ALB as a 5-star “STRONG BUY”, with a 12-month target price of $100.00.
I came out right in the middle. Averaging out the three numbers gives us a final valuation of $113.77, which would indicate the stock is possibly 79% undervalued.
Bottom line: Albemarle Corp. (ALB) is a high-quality company that’s on the leading edge of one of the world’s greatest megatrends. With 25 consecutive years of dividend raises, double-digit long-term dividend growth, a market-beating yield, a very low payout ratio, and the potential that shares are 79% undervalued, this could be one of the greatest long-term investment opportunities you’ll ever have.
-Jason Fieber
Note from DTA: How safe is ALB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, ALB’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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