Boy, what a rocky start to the year.
Stocks have been whipped around by a US impeachment process, Brexit, and the novel coronavirus outbreak.
But there’s something very important to keep in mind.
Short-term volatility is a long-term opportunity.
The greater the volatility, the bigger the opportunity.
The Fund is my real-money stock portfolio.
It generates enough passive dividend income for me to live off in my 30s.
Indeed, I went from below broke at 27 years old to financially independent and retired at 33.
And I lay out exactly how I did that in my Early Retirement Blueprint.
Suffice to say, I always looked at big drops in stock prices as a gift.
The cheaper you can buy a stock, the higher the yield and greater the long-term upside.
While I’m certainly not happy that people are suffering from a virus, and while the global economy will probably take a short-term hit from the virus, it’s not like businesses or stocks get infected.
Volatility can create opportunities.
But not every opportunity is equal.
In my view, the best long-term opportunities are high-quality dividend growth stocks.
Stocks like those you’ll find on the vaunted Dividend Champions, Contenders, and Challengers list.
This virus is just the newest test. There have been tests many before it. And many more will come.
But I’ll tell you something.
Short-term volatility is much easier to stomach when you’re collecting growing cash dividend payments.
Better yet, volatility can also allow for even bigger dividends.
That happens when a stock’s valuation drops, creating a higher yield.
After all, price is what you pay, but value is what you get.
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.
Prospective investment income is boosted 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 quality company naturally 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 lessen a company’s fair value. It’s protection against the possible downside.
All of that means volatility can be your friend, not your enemy.
But this does require you to be able to estimate intrinsic value.
Fortunately, fellow contributor Dave Van Knapp has made that easier than ever.
His Lesson 11: Valuation, part of an overarching series on dividend growth investing, furnishes a fantastic valuation template that you can apply 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…
3M Company (MMM)
3M Company (MMM) is a diversified global manufacturing conglomerate.
Founded in 1902, the company now operates across four business segments: Safety and Industrial, 36% of FY 2019 sales; Transportation and Electronics, 30%; Healthcare, 23%; Consumer, 16%. Corporate and Unallocated accounted for -5% of sales.
The company employs over 90,000 people across the world, focusing on applying science across 12 areas of expertise: Automotive; Design & Construction; Manufacturing; Commercial Solutions; Electronics, Mining, Oil & Gas; Communications; Energy; Safety; Consumer; Healthcare; and Transportation.
Their products are used in various end applications. Think appliances, packaging, aerospace, electronics, construction, surgical supplies, telecommunications networks, and renewable energy.
And they have numerous brands that convey quality and consistency both on the consumer and industrial sides. These brands include the likes of Scotch, Scotchgard, Post-it, Scotch-Brite, ACE, and the eponymous 3M.
Put simply, 3M is a diversified, global, powerhouse of an industrial firm.
Their products touch almost every facet of life across the world.
Short-term events definitely affect stock prices.
But the world will continue to turn. Life will carry on. More products and services will be demanded.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As long as that all happens, it’s very likely that 3M will also continue to pump out an increasing dividend.
This is something they’ve done for 62 consecutive years.
Just think of all the things that have happened over the last 62 years.
Wars. Viruses. Political upheaval. Technological advancement.
Yet 3M continued to pay an increasing dividend.
I see nothing about the current state of affairs that negatively impacts the company’s ability to continue doing so.
The 10-year dividend growth rate is a very strong 10.9%.
More recent dividend raises have been a touch light, including the ~2% raise announced just this week.
But even an industrial giant like 3M has some cyclicality in the business.
On top of that dividend growth comes a starting yield of 3.62%.
That yield is almost twice as high as the broader market, and it’s more than 90 basis points higher than the stock’s own five-year average yield.
It’s not often you get that kind of yield on this kind of stock.
In fact, that’s about as high as I’ve seen the yield on 3M.
And with a payout ratio of 64.6% on adjusted FY 2019 EPS, the dividend remains secure.
The dividend growth legacy here is about as good as it gets.
But investors invest in the future, not the past.
We put our money on the line based on where a company is going, not where it’s been.
It’s the dividends that haven’t yet been paid that ultimately matters.
So I’ll build out a forward-looking growth trajectory, which will also later help estimate intrinsic value.
I’ll first show you what 3M has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prediction of future profit growth.
Blending the proven past with a future forecast like this should tell us quite a bit about where 3M’s growth might be going.
The company grew its revenue from $26.662 billion in FY 2010 to $32.136 billion in FY 2019.
That’s a compound annual growth rate of 2.10%.
I would classify this as just “okay”.
I’d prefer to see something closer to mid-single-digit top-line growth.
But 3M has done plenty with this, buying back shares and expanding margins. This has had the effect of creating excess bottom-line growth.
Revenue and Earnings Growth
Earnings per share have advanced from $5.63 to $9.10 over this period, which is a CAGR of 5.48%.
I used adjusted EPS for FY 2019, to factor out irregular but significant litigation deconsolidation charges.
Free cash flow per share and EPS tend to closely track each other, and the adjusted numbers do more accurately reflect the true earnings power in this case.
EPS grew at roughly double the rate of revenue, which is owed to the aforementioned margin expansion and buybacks.
For context, the company reduced its outstanding share count by approximately 17% over the last decade.
Looking forward, CFRA is predicting that 3M will compound its EPS at an annual rate of 12% over the next three years.
New products, a recovering global economy, a bounce in margins, and a cost-cutting restructuring plan are all cited as growth tailwinds. There’s also the buybacks.
These tailwinds are somewhat offset by trade wars, heightened global uncertainty, and some questionable steps by 3M itself (like its $6.7 billion acquisition of Acelity, Inc.).
Giving further color to this, the top end of 3M’s own guidance for FY 2020 would give us ~7% YOY EPS growth.
In my view, 12% EPS growth is an awfully aggressive prognostication.
3M could surprise us, but I’d prefer to temper expectations here.
The good news is, 3M doesn’t need to grow at 12% in order to be a highly satisfactory long-term investment.
With a starting yield of over 3.5%, mid-single-digit dividend growth gets you a total return near 10% (assuming a static valuation).
That’s on a blue-chip stock with one of the most impressive dividend legacies in existence.
I don’t think that’s unappealing at all.
Moving over to the balance sheet, 3M has long had some of the best numbers out there.
However, that big Acelity, Inc. acquisition, which was arguably too expensive, did cause some balance sheet deterioration.
Still, 3M does maintain a rock-solid financial position.
The long-term debt/equity ratio, at 1.73, belies their strength. It’s elevated largely because of so much treasury stock (relating back to share repurchases).
On the other hand, the interest coverage ratio is sitting at near 16.
Yes, these numbers aren’t as good as they were even just five years ago. But the company is undoubtedly still in fine shape.
It remains to be seen if the balance sheet deterioration was ultimately worth it. The jury is still out on that one.
While the balance sheet isn’t as good as it once was, profitability is as robust as ever.
Over the last five years, the company has averaged annual net margin of 16.0% and annual return on equity of 42.35%.
Fantastic metrics here, in my view. And ROE was very high even before the recent debt.
3M is a high-quality business across the board.
It’s in rarefied company in terms of its staying power, dividend track record, and overall reverence.
There’s little to fault.
And durable competitive advantages, like scale, brands, patents, technological know-how, and innovation give it the ability to thrive for decades to come.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The Acelity, Inc. acquisition adds a layer of uncertainty and execution risk.
As diversified as they are, a global recession would slow sales.
And the recent balance sheet weakening has left them less flexible.
Overall, however, it strikes me as a low-risk business. If there were a lot of inherent risk, they wouldn’t have been able to pay a growing dividend for more than 60 straight years.
Stock Price Valuation
At the right valuation, this could be a great long-term investment.
Well, the current valuation looks extremely appealing after so much short-term volatility…
The stock is trading hands for a P/E ratio of 17.84 (on adjusted FY 2019 EPS) after dropping ~20% over the last year.
That’s well below where the S&P 500 is at. It’s also markedly lower than the stock’s five-year average P/E ratio of 23.1.
This is a stock that has typically commanded a premium for its quality.
It’s now available at a discount.
Even if we factor out the messy EPS, the P/CF ratio of 13.4 is well off of its own three-year average of 18.9.
And the yield, as noted earlier, is substantially 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 dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7%.
This is a lower DGR than what 3M has produced over the last decade.
But I think it’s a sensible, if cautious, estimate of the company’s long-range dividend growth capabilities.
That’s because the payout ratio has expanded on the back of dividend growth that outpaced EPS growth, slowing recent dividend raises.
And recent top-end guidance for YOY EPS growth puts us near this 7% mark.
It’s certainly possible that 3M could do slightly better than this over the long run, but I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $205.44.
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 doesn’t strike me as aggressive, yet it gives us a valuation that suggests a big disconnect between price and value.
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 MMM as a 3-star stock, with a fair value estimate of $177.00.
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 MMM as a 3-star “HOLD”, with a 12-month target price of $164.00.
My number was a bit high. Averaging the three numbers out gives us a final valuation of $182.15, which would indicate the stock is possibly 15% undervalued.
Bottom line: 3M Company (MMM) is a blue-chip company with few peers. It’s positioned well to continue delivering higher profits and dividends for years to come. With a market-smashing 3.6%+ yield, more than 60 consecutive years of dividend raises, and long-term double-digit dividend growth, this is a case where short-term volatility has led to a long-term opportunity. Dividend growth investors should take a close look at this stock right now.
Note from DTA: How safe is MMM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, MMM’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Wall Street legend warns "A strange day is coming" [sponsor]
A massive and surprising new transition could soon impact the wealth of thousands, while leaving everyone else worse off than before. Click here to learn more.