The global pandemic that is COVID-19 has people acting very strangely.
Stocking up on tissue paper has no value, and tissue certainly won’t help fight a virus.
Yet that’s exactly what a lot of people are doing.
I’m stocking up on high-quality dividend growth stocks.
And I’m stocking up on these stocks at much lower prices than they were only a month ago.
$1,000 worth of tissue paper isn’t going to do anything other than take up a lot of room in your home.
But $1,000 worth of high-quality dividend growth stocks could actually change your life for the better.
I’d know a lot about this.
I built my FIRE Fund $1,000 at a time.
Try to squeeze out passive income from tissue paper. Ain’t gonna happen.
By routinely stocking up on the appropriate merchandise, I went from below broke at 27 years old to financially free and retired at only 33.
And I lay out precisely how I went about doing that in my Early Retirement Blueprint.
The investment strategy I’ve been using is a key element of the Blueprint.
High-quality dividend growth stocks are some of the best stocks in the world.
That’s partly evidenced by their lengthy track records of growing dividends, as you can see by checking out the Dividend Champions, Contenders, and Challengers list.
Reliable and rising cash dividends are a great initial litmus test of business quality.
You can’t run a poor, unprofitable business while simultaneously writing ever-larger checks to your shareholders.
Moreover, those growing dividends are an excellent source of passive income. Dividend income could be used to supplant a paycheck and retire early.
However, there’s more to it than just buying dividend growth stocks.
One must do their homework to find the right businesses at the right prices.
That last part can be particularly important.
While price is what you pay, it’s value that 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.
It’s undervalued high-quality dividend growth stocks that you should be “stocking up on” right now.
Fortunately, finding these stocks isn’t as difficult as you might think.
Valuing dividend growth stocks has certainly been made easier via Lesson 11: Valuation, which was put together by fellow contributor Dave Van Knapp.
Part of an overarching series of “lessons” on dividend growth investing, that lesson provides a 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…
Lockheed Martin Corporation (LMT)
Lockheed Martin Corporation (LMT) is the world’s largest defense contractor.
Fiscal year 2019 revenue is broken out by segment: Aeronautics, 40%; Rotary and Mission Systems, 25%; Space Systems, 18%; Missiles & Fire Control, 17%.
In terms of military weapons manufacturers, Lockheed Martin stands alone at the top.
Lockheed Martin produces an arsenal of major military aircraft, including the F-35 Lightning II, the F-22 Raptor, the F-16 Fighting Falcon, the SH-60 Seahawk. In addition, the company provides a variety of offensive and defensive weapons, including missiles, missile defense systems, and electronics.
The F-35, a fifth-generation combat aircraft, is the largest and most expensive military weapons system in the world.
The US Department of Defense accounts for approximately 60% of revenue. International sales account for almost 30% of revenue. The remaining 10% comes from various US government agencies. Commercial sales are insignificant.
The current COVID-19 outbreak has added a great deal of uncertainty to the world, which obviously affects all manners of business concerns.
However, there are few things more certain than the fact that governments will continue to spend a lot of money to protect their sovereignty and citizenry. That’s especially true for the US government.
I’ll show you what I mean.
President Donald Trump’s final proposed FY 2020 $750 billion Defense Budget is a sizable increase over the $716 billion DoD Defense Budget for FY 2019.
That’s creeping up on a trillion dollars. Per year!
The odds seem quite low that the US – and the world – will be spending less money on their defense needs a decade from now. That’s despite the current pandemic. If anything, it’s possible that elements of the military may need to be mobilized in some capacity if the pandemic gets worse.
This bodes well for Lockheed Martin’s long-term prospects.
It also bodes well for their ability to pay a growing dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, the company has increased its dividend for 17 consecutive years.
The 10-year dividend growth rate is 14.4%, although there has been some modest dividend growth deceleration in recent years.
And with a payout ratio of 43.7%, there’s still plenty of room for the company to continue increasing the dividend – even with the current virus outbreak.
On top of that yield, the stock offers a juicy yield of 2.88%.
That’s well in excess of what the broader market yields, even after the massive drop in the averages.
Revenue and Earnings Growth
Of course, it’s those future dividend raises that today’s investors ultimately care most about.
We invest in where a company is going, not where it’s been.
I’ll now build out a future growth trajectory estimate for the company.
This will rely partially on what the company has done in terms of top-line and bottom-line growth over the last decade (using that as a proxy for the long term).
I’ll also compare that to a near-term professional projection for profit growth.
Blending the proven past with a future forecast in this manner should tell us a lot about where the company might be going, which should translate into dividend growth.
Lockheed Martin grew its revenue from $45.803 billion to $59.812 billion between FY 2010 and FY 2019.
That’s a compound annual growth rate of 3.01%.
Meanwhile, earnings per share expanded from $7.81 to $21.95 over this time frame, which is a CAGR of 12.17%.
A combination of share buybacks and margin expansion helped fuel the excess bottom-line growth.
For context, the outstanding share count is down by ~23%.
Looking forward, CFRA is predicting that Lockheed Martin will compound its EPS at an annual rate of 13% over the next three years.
That would be in line with what’s transpired over the last decade. Status quo, essentially.
CFRA cites strong funding from the US government, improved operational execution, production ramps, and lower pension costs as growth drivers.
Headwinds include higher raw materials costs. There’s also the political upheaval over the cost of the F-35 program.
It’s always difficult to forecast earnings growth. That difficulty is heightened now as the world responds to the COVID-19 outbreak.
I don’t think it directly impacts any of Lockheed Martin’s long-term projects, but it’s impossible to say if some governments might temporarily cut back on defense spending as they spend to combat the economic effects of the virus.
Either way, Lockheed Martin does not need to grow at 12% in order to be a highly satisfactory investment.
With a moderate payout ratio and a yield near 3%, they only need to provide for high-single-digit dividend growth in order to give investors a great long-term total return.
Assuming a static valuation, the sum of yield and dividend growth should equate to total return.
So a ~3% yield and ~7% dividend growth gets you to double-digit long-term total return pretty quickly.
And that’s roughly the expectation that I’d have with Lockheed Martin, knowing that there’s some room for upside surprise.
Moving over to the balance sheet, the company is in a solid financial position.
They do hold quite a bit of debt, which isn’t a surprise for a capital-intensive business.
The long-term debt/equity ratio is high, at 3.65.
However, that’s due to low common equity, not an unreasonably large amount of long-term debt.
The interest coverage ratio, at just over 12, suggests that Lockheed Martin is easily covering its interest expenses.
Notably, the balance sheet has deteriorated in recent years, mostly due to the $9 billion acquisition of Sikorsky Aircraft business from United Technologies Corporation (UTX) in 2015.
I would say that the balance sheet could stand to be improved. But it’s in good condition as it is.
Profitability is fairly robust, even if the company has in some years trailed peers.
Over the last five years, the company has averaged annual net margin of 8.55%. Return on equity is not applicable due to low common equity.
Overall, I see this as a high-quality company and fantastic long-term investment.
That could be particularly true in this environment, with industries ranging from lodging to restaurants buckling under the COVID-19 pressure.
This is an industry leader in an industry where scale very much matters.
This is about producing fighter jets and complicated weapons systems. You can’t just start up a new Lockheed Martin in your garage.
The company has durable competitive advantages, including immense scale, huge barriers to entry, technological know-how, complex relationships with global governments, and high switching costs.
Of course, there are risks to consider.
Regulation, competition, and litigation are omnipresent risks in every industry.
Lockheed Martin also has unique geopolitical risks to manage, being a global weapons manufacturer. They must deftly navigate relationships with various government entities around the world.
Also, any production setbacks with its programs, especially the F-35, could impact EPS and dividend growth.
Even with the risks known, this is a blue-chip company with a unique position in the global defense hierarchy.
At the right valuation, this could be one of the surest long-term investments in today’s volatile market.
With a 25% plunge from the 52-week high reached only in February, the valuation has become compelling…
Stock Price Valuation
The stock is currently available for a P/E ratio of 15.19.
That’s a nice discount relative to the stock’s own five-year average P/E ratio of 23.7.
It’s admittedly difficult to use past earnings as a valuation gauge when the global economy is convulsing. But Lockheed Martin’s projects are long term and their products almost always in demand. Unrest doesn’t change that. If anything, it cements it.
We can also look at cash flow.
The P/CF ratio, at 12.9, is well off of the stock’s three-year average P/CF ratio of 20.0.
And the yield, as noted earlier, is higher than both the market and the stock’s own recent historical average.
So the stock looks slightly cheap here. What would a rational 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 7.5%.
That DGR is slightly lower than what I’ve used in the past to value Lockheed Martin.
I think it makes sense to be conservative right now.
The short term could certainly be bumpy. But the long-term picture is very bright for Lockheed Martin.
Moreover, their payout ratio gives some support to the dividend while we enter this global turbulence.
If CFRA’s projection is even in the same universe as what Lockheed Martin does over the next few years, the company is set up well to do even better than I’m projecting.
The DDM analysis gives me a fair value of $412.80.
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 after erring on the side of caution, the stock still looks very cheap right now.
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 LMT as a 4-star stock, with a fair value estimate of $429.00.
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 LMT as a 5-star “STRONG BUY”, with a 12-month target price of $523.00.
I came out similar to Morningstar this time. Averaging the three numbers out gives us a final valuation of $454.93, which would indicate the stock is possibly 36% undervalued.
Bottom line: Lockheed Martin Corporation (LMT) is a high-quality company that leads its industry in scale. This could be one of the surest long-term bets out there as numerous industries start to buckle under the pressure of COVID-19. With a yield near 3%, 17 consecutive years of dividend raises, a moderate payout ratio, double-digit long-term dividend growth, and the potential that shares are 36% undervalued, this stock deserves a good look from dividend growth investors.
— Jason Fieber
Note from DTA: How safe is LMT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 84. 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, LMT’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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