Volatility in the US stock market has hit unprecedented levels in recent weeks.
However, there’s something to keep in mind here.
Volatility is a short-term phenomenon.
Opportunity, on the other hand, is a long-term phenomenon.
Short-term volatility is a long-term opportunity.
If you pull up a 40-year chart of the S&P 500, you’d never notice day-to-day volatility.
Even the Black Monday crash in 1987, which sent the S&P 500 down ~20% in one day, barely shows up now.
Black Monday was undoubtedly volatile in real-time.
But that was also an incredible long-term opportunity to buy stocks.
For perspective, the S&P 500 closed at less than 225 points on Black Monday.
It’s now over 2,300 points.
A tenfold increase!
And that’s even after the massive drop over the last month.
Don’t pass up the long-term opportunity out of fear of short-term volatility.
More importantly, don’t miss out on the best long-term opportunities of all.
I’m talking about high-quality dividend growth stocks.
Stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
These are world-class enterprises paying reliable and rising cash dividends to their shareholders.
They’re able to send out those growing dividends because they’re selling the products and/or services the world demands.
And they’re selling more of all of it at increasingly higher prices.
I saved money from a regular day job and consistently plowed that capital into high-quality dividend growth stocks, building the real-money FIRE Fund in the process.
And that allowed me to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
The Fund now generates the five-figure passive dividend income I live off of.
Of course, I didn’t build the Fund by randomly buying stocks.
It’s important to analyze and value a stock before you buy it. And you want to understand what a business does and how it makes money.
Investing in an above-average stock at a below-average valuation can lead to tremendous long-term investment results.
While price is what a stock costs, 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.
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.
Short-term volatility can indeed lead to long-term opportunity, since extreme volatility can compress valuations on high-quality dividend growth stocks.
Fortunately, valuing stocks and finding some of the best deals isn’t that difficult of an endeavor.
Fellow contributor Dave Van Knapp has even provided a valuation template that you can apply to just about any dividend growth stock out there.
That valuation template can be found in Lesson 11: Valuation, which is part of an overarching series on dividend growth investing.
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…
Honeywell International Inc. (HON)
Honeywell International Inc. (HON) is a global aerospace and industrial conglomerate.
Founded in 1885, Honeywell International operates across 70 countries and has 113,000 employees.
Commanding a market capitalization of just over $90 billion, this is one of the largest industrial conglomerates in the world.
The company operates in four segments: Aerospace, 38% of FY 2019 sales; Performance Materials and Technologies, 30%; Safety and Productivity Solutions, 17%; Honeywell Building Technologies, 16%.
Honeywell International is a major manufacturer of avionics, small jet engines, climate control equipment, automotive products, industrial materials, and process control systems.
Every 10 years or so, some kind of event comes to pass and people start to think the world is ending.
When these events happen, the stock market tends to get punished from emotional reactions to widespread panic. People sell stocks in a rush, causing extreme but temporary downward pressure on stock prices.
There was the tech bubble bursting and 9/11 terrorist attack as the new century started.
Then we had the financial crisis and ensuing Great Recession.
We now have the COVID-19 global pandemic.
This most recent crisis has caused the fastest bear market in history. And a lot of high-quality stocks have been relegated to the bargain bin.
Honeywell International’s stock is one such example.
This is one of the premier global industrial firms, but that hasn’t stopped its stock from absolutely cratering – now down ~28% YTD.
But long-term investors know short-term volatility is a long-term opportunity.
And lower valuations create a better dividend story, too.
Dividend Growth, Growth Rate, Payout Ratio and Yield
The stock’s yield is up to 2.78%, almost 80 basis points higher than the stock’s five-year average yield.
This is also one of the safer dividends out there, with a payout ratio of only 42.8%.
Further evidence of the company’s commitment to its dividend and the growth of it is the fact that the company has increased its dividend for nine consecutive years.
The 10-year dividend growth rate is a stout 10.8%.
They’re not due to increase the dividend again until late September, which gives the company some time to digest and adjust to sales interruptions from the pandemic.
A yield near 3% along with double-digit dividend growth is kind of that “sweet spot” between yield and growth. It’s a nice balance.
Revenue and Earnings Growth
Of course, we investors care most about where a company is going, not where it’s been. It’s those future dividends that we’re investing in today.
To that end, I’ll build out a future growth trajectory, which will later help us estimate the intrinsic value of the stock.
I’ll first show you what Honeywell International 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 prognostication for profit growth.
Combining the proven past with a future forecast in this manner should allows us to extrapolate out a reasonable approximation of where the company is going (keeping in mind that the next couple months are highly uncertain for all businesses).
The company grew its revenue from $33.370 billion in FY 2010 to $36.709 billion in FY 2019.
That’s a compound annual growth rate of 1.07%.
This is a disappointing number on the face of it. I’d usually like to see mid-single-digit top-line growth from a mature firm like this.
However, the number is misleading.
Honeywell International spun off two large businesses in 2018. These businesses are Garrett Motion Inc. (GTX) that and Resideo Technologies Inc. (REZI). The spin-offs were completed in October 2018, and they combined to account for over 18% of Honeywell International’s 2017 revenue.
Meanwhile, earnings per share expanded from $2.59 to $8.41 over this 10-year period, which is a CAGR of 13.98%.
We can now see where that double-digit dividend growth has been coming from. The company has been powering big dividend growth from big EPS growth.
The excess bottom-line growth came mostly from margin expansion. That’s impressive. Share buybacks have been relatively insignificant over the last 10 years.
Looking forward, CFRA believes Honeywell International will compound its EPS at an annual rate of 10% over the next three years.
CFRA sees demand growth in key segments, especially Aerospace. There’s also the huge backlog, which stands at $25 billion – up 10% YOY.
On the other hand, it’s the Aerospace segment that is probably most directly impacted by the sudden and significant drop in overall air travel (to slow the pace of the spread of COVID-19).
To be fair, it’s always difficult to forecast a company’s earnings growth. But it’s particularly difficult right now in light of the global pandemic.
On the other hand, Honeywell International’s long-term growth profile – looking out over decades to come – should be more or less unimpeded by recent events.
I don’t think Honeywell International must continue growing at 14% in order to be an attractive long-term investment. They don’t even have to grow at CFRA’s projected rate.
A high-single-digit bottom-line growth rate over the coming 5-10 years would allow for like dividend growth, which is ample when it’s coming off of a 2.8% base yield.
And that’s exactly what I’d expect from Honeywell International over the long run.
Moving over to the balance sheet, the company has an outstanding financial profile. They have a rock-solid balance sheet. That’s heartening in this environment.
The long-term debt/equity ratio is 0.60, while the interest coverage ratio is over 22.
Profitability is outstanding. Not only that, it’s been regularly and markedly improving over the last decade.
Over the last five years, the company has averaged annual net margin of 12.32% and annual return on equity of 26.55%.
ROE hasn’t been juiced by tons of debt. And net margin is even better than it looks, with the average being negatively impacted by an anomalous FY 2017. Net margin for the last two fiscal years has been over 16%.
This is a high-quality company, in my view. Truly one of the highest-quality industrial conglomerates out there.
They have incredible fundamentals.
And durable competitive advantages protect the business from erosion.
Those competitive advantages include scale, barriers to entry, technological know-how, and switching costs.
Their global installed industrial base works to their long-term benefit. This is especially true in Aerospace, where the firm’s installed products and services work in sync and support healthy repeat business.
However, there are risks to consider.
Regulation, competition, and litigation are omnipresent risks in every industry.
The company is sensitive to economic cycles, with the upcoming downdraft (due to effects from social isolation and lockdowns) sure to test almost every business out there.
Broader macroeconomic and geopolitical risks are present, ranging from currency exchange to navigating tariffs.
And while broadly diversified, they heavily rely on the Aerospace business segment to drive revenue and profit.
Even with these risks, Honeywell International strikes me as a fantastic long-term investment opportunity when the stock is available at an appealing valuation.
With a drastic drop of 28% YTD, I think the stock is now attractively valued…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 16.15.
That’s well off of the stock’s own five-year average P/E ratio of 27.6.
In addition, the multiple on cash flow, currently at 13.7, is much lower than the stock’s three-year average P/CF ratio of 18.6.
And the yield, as noted earlier, is substantially higher than its 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%.
I’d usually use an 8% long-term growth rate for a company like this. Honeywell International deserves the benefit of the doubt.
However, if there’s ever a time in which it makes sense to err on the side of caution, it’s now.
This DGR is much lower than both the company’s proven long-term EPS growth rate and long-term DGR, as well as CFRA’s three-year EPS forecast.
With the payout ratio being so low, and with the balance sheet being so healthy, I can’t imagine that Honeywell International would come in lower than this DGR over the long run.
This is a conservative valuation to account for so many unknowns in the global economy at this particular period in time.
Ultimately, any company is worth the sum of its future cash flow discounted back to today, and I think Honeywell International’s aggregate cash flow from now until the end of time is unlikely to be notably impacted by the current situation.
The DDM analysis gives me a fair value of $154.80.
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.
This stock looks cheap, even after a fairly conservative valuation model.
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 HON as a 5-star stock, with a fair value estimate of $178.00.
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 HON as a 3-star “HOLD”, with a 12-month target price of $177.00.
I came out on the low end this time. Averaging the three numbers out gives us a final valuation of $169.93, which would indicate the stock is possibly 31% undervalued.
Bottom line: Honeywell International Inc. (HON) is a high-quality company with excellent fundamentals. Short-term volatility has presented investors with a long-term opportunity here. With a 2.8% yield, double-digit long-term dividend growth, nine consecutive years of dividend raises, low payout ratio, and the potential that shares are 31% undervalued, dividend growth investors would be wise to take a long look at this stock right now.
Note from DTA: How safe is HON’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, HON’s dividend appears Very Safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Grocery store billionaire predicts Oct. surprise [sponsor]
Billionaire who made his fortune with groceries and real estate says a big shift in U.S. economy and financial system will reveal itself this October.