The stock market has been extremely volatile since COVID-19 went global.
This is why it’s always a good idea to “keep your eye on the prize”.
That prize isn’t stock prices tomorrow or next week.
The prize is significant wealth and passive income after decades of compounding.
Indeed, it’s more important than ever to invest in companies that have durable competitive advantages, strong fundamentals, and long-term tailwinds to take advantage of.
That’s because these companies are the most likely to survive the economic lockup and then thrive when things are reopened.
Well, it just so happens that many high-quality dividend growth stocks fit that description.
Stocks like those you can find on the Dividend Champions, Contenders, and Challengers list.
This shouldn’t be a surprise.
After all, it requires a rather incredible business in order to sustain ever-growing cash dividend payments to shareholders.
Dividend growth investing tends to filter out low-quality business by the very nature of the strategy.
This is a big reason why I’ve relied on dividend growth investing to afford me financial independence and an early retirement, as I describe in my Early Retirement Blueprint.
I’ve used this strategy to build my FIRE Fund, which is my real-money dividend growth stock portfolio.
It now generates the five-figure passive dividend income I live off of.
I diligently built this portfolio with hard-earned savings by focusing on the best businesses at the best valuations.
Valuation in particular can greatly impact the success of any one investment.
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.
Buying above-average businesses at below-average valuations can allow you to win “the prize” over time.
Stocks have been battered. This has led to more opportunities than usual.
However, it’s still critical that you use your analysis process.
Fortunately, a valuation process isn’t that difficult to formulate.
Fellow contributor Dave Van Knapp even formulated one for you, as you can find in Lesson 11: Valuation.
Part of a more comprehensive series of “lessons” on dividend growth investing, this lesson shares a great 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…
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, 38% of FY 2019 sales; Catalysts, 30%; and Bromine Specialties, 28%. All Other and Corporate account for an insignificant remainder of sales.
I mentioned long-term tailwinds earlier.
Well, there are few tailwinds blowing harder than the move toward clean energy.
Renewable energy sources like solar and wind will power our future society.
It’s better for the environment. And we simply don’t have enough hydrocarbons to last forever. The world will have to adapt to this.
One of the most important technologies in clean energy right now is the lithium-ion battery. It can be found in products ranging from smartphones to electric vehicles.
These batteries are integral to clean energy because of the need for energy storage.
For instance, solar power is great. But the sun doesn’t shine 24/7 in all places.
This need for storage bodes well for major producers of lithium, which these batteries rely on.
As the #1 lithium producer, Albemarle is clearly positioned well.
And that’s before mentioning the fact that Albemarle is exposed to other profitable businesses in bromine and catalysts.
Albemarle has historically been a high-quality chemicals company. That’s the foundation of the business.
Then Albemarle acquired Rockwood Holdings, Inc. in 2015 for $6.2 billion, which catapulted them into a premier lithium producer.
So they took an already-great chemicals business, and then they built a growth-oriented lithium business on top of that.
This should translate into plenty of profits.
And that should filter down to shareholders in the form of growing dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Albemarle has already increased its dividend for 26 consecutive years, which makes them a Dividend Aristocrat.
Keep in mind, most of that time frame predates their move into lithium. This speaks volumes about underlying chemicals operations.
It was already a high-quality company. Then they added big exposure to a global megatrend.
The 10-year dividend growth rate is a stout 11.1%.
And with a payout ratio of 30.7%, there’s still plenty of room for the company to continue increasing the dividend for years to come.
I think it’s important to mention here, though, that free cash flow has recently been weak. Albemarle has had to aggressively invest in their lithium business, leading to smaller dividend raises and weaker cash flow.
But this is designed to set the company up for an extremely long runway of growth and success.
The stock yields 2.64% right now.
That’s actually a pretty attractive yield when you consider the proven dividend growth to date, as well as the future dividend growth potential.
By the way, this yield is more than 100 basis points higher than the stock’s five-year average yield.
This is emblematic of the relationship between price and yield that I noted earlier. And that spread is an opportunity.
Revenue and Earnings Growth
Now, that’s looking at what’s already transpired.
But we are investing in a business for what’s yet to come.
Investors care more about what’s going to happen than what’s already happened.
And it’s the future results that we base a company’s valuation on.
I’ll now estimate a future growth trajectory for Albemarle, which will later greatly aid us when it comes time to value the stock.
This trajectory will partially rely on what Albemarle has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll show you a professional prognostication of near-term profit growth.
Combining the proven past with a future forecast like this should allow us to come to a reasonable conclusion regarding the company’s growth path.
Albemarle has grew its revenue from $2.363 billion in FY 2010 to $3.589 billion in FY 2019.
That’s a compound annual growth rate of 4.75%.
Pretty solid. I typically look for a mid-single-digit top-line growth rate from a mature company.
Albemarle is somewhat unique, though.
The underlying chemicals business is mature. On the other hand, the lithium business has this long runway of growth that is really just starting.
However, the lithium business hasn’t been up and running at full speed for long.
If we look at top-line growth before Rockwood Holdings, it was basically flat. Revenue growth accelerated after 2014.
Earnings per share increased from $3.43 to $5.02 over this 10-year period, which is a CAGR of 4.32%.
It’s the same story here as it is with revenue growth.
The numbers have been a little bit choppy and underwhelming because of the integration of and investments into the lithium business.
I expect things to smooth out and look a lot better within the next few years, especially after we’re past this current pandemic.
Looking forward, CFRA is predicting that Albemarle will compound its EPS at an annual rate of 6% over the next three years.
Notably, that projection is factoring in the uncertainty resulting from the pandemic.
CFRA used to have a 10% projection on the three-year EPS CAGR. They scaled that way back after the health crisis went global.
This is a good time to think about whether you’re a short-term trader or long-term investor.
The next 6-12 months is going to be highly volatile and uncertain. But if you believe in the future of clean energy – thinking about the next 20-30 years here – Albemarle will almost certainly be a key player in that revolution.
Mid-single-digit bottom-line growth over the next few years would be a sensible expectation, considering the 10-year track record and 6% forecast.
And that would likely highly correlate to dividend growth.
But the long-term dividend growth picture here looks quite a bit better, especially after factoring in the low payout ratio.
The 10-year dividend growth rate is in the low double digits – and half of that time period was an Albemarle without Rockwood Holdings.
I believe they can get the dividend growth into the high-single-digit range once we move past this pandemic.
Moving over to the balance sheet, Albemarle has a very good financial position.
The long-term debt/equity ratio is 0.73, while the interest coverage ratio is over 10.
Investments in lithium have required the company to be aggressive with capital allocation, so the balance sheet has deteriorated somewhat compared to where it was a decade ago. Offsetting that is the new growth capacity.
I think it’s a fair trade-off, but I wouldn’t like to see balance sheet worsen from here.
Profitability is strong, with Albemarle consistently putting out impressive numbers for what is still largely a chemicals business.
Over the last five years, the firm has averaged annual net margin of 14.08% and annual return on equity of 13.51%.
Some of the recent results in net margin have been great and compare very well to what this company was doing a decade ago.
Overall, this looks like a fantastic long-term investment.
It’s been a tremendous chemicals operator for a very long time, as evidenced by their status as a Dividend Aristocrat. And then they installed an incredible lithium business on top of that.
The company’s unique assets, especially their brine assets in Salar de Atacama (the lowest-cost source of lithium in the world), give them durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
There are also geopolitical risks here, particularly as it relates to the company’s exposure to Chile.
Changes in raw material costs can shift profitability dramatically.
A reduction in lithium battery demand, or a wholesale change in battery technology, would have a material effect on the company’s profit.
As with every major company, they’re exposed to the global economy at a macroeconomic level. The current pandemic will affect Albemarle’s near-term results.
Lastly, elevated capital expenditures have recently created a severe drag on free cash flow. This is something to watch.
That all said, I still think the prospective reward greatly outweighs the risks.
At the right valuation, this could be a home run of a long-term investment.
This has been one of my best ideas for 2020. And the stock started the year off strong, rocketing up to almost $100/share in February.
Then the pandemic hit and caused the stock to fall off a cliff.
Now 41% off of its 52-week high, this stock’s valuation looks awfully appealing…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 11.61.
That’s well below the broader market, and it’s silly cheap for the asset quality here.
Furthermore, that’s not even 1/3 the stock’s five-year average P/E ratio (one that is, admittedly, clouded by volatile results).
Then there’s cash flow.
The P/CF ratio, at 8.6, is almost 2/3 lower than its three-year average of 23.0.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? 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 8%.
This is a modestly less aggressive valuation than I’ve used in the past for Albemarle. They’re a bit more economically sensitive than some other businesses, and I think it makes sense to err on the side of caution here.
The long-term DGR I’m modeling in would be more than 300 basis points lower than what Albemarle has produced over the last decade.
With a low payout ratio and their world-class assets just now starting to work in their favor, I think the dividend growth stands a decent chance of being higher than this over the long run – the caveat being that the short term will likely be volatile and uncertain.
The DDM analysis gives me a fair value of 83.16.
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 might have gotten ahead of itself at ~$100/share. After a precipitous drop, it now looks greatly undervalued.
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 $125.00.
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 3-star “HOLD”, with a 12-month target price of $70.00.
I came out in the middle. Averaging the three numbers out gives us a final valuation of $92.72, which would indicate the stock is possibly 59% undervalued.
Bottom line: Albemarle Corp. (ALB) is a high-quality company that has big exposure to one of the biggest global megatrends that exists. With over 25 consecutive years of dividend raises, a low payout ratio, double-digit long-term dividend growth, a market-beating yield, and the potential that the stock is 59% undervalued, this is a stock that dividend growth investors must take a close look at right now.
— 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 a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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