13 new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on August 29, 2019.

Recap from July’s Picks

Our Dividend Growth Stocks Model Portfolio underperformed the S&P 500 from July 26, 2019 through August 27, 2019. The Model Portfolio fell 8.9% on a price return basis and 8.6% on a total return basis. The S&P 500 fell 5.0% on a price and total return basis. The portfolio’s best performing stock was up 18%. Overall, 10 out of the 30 Dividend Growth Stocks outperformed the S&P from July 26, 2019 through August 27, 2019.

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The long-term success of our model portfolio strategies highlights the value of our Robo-Analyst technology[1], which scales our forensic accounting expertise (featured in Barron’s) across thousands of stocks[2].

The methodology for this model portfolio mimics an All-Cap Blend style with a focus on dividend growth. Selected stocks earn an Attractive or Very Attractive rating, generate positive free cash flow (FCF) and economic earnings, offer a current dividend yield >1%, and have a 5+ year track record of consecutive dividend growth. This model portfolio is designed for investors who are more focused on long-term capital appreciation than current income, but still appreciate the power of dividends, especially growing dividends.

Featured Stock from August: Carter’s Inc. (CRI: $93/share)

Carter’s Inc. (CRI) is the featured stock from August’s Dividend Growth Stocks Model Portfolio. We made CRI a Long Idea in April 2017 and closed the position in July 2018 after the stock outperformed the market (up 31% vs. S&P up 19%) and was downgraded to Neutral. Since we closed the position, CRI has fallen over 20%. This decreased valuation, combined with improved fundamentals, means CRI once again earns our Very Attractive rating and offers compelling risk/reward.

Over the past decade, CRI has grown revenue by 9% compounded annually and after-tax operating profit (NOPAT) by 11% compounded annually. Trailing twelve months (TTM) NOPAT is up 8% over the prior TTM period. NOPAT margin increased from 7% in 2008 to 9% TTM while return on invested capital (ROIC) improved from 10% to 12% over the same time.

Figure 1: CRI Revenue & NOPAT Over Past Decade

Sources: New Constructs, LLC and company filings

Steady Dividend Growth Supported by FCF

Carter’s has increased its annual dividend in each of the past five years. The annual dividend has grown from $0.76/share in 2014 to $1.80/share in 2018, or 24% compounded annually. Carter’s TTM dividend has totaled $1.90/share. CRI easily generates the cash flow needed to continue paying and growing its dividend. Since 2014, CRI has generated cumulative FCF of $938 million (22% of market cap) while paying $307 million in dividends.

Companies with FCF well in excess of dividend payments provide higher quality dividend growth opportunities because we know the firm generates the cash to support a higher dividend. On the other hand, the dividend of a company where FCF falls short of the dividend payment over time cannot be trusted to grow or even stay the same because of inadequate free cash flow.

Figure 2: Free Cash Flow (FCF) vs. Regular Dividend Payments

Sources: New Constructs, LLC and company filings

CRI Offers Upside Potential

At its current price of $93/share, CRI has a price-to-economic book value (PEBV) ratio of 1.1. This ratio means the market expects CRI to grow NOPAT by no more than 10% over the remaining life of the firm. This expectation seems rather pessimistic for a firm that has grown NOPAT by 11% compounded annually over the past decade and 14% compounded annually since 2003.

If CRI can maintain TTM NOPAT margins (9%) and grow NOPAT by just 4% compounded annually for the next decade, the stock is worth $117/share today – a 26% upside. See the math behind this dynamic DCF scenario. Add in CRI’s 2.1% dividend yield and history of dividend growth, and it’s clear why this stock is in August’s Dividend Growth Stocks Model Portfolio.

Critical Details Found in Financial Filings by Our Robo-Analyst Technology

As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings. Below are specifics on the adjustments we make based on Robo-Analyst findings in Carters’ 2018 10-K:

Income Statement: we made $145 million of adjustments with a net effect of removing $45 million in non-operating expense (1% of revenue). See all adjustments made to CRI’s income statement here.

Balance Sheet: we made $1.1 billion of adjustments to calculate invested capital with a net increase of $945 million. The most notable adjustment was $750 million (43% of reported net assets) in off-balance sheet operating leases. See all adjustments to CRI’s balance sheet here.

Valuation: we made $1.5 billion of adjustments with a net effect of decreasing shareholder value by $1.5 billion. Apart from $1.4 billion in total debt, which includes the operating leases noted above, the largest adjustment to shareholder value was $89 million in deferred tax liabilities. This tax adjustment represents 2% of CRI’s market value. See all adjustments to CRI’s valuation here.

This article originally published on September 5, 2019.

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.

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[1] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.

[2] This paper compares our analytics on a mega cap company to other major providers. The Appendix details exactly how we stack up.

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