13 new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on August 30, 2018.

Recap from July’s Picks

Our Dividend Growth Stocks Model Portfolio outperformed the S&P 500 last month. The Model Portfolio rose 3.5% on a price return basis and 3.8% on a total return basis. The S&P 500 rose 3.0% on a price return and total return basis. The best performing stock was up 13%. Overall, 17 out of the 30 Dividend Growth Stocks outperformed the S&P last month, and 25 had positive returns.

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: Snap-On (SNA: $178/share)

Snap-On (SNA) is the featured stock in August’s Dividend Growth Stocks Model Portfolio. Snap-On was previously featured as a Long Idea in February 2018. Since then, the stock is up 11% while the S&P 500 is up just 7%.

Since 2009, SNA has grown after-tax profit (NOPAT) by 18% compounded annually, to $651 million in 2017. Over the same time, NOPAT margin improved from 7% in 2009 to 16% TTM while its return on invested capital (ROIC) improved from 7% to 13%. The company has also generated free cash flow of $1.1 billion (11% of market cap) over the past five years.

Figure 1: SNA’s Revenue and NOPAT Since 2009

Sources: New Constructs, LLC and company filings

Steady Dividend Growth Supported by FCF

Snap-On has increased its annual dividend each of the past nine years. From $1.58/share in 2013 to $2.95/share in 2017, SNA’s annual dividend has grown 17% compounded annually. SNA’s TTM is $3.28/share. Most importantly, SNA easily generates the cash flow needed to continue paying and growing its dividend. Over the past five years, SNA has generated a cumulative $1.1 billion in FCF while paying $644 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 the current dividend as well as a higher dividend. On the flip side, the dividend growth trajectory of a company where FCF falls short of the dividend payment over time cannot be trusted to grow or sustain its dividend because of inadequate free cash flow.

SNA Provides Upside Potential

At its current price of $178/share, SNA has a price-to-economic book value (PEBV) ratio of 1.2. This ratio means the market expects SNA’s NOPAT to grow by no more than 20% over the remainder of its corporate life. This expectation seems rather pessimistic for a firm that has grown NOPAT by 18% compounded annually since 2009 and 17% compounded annually since 1998.

If SNA maintains current margins (16%) and grows NOPAT by just 6% compounded annually over the next decade, the stock is worth $216/share – a 21% upside. See the math behind this dynamic DCF scenario. Add in SNA’s 1.8% 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 Snap-On’s 2017 10-K:

Income Statement: we made $331 million of adjustments with a net effect of removing $93 million in non-operating expense (2% of revenue). See all adjustments made to SNA’s income statement here.

Balance Sheet: we made $1.3 billion of adjustments to calculate invested capital with a net increase of $830 million. The most notable adjustment was $358 million (9% of reported net assets) related to other comprehensive income. See all adjustments to SNA’ balance sheet here.

Valuation: we made $1.6 billion of adjustments with a net effect of decreasing shareholder value by $1.5 billion. Apart from total debt, which includes off-balance sheet operating leases, the largest adjustment to shareholder value was $202 million in underfunded pensions. This pension adjustment represents 2% of SNA’s market value. Despite the decrease in shareholder value, SNA remains undervalued.

This article originally published on September 5, 2018.

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] Ernst & Young’s recent white paper “Getting ROIC Right” proves the superiority of our holdings research and analytics.

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