Five new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on December 27, 2019.

Recap from November’s Picks

Our Dividend Growth Stocks Model Portfolio outperformed the S&P 500 from November 26, 2019 through December 24, 2019. The Model Portfolio rose 2.8% on a price return basis and rose 3.2% on a total return basis. The S&P 500 rose 2.3% on a price return basis and rose 2.8% on a total return basis. The portfolio’s best performing stock was up 23.2%. Overall, 15 out of the 30 Dividend Growth Stocks outperformed the S&P from November 26, 2019 through December 24, 2019, and 25 had positive returns.

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Only our research utilizes the superior data and earnings adjustments featured by the HBS & MIT Sloan paper, "Core Earnings: New Data and Evidence.” 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 December: Royal Bank of Canada (RY: $80/share)

Royal Bank of Canada (RY) is the featured stock from December’s Dividend Growth Stocks Model Portfolio. We first made RY a Long Idea in April 2018, and despite underperforming the market, the fundamentals remain strong and the stock undervalued.  

Since 2012, RY has grown revenue by 4% compounded annually and net operating profit after tax (NOPAT) by 3% compounded annually. The firm currently earns a top-quintile 15% return on invested capital (ROIC), which equals its average ROIC since 2012.

Figure 1: RY’s Revenue & NOPAT Since 2012

Sources: New Constructs, LLC and company filings

Steady Dividend Growth Supported by FCF

RY has increased its annual dividend each year since 2012. The annualized dividend has grown from $2.26/share in 2012 to $3.21/share in 2019, or 5% compounded annually. RY easily generates the cash flow needed to continue paying and growing its dividend. Since 2013, RY has generated $41.8 billion in cumulative FCF (37% of market cap) while paying $27.8 billion 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 maintain its dividend because of inadequate free cash flow.

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

Sources: New Constructs, LLC and company filings

RY’s Valuation Holds Significant Upside Potential

At its current price of $80/share, RY has a price-to-economic book value (PEBV) ratio of 0.6. This ratio means the market expects RY’s NOPAT to permanently decline by 40%. This expectation seems overly pessimistic for a firm that has grown NOPAT by 3% compounded annually since 2012.

If RY can maintain a 17% NOPAT margins (below 2019 margins of 19%), and grow NOPAT by just 1% compounded annually over the next decade, the stock is worth $145/share today – an 81% upside. See the math behind this dynamic DCF scenario. With RY’s 4.0% dividend yield and history of dividend growth, it’s clear why this stock is in December’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 as shown in the Harvard Business School and MIT Sloan paper, "Core Earnings: New Data and Evidence”.

Below are specifics on the adjustments we make based on Robo-Analyst findings in Royal Bank of Canada’s 2019 40-F:

Income Statement: we made $1 billion of adjustments with a net effect of removing $389 million in non-operating expense (1% of revenue). See all adjustments made to RY’s income statement here.

Balance Sheet: we made $13.9 billion of adjustments to calculate invested capital with a net decrease of $296 million. The most notable adjustment was $3.6 billion (5% of reported net assets) related to operating leases. See all adjustments to RY’s balance sheet here.

Valuation: we made $10 billion of adjustments with a net effect of decreasing shareholder value by $10 billion. There were no adjustments that increased shareholder value. The largest adjustment to shareholder value was $4.3 billion in preferred stock, which is 4% of RY’s market value. See all adjustments to RY’s valuation here. Despite these subtractions from shareholder value, RY remains undervalued.

This article originally published on January 9, 2020.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Sam McBride 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.

Click here to download a PDF of this report.

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