Six new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on July 29, 2020.

Recap from June’s Picks

On a price return basis, our Dividend Growth Stocks Model Portfolio (+3.1%) underperformed the S&P 500 (+4.8%) by 1.7% from June 30, 2020 through July 27, 2020. On a total return basis, the Model Portfolio (+3.2%) underperformed the S&P 500 (+4.8%) by 1.6% over the same time. The best performing stock was up 12%. Overall, 11 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from June 30, 2020 through July 27, 2020.

Learn more about the best fundamental research

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 July: Cisco Systems, Inc. (CSCO: $47/share)

Cisco Systems, Inc. (CSCO) is the featured stock from July’s Dividend Growth Stocks Model Portfolio.

We made Cisco Systems a Long Idea in November 2014 and closed the position in October 2018 for a 62% gain (vs. 32% for the S&P 500). The stock now presents a much more favorable risk/reward than when we closed the position.

Cisco Systems has grown revenue by 4% compounded annually and net operating profit after-tax (NOPAT) by 6% compounded annually over the past decade. Longer term, Cisco Systems has grown NOPAT by 12% compounded annually over the past two decades. The firm’s NOPAT margin has increased from 17% in 2009 to 23% over the trailing twelve months (TTM), while return on invested capital (ROIC) has improved from 15% to 17% over the same time.

Figure 1: Cisco Systems’ Revenue & NOPAT Since 2009

Sources: New Constructs, LLC and company filings

Steady Dividend Growth Supported by FCF

Cisco Systems has increased its dividend for nine consecutive years and from $0.80/share in 2015 to $1.36/share in 2019, or 14% compounded annually. The current quarterly dividend, when annualized, equals $1.44/share and provides a 3% dividend yield.

More importantly, Cisco Systems’ strong free cash flow (FCF) supports the firm’s dividend payment. Cisco Systems generated $39.3 billion (20% of current market cap) in FCF while paying $26.3 billion in dividends from 2015 to 2019, per Figure 2. Over the TTM period, Cisco Systems generated $13.1 billion in FCF and paid out $6 billion in dividends.

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

Sources: New Constructs, LLC and company filings

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.

CSCO Has Upside Potential

At its current price of $47/share, CSCO has a price-to-economic book value (PEBV) ratio of 1.0. This ratio means the market expects Cisco Systems’ NOPAT to never meaningfully grow over its remaining corporate life. This expectation seems overly pessimistic given that Cisco Systems has grown NOPAT by 7% compounded annually over the past five years and 6% compounded annually over the past decade.

If Cisco Systems maintains TTM NOPAT margins of 23%, grows NOPAT by just 4% compounded annually for the next decade, the stock is worth $61/share today – a 30% upside. See the math behind this reverse DCF scenario.

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 Cisco Systems’ 2019 10-K:

Income Statement: we made $3.2 billion of adjustments with a net effect of removing $384 million in non-operating income (1% of revenue). See all adjustments made to Cisco Systems’ income statement here.

Balance Sheet: we made $79 billion of adjustments to calculate invested capital with a net increase of $2.4 billion. The most notable adjustment was $19.1 billion (29% of reported net assets) related to goodwill. See all adjustments to Cisco Systems’ balance sheet here.

Valuation: we made $46.9 billion of adjustments with a net effect of increasing shareholder value by $8.2 billion. Apart from total debt, one of the most notable adjustments to shareholder value was $27.6 billion in excess cash. This adjustment represents 14% of Cisco Systems’ market value. See all adjustments to Cisco Systems’ valuation here.

This article originally published on August 10, 2020.

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler 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] Compare our analytics on a mega cap company to Bloomberg and Capital IQ’s (SPGI) analytics in the detailed appendix of this paper.

Click here to download a PDF of this report.

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