19 new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on March 26, 2020.
Recap from February’s Picks
Our Dividend Growth Stocks Model Portfolio underperformed the S&P 500 from February 27, 2020 through March 24, 2020. The Model Portfolio fell 24.0% on a price return basis and 23.8% on a total return basis. The S&P 500 fell 18.3% on a price return basis and 17.8% on a total return basis. Overall, 11 out of the 30 Dividend Growth Stocks outperformed the S&P from February 27, 2020 through March 24, 2020.
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, which scales our forensic accounting expertise (featured in Barron’s) across thousands of stocks.
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 March: W.W. Grainger (GWW: $249/share)
W.W. Grainger, Inc. (GWW) is the featured stock from March’s Dividend Growth Stocks Model Portfolio.
GWW has grown revenue by 6% compounded annually and net operating profit after-tax (NOPAT) by 9% compounded annually over the past decade. Longer-term, GWW has also grown NOPAT by 9% compounded annually over the past two decades. GWW’s NOPAT margin increased from 7% in 2009 to 9% in 2019 while its ROIC improved from 13% to 18% over the same time. Economic earnings, the true cash flows of a business, increased from $236 million in 2009 to $719 million in 2019, or 12% compounded annually.
Figure 1: GWW’s Revenue & NOPAT Since 2009
Sources: New Constructs, LLC and company filings
Steady Dividend Growth Supported by FCF
GWW has increased its dividend on common stock in each of the past 48 years. The company increased its annualized dividend from $4.59/share in 2015 to $5.68/share in 2019, or 5% compounded annually. Its current quarterly dividend, $1.44/share equates to $5.76/share annually. More importantly, GWW easily generates the cash flow needed to continue paying and growing its dividend. Over the past five years, GWW has generated a cumulative $3.6 billion in FCF (27% of market cap) while paying $1.6 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
GWW Is Undervalued
At its current price of $249/share, GWW has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects GWW’s NOPAT to permanently decline by 20% over its remaining corporate life. This expectation seems overly pessimistic for a firm that grew NOPAT by 17% year-over-year (YoY) in 2019 and 9% compounded annually over the past decade.
If GWW maintains its 2019 NOPAT margin of 9% and grows NOPAT by just 5% compounded annually over the next decade, the stock is worth $419/share today – a 68% upside. See the math behind this reverse DCF scenario.
Add in GWW’s 2.3% dividend yield and history of dividend growth, and it’s clear why this stock is in March’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 W.W. Grainger’s 2019 10-K:
Balance Sheet: we made $1.7 billion of adjustments to calculate invested capital with a net increase of $1.5 billion. The most notable adjustment was $426 million (10% of reported net assets) related to total reserves. See all adjustments to GWW’s balance sheet here.
Valuation: we made $3.0 billion of adjustments with a net effect of decreasing shareholder value by $3.0 billion. There were no adjustments that increased shareholder value. The largest adjustment to shareholder value was $2.7 billion in total debt, which includes $207 million in operating leases. This lease adjustment represents 2% of GWW’s market value. See all adjustments to GWW’s valuation here. Despite these subtractions from shareholder value, GWW remains undervalued.
This article originally published on April 1, 2020.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
 Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.