Recap From July’s Picks
On a price return basis, the Dividend Growth Stocks Model Portfolio (+1.3%) underperformed the S&P 500 (+1.7%) by 0.4% from July 29, 2021 through August 24, 2021. On a total return basis, the Model Portfolio (+1.5%) underperformed the S&P 500 (+1.7%) by 0.2% over the same time. The best performing stock was up 10%. Overall, 15 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from July 29, 2021 through August 24, 2021.
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: 3M Company
3M Company (MMM) is the featured stock from August’s Dividend Growth Stocks Model Portfolio.
3M has grown revenue by 2% compounded annually and net operating profit after-tax (NOPAT) by 3% compounded annually over the past decade. Longer term, the firm has grown NOPAT by 6% compounded annually since 2000. The firm’s NOPAT margin rose from 16% in 2016 to 18% over the trailing twelve months (TTM).
Figure 1: 3M Company’s NOPAT & Revenue Since 2016
Steady Dividend Growth Supported by FCF
3M has increased its regular dividend in every year from $0.325/share in 1989 to $5.88/share in 2020, or 10% compounded annually. The current quarterly dividend, when annualized, equals $5.92/share and provides a 3% dividend yield.
More importantly, 3M’s strong free cash flow (FCF) supports the firm’s growing dividend payments. 3M generated a cumulative $18.4 billion (16% of current market cap) in FCF while paying $15.4 billion in dividends from 2016 to 2020, per Figure 2. In the TTM period, 3M generated $6.6 billion in FCF and paid $3.4 billion in dividends.
Figure 2: Free Cash Flow vs. Regular Dividend Payments
Companies with FCF well in excess of dividend payments provide higher quality dividend growth opportunities because I 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.
MMM Has Upside Potential
At its current price of $193/share, MMM has a price-to-economic book value (PEBV) ratio of 0.9. This ratio means the market expects 3M’s NOPAT to permanently decline by 10%. This expectation seems overly pessimistic for a firm that has grown NOPAT by 6% compounded annually over the past two decades.
Even if 3M’s NOPAT margin falls to 15% (equal to 10-year low, compared to 18% TTM) and the firm’s NOPAT grows by just 2% compounded annually for the next decade, the stock is worth $238/share today – a 23% upside. See the math behind the reverse DCF scenario.
Should the firm grow NOPAT more in line with historical growth rates, the stock has even more upside. Add in 3M’s 3% 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 My Firm’s Robo-Analyst Technology
Below are specifics on the adjustments I make based on Robo-Analyst findings in 3M’s 10-K and 10-Qs:
Income Statement: I made $1.4 billion in adjustments with a net effect of removing $272 million in non-operating expenses (>1% of revenue). See all adjustments made to 3M’s income statement here.
Balance Sheet: I made $16.0 billion of adjustments to calculate invested capital with a net decrease of $4.4 billion. The most notable adjustment was $7.7 billion (19% of reported net assets) in other comprehensive income. See all adjustments to 3M’s balance sheet here.
Valuation: I made $30.8 billion in adjustments, with a net decrease of $21.2 billion to shareholder value. Other than total debt, the most notable adjustment to shareholder value was $4.8 billion in excess cash. This adjustment represents 4% of 3M’s market value. See all adjustments to 3M’s valuation here.
Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
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