I like to have a mix of different stocks in my portfolio. In the first place, we are talking about sector diversification here. According to Vanguard the stock market is divided into 10 major sectors representing the key areas of the economy: 1) Consumer Discretionary, 2) Consumer Staples, 3) Energy, 4) Financials, 5) Health Care, 6) Industrials, 7) IT, 8) Materials, 9) Telecommunication and 10) Utilities. While my portfolio has a higher exposure to the defensive sector (Consumer Staples, Health Care, and Utilities), I still aim to cover all the other major fields of the economy, too. This is the first diversification approach.
The second diversification method relates to the interplay of dividend yield and dividend growth. In this regard, I want to have a basket of stocks that have a high yield and relatively slow growth and vice versa. I own both categories. For example AT&T (T) and Starbucks (SBUX). In the last post, I expressed my intention to put a little bit more focus on stocks that have good prospects for strong dividend growth. Above all, I believe there are two important factors that will increase a company’s ability to raise its payout. First, the organic growth of a business. And second, the amount of available free cash flow. Screening through these metrics, I was more than happy to purchase two high-quality names that fulfill this requirement.
On March 6, I have purchased 8 shares of Amgen Inc (AMGN) for a total investment of €1,295.17 ($1,465.28). Amgen is a new position in my DGI portfolio.
On March 8, I have purchased 5 shares of Home Depot Inc (HD) for a total investment of €809.74 ($910.15). This purchase adds 5 shares to my existing position.
(1) Amgen Inc
Dividend Yield: 3.17% | 5-yr. Dividend Growth Rate: 22.90% | FCF Payout Ratio: 33% | Consecutive Dividend Increases: 9 years
Amgen is a leader in biotechnology-based human therapeutics, with historical expertise in renal disease and cancer supportive care products. When I choose to purchase a stock, I examine the quality of its business first. There are plenty of ways to define quality, of course. Personally, I’ve created my own quality rating that helps me to find out whether a company suits as a potential investment. For those, who want to simplify that process, some widely used quality indicators are a good way to start. In the following, I have utilized five popular services to shed some light on Amgen’s quality characteristics. Here is the result:
- Value Line Safety: 1 (best possible grade)
- Value Line Financial: A++ (best possible grade)
- Morningstar MOAT: Wide (best possible grade)
- S&P Credit Rating: A (second best possible range)
- Simply Safe Dividend: 87 (best possible range)
As an investor who appreciates high-class businesses, I really like what I see. Amgen delivers a very impressive quality score. Therefore it’s not an exaggeration to say that Amgen finds its place among some of the best names in the entire market.
Organic Growth & Free Cash Flow
Now let’s take a look at how Amgen performs with respect to organic growth and free cash flow. As stated before, these are some key drivers for strong and sustainable dividend growth.
Over the course of 5 years, the revenue grew from $18.68 Bil. to $23.75 Bil. That is a compound annual growth rate (CAGR) of 4.92%. So organic growth is definitely there. Fantastic! Moreover, the trend is positive, too. With the exception of 2017, where organic growth was flat, Amgen managed to grow the revenue every year. That is exactly what I want to see.
Supported by solid revenues and earnings, Amgen also continues to generate more than enough free cash flow to easily cover its dividend payment. The above chart shows a steady positive trend on that score. As a result, Amgen offers a very attractive free cash flow payout ratio of 33% in 2018. So let’s put one and one together and conclude that we can expect plenty of solid dividend raises going forward.
On the quality side, Amgen presents itself as a high-class investment. But what about valuation? Is this stock trading at a reasonable price, too? First, when reviewing the normalized P/E ratio, AMGN’s share price appears to be undervalued.
FastGraphs’ forecasting tool shows a current P/E ratio of 12.7, compared to the normal 5-Yr. based P/E ratio of 14.5. We can conclude the degree of undervaluation by relating both figures: 12.7/14.5 = 0.88 (Price/Fair Value estimate). AMGN is 12% undervalued based on its own historical prices.
Morningstar uses a discounted cash flow approach to define the fair value of a business. The leading stock analysis firm rates AMGN as a 3-star stock, with a fair value estimate of $205. In other words, AMGN is about 13% undervalued, taking its current share price of $181.50 into account.
Finally, I like to combine four different valuations method to derive the end result. Running the numbers, I get a fair value estimate of 0.83. That means that Amgen’s share price might be 17% undervalued today.
(2) Home Depot Inc
Dividend Yield: 3.00% | 5-yr. Dividend Growth Rate: 21.40% | FCF Payout Ratio: 42% | Consecutive Dividend Increases: 10 years
Home Depot is the world’s largest home improvement specialty retailer, operating nearly 2,300 warehouse-format stores offering more than 35,000 products in store and 1 million products online in the United States, Canada, and Mexico.
HD achieves one of the highest scores in my quality rating. However I was still surprised to see this stock beating the S&P 500 on any possible time frame that clearly. When we take a 10-year period as an example, the picture looks as followed:
Market’s total return of +274% is facing HD’s total return of +774%. Wow! Congratulations to those who had the brilliant idea to put some money into Home Depot 10 years ago. I wish I was one of you. While past performance isn’t always a guarantee for future success, I remain optimistic that HD has more good years ahead. Winners tend to keep winning. And HD is a winner. No doubt about it.
Organic Growth & Free Cash Flow
There are many reasons that make me feel comfortable about HD’s future. Organic growth and free cash flow just to name a few. A solid performance in both of them is incredibly important to maintain a fast growing and sustainable dividend. Let’s start with organic growth first.
Over the course of 5 years, Home Depot grew its revenue from $74.75 Bil. in 2013 to $100.9 Bil. in 2018. It’s a CAGR of 6.18%. Even more: the home improvement giant managed to increase the revenue every year starting from 2010. So we are looking at 8 consecutive periods of organic growth here. Taking these figures into account, it’s not surprising that HD has such a unique track record of rewarding its shareholder with a fast-growing dividend.
Have a look at these double-digit raises starting from 2011. Impressive, isn’t it? It’s hard to find something comparable in the market. In February 2019 the company has announced its recent dividend hike of 32%. As a result, Home Depot has a solid dividend yield of 3% nowadays. I absolutely love that kind of combination of yield and growth!
On top of that, we have good reasons to believe that Home Depot will continue with strong dividend increases in the future. Why? Simply because it is generating a huge amount of free cash flow that easily covers the dividend. In 2018 the FCF payout ratio was sitting at 42%. That is a very healthy proportion. So more raises coming ahead is almost guaranteed.
If you weren’t comfortable investing in HD with a P/E ratio north of 22 back a year ago, you may feel more comfortable now. The P/E ratio came down to a more attractive level. Today the shares are trading below their historical valuation.
Home Depot’s current P/E ratio (black line) is 18.4, compared to the normal 5-Yr. based P/E ratio (blue line) of 22.0. By relating these numbers we get the following Price/Fair Value Estimate: 18.4/22.0 = 0,84. According to this valuation approach HD’s share price is about 16% undervalued.
Morningstar uses a discounted cash flow approach to define the fair value of a business. The leading stock analysis firm rates HD as a 3-star stock, with a fair value estimate of $170. So based on Morningstar’s DCF-approach, HD is about 7% overvalued, taking its current share price of $181.23 into account.
To top it off, I simply calculate an average of four different valuation methods to come to the end result. Doing the math, I get a fair value estimate of 0.95. The final result states that Home Depot might be 5% undervalued. Personally, I require at least a fair value ratio of 0.90 (in other words: min. 10% discount) to call a stock undervalued. Below is a valuation scale that I use to define whether the shares are over-, under-, or fairly priced.
Based on that table, HD seems to be fairly valued at the moment (yellow section). In general, I have no problem to purchase a high-quality company that is trading at a fair price. On the contrary, to say it with Buffett’s words: I’d rather buy a wonderful company at a fair price than a fair company at a wonderful price.
Over the last few months, I have been able to collect some high-yield companies like MO (6.1%), T (6.5%), ABBV (5.4%), D (4.6%) and ALV (4.1%). Since these stocks offer a high yield already, future dividend growth might happen at a slower rate. To maintain a good balance in my portfolio, I have therefore decided to invest new capital into stocks that have good prospects for strong growth ahead. Sure, there are many factors that can affect a company’s ability to grow its dividend. Personally, I believe two major conditions will benefit strong and sustainable dividend growth over the long haul: 1) Organic growth of a business and 2) sufficient amount of free cash flow.
In this relation both of my purchases, Amgen and Home Depot, achieve a fantastic grade. Both offer increasing revenues and enough free cash flow to fuel future dividend raises. Interestingly there are even more similarities. Let’s take the dividend characteristics as an example. AMGN and HD offer a comparable dividend yield (approx. 3%) and a similar 5-yr. dividend growth rate (about 22%). Beyond that, the track record of consecutive dividend increases is almost identical. 9 respectively 10 years. Not convinced yet? Here is a final fun fact: the share prices of AMGN and HD are just cents apart from each other. HD closed at $181.23 and AMGN at $180.87 last Friday. Now, if that isn’t a good omen.
What are your thoughts on AMGN and HD? Also, let me know about the stocks you have been buying lately.