Recap From June’s Picks
On a price return basis, the Dividend Growth Stocks Model Portfolio (+2.9%) outperformed the S&P 500 (+2.8%) by 0.1%, and on a total return basis, the Model Portfolio (+3.0%) outperformed the S&P 500 (+2.8%) by 0.2%. The best performing stock was up 18%. Overall, 11 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from June 29, 2022 through July 26, 2022.
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: Masco Corporation
Masco Corporation (MAS) is the featured stock from July’s Dividend Growth Stocks Model Portfolio.
Masco has grown revenue by 1% compounded annually and net operating profit after-tax (NOPAT) by 19% compounded annually over the past ten years. Masco’s NOPAT margin rose from 4% in 2012 to 12% over the trailing twelve months (TTM), while invested capital turns improved from 0.7 to 0.9. Rising NOPAT margin and invested capital turns drive Masco’s return on invested capital (ROIC) from 3% in 2012 to 10% over the TTM. The company’s economic earnings, the true cash flows of the business, rose from -$90 million to $522 million over the same time.
Figure 1: Masco’s NOPAT & Revenue Since 2011
FCF Exceeds Dividends by a Wide Margin
Masco has increased its dividend in each of the past 9 years. The company increased its regular dividend from $0.41/share in 2017 to $0.85/share in 2021, or 20% compounded annually. The current quarterly dividend, when annualized, equals $1.12/share, and provides a 2.0% dividend yield.
More importantly, Masco’s strong free cash flow (FCF) easily exceeds the company’s growing dividend payments. From 2017 – 2021, Masco’s cumulative $4.9 billion (40% of current market cap) in FCF is more than 6x the $763 million in dividends paid out, per Figure 2. Over the TTM, the company generated $749 million in FCF and paid out $246 million in dividends.
Figure 2 also shows that Masco’s FCF significantly exceeded its dividend payments in each of the past five years.
Figure 2: Free Cash Flow vs. Regular Dividend Payments
Companies with FCF well above dividend payments provide higher quality dividend growth opportunities because I know the company 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.
Masco Has Upside Potential
At its current price of $55/share, MAS has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects Masco’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic for a company that has grown NOPAT by 8% compounded annually over the past five years and 19% compounded annually over the past decade.
If Masco’s NOPAT margin falls to 10% (ten-year average vs. 12% TTM) and the company grows NOPAT by just 3% compounded annually for the next decade, the stock would be worth $70+/share today – a 27% upside. See the math behind the reverse DCF scenario.
Should the company grow NOPAT more in line with historical growth rates, the stock has even more upside. Add in Masco’s 2.0% dividend yield and history of dividend growth, and it’s clear why this stock is in July’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 Masco’s 10-K and 10-Qs:
Income Statement: I made $1.1 billion in adjustments with a net effect of removing $661 million in non-operating expenses (8% of revenue).
Balance Sheet: I made $8.1 billion in adjustments to calculate invested capital with a net increase of $6.4 billion. The most notable adjustment was $3.8 billion (105% of reported net assets) in asset write-downs.
Valuation: I made $3.7 billion in adjustments with a net effect of decreasing shareholder value by $3.7 billion. Apart from total debt, the most notable adjustment to shareholder value was $227 million in underfunded pensions. This adjustment represents 2% of Masco’s market value.
Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation to write about any specific stock, style, or theme.