RTX - 3 Countercyclical Intrinsically Undervalued Dividend Aristocrats

2023-07-26 09:59:20 ET

Summary

• The market can be unpredictable in the short term, similar to an election, but in the long term, it is more reliable and predictable, like a weighing machine.
• Long-term investing is beneficial as it allows for compounding and avoids rapid market changes; buying quality stocks and holding onto them is one of the surest ways to alpha.
• The start of a bull market is an excellent time to buy undervalued long-term dividend stocks, as the crowd's attention is often focused on growth and new technological trends.

In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

Benjamin Graham.

Markets are as perplexing as they can be lucrative or impoverishing. The human mind is poorly equipped to judge risk in a way that can reliably produce returns. However, one of the greatest minds in the history of market valuation makes an interesting point about valuation. The good Mr. Graham also illustrates why time horizon is so important in investing.

Weighing is reliable. You can weigh something and get the same reading over and over again. There's a certain orderliness to it, predictability. This is why long-term investors hang their hats on valuation more than short-term investors. There is an effective insurance policy when something is intrinsically undervalued; it will appeal to other investors searching for underpriced investments.

On the other hand, elections are a picture of unpredictability. There are ways to anticipate and measure their results, but uncertainty remains until the very moment of truth. The whims of the crowd are unpredictable, and emotionality and last-minute developments can always sway an outcome that seems inevitable. Sometimes, elections can be close. Other times, they can be utter landslides, like when Richard Nixon won nearly every state in 1972.

Use this example to understand why sometimes the price can become so divorced from valuation. The crowd chases the gains; it's hard to find sellers before you know it. But there always comes a time when the last buyer buys, and the symbolic downfall of Nixon always occurs. In 1972, Nixon had the most successful election in American history; two years later, he ignominiously resigned. Every market rally is just waiting for its Watergate.

This is why bull market rallies are a great time to load up on the red-headed stepchildren of defensive and countercyclical stocks that pay healthy dividends. When the crowd is focused on the hot new thing that may or may not work, you can focus on building long-term wealth through compounding and locking in lower yields at their expense. Have fun chasing the Titans of tomorrow's AI revolution, but also, don't forget to eat your vegetables (in a portfolio sense.)

When everyone's voting for Tricky Dick Nixon, vote for McGovern. Buy countercyclical Dividend Aristocrats when the bull market is raging, even if you're participating in the exuberance. You'll be glad you did when the bull market is over. Remember, the best way to beat the market is with patience.

Using the Bull/Bear Cycle to Boost Compounding Potential

Of course, this electoral unpredictability permeating markets is the investor's bane. The rapid changes of fortune that can occur when the whims of the crowd are at a fever pitch can cause drawdowns that cripple long-term returns, and if you sell in a panic, you can be stuck with a loss that can be hard to recover from. And that is why one of the surest ways to avoid drawdowns (and thus access the miracle of compounding) is to buy quality stocks and pretty much never sell.

But the other side of making compounding work is to continue buying. Of course, one of the easiest ways to do this is to enroll directly in a Dividend Reinvestment Program and buy stock directly from companies on computershares.com if possible. But how you time your buys are essential in compounding, and an early bull market is always an opportunity to load up the stalwarts you'll be glad you own when the party's over.

Of course, one way to avoid this risk is to invest long-term in stocks that provide the benefit of compounding. However, finding the suitable yield is no easy task. Simply picking the highest yield will expose you to the same value traps that a blind value-driven strategy will. It is just as much an art to evaluate a stock's dividend safety as it is to conduct a relative or intrinsic valuation and pair it with other information like management quality.

Be Greedy With Quality Countercyclical Dividend Aristocrats When Others Are Greedy

There appears to be a new bull market underway. Of course, things could reverse, and there is no shortage of formidable risks stalking the market's strength. Still, the level of gains and the duration since the last major low in October are promising. Many folks will begin chasing the next hot thing other investors flock to. Still, for some investors, a bull market is always an opportunity to use compounding.

This might not be your first thought, but you must remember something. Stock can be intrinsically valued, and they can be relatively valued. Many great long-term dividend stocks will be available on the cheap when a bull market begins because the crowd's attention is elsewhere. It is on growth, and it is usually on stocks with exposure to a promising new technological trend.

So, with that, I have three countercyclical dividend aristocrats I'd like to recommend that you consider accumulating more prominent positions and raising your effective yield.

Kimberly-Clark Corporation

Kimberly-Clark Corporation ( KMB ) is the Titan of Tissues and is a stalwart household products name that you can feel comfortable owning for the long term. The firm is undervalued relative to peers and has one of the lower PEG ratios in the industry, meaning you're getting growth more cheaply than at more richly priced peers.

On the intrinsic valuation front, the stock also looks advantageously priced from several different methodologies. The firm is significantly undervalued when using several different kinds of discounted cash flow, or DCF, models. Using the Dividend Discount Model, the picture is more mixed, but there is still some upside in the multi-stage version. Anomalous COVID data compromises the Peter Lynch Fair Value methodology.

The firm is also competitive on several metrics with its peers in terms of its dividend payments. This is why I think you can feel very comfortable owning this company and beginning to build a position over time if you're not already an owner.

Of course, the dividend history speaks for itself, but I also am a big fan of Seeking Alpha's dividend grades and extensive suite of tools for dividend investors. I'm highly encouraged by the good marks it receives.

The company reported earnings yesterday and, after adjustments, handily beat analyst estimates. Kimberly Clark also raised its organic sales growth estimates from 2-4% in 2023 to 3-5%. I think this stock is a buy for discerning dividend investors. I also always like to look at the financial effectiveness of stocks I recommend for the long-term, and the firm does well here versus peers.

This firm has a high payout ratio and a half-century of dividend growth. It is one of the most countercyclical product mixes that should do well in an environment of decelerating growth. This is a good entry point for yield hounds seeking compounding.

Coca-Cola

The Coca-Cola Company ( KO ) is a famous compounder and well-known to be a favorite of legendary investor Warren Buffett (both stock products). It is rare to find the cherished blue-chip intrinsically undervalued, and there's a lot more room for growth at this classic American company than you might think, given its age.

The firm has many products besides its flagship offerings and much room for international growth in promising markets. The firm has a history and dedication to returning capital to shareholders that precedes it. While the dividend safety grade is a B-, consistency and growth compensate for this.

Of course, the dividend is legendary, and the firm has managed to grow the dividend for 60 years. That means since 1963, ladies and gentlemen. Of course, the stock is mature, so growth is not what you're after here. If you're loaded up on Growth names with high beta, Coca-Cola's tame beta of .53 can provide some nice portfolio characteristics. Since J K's assassination, they've raised the dividend through every tragic American event and risk thrown at the market.

Of course, as one of the most stalwart names that sells a product billions of people use daily, KO's countercyclical nature is self-evident. But its earnings growth is also accelerating this year compared to last year.

Coca-Cola reported earnings this morning that showed pricing power. Despite raising prices significantly in the first quarter, consumers showed a willingness to pay for company's wares. The firm handily beat Wall Street expectations and raised guidance.

General Dynamics

Countercyclical companies are ideal candidates for compounding because the volatility associated with extreme cycles for cyclical companies is one of the primary things that can kill or a reduce a dividend. Therefore, owning countercyclical dividend aristocrats over the long-term is a winning strategy for beating the market.

When your primary customer is the U.S. government, and their demand is relatively uncorrelated to the economic cycle, you're going to get that desired countercyclical characteristic. General Dynamics Corporation ( GD ) is a proven compounder that will be a primary beneficiary of secular trends with regard to defense spending.

When measured against peers and the wider market, General Dynamics has an attractive valuation. One of the things that makes me even more confident of owning General Dynamics is that they have a world-class CEO who has run the defense budget for a U.S. President before. This is a major asset for a Defense Industry participant.

There are very few examples of advantageously priced dividend aristocrats with such strong medium and long term catalysts as the increased demand caused by the deteriorating geopolitical threat environment. The firm builds the Abrams Tank, but it is also the most crucial firm in the future of the U.S. nuclear triad. This is what is known in the defense industry as a "sacred cow" project.

As the high-intensity conflict in Ukraine rages, and as governments realize they are massively underequipped for the new tempo of 21st century warfare, General Dynamics will also benefit as one of the primary U.S. ordinance and munitions manufacturers.

The firm is also intrinsically valued across several different methodologies. While there is weakness in a stable Dividend Discount Model, the multistage DDM reveals significant upside. All of the DCF methodologies suggest significant upside. Furthermore, when you compare the company with peers it is more advantageously valued and also has a more robust financial position.

The company is also experiencing momentum this year. Increasing defense demand is responsible for growth across segments and is complemented by the premier private aviation segment, Gulfstream. Furthermore, recent setbacks for peers such as Raytheon, now RTX Corporation ( RTX ), may put a favorable light on its smaller and more undervalued peer.

The last earnings report suggest there could be tailwinds for share price appreciation this year. All indications currently suggest the company will have a strong year marked be increased demand and declining supply chain snags.

Risks and Where I Could Be Wrong

One of the best ways to mitigate risk when investing in the stock market is to stretch out your time horizon. The easiest way to beat the market is with something we can all possess with discipline: patience. When a company has history of increasing the dividend for decades, that is one of the strongest endorsements that an investment and management team has what it takes to fight for shareholder interests through thick and especially thin.

I am a millennial and I have been investing since I was a legal adult. It is very unfortunate that my generation often shuns the dividend aristocrats in favor of the hot new thing. If they want to manage risk, maybe they'll buy VIX options or some other fancy instrument to control their risk.

As you can see above, these stocks would have served as a hedge to plummeting markets in 2022. Unlike using derivatives, there is no expiration, these are permanent hedges that can always help your portfolio weather the natural undulations of market cycles. These companies are low-risk compared to many peers, but they are still vulnerable in market-wide volatility events. Any of the following risks, or even ones now unforeseen could cause such an adverse outcome:

• Monetary policy lag and QT cause a rapid reversal of economic conditions.
• Debt-strapped companies start to buckle under the weight of higher rates, causing higher unemployment than predicted by the SEP.
• Inflation returns.
• Fed policy error.
• Escalation of geopolitical tensions.

Still, despite the fact that equities will always have risks there are few more proven strategies then letting compounding work for you and disregarding the market's short-term catalysts for a strategy grounded in valuation.

Conclusion

"Everyone has the brain power to make money in stocks. Not everyone has the stomach." -Peter Lynch.

Owning dividend aristocrats is a simple strategy. You buy, you keep accumulating on price weakness, and you don't sell until you're ready to retire. This has minted many millionaires in the United States, and there's not any particular consistent in-depth research involved. As Peter Lynch famously said above, brain power is not required for investing success, but rather a steely resolve and patience.

The three stocks I've recommended in this piece are names that have proven their reliability and dedication to shareholders. If you're spending all time looking at a brokerage account screen or trading software, you're probably just killing returns that you could get by instead pursuing a hobby or time with the family.

We have become growth focused and technology focused in modern markets, which is understandable. But it's important to remember that the equity asset class came far before these things, and investors are perfectly capable making life changing money with businesses that might be considered boring in today's fast-paced market discourse.

Remember, the most successful retail investors were found by Fidelity to have forgotten their accounts . So buy some dividend aristocrats and forget about your account, friends!

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