LOW - Buy These 3 Ultra SWAN Bargains Before Everyone Else Does

2023-11-20 07:05:00 ET

Summary

• Many investors understandably fear buying anything related to stocks when the market is 18.5X earnings and 10% overvalued ahead of a likely recession next year.
• But it's always and forever a market of stocks, not a stock market. There are incredible world-beater blue-chip bargains that are good to great buys right now.
• Here are three three excellent examples of Buffett-style "wonderful companies at fair prices," and some of them are even trading at wonderful prices.
• They are 16% undervalued and offer market-smashing long-term return potential.
• Over the following decade, analysts expect about 377% total returns from these three compared to 137% from the S&P 500; from 3 of the safest world-beater blue chips on earth.

This article was co-produced with Kody Kester of Kody's Dividends .

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Even as the S&P 500 (SP500) has roared higher in 2023, some of the world’s best qualitative companies are relatively cheaply valued.

The trifecta is discounted by anywhere from 10% to 19%, which provides room for error as an investor.

These cheap valuations could also act as a coiled spring for future returns.

The three high-quality dividend stocks vary in yield from 0.6% to 3% and can keep growing their dividends at strong rates moving forward.

They can provide market-beating 8% to 25% annual total returns over the next two years and a 10-year cumulative total return potential of between 264% and 556%, nearly 2X to 4X the S&P 500.

After falling 19% in 2022, the S&P 500 (SPX) has been on a tear this year. As of this 2%+ up day on November 14th, the index has rallied 18% year to date, clawing back much of last year's losses.

Recent economic reports have inspired confidence from market participants that a soft landing can occur. Two weeks ago, the best U.S. nonfarm productivity report (4.7% growth versus 4.1% consensus) came out in three years. The 3.2% headline CPI for October 2023 was also better than the 3.3% that economists expected.

However, there are reasons to be less than optimistic that a recession can be avoided. Cracks could be emerging in the U.S. consumer: Adjusting for seasonal items, U.S. retail spending was down marginally (0.03%) in October versus the prior month. We could already be in a recession, but we'll have to wait on whether this becomes a trend.

Just days ago, the bond market implied that a recession between now and 2024 is a near-certainty, at over 98% probability. This could also translate into a dip in earnings while the market is pricing in growing earnings. For context, the average dip in earnings during a recession is 13%.

Simply put, now is the time to gear your portfolio toward protecting yourself against an earnings recession and an almost inevitable fall in the S&P on the horizon.

Here are three high-quality dividend stocks that are already priced for a recession. These businesses could realistically nearly double to quadruple the total returns of the S&P in the next two years and beyond.

Home Depot: The King Of Home Improvement Retail

As mentioned in our previous listicle , The Home Depot, Inc. ( HD ) is the most dominant home improvement retailer, while Lowe's Companies, Inc. ( LOW ) is a distant second. In a trillion-dollar U.S. home improvement retail market, analysts think Home Depot will generate $152.9 billion in current fiscal year revenue versus $87.6 billion for Lowe's.

As the higher cost of living of the last few years is locked in (short of a depression), consumers are temporarily expected to pull back on discretionary spending. The days of the easy money that led to a spike in home renovations and new home sales are gone and likely won't return for a while. That's why Home Depot expects sales and comparable sales to decline between 3% and 4% over the prior fiscal year.

Like Lowe's, the good news is that a rebound should begin next fiscal year for Home Depot. Analysts think that diluted EPS will grow by nearly 5% over this fiscal year in the coming fiscal year to $15.88.

Long-term demographic trends (e.g., Millennial and Gen Z homebuyers) and increasing sales to the more lucrative professional contractor market bode well for Home Depot. This is why the FactSet Research annual earnings growth consensus is 9.7%.

Home Depot's 2.7% is also reasonably attractive versus the S&P 500 index's 1.5% yield. Not to mention that with a 53% EPS payout ratio (in a trough earnings year), the dividend is just below the safe payout guideline of 60% for its industry set forth by rating agencies. This should continue to drive healthy dividend growth moving forward.

The final promising fundamental indicator of Home Depot is its excellent credit rating. Thanks to its favorable competitive positioning and profitability, the company enjoys an A credit rating from S&P on a stable outlook. That implies the 30-year risk of bankruptcy is just 0.66%.

Fundamentals aside, negative market sentiment toward Home Depot could favor those intent on buying here and especially holding for the long term. The current $307 share price is priced at a 13% discount to its historical fair value of $354 a share.

If Home Depot can match growth expectations and revert to its fair value, here is what total returns could be for the next ten years:

• 2.7% yield + 9.7% annual earnings growth + a 1.4% annual valuation multiple boost = 13.8% annual total return potential or a cumulative total return of 264% versus the 9% annual total return potential of the S&P 500 or a cumulative total return of 137%

Cummins Inc. ( CMI ): Vital To The U.S. Economy

In America, we tend to take for granted the availability of goods. Thanks to the American trucking industry, products at your local supermarket or e-commerce sites are almost always available. Without Cummins' industry-leading engines , transmissions, and batteries, almost three-quarters of freight weight moved by trucks in this country wouldn't be possible.

As the U.S. becomes wealthier over time, it's a safe bet consumption will continue to increase. This should also result in higher demand for Cummins' products to move these goods from point A to point B smoothly.

In recent years, the company's commitment to allocating 4% to 5% of its net sales to research, development, and engineering expenses keeps spurring innovation. Thus, no matter whether goods are moved with diesel engines, electric engines, or hybrid engines, they'll almost certainly be moved with Cummins' products. FactSet Research thinks the company's earnings can compound by 11.2% annually over the long run.

Cummins' 3% dividend yield is well-covered. The company's 34% EPS payout ratio is below the 40% rating agencies prefer from its industrial peers. This is why I expect Cummins to rev up its dividend at a high- single-digit pace annually for the foreseeable future.

Thanks to its industry-leading status and mere 28% debt-to-capital ratio, Cummins also enjoys an A+ credit rating from S&P on a stable outlook. This signals the risk of Cummins closing between now and 2053 is just 0.6%.

As if these respectable fundamentals weren't enough, the stock's current $223 share price represents a 19% discount to its fair value of $276. If Cummins meets growth expectations and returns to fair value, this is what total returns could look like in the next decade:

• 3% yield + 11.2% annual earnings growth + 2.2% annual valuation multiple upside = 16.4% annual total return potential or 357% cumulative total returns

Mastercard: Massive Secular Tailwinds

Last but not least, we have Mastercard Incorporated (MA). Mastercard and Visa Inc. ( V ) are analogous to my earlier comparisons between Lowe's and Home Depot. As of its third quarter, Mastercard processed nearly $9 trillion of transactions in the last four quarters. That's compared to the roughly $14 trillion of transactions handled by Visa in its last four quarters.

Mastercard is in the enviable position of being the clear runner-up to Visa in an industry set for solid growth. Per Boston Consulting Group, global payment industry revenue is expected to grow 6.2% annually between 2023 and 2027, reaching $2.2 trillion by 2027.

As Mastercard works to expand its network further and gain even more acceptance at merchant locations worldwide, high growth should persist. FactSet Research believes that Mastercard can grow its earnings by 19.1% annually.

In exchange for these fantastic growth prospects, investors are giving up starting income as Mastercard's starting yield is a modest 0.6%. But with a 19% EPS payout ratio, the company can double its dividend every four years. That level of compounding can add up for investors with a decade-plus time horizon.

Mastercard's light capital expenditure business model and growth prospects earn it an A+ credit rating from S&P on a stable outlook. This suggests the company's 30-year probability of bankruptcy is just 0.6%.

The icing on the cake is that relative to its $448 per share historical fair value, Mastercard's $401 share price suggests shares are 10% undervalued. If growth materializes as anticipated and the company returns to fair value, here is what 10-year total returns could be:

• 0.6% yield + 19.1% annual earnings growth + 1% annual valuation multiple expansion = 20.7% annual total return potential or a cumulative 556% total return.

Summary: These 3 Picks Could Crush The Market For Years To Come

Out of thousands of businesses/stocks in the investment universe, Home Depot, Cummins, and Mastercard stand out as three of the most fundamentally exceptional.

Collectively, the trio can provide a market-topping 2.1% dividend yield, 13.3% annual earnings growth, and a 1.5% annual valuation multiple boost. This is an average annual total return of 16.9%, a 377% total return over ten years. That's leagues ahead of the 9% annual total return potential and 137% cumulative 10-year total return prospects of the S&P 500.

In closing, low payout ratios, robust balance sheets, healthy growth prospects, and cheap valuations make these three no-brainer buys for qualitative-focused investors.

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