Summary
- Where would you invest $10,000? In this article, we dive into this question - especially in light of recession risks and nervous markets.
- I present three dividend growth stocks with stellar business models, healthy balance sheets, decent yields, high dividend growth, and a high probability of long-term outperformance.
- Moreover, the stocks are likely to add low-volatility outperformance, thanks to the characteristics of dividend growth stocks.
- All stocks are on my watchlist, which means I'm buying on weakness.
Introduction
It's time to do one of my favorite things: discussing top-tier dividend (growth) stocks. In this article, I will give you three dividend stocks that make a lot of sense in almost all dividend portfolios - except for the ones aiming to generate high yields - we discussed that last month. The companies I present do not have very high yields. However, dividend growth is strong and consistent. Even better, they're backed by rock-solid business models and balance sheets that will protect investors against recessions while generating above-average total returns on a long-term basis.
Moreover, the combination of the three stocks provides investors with one of the best risk/reward profiles I've seen in a very long time.
While I might disappoint investors looking for high yields, I believe I've found something worth putting on your watchlist or directly in your portfolio.
Now, let's get to it!
The $10,000 Question
The other day, I read an article on Bloomberg, which covered the opinion of four professional investors who answered the following question: how to invest $10,000 right now?
I think asking that question is fun, as answers often include pieces of valuable information, even if one decides to ignore specific investment tips. Also, $10,000 doesn't exclude people. It's not like asking where to put $10 million after selling your grandfathers' rare car collection.
Starting investors often have portfolios close to $10,000. Larger investors invest $10,000 in a single stock. I'm painting with a broad brush here, but my point is that answering the $10,000 question should offer value to everyone.
That's what I'm trying to achieve in articles like this one.
Going back to the Bloomberg article, the $10,000 question was based on a few guidelines, in this case, recession fears, volatile markets, and what this might do to allocation changes.
With recession fears swirling, announcements of big job cuts rolling out daily and retirement savings battered by a turbulent year in the markets, investors can’t be faulted for feeling nervous.
Rather than retreat into cash, however, now may be a good time to expand your horizons abroad, according to wealth advisers. After a decade of strong US returns, the four money managers who shared their top ideas with Bloomberg see international opportunities ranging from Europe to Japan to emerging markets.
Answers ranged from buying emerging market ETFs to buying undervalued bonds.
I decided to go in a different direction. I'm staying in the US, as I believe that there are always opportunities in the US of A. In this case, I'm still keeping an eye on the recession, as I will give you;
- Stocks that perform well during recessions (downside protection)
- Stocks that outperform the market on a long-term basis
- Stocks with bulletproof business models
- Stocks with healthy balance sheets
- Stocks that cannot be (seriously) harmed by ongoing macro woes, including high rates, slowing economic growth, and geopolitical issues.
Between January 1994 and January 2023, these three stocks returned 14.8% per year in an equal-weight portfolio. The standard deviation was just 15.5%. And, even better, the performance was consistent!
In other words, we're focusing on dividend growers that have proven to be a great mix of low volatility and high returns.
Now, let's start with stock number one.
1. Northrop Grumman ( NOC ) - 1.6% Yield
- Defensive business model (100% defense)
- Great valuation after an 18% sell-off
- Rock-solid dividend growth
- Total return outperformance
Northrop Grumman is one of my all-time favorite dividend growth stocks. The company is a defense-focused contractor with close to zero commercial exposure. This means the company has an anti-cyclical business model, as its sales depend on government agency orders.
With a market cap of $68.5 billion, the company is the fourth-largest defense company in the United States.
The company has a well-diversified business model consisting of next-gen technologies, including cyber, space, missile (defense), and the next-generation bomber named B-21 Raider.
Northrop Grumman
In the past two years, defense companies struggled with severe supply chain problems and labor shortages on top of high defense budget uncertainty.
Now, both problems are gone (technically). The defense budget has been raised by 10%, with expectations that the budget in 2024 might be raised again to incorporate new defense challenges, inflation, and other issues like the robustness of the national defense supply chain. Meanwhile, supply chains are more than likely normalizing toward the end of this year.
According to Northrop :
We ended the year with nearly $79 billion in backlog, reflecting strong demand for our products and capabilities. We continue to convert our backlog into revenue at an accelerating rate, with fourth-quarter sales growth of 16%.
This is terrific news for the company's dividend and buybacks.
Since 2012, the company has hiked its dividend by 12% per year. It has also bought back 38% of its shares during this period.
This continued in 2022. The company hiked its dividend by 10% to $1.73 per share, which translates to a 1.6% yield. This was the 19th consecutive annual dividend hike. The company also repurchased shares worth $1.5 billion.
As a result, there's just one low grade on the Seeking Alpha dividend scorecard. The company's 1.6% yield isn't extremely attractive. However, it has consistent and outperforming dividend growth. The dividend payout ratio is 26%. Its balance sheet has a BBB+ rating.
The good news is that the low yield didn't cause the total return to be disappointing. The company has outperformed its peers by a wide margin over the past ten years and on a very consistent basis.
On top of that, I put NOC in this article because of its valuation.
On January 2, I wrote an article titled: Northrop Grumman: Buy The Next Correction .
What followed was the biggest correction since the pandemic.
While it has caused my portfolio to underperform due to the size of NOC in my portfolio, I'm quite happy with the decline. It allowed me to buy some shares for portfolios that I manage, and I know that many people who read my articles were on the hunt for a bargain.
NOC is now trading at slightly less than 15x forward EBITDA, which I believe is a good valuation to start buying.
Stock number two is different. However, it's also a fantastic low-volatility dividend growth stock.
2. Equity LifeStyle Properties ( ELS ) - 2.3% Yield
- A low-maintenance and secular-growth-driven real estate portfolio
- A very healthy balance sheet
- Strong and consistent dividend growth
- Total return outperformance
Equity LifeStyle is one of my all-time favorite REITs, which I don't own. At least not yet. I put the stock on my watchlist a while ago, as I'm planning to make it a part of my increasing real estate portfolio.
Just recently, I covered the stock in a separate article , as I believe that the company deserves a lot more attention than it is currently getting.
ELS is the second-largest manufactured-housing-focused REIT in the United States. Founded in 1969, the company has 445 properties in 35 states and one Canadian province. These sites cover more than 170,000 sites and are maintained and managed by the company's 4,100 employees.
Unlike operators of malls and other maintenance-heavy buildings, ELS has a business model that is easily scalable and very efficient as it leases sites to customers who own manufactured houses, RVs, or boats (it also owns marinas).
To use the company's own words:
Our customers may lease individual developed areas (“Sites”) or enter into right-to-use contracts, also known as membership subscriptions, which provide them access to specific Properties for limited stays. Compared to other types of real estate companies, our business model is characterized by low maintenance costs and low customer turnover costs .
Roughly 65% of total operating expenses go toward utilities, payroll, and maintenance. This includes amenity improvements and renovations to keep its parks tidy.
Thanks to pricing and cost management, ELS has grown its net operating income by 4.3% per year going back to 1998. This beats the average REIT by 120 basis points per year, which adds up over time.
Its occupancy rates are high. The average is 95%. 54% of MH communities have occupancy rates of more than 98%. 92% of clients are homeowners, which means that they tend to stay longer, which gives the company a lot of safety. That's why I prefer ELS over MH operators with more leisure exposure.
The second major benefit is that MH communities aren't what used to be trailer parks with a bad reputation.
While ELS' main customer base is people aged between 55 and 80, MH housing is reaching an ever-increasing target audience thanks to cost benefits.
In the United States, the average manufactured home costs $121,600. That is 76% below the average cost of a single-family house. The monthly cost is 71% lower. The only difference is that upfront costs are higher.
It also helps that the company has a stellar balance sheet. Only 9% of its debt is due within the next three years. The average weighted interest rate is just 3.6%. Moreover, 90% of ELS' debt has a fixed rate. All of this protects the company against the current high-rate environment, even if it lasts for a few more years.
With all of these benefits in mind, the stock offers a very decent dividend.
The company pays a $0.41 per share per quarter dividend. This translates to a 2.3% yield. Over the past ten years, the average annual dividend growth rate was 11.9%. This growth rate benefited a lot from the strong years after 2012 when US housing recovered.
The company did NOT cut its dividend during the Great Financial Crisis.
Over the past five years, the average annual dividend growth rate is still 11.0%.
On March 8, the company announced a 13.1% dividend hike.
The AFFO payout ratio is 71%, which is slightly below the sector median of 73%.
That said, the stock rallied more than 6% after earnings. The company is now trading at 25x 2023E normalized FFO.
FINVIZ
While I'm glad that my bullish call is working out well, I haven't bought the stock. I'm still looking for a lower entry, as I believe that the market will provide us with a new buying opportunity. I'm not buying the market's extremely dovish expectations and expect at least one major buying opportunity in the months ahead.
Needless to say, it comes with the risk that a correction won't happen. In that case, the risk is not owning ELS when it continues its long-term outperformance.
However, given my strategy to mainly buy on weakness, I'm willing to take that risk.
Stock number three is also a stock I have on my watchlist.
3. Automatic Data Processing ( ADP ) - 2.2% Yield
- A solid business model allowing for fast growth
- High free cash flow generation and growth
- A satisfying dividend yield and dividend growth
- A history of low-volatility outperformance on the stock market
Founded in 1949, ADP is still a terrific dividend growth stock and a fast-growing player in global human resource operations. The company provides cloud-based human capital management ("HCM") services that unite human resources, payroll, talent, time, tax and benefits administration, and other services.
The company serves close to one million clients, covering 39 million workers in 140 countries.
Automatic Data Processing
Essentially, the company provides services for companies ranging from fewer than 50 employees to large businesses with thousands of employees.
One of the biggest tailwinds for the company is outsourcing. Companies want to focus on what they do best, which means getting rid of non-core tasks like human resources. As a lot of human resources is standardized work (like payroll), ADP has the right tools for the right tasks.
In its fiscal 2023 year, the company expects between 6% to 9% in new business bookings growth, leading to at least 8% revenue growth. Adjusted diluted EPS growth is expected to be at least 15%.
With that said, the company behind the ADP ticker is a dividend aristocrat, which means it has raised its dividend for at least 25 consecutive years. Even better, the company is two years away from becoming a dividend king, which is a group of stocks with at least 50 consecutive annual hikes.
In a recent article , I shared the comments from CEO Carlos Rodriguez. I still believe his words are valid, as he highlights the importance of the dividend.
[...] I don't want to get ahead of the Board, but if the Board approves a dividend increase in November, this will be our 48th year of increasing dividends, which I think is a pretty elite group out there. And if you look at our payout ratio and you assume the Board will want to stay in the same payout ratio, you can do the math in terms of what's going to happen with our dividend. I think people really way underestimate. I hope this doesn't become an environment where for the next 10 years people are very focused on dividends because that has its own negative implications. But if you look at over 50 years or 70 years or 100 years, dividends matter, right? And compounding growth of dividends matters a lot.
The good news is that the company did raise its dividend. In November, ADP raised its quarterly dividend by 20% to $1.25. This implies a yield of 2.2%.
With this in mind, the company has a very attractive dividend scorecard.
This is the result of a few impressive numbers:
- The 10-year average annual dividend growth rate is 11.8%.
- The 5-year average annual dividend growth rate is 13.3%.
- The cash flow payout ratio is 39%.
- Free cash flow is growing by 11.5% CAGR in the FY2013-2025E period.
Moreover, the company is expected to end FY2023 with negative net debt. ADP has an Aa3 credit rating, which beats a lot of developed nations.
Due to economic headwinds, the stock is trading below $230 (17% below its all-time high). The EV/EBITDA multiple is 20.0. The forward multiple is 19x. These numbers are fair, yet not cheap. As I said in my prior article, aim to buy ADP as close to $200 as possible. I believe that the Fed will have to weaken the jobs market to combat sticky wage inflation. That is a major headwind for ADP.
Needless to say, these headwinds are temporary. I have little doubt that ADP shares will continue to outperform the market on a long-term basis. Please note that ADP did not outperform the Vanguard Information Technology ETF ( VGT ) over the past ten years. This is because the ETF has more than 40% Apple ( AAPL ) and Microsoft ( MSFT ) exposure, which did very well after the pandemic. I expect ADP to outperform the "average" peer for many years to come.
Now, onto the bigger picture.
Dividend Growth Benefits Confirmed
Before I end this article, I want to give you a summary of the benefits that come with holding all three stocks.
I already gave you some numbers, but I didn't give you the big picture to avoid spoilers.
One of the biggest benefits of buying dividend growth stocks is the high likelihood of outperforming the market with subdued volatility. That's exactly what these stocks have accomplished since 1994. The average annual return was 14.8%, which beat the market by more than 500 basis points per year. The standard deviation was 15.5%, which is similar to the market. Bear in mind, we're comparing a basket of three stocks to a basket of 500 stocks.
It's also important to mention that these returns are consistent. Below are the results using different timeframes.
Moreover, these companies have NOT cut their dividend in past recessions.
I'm not making the case that one should have a three-stock portfolio. My point is that there's a benefit when it comes to buying conservative dividend growth stocks. These three stocks are some of the best on the market, and all of them are on my watchlist/in my portfolio.
As some of you know, I have a physical watchlist on my desk. I write down all stocks that I like, including the ones that I own. Whenever I like the valuation of a given stock, I consider investing. While I have missed some gains due to being too careful every now and then, it's a strategy that has guided me very well.
Takeaway
In this article, I presented three of my favorite dividend growth stocks. Every single one of these stocks has a rock-solid business model, a healthy balance sheet, steady long-term growth, a decent yield, high and consistent dividend growth, and the ability to outperform its peers and the market on a long-term basis with subdued volatility.
I believe that dividend growth investors will benefit greatly from keeping a close eye on the stocks discussed in this article.
That said, going forward, we'll discuss similar opportunities. This includes high-yield investments, as investors sometimes want more "juice".
Let me know what you think of my picks and buying strategy in the comment section down below. Do you agree or disagree? What would you do with $10,000?
For further details see:
Investing $10,000 In These 3 Dividend Growth No-Brainers