14 new stocks make our Dividend Growth Stocks Model Portfolio this month, which was made available to members on May 28, 2020.
Recap from April’s Picks
On a price return basis, our Dividend Growth Stocks Model Portfolio (+1.2%) underperformed the S&P 500 (+2.0%) by 0.8% from April 29, 2020 through May 26, 2020. On a total return basis, the Model Portfolio (+1.5%) underperformed the S&P 500 (+2.0%) by 0.5% over the same time. The best performing stock was up 14%. Overall, 13 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from April 29, 2020 through May 26, 2020.
Only our research utilizes the superior data and earnings adjustments featured by the HBS & MIT Sloan paper,"Core Earnings: New Data and Evidence.” The long-term success of our model portfolio strategies highlights the value of our Robo-Analyst technology, which scales our forensic accounting expertise (featured in Barron’s) across thousands of stocks.
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 May: Cummins Inc. (CMI: $171/share)
Cummins Inc. (CMI) is the featured stock from May’s Dividend Growth Stocks Model Portfolio.
We first made Cummins a Long Idea in November 2018 and reiterated the idea in February 2019. Since our original article, the stock has outperformed the S&P 500 (+21% vs. S&P +15%) but still presents favorable risk/reward.
Cummins has grown revenue by 8% compounded annually and net operating profit after-tax (NOPAT) by 16% compounded annually over the past decade. Longer term, Cummins has grown NOPAT by 11% compounded annually over the past two decades. The firm’s NOPAT margin has increased from 5% in 2009 to 9% over the trailing twelve months (TTM), while return on invested capital (ROIC) has improved from 7% in 2009 to 13% over the same time.
Figure 1: Cummins’s Revenue & NOPAT Since 2009
Sources: New Constructs, LLC and company filings
Steady Dividend Growth Supported by FCF
Cummins has increased its dividend for 11 consecutive years and highlighted the importance of dividend payments in its 1Q20 earnings call by stating, “the dividend remains an important part of our capital returns to shareholders, and we currently have no plans to reduce it.” The firm increased its dividend from $3.51/share in 2015 to $4.90/share in 2019, or 9% compounded annually. The current quarterly dividend, when annualized, equals $5.24/share and provides a 3.1% dividend yield.
More importantly, Cummins’s strong free cash flow (FCF) supports the firm’s dividend payment. Cummins generated $5.9 billion (23% of current market cap) in FCF while paying $3.5 billion in dividends from 2015 to 2019, per Figure 2. Over the TTM period, Cummins has generated $1.8 billion in FCF and paid out $777 million in dividends.
Figure 2: Free Cash Flow (FCF) vs. Regular Dividend Payments
Sources: New Constructs, LLC and company filings
Companies with FCF well in excess of dividend payments provide higher quality dividend growth opportunities because we know the firm 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.
CMI Has Upside Potential
At its current price of $171/share, CMI has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects Cummins’s NOPAT to permanently decline by 20% over its remaining corporate life. This expectation seems overly pessimistic over the long term given that Cummins has grown NOPAT by 16% compounded annually over the past decade.
Even if Cummins’s NOPAT margin falls to 8% (10-year low vs. 9% TTM) and the firm grows NOPAT by just 3% compounded annually for the next decade, the stock is worth $256/share today – a 50% upside. See the math behind this reverse DCF scenario.
Add in Cummins’s 3.1% dividend yield and history of dividend growth, and it’s clear why this stock is in May’s Dividend Growth Stocks Model Portfolio.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings as shown in the Harvard Business School and MIT Sloan paper, "Core Earnings: New Data and Evidence”.
Below are specifics on the adjustments we make based on Robo-Analyst findings in Cummins’s 2019 10-K:
Balance Sheet: we made $5.1 billion of adjustments to calculate invested capital with a net increase of $2.1 billion. The most notable adjustment was $2.0 billion (15% of reported net assets) related to other comprehensive income. See all adjustments to Cummins’s balance sheet here.
Valuation: we made $6.5 billion of adjustments with a net effect of decreasing shareholder value by $4.0 billion. Apart from total debt, the most notable adjustment to shareholder value was $950 million in minority interests. This adjustment represents 4% of Cummins’s market value. See all adjustments to Cummins’s valuation here.
This article originally published on June 4, 2020.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
 Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.