Summary of July choices
Based on price performance, the Safest Dividend Yields model portfolio (+ 2.0%) outperformed the S&P 500 (+ 0.9%) by 1.1% from July 22, 2021 to August 18, 2021. Based on of total return, the model portfolio (+ 2.3%) outperformed the S&P 500 (+ 0.9%) by 1.4% over the same period. The best performing large cap stock rose 5% and the best performing small cap stock rose 10%. Overall, 11 of the 18 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from July 22, 2021 to August 18, 2021.
This model portfolio only includes stocks that achieve an attractive or very attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield above 3%. Companies with high free cash flow offer better and safer dividend yields because I know they have the cash to support the dividend. I think this portfolio provides a particularly well-selected group of stocks that can help clients outperform.
Featured Action For August: MSC Industrial Direct Co, Inc.
MSC Industrial Direct Co, Inc. (MSM) is the featured stock in August’s Safest Dividend Yield Model Portfolio.
Over the past five years, MSC Industrial Direct has increased its revenue by 2% compounded annually and net operating profit after tax (NOPAT) by 3% compounded annually over the past five years. MSC Industrial Direct NOPAT’s margin remained stable at 8% from 2015 to the rolling twelve month period (TTM) while its return on invested capital (ROIC) fell from 12% to 13% during the same period.
The company’s economic profits, or the company’s true cash flow, have grown from $ 143 million in 2015 to $ 178 million during the TTM.
Figure 1: MSC Industrial Direct Turnover and economic profit since 2015
Free cash flow supports dividend payments
MSC Industrial Direct has paid a quarterly dividend since 2003, and its standard dividend for fiscal 2020 was $ 3 / share. The current quarterly dividend, when annualized, yields a dividend yield of 3.6%.
As of 2015, MSC Industrial Direct’s accumulated Free Cash Flow (FCF) easily covers its standard dividend payments. Over the past five years, MSC Industrial Direct has generated $ 1.2 billion (25% of current market cap) in FCF while paying out $ 646 million in dividends, according to Figure 2.
Figure 2: MSC Industrial Direct Co’s FCF vs. Standard Dividends Since 2016
Companies with a strong FCF offer better quality dividend yields because I know the company has the cash to support its dividend. On the other hand, dividends from companies with a low or negative FCF cannot be as reliable as the company may not be able to continue paying dividends.
MSM is undervalued
At its current price of $ 85 / share, MSM has an economic price to book value (PEBV) of 0.8. This ratio means that the market expects MSC Industrial Direct’s NOPAT to permanently decrease by 20%. This expectation seems too pessimistic given that MSC Industrial Direct Co has grown NOPAT by 6% per year for the last decade and 9% per year for the last two decades.
Even though MSC Industrial Direct Co’s NOPAT margin remains at 8% (equal to TTM and the lowest level of the last decade) and the company’s NOPAT increases by less than 1% compounded annually over the next decade, the stock is worth $ 110 / share today – an increase of 29%. See the math behind this reverse DCF scenario. If the company grows NOPAT more in line with historical growth rates, the stock has even more potential.
Critical details found in financial documents by my company’s Robo-Analyst technology
Below are details of the adjustments I make based on Robo-Analyst’s results in the 10-K and 10-Q from MSC Industrial Direct:
Income statement: I made $ 42 million of adjustments with a net effect of eliminating $ 21 million of non-operating expenses (1% of revenue). See all adjustments to MSC Industrial Direct’s income statement here.
Balance sheet: I made $ 174 million of adjustments to calculate invested capital with a net increase of $ 154 million. The most notable adjustment was $ 21 million (1% of reported net assets) in other comprehensive income. See all MSC Industrial Direct balance sheet adjustments here.
Valuation: I made $ 936 million in adjustments with the net effect of decreasing shareholder value by $ 936 million. Besides total debt, one of the most notable adjustments to shareholder value was $ 110 million in net deferred tax liability. This adjustment represents 2% of the market value of MSC Industrial Direct. See all valuation adjustments from MSC Industrial Direct here.
Disclosure: David Trainer, Kyle Guske II, Alex Sword, and Matt Shuler receive no compensation for writing about a specific action, style, or theme.