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Spotlight on 10 undervalued US equities

Karen Wallace  |  04 Sep 2018Text size  Decrease  Increase  |  
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Companies' management teams tend to take their commitment to return cash to shareholders pretty seriously.

Dividend cuts or eliminations are often severely punished by the market because they indicate financial distress (General Electric GE is a recent case in point).

Therefore, companies that have a history of paying (or increasing) their dividends tend to be the types of businesses that investors like to own: many are competitively well-positioned, steady cash-generating businesses.

It's worth nothing, however, that shareholders who are not US citizens do receive dividends on these offshore-domiciled companies, but are generally subject to a withholding tax – in this case, from the US Internal Revenue Service.

This is generally about 15 per cent of the dividends, but can be as much as 30 per cent – meaning a US$100 dividend from your shares in Walmart, for example, could amount to only US$75 after the US IRS takes its $15 clip.

To find companies with a history of dividend growth - and the ability to sustain it - the Morningstar US Dividend Growth Index uses several screens.

First, we cull the US equity market for securities that pay qualified dividends. (This excludes real estate investment trusts.) Index constituents must exhibit a five-year history of increasing their dividend payments.

To gauge the sustainability of dividend growth, eligible constituents must display positive consensus earnings forecasts from the analyst community. As a safeguard against dividend cuts and financial distress, stocks with indicated dividend yield in the top 10 per cent of the universe are excluded.

Finally, existing constituents are allowed to remain if they have recently bought back shares and have not decreased their dividend payment.

To find some investment opportunities among wide-moat companies that are well-positioned to increase their payout, we sorted the 450-plus constituents in the US Dividend Growth Index to find the 10 cheapest stocks relative to our analysts' estimate of their intrinsic value.

Below, we dive into our analysts' takes on three of the undervalued names.

10 undervalued wide-moat stocks with growing dividends

Microchip Technology

Director of technology sector equity research Brian Colello believes Microchip has a wide economic moat stemming from intangible assets around proprietary chip designs and manufacturing expertise.

In addition, switching costs make it difficult to swap out Microchip's chips for competing offerings once they are designed into a given electronic device. Given Microchip's track record of stellar profitability in recent years and ability to retain its leadership position in microcontroller chips while expanding its analog business, Colello thinks it is more likely than not that Microchip will earn on excess capital over the next 20 years.

Colello believes Microchip's management team understands the importance of its dividend as part of an investment thesis, and he thinks Microchip has done a stellar job of distributing cash to shareholders. He points out that the firm has a very attractive dividend policy, paying out over half of its earnings and increasing the dividend a little bit on a quarterly basis.

Starbucks

Nonexistent switching costs, intense industry competition, and low barriers to entry make it difficult for restaurants and specialty retailers to establish long-lasting competitive advantages.

Consumer equity strategist R.J. Hottovy believes Starbucks is an exception, however, owing to brand intangible assets that command premium pricing combined with meaningful scale advantages. He expects the company to maintain its specialty coffee leadership while successfully finding new growth avenues.

Hottovy also lauds the company's capital allocation approach. In general, Hottovy prefers consumer companies that show the willingness to invest in or acquire high-growth potential projects while still returning cash to shareholders through dividends and buybacks. Starbucks fits this bill, Hottovy says, with several investments and acquisitions in recent years like Princi, Teavana, Evolution Fresh, La Boulange, and the purchase of the remaining stakes of Starbucks Japan and Starbucks China that it didn't own.

General Mills 

Analyst Sonia Vora thinks General Mills enjoys a wide moat formed by intangible assets and cost advantages. She expect the firm's returns on invested capital to remain above its cost of capital (even in a pessimistic scenario) over the next 20 years.

The firm's portfolio includes several recognizable brands, including Cheerios, Haagen-Dazs, and Yoplait, which have bolstered its relationships with retailers that depend on leading brands to drive store traffic and inventory turnover.

In general, Vora thinks General Mills' stewardship of shareholder capital has been decent, as evidenced by its returns on invested capital averaging 25 per cent over the past decade, well in excess of our 7 per cent cost of capital estimate. Vora expects General Mills will return substantial amounts of cash to shareholders via dividends and share repurchases. She estimates a dividend payout ratio averaging 65 per cent (in line with the firm's five-year historical average) over her forecast period.

 

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Karen Wallace is a columnist at Morningstar US.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is a senior editor with morningstar.com.

© 2020 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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