The stock market continues to be volatile in the face of several economic and geopolitical uncertainties including the Federal Reserve’s changes to monetary policy to combat inflation. The most recent symptom of these actions involved the implosion of Silicon Valley Bank and whispers of financial crisis prompting swift action by the FDIC, Federal Reserve and US Treasury to reinstill confidence in the banking system. This was followed by the blow up of the Swiss bank, Credit Suisse. While a crisis may have been averted, the inflation fight is not over and further volatility in the stock market should be expected.
As a long-term investor, volatility created welcome opportunities to buy wonderful companies at more reasonable valuations.
In a previous article, I outlined 10 factors that I use to evaluate dividend growth stocks including thresholds that I seek to identify opportunities. Using the outlined criteria, I have identified three dividend growth stocks with consistent dividend growth and solid fundamentals. These particular stocks are, however, trading above my valuation criteria’s thresholds making them excellent candidates for a shopping list given the potential for pullbacks in this market.
#1 Fastenal (FAST)
Company Overview
The first name on the list is perhaps a lesser known industrial company called Fastenal. With a market cap of $30 billion, Fastenal is a distributor of industrial and construction supplies providing a wide range of products to customers including fasteners, tools, electrical and plumbing supplies, safety equipment, and various other industrial products. The Winona, Minnesota company has a unique business model that centers around a network of in-market locations that utilizes proprietary technology including vending machines and bin stock devices. At the end of 2022, Fastenal had 3,306 in market locations in 25 countries supported by 15 distribution centers in North America (12 in the United States, two in Canada, and one in Mexico), and one in Europe.
Fastenal’s Dividend Growth Criteria
Fastenal’s Wide Moat
Fastenal scores highly in terms of the criteria sought for dividend growth stocks. The company has been the beneficiary of strong manufacturing activity over the last couple of years. Over the past 5 years, the company has seen earnings increase on a CAGR of over 13%. Earnings growth can also be attributed to management execution on Fastenal’s business model. With an extensive distribution network and its ability to provide customized inventory management solutions to its customers, Fastenal business model is centered around its proprietary vending machines and bin stock devices as well as a more recent growth driver, its On-site program, that allows customers to access products at the customer’s location. This allows Fastenal to track inventory levels and meet customers’ needs in real time resulting in high customer retention rates and pricing power. Fastenal has invested heavily to develop a sophisticated supply chain management system that enables it to quickly and efficiently move products from its suppliers to its in-market locations.
The result is a solid moat based on its distribution network and customized solutions creating significant switching costs for customers, as well as high barriers to entry for potential competitors effectively positioning Fastenal as a formidable player in the industrial and construction supplies industry.
Dividend Growth and Coverage
Fastenal has consistently increased its dividend for the past 24 years to $1.40 per share with a 2.67% yield. The company’s earnings growth has afforded Fastenal the ability to increase the dividend at a CAGR of 14% over the past 5 years and most recently increasing the dividend 12.9% to $0.35 per quarter. With a payout ratio of 65%, slightly above the threshold sought, the dividend appears well covered particularly when considering the FCFE dividend coverage ratio of 0.99. The company’s solid, consistent free cash flow more than covers Fastenal’s dividend while also allowing for the flexibility to make debt payments and repurchase shares.
While these metrics may suffer as a result of margin pressure stemming from the cyclical nature of the industrial sector, Fastenal appears well positioned to maintain and continue to grow its dividend. The dividend is further buoyed by Fastenal’s strong balance sheet. The company’s current ratio is nearly 4 and net debt to EBITDA of 0.35.
Look For Pullbacks Based on Valuation
Fastenal’s dividend score falls short on the valuation metrics trading above 25x 2023 earnings estimates with a PEGY of 2.46 assuming 8% earnings growth. While Fastenal should continue to benefit from both its vending and On-site initiatives both with existing customers and through the addition of new locations, we should expect the cyclical nature of the industrial sector should have a near term impact on Fastenal’s business. Given this, we should look for an opportunity to buy the stock at lower valuation levels despite these multiples being near historic averages. A compelling buying opportunity for Fastenal would be in the low $40s. At those levels, Fastenal will be trading around 20x 2023 earnings estimates with a dividend yield closer to 3.5% while still offering the potential to maintain its dividend growth record.
#2 Microsoft (MSFT)
Company Overview
Next on the list is a company that needs to introduction, Microsoft. Still, a quick overview is warranted to maintain a confluence of structure for the article.
Microsoft Corporation is a technology company focused on a wide range of both consumer and enterprise products and services including flagship products like the Windows operating system, Microsoft Office, the company’s cloud computing platform, Azure. Headquartered in Redmond, MA, Microsoft also offers a range of devices such as the Surface products and the Xbox gaming console as well as brand name services like Skype and LinkedIn added through acquisitions. With a market cap of over $2 trillion, this tech behemoth has its hand in emerging areas including artificial intelligence, cybersecurity, and education, with a mission to empower people and organizations to achieve more through innovation and technology.
Microsoft’s Dividend Growth Criteria
Dividend Growth and Coverage
Microsoft’s dividend does not get much attention, but finds itself as one of the largest holdings in the Vanguard’s Dividend Appreciation ETF for a reason. The company sports a $2.72, quietly increasing the dividend for the past 18 years. While the forward yield is low at around 1% as of this writing, Microsoft has increased the dividend at a CAGR of 10% over the last 5 years, and nearly 12% over the last 10 years.
The dividend is well covered by free cash flow with a FCFE dividend coverage ratio of 1.15 despite the company’s aggressive share repurchase program repurchasing over $70 billion in shares over the past 3 years. The dividend is also covered by earnings nearly 4x with a payout ratio around 25%. This is as a result of Microsoft’s earnings CAGR of over 25% over the last 5 years. This growth can be attributed to revenue growth across Microsoft’s three reported segments – Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. In 2022, the Productivity and Business Processes segment comprised of a family of products to empower a hybrid work environment powered by Office 365, Dynamic 365, and LinkedIn, saw operating income grow 22% year over year, Intelligent Cloud which include server product and cloud services such as Azure grew by 25% year over year, and More Personal Computing consisting of products and services like Windows, Surface devices and Xbox, grew 8% year over year.
The dividend is further buttressed by its fortress balance sheet. Microsoft is sitting on over $100 billion in cash. The company can more than pay for its existing $61 billion in debt while also funding its acquisitions including the $68 billion price tag for Activision Blizzard (should it get regulatory approval). A balance sheet like Microsoft’s positions the company well to support increases in its dividend and share repurchase programs.
Microsoft’s Moat
Despite near term macro issues that are expected to impact Microsoft’s performance, we should continue to expect dividend growth driven by earnings growth. Microsoft possesses a wide moat stemming from the size of its operations and the scale of its offerings particularly to support its strategy to focus on enterprise customers. Future growth will be driven by trends in the adoption of enterprise adoption of the cloud, efficiency tools for hybrid work environments, gaming, education and potentially, the metaverse. Microsoft is capitalizing on these trends by making investments across its offerings as well as through acquisitions and partnerships including Activision Blizzard to execute its strategy to improve new gaming experiences, Nuance Communications to accelerate goals related to the security focus of its cloud solutions, and its investment in OpenAI to bolster its access to generative AI with potential synergies with many of Microsoft’s products and services.
Valuation: Look To Take Advantage of Pullbacks
Microsoft’s performance may justify a premium to the market multiple, however, the company’s stock has been a beneficiary of the AI hype of late. The result is a company trading at pre-pandemic multiples around 30x 2023 earnings and PEGY just under 2x using an earnings growth rate of 14%. While these are not egregious relative to where Microsoft has traded over the last decade and in light of the tailwinds and fundamentals of the company, near-term headwinds and turbulence in the market may give us an opportunity to buy this wonderful company at more reasonable valuations closer at or below our threshold of 25x. We had this opportunity at the lows of 2022 and would be looking for a similar opportunity to add shares.
#3 Costco (COST)
Company Overview
Last on the list is the retail giant, Costco.
Costco is a membership-based warehouse club that offers a wide variety of merchandise, including groceries, appliances, electronics, furniture, and clothing. The company is known for its bulk offerings at discounted prices, which are made possible through its efficient supply chain and membership-based business model. At the end of 2022, Costco had over 65.8 million paid members consisting of Gold and Executive memberships, the two membership tiers, up from 61.7 million in 2021 and 58.1 million in 2020. With over 800 locations worldwide and a loyal customer base, Costco has established itself as one of the world’s largest retailers and a leader in the wholesale industry.
Costco’s Dividend Growth Criteria
Dividend Growth and Coverage
Like Microsoft, the elephant in the room for a dividend growth stock like Costco is its low dividend yield of 0.73%. Costco is, however, a solid dividend growth company with 24 years of consecutive dividend increases. Over the past 5 years, Costco has increased the dividend at a CAGR of over 12% with the most recent dividend raise of nearly 14%. Costco is also known for issuing hefty special dividends, the last one being $10.00 per share at the end of 2020.
Costco’s existing dividend appears quite safe with a payout ratio around 26%. With a FCFE dividend coverage ratio of 1.39, Costco’s free cash flow covers the dividend even after debt payments and share buybacks. If we consider the state of the balance sheet, cash covers Costco’s debt 1.2x so we should not expect the dividend to be threatened by debt payments should economic headwinds impact cash flows.
Could we expect another special dividend, though? I think this will depend on how Costco’s cash flows hold up given the economic environment. Management will probably wait until there is more clarity on the direction of the economy.
Costco’s Moat
Despite these potential headwinds, Costco should hold up well given the wide moat the company possesses. Costco’s business model is simple led by its membership-based system and focus on quality offerings at low prices as a result of the company’s scale and efficiencies in its supply chain. Management recognizes growth opportunities stemming from new store openings, growth in e-commerce sales, expansion of its membership base, and increases in comparable same store sales growth through greater store visit frequency of members and higher average ticket per visit. These initiatives have allowed Costco to grow earnings at a CAGR of around 16% over the past 5 years with a 12% CAGR expected for the next 5 years.
Valuation
Like Fastenal and Microsoft, Costco’s appears pricey trading at these levels trading at 34x 2023 estimates and a PEGY of 2.5 assuming a 12% earnings growth rate. Costco’s premium can be attributed to many of the qualities mentioned including the durability of the business model and the consistency of revenue from membership fees, but also because Costco was a clear beneficiary of the pandemic. As a result, during the height of the pandemic, Costco traded at nearly 50x earnings. Since then, we have begun to see its valuation return to more normal levels.
Still, on a P/E basis, Costco rarely appears ‘cheap’. The company is trading around its 5 year average multiple, but we should be looking to take advantage of volatility for an opportunity to buy the stock closer to its 10 year average pre-pandemic below 30x and ideally closer to our threshold around 25x. This may be made possible if growth rates moderate, but also has investors move away from defensive company’s as many of the economic clouds lift. Based on 2023 estimates, we would be looking for opportunities sub $400 per share.
Conclusion
Warren Buffett wrote that “The stock market is a device for transferring money from the impatient to the patient.” The potential for continued volatility in the markets offers those that are patient the opportunity to buy wonderful companies at more reasonable valuations. The three companies described – Fastenal, Microsoft and Costco – are wonderful companies with solid fundamentals, wide moats, and well supported, growing dividends. This makes them excellent candidates for a shopping list given their premium valuations.
Disclosure
Microsoft is the only company on this list that I currently have a long position in. As always, before making any investment, please do your own due diligence or seek advice from a financial professional.
