Cash-rich businesses with sustainable and growing yields don't often go on sale, but we found 10 bargain stocks in the Morningstar US Dividend Growth Index.
By Karen Wallace | 03-14-18 | 05:00 AM | Email Article

It's not hard to understand the appeal of investing in companies that are sturdy enough to pay dividends. As Dan Lefkovitz, content strategist for Morningstar Indexes, explains, corporate management must be confident of future cash flows in order to commit to a dividend payment. That's because once a dividend commitment is made, it’s not withdrawn lightly: The market usually punishes dividend cuts or eliminations severely because they indicate financial distress. So it follows that dividend-paying companies tend to be competitively well-positioned, cash-generating businesses. 

Karen Wallace is a senior editor with Follow her on Twitter @KarenW60602.

Dividend growth investment strategies home in on companies whose cash flows have translated into a rising payout. To find companies with a history of dividend growth--and the ability to sustain it--the Morningstar US Dividend Growth Index uses several screens, Lefkovitz explains. First, we cull the U.S. 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% 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.

It's important for investors to have reasonable expectations for dividend growth strategies, though. Investors seeking current income might not be satisfied with a yield such as the one supplied by the Dividend Growth Index. In fact, at just over 2%, the dividend yield for the index is only slightly higher than that of the market as a whole.

So why would an investor favor dividend growth over a high-yielding strategy? 

"From an investor's standpoint, dividend growth determines the extent to which equity income will keep pace with the inflation rate. A rising dividend is fundamental to investors' ability to preserve purchasing power through their equity portfolio," Lefkovitz said. 

However, he adds, "companies whose dividend payments increase at a rate that outstrips inflation become more attractive to own, boosting their share price."

Indeed, finding cheap dividend growers can be difficult. But luckily, we are always up for a challenge. To find some bargains, we sorted the 450-plus constituents in the the 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. 

Senior equity analyst Dan Wasiolek sees Expedia as having a narrow moat driven by its sustainable network effect in the online travel industry. Over the past two decades, Expedia has built a strong network of properties (supply side of the network effect equation), which has driven strong end-user traffic and bookings (demand side of the network effect equation), Wasiolek says. Our narrow-moat rating is further justified by the company's return on invested capital and market share gains. And Wasiolek projects ROIC to average 16.5% over the next five years, comfortably above the cost of capital (8.5%). He also forecasts Expedia's market share of global travel bookings to reach 7.5% in 2022, up from 6.1% in 2017.

Expedia's share price has underperformed recently, due to the market's concern over increasing competition and investment; however, Wasiolek believes these concerns are overdone. "Expedia's market position is unwavering with no signs of cracks, supported by solid trends in its international and vacation rental segments," he said.

CBS' competitive advantage lies in its television production studios and national broadcast network, says equity analyst Neil Macker. The company owns one of four major national broadcast networks and affiliated TV stations in 16 markets. While network ratings have declined over the past decade, the broadcast networks are the only outlet to reach almost all 116 million households in the U.S., Macker said. Network ratings still outpace cable ratings and provide advertisers with one of the only remaining methods for reaching a large number of consumers. 

Indeed, with its high ratings in prime time and strong slate of rights to sports, including the NFL and college football, CBS provides a platform for advertisers to reach a mass audience, Macker said. Live sports remains the one programming category to remain largely immune to DVR/time-shifted viewing, an important consideration for advertisers promoting time-sensitive events. Macker believes the combination of highly rated original programming and exclusive sports rights will allow CBS to continue to increase its revenue. With CBS trading at a 27% discount to our fair value estimate, the stock may offer an attractive entry point for investors.

Medtronic's acquisition of Covidien has produced a combined company that's a force to be reckoned with in the med-tech landscape, says senior equity analyst Debbie Wang. Pairing Medtronic's diversified product portfolio aimed at a wide range of chronic diseases with Covidien's breadth of products for acute care in hospitals has bolstered Medtronic's position as a key partner for its hospital customers.

Medtronic's wide moat comes from several sources, Wang says. First, in the cardiac area, Medtronic has few competitors. In the spine area, Medtronic's moat is strengthened by high switching costs for surgeons. And finally, its moat is bolstered by several intangibles, including intellectual property and carefully nurtured relationships with physicians. Thanks to its persistent ability to innovate, Medtronic is often first to market with new products in various therapeutic areas. Wang expects Medtronic to continue its record of innovation, based on its extensive patent portfolio. 

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