Allocating capital is one of the most important and most exciting responsibilities that an investor has. When you think about how many stocks are out there, you have a lot of choices.
And since money is always limited, you have to be selective. So what does it all come down to? Well, you have to consider a lot of criteria.
But I’d argue that valuation is near the top of the list, if not at the top. Now, I’m a dividend growth investor. And I’ve already laid out in countless videos why dividend growth investing is so powerful.
While this strategy tries to funnel you into some of the very best businesses in the world, valuation at the time of investment is still crucial.
There are hundreds of dividend growth stocks out there. Of all possible dividend growth stocks, Dividend Aristocrats are the creme de la creme.
These are stocks that have increased their dividends for at least the last 25 consecutive years, indicating a world-class level of reliability and consistency.
Look, some dividend growth stocks are expensive. And some are not so expensive. It could benefit you to focus on the latter.
Today, I want to tell you about three great Dividend Aristocrats that look expensive, and three cheaper alternatives to consider. Ready? Let’s dig in.
The first Dividend Aristocrat that looks a bit pricey is NextEra Energy (NEE).
NextEra is a North American utility holding company with a market cap of $163 billion.
This is a great utility business. No doubt about it. And they’re right you want a utility to be. Their main business segment, Florida Power & Light Co., is the largest electric utility in the state of Florida. With Florida going gangbusters, NextEra is sitting pretty. The company’s second-biggest business segment – at 28% of the company’s FY 2020 revenue – is NextEra Energy Resources, which is the world’s largest generator of renewable energy from the wind and sun, as well as a world leader in battery storage.
I mean, this combination is almost the perfect setup for a utility.
However, every basic valuation metric is running well ahead of its respective recent historical average. And the yield of 1.9% isn’t just low for a utility in general but also 20 basis points lower than its own five-year average. How about a cheaper alternative?
Enter Algonquin Power & Utilities (AQN).
Algonquin is a renewable energy and regulated utility conglomerate with a market cap of $12 billion Canadian.
This name offers a similar one-two punch in terms of traditional regulated utility assets and renewable energy exposure. Indeed, their Renewable Energy Group made up 16% of the company’s FY 2020 revenue. Not quite as high as what you’ve got going on with NextEra, but still very respectable. On the other hand, Algonquin has a unique geographic footprint, where they’re not overly dependent on any one area.
In addition, Algonquin has water exposure.
Water is estimated to come in at 13% of their rate base for the upcoming fiscal year. With how vital water is becoming, this bodes well for the company. NextEra has 28 consecutive years of dividend increases, with a 10-year dividend growth rate of 10.8%. That qualifies them as a Dividend Aristocrat. Algonquin has 13 consecutive years of dividend increases, with a 10-year dividend growth rate of 9.6%.
Similar long-term dividend growth rates, but NextEra obviously has that much longer streak going for it. However, and this is a big difference, Algonquin’s stock yields 4.9%. That’s more than twice as high as what NextEra gives you. And whereas NextEra’s yield is below its recent historical average, Algonquin’s current 4.9% yield is 60 basis points above its five-year average.
Despite the similar business mix, Algonquin is way cheaper and offers a way higher yield.
Earnings and cash flow are messy right now for both companies, so I’ll instead go to what’s not messy and show you their respective sales multiples. NextEra’s stock is trading hands for 10 times sales, which is well over its own five-year average of 6.1. Algonquin’s P/S ratio is 3.9, which is basically right in line with its own five-year average.
I’d argue that NextEra is worth paying more for, and the stock has usually commanded a premium relative to Algonquin. Fair enough. I don’t see a problem with that at all. But the premium being commanded today for NextEra is particularly heavy. Both companies offer a nice mix of regulated utility assets and renewable exposure. It’s just that Algonquin gives you a cheaper and higher-yield way to play it.
Next up, let’s talk about Sherwin-Williams (SHW).
Sherwin-Williams is a paint and coatings company with a market cap of $81 billion.
The company has that famous jingle – Ask Sherwin-Williams. Well, there’s no need to ask them about how great they are. The numbers speak for themselves. They’ve more than doubled revenue and more than quintupled EPS over the last decade.
Phenomenal performance.
They routinely buy back stock. Margins are impressive. And the balance sheet is solid. What more could you ask for? Well, how about a lower valuation? Don’t worry, though, because I have an alternative to consider.
That alternative is PPG Industries (PPG).
PPG is a paints, coatings, and specialty materials company with a market cap of $39 billion.
Sherwin-Williams is the industry leader and larger company. But PPG is no slouch. Take the dividend growth track record, for instance. PPG has increased its dividend for 50 consecutive years, with a 10-year dividend growth rate of 7.2%.
That track record makes them not just a Dividend Aristocrat but a Dividend King.
Well, paint and coatings seems to be ripe for dividend growth, because Sherwin-Williams is also a Dividend Aristocrat. They’ve increased their dividend for 43 consecutive years, with a 10-year dividend growth rate of 16.3%. Much faster dividend growth, because the company has grown faster, but you give up yield. PPG yields 1.4%. While that’s admittedly nothing to brag about, it’s still twice as high as the 0.7% yield that Sherwin-Williams gives you right now. There’s not just a difference in yield, either. There’s a big valuation difference.
PPG isn’t cheap, but its valuation looks a lot more reasonable than what you get with Sherwin-Williams.
The P/E ratio on PPG is 27.7. I’m not saying that’s low, but it is basically right in line with its own five-year average. So you’re looking at a typical earnings multiple here. On the other hand, the P/E ratio on Sherwin-Williams stock is 42.2. That’s not just higher than PPG and the broader market as a whole, but it’s also running way ahead of its own five-year average of 31.9.
Now, Sherwin-Williams is the better company. I wouldn’t argue otherwise. It deserves a premium valuation relative to PPG. And you can see, over the last five years, that the market has been awarding it the higher earnings multiple. However, that premium has grown well beyond what’s usually been acceptable. If you want to get into paints and coatings, an area which is obviously fertile for dividend growth, PPG has a yield that’s twice as high and a valuation that’s more reasonable.
Let’s now have a quick discussion about Realty Income (O).
Realty Income is a net-lease real estate investment trust with a market cap of $40 billion.
When it comes to REITs, Realty Income is one of the very best out there for long-term dividend growth investors. They have consistently performed across all areas of the business since going public in 1994. This company gives you instant exposure to, and scale in, commercial real estate, as Realty Income has a portfolio of nearly 11,000 commercial properties rented out to clients in industries ranging from convenience stores to fitness centers.
This is the kind of real estate that keeps local communities running.
Realty Income has long been one of my favorite dividend growth stocks, and I’ve highlighted it numerous times on the channel. However, the valuation is now creeping up there. And there is a cheaper alternative to look at.
It’s Store Capital (STOR).
Store Capital is a net-lease real estate investment trust with a market cap of $9 billion.
Yep. They basically have the same business model, except Realty Income is much larger. Now, Realty Income also has the much longer dividend growth track record. Realty Income has increased its dividend for 29 consecutive years, with a 10-year dividend growth rate of 5.0%. That easily makes them a Dividend Aristocrat.
Store Capital has increased its dividend for seven consecutive years, with a five-year dividend growth rate of 5.9%. However, this isn’t really a fair comparison, as Store Capital didn’t go public until 2014 – a full 20 years after Realty Income.
Based on Store Capital’s business model and growth trajectory, I expect them to also become a Dividend Aristocrat one day.
Store Capital is newer and smaller, with their portfolio of 2,800 properties being used for purposes ranging from pet care centers to restaurants. They’re treading a very similar path, using a very similar approach, with a very similar business model to Realty Income. But I can tell you what’s not similar. Yield, for one. Realty Income’s yield of 4.1% is not nearly as attractive as Store Capital’s 4.6% yield. Another thing that’s not similar?
Valuation. These two stocks have very different valuations.
Realty Income has proven its durability to investors. There’s no question. But the valuation seems to price that in – and then some. Now, you can’t value REITs on a P/E ratio because of the way they report results. You instead want to look at funds from operations, or cash flow. Realty Income’s P/CF ratio is 20.9. That’s not obscene for a REIT of this quality. Indeed, Realty Income’s five-year average P/CF ratio is 19.3.
So it’s typically commanded a cash flow multiple of nearly 20. That said, it’s now measurably over 20. The P/CF ratio for Store Capital, on the other hand, is 16.4. You can see the clear disconnect there when compared to Realty Income, despite similar dividend growth rates. And Store Capital’s five-year average P/CF ratio is 16.3.
So it’s barely above its recent historical average. It’s also worth noting that Store Capital is the only REIT in Warren Buffett’s $330 billion common stock portfolio that he manages for his conglomerate, Berkshire Hathaway. If you’re looking for a cheaper, higher-yielding, Buffett-approved way to play the net-lease REIT space, take a look at Store Capital.
— Jason Fieber
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
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