Building wealth with US stocks is a time-tested, battle-tested concept that has been incredibly successful for generations of investors.
But building wealth is only part of the puzzle.
We also need to eventually “monetize” that wealth in a way that allows us to accomplish our financial goals, such as living off of our investments and/or retirement.
Well, that’s exactly why it’s so important to be thoughtful when it comes to the stocks one buys and the portfolio one builds.
Specifically, this is where dividend growth investing can come in handy.
This is a long-term investment strategy that involves buying and holding shares in world-class businesses that pay reliable, rising dividends to shareholders.
To see what I mean, take a look at the Dividend Champions, Contenders, and Challengers list, which has assembled pertinent data on hundreds of US-listed stocks that have raised dividends each year for at least the last five consecutive years.
The reason why this strategy can be so handy is, it easily allows one to monetize their stock holdings – without actually selling those stocks.
Extracting income from stocks without selling stocks is as close as it gets to having cake and eating it, too.
I’ve been a faithful follower of this strategy for nearly 15 years now.
It’s helped to direct me as I’ve gone about building the FIRE Fund.
That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of – income I can live off without slowly liquidating my wealth.
Gratefully, I’ve been able to live off of this dividend income since I quit my job and retired in my early 30s.
If you’re looking to also retire extremely young, make sure to check out my Early Retirement Blueprint.
The dividend growth investing strategy can be so effective and powerful, but it involves more than selecting the right businesses to invest in.
That’s because price is just what you pay, but value is what you ultimately get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide if it were fairly valued or overvalued.
Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Buying undervalued high-quality dividend growth stocks can allow you to both build significant wealth and monetize that same wealth – simultaneously.
Of course, the preceding passage does assume that one already understands how valuation works.
If that understanding isn’t already in place, no worries.
This is why Lesson 11: Valuation was written by fellow contributor Dave Van Knapp.
Part of an overarching series of “lessons” designed to teach the dividend growth investing strategy from the ground up, it lays out valuation in simple-to-understand terminology and even includes an easy-to-apply valuation template.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
LyondellBasell Industries NV (LYB) is a global petrochemical company.
Founded in 2007 under its current form, but with certain corporate roots dating back many decades, LyondellBasell is now a $25 billion (by market cap) petrochemicals leader that employs more than 19,000 people.
LyondellBasell, which is incorporated in the Netherlands but headquartered in Texas, is the world’s largest producer of polypropylene, and it’s a major producer of polyethylene and propylene oxide.
It’s a global leader in polymers and chemicals that are ultimately used as the building blocks for a wide variety of everyday downstream applications and products, such as adhesives, building insulation, coatings, packaging, plastics, and solar panels.
In addition, LyondellBasell has significant exposure to crude oil refining (although there’s a planned exit from this side of the business).
The company is exposed to nearly every end market across the globe, with overall sales almost evenly split between the US and the rest of the world.
Because of the diverse end markets it’s exposed to, along with the fact that these downstream applications and products are vital to everyday life, LyondellBasell plays a critical role in the global supply chain.
Now, in some ways, one might initially think of this company as purely a commodity player, but its size, scale, and expertise implies an enterprise that adds a lot of value through innovative, proprietary technologies without which it would be difficult to produce the chemicals at the current amounts, costs, and overall effectiveness.
To this point, LyondellBasell benefits from its cost-advantaged North American operations which use low-cost natural gas-based feedstock, and LyondellBasell has been increasingly shifting more and more of its operations toward North America.
We have a company that has positioned itself very nicely for continued revenue, profit, and dividend growth for years to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
To date, the company has already increased its dividend for 14 consecutive years.
This track record is actually as long as it possibly could be, as the current iteration of LyondellBasell dates back to 2010.
2010 was transformational for LyondellBasell.
It was a new start.
During that year, the company’s US operations emerged from bankruptcy, the former parent company was replaced, and the new company was listed on the NYSE.
I can’t really speak on a pre-2010 LyondellBasell, as the company we see now has gone through many changes and is almost certainly radically different from what it was before 2010.
The 10-year dividend growth rate is 9.5%, which is strong, although more recent dividend raises have been in a mid-single-digit range.
But a mid-single-digit dividend growth rate would be more than enough in this case.
I say that because the stock yields a market-smashing, mouth-watering 7%.
That’s in telecom stock territory, despite this business featuring better fundamentals almost right across the board.
And that makes sense.
It’s a capital-intensive, cyclical business that isn’t growing briskly.
That said, this 7% yield is particularly high.
To put it in perspective, this yield is 180 basis points higher than its own five-year average.
That’s a crazy spread, giving us some early indication that undervaluation may be present.
The one thing to dislike about the dividend is the payout ratio, which is 81.7%.
That is very high; however, the company’s GAAP EPS are currently at a low point.
The business is extremely cyclical and exposed to seasonality, and its GAAP EPS can swing wildly from quarter to quarter and year to year – even under the best of circumstances.
Making things even more volatile recently is activity management has been engaging in regarding the portfolio in recent years, trying to shift the business away from certain “dirty” activities such as refining and toward “clean” activities with better margins such as advanced recycling technology (exemplified by the company’s MoReTec-1 facility being built in Germany).
Expansion activities are also pressuring free cash flow, further limiting flexibility around the dividend.
While I don’t see the dividend as necessarily being in any near-term danger, it would make a lot of sense to curb one’s enthusiasm around dividend growth over the next few years (and, possibly, beyond).
And I think that helps to explain why the yield has risen (compensating for the lower growth rate).
If one is an income-oriented dividend growth investor, or if one is just looking to boost the yield/income of a portfolio, this might be one of the more appealing dividend profiles out there.
Revenue and Earnings Growth
As appealing as it may be, though, many of the metrics are looking backward.
However, investors must always be looking forward, as the capital of today is getting risked for the rewards of tomorrow.
As such, I’ll now build out a forward-looking growth trajectory for the business, which will be instrumental for the valuation process.
I’ll first show you what the business has done over the last decade in terms of its top-line and bottom-line growth.
And I’ll then reveal a professional prognostication for near-term profit growth.
Lining up the proven past with a future forecast in this manner should give us what we need to confidently estimate where the business could be going from here.
LyondellBasell’s revenue has actually fallen from $45.6 billion in FY 2014 to $41.1 billion in FY 2023.
A decline in revenue over a decade is obviously not what we want to see, but I’d again point to the company’s active management of the portfolio leading to a lot of moving parts.
Furthermore, because of the cyclicality, the two points in time one uses matters a lot.
If we back up to last year when revenue was over $50 billion, things suddenly look better.
Put simply, I don’t think it’s helpful to be overly judgmental of these numbers.
Earnings per share grew from $7.99 to $8.65 (adjusted) over this period, which is a CAGR of 0.9%.
I used adjusted EPS for FY 2023 because of those moving parts and just how impacted GAAP EPS has been.
Again, not a good look.
But if we back up to one year ago, EPS was nearly $12.
From what I can see, this is decidedly not a high-growth enterprise.
It’s mature and cyclical, but the portfolio management does seem to be thoughtfully designed to make sure the business stays relevant and doesn’t fade into oblivion.
And that should set up the business for modest growth through the cycles, meaning a large chunk of the total return story is based on the outsized dividend.
I’d also like to quickly point out that LyondellBasell has been a buyback monster.
The company has reduced its outstanding share count by approximately 37% over the last 10 years, which is very impressive and counter to the dilution I often see when looking at a lot of competing ideas in the high-yield space.
Looking forward, CFRA does not currently have a three-year growth forecast for LyondellBasell’s EPS.
This is unfortunate, as I do like to compare the proven past with a future forecast.
But we can still glean quite a bit from what’s being said.
First, CFRA notes that 2024 has been difficult due to “…lower demand levels (especially in China with slow recovery) and elevated rates (which have recently cooled a bit with recent rate cuts). We also think packaging markets may continue to see weakness due to a gradual transition away from plastics in packaging, and we expect auto to show continued weakness driven by high inventories.”
Tough to like the sound of any of that.
However, this is a 2024 thing, rehashing the past.
Ultimately, we invest in where a business is going (not where it’s been).
And there could be sunshine on the horizon.
CFRA states that it’s enthusiastic about LyondellBasell’s setup right now because of: “…our belief that shares have attractive upside, our view of margin expansion in 2025 (despite lower sales), and [LyondellBasell]’s ability to generate strong cash flow. We also see long-term tailwinds in building and construction from U.S. stimulus (infrastructure, CHIPS) and reshoring of industrial production back to the U.S., especially after Donald Trump’s victory in November. We note [LyondellBasell] continues to generate strong cash flow, despite declines in sales, with YTD (through Q3) cash from operations totaling over $1.9B. Regarding the expansion of renewable solutions, which we think provides some offset to [LyondellBasell]’s plastic exposure, the company’s goal is to sell 2M+ tons of recycled/renewable-based polymers annually by 2030.”
It’s a case of near-term weakness against longer-term promise.
I’d also note that the company has thousands of patents and has leveraged them into a lucrative licensing business, reducing overall capital intensity.
It strikes me as unwise to expect anything more than mid-single-digit EPS and dividend growth out of LyondellBasell over time.
With the starting yield being so high, though, that would be enough to get one to a very respectable (say, 10% or so) annual total return.
And the vast majority of that return would be coming through via a very large dividend.
For what is clearly an income play, that’s not bad at all.
Financial Position
Moving over to the balance sheet, LyondellBasell has a good financial position.
The long-term debt/equity ratio is 0.8, while the interest coverage ratio is over 6.
That latter number is negatively (and temporarily) affected by weak GAAP EPS, and I suspect it’ll be quite a bit higher over the coming year or so.
A net long-term debt load of ~$7 billion is not overly worrisome for a company with a market cap of $25 billion.
The company also has investment-grade credit ratings: Baa2, Moody’s; BBB, Fitch; BBB, S&P.
To be honest, when I first started to look into this name, I was expecting a far worse balance sheet with much more debt (due to the capital-intensive nature of the business model).
I’m pleasantly surprised by what I see, although it’s certainly nowhere near a fantastic balance sheet.
Profitability is also surprisingly good.
Return on equity has averaged 31.8% over the last five years, while net margin has averaged 7.9%.
ROE is juiced by the balance sheet, but even ROIC is routinely coming in at between 15% and 25% (results swing wildly).
In my view, this is a pretty good, albeit cyclical and capital-intensive, business.
And with economies of scale, R&D, IP, and switching costs, the company does benefit from durable competitive advantages.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
It’s a capital-intensive, cyclical business model exposed to seasonality, which makes it difficult/impossible to produce smooth results and create consistent returns to shareholders.
Although it is widely diversified across global end markets, any kind of large-scale economic weakness would heavily impact the firm (as evidenced by the predecessor’s bankruptcy during the GFC).
Input costs, especially raw materials such as oil and gas, are volatile and outside of the company’s control.
In addition to the lack of control over input costs, the company is largely exposed to commodities, making it a price taker rather than a price maker.
A global transition away from plastics is a secular headwind for the business.
I see an above-average risk profile here.
At the same time, though, with the stock down more than 20% YTD against a broader market that is up more than 20% YTD, I see a below-average valuation that makes this idea more compelling than usual…
Valuation
The stock is trading hands for a P/E ratio of 11.8.
That’s less than half that of the broader market’s earnings multiple.
While I won’t pretend that this is some amazing, world-class business, less than 12 times earnings in a sky-high market is pricing in awfully low expectations.
The sales multiple of 0.6 is also low, and it’s below its own five-year average of 0.7.
And the yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 5%.
As I showed earlier, a mid-single-digit growth rate (both in terms of EPS and the dividend), though the cycles, is a realistic target for LyondellBasell to shoot for.
It doesn’t seem wise to expect a lot more.
Equally so, it’d be surprising to see the business fail to live up to this.
While LyondellBasell is far from the best business I’ve ever seen, I’m also placing an appropriately low hurdle in front of it to clear.
The DDM analysis gives me a fair value of $112.56.
The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.
The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.
It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.
I find it to be a fairly accurate way to value dividend growth stocks.
Even with a low growth rate, the stock still comes out looking extremely cheap to me.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.
1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.
Morningstar rates LYB as a 5-star stock, with a fair value estimate of $115.00.
CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.
They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.
CFRA rates LYB as a 4-star “BUY”, with a 12-month target price of $90.00.
I ended up very close to were Morningstar is at, and we all generally agree on the pricing being too low. Averaging the three numbers out gives us a final valuation of $105.85, which would indicate the stock is possibly 28% undervalued.
-Jason Fieber
Note from D&I: How safe is LYB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 51. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, LYB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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.
Disclosure: I have no position in LYB.
