Screening For Dividends: My Top Pick In Materials

seekingalpha07-12

I screen the Materials sector to identify the best dividend-growth companies.Just eight meet my minimum criteria, with Linde coming out on top.Linde is a defensive pick that offers diversification, ...

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While Air Products and Chemicals (APD) may appear to be a more suitable choice for income investors, Linde has had a superior total return over the past five- and ten-year intervals. Attractive aspects of their business model include (1) consistent global demand for industrial gases, (2) their equipment leasing operation, (3) their focus on long-term contracts, and (4) their fully integrated supply chain. The Materials Sector and Dividends My interest in Materials is part of a larger diversification strategy. Just over half of my invested capital is in ETFs, where Materials is often among the lowest weighted sectors. To illustrate, here are the weightings in some of the largest ETFs. Note that most dividend-focused ETFs do not hold REITs, so those rankings are out of ten rather than eleven.   Ticker Weighting Sector Rank*   (SPY) 1.95% 11 of 11   (VTI) 2.33% 11 of 11   (QQQ) 1.42% 7 of 11   (VIG)* 3.91% 7 of 10   (IWM) 4.73% 8 of 11   (SCHD)* 1.79% 9 of 10   (VYM)* 2.43% 10 of 10   (DGRO)* 2.44% 10 of 10   Click to enlarge Given the scarcity of Materials companies in most ETFs, some investors may wish to stock pick in this sector as a portfolio hedge. Matching the performance of a NVIDIA Corporation (NVDA) or Super Micro Computer (SMCI) may be unlikely, but Materials does have some strong, long-term compounders and even some dividend aristocrats and kings. Here's how and why Linde became my top pick in the sector. LIN Rises to the Top Just over 20% of the companies in Materials worldwide (closer to 30% for those in the U.S.) pay a dividend. To narrow the pool, I start with my usual screening filters:  Years of increasing dividends - minimum five years of growth  Five-year dividend growth rate - minimum CAGR of 7%  Dividend Yield - minimum 1%  Dividend Payout ratio - maximum 60%  Three-year revenue growth - minimum CAGR of 5%  Three-year EPS growth - minimum CAGR of 7%  Overall Quant rating - minimum 2.5 (Hold)  Market cap - minimum $5 billion   Compared to Financials, I want a somewhat higher dividend growth rate and starting yield - if I'm going to own just one or two companies in a sector, I want the best of the best. These filters reduce the pool to just eight, sorted by market cap. Seeking Alpha Next, I consider two profitability metrics for which I want to see stable and/or increasing percentages over time: Net Income Margin and Return on Invested Capital.     NIM ROIC     TTM 5Y Current Trend since 2020   LIN 19.3% 12.8% 9% up significantly   APD 20.3% 19.6% 8% down moderately   (NUE) 12.4% 11.8% 17% highly variable   (MLM) 31.3% 15.6% 9% up slightly   (VMC) 11.9% 11.3% 8% stable   (STLD) 12.9% 12.1% 21% highly variable   (RS) 8.7% 8.0% 17% highly variable   (BCPC) 12.4% 11.9% 9% stable   Click to enlarge Based on this data, I eliminate any companies deemed weak relative to their industry that or show undesirable volatility, here Nucor Corporation, Steel Dynamics, and Reliance. Finally, I compare the forward dividend yield and five-year CAGR:     Fwd Yield 5-Year CAGR   LIN 1.28% 13.87%   APD 2.80% 9.27%   MLM 0.55% 9.04%   VMC 0.75% 8.57%   BCPC 0.49% 10.94%   Click to enlarge Martin Marietta Materials (MLM), Vulcan Materials (VMC), and Balchem (BCPC) are not competitive here, leaving the industrial \"gas giants\" Linde and APD. Both are excellent companies with long track records of dividend growth, but in terms of both fundamentals and performance over the past decade, I give Linde the edge.     LIN APD   Total Return (10Y) 296% 171%   Total Return (5Y) 132% 24%   Total Return (3Y) 56% -6%   Revenue (5Y CAGR) 11.8% 6.3%   Revenue (3Y CAGR) 5.7% 9.5%   EBITDA (3Y CAGR) 10.4% 5.6%   EPS (5Y CAGR) 13.5% 8.2%   EPS (3Y CAGR) 32.8% 9.3%   NIM 5Y 12.8% 19.6%   ROIC (last five) 3%  9% 12%  8%   Click to enlarge Of the two companies, APD gets far more attention; Seeking Alpha analysts have published 33 articles on APD since Jan 1, 2023, versus 19 for Linde. The first reason, I suspect, is APD's higher dividend yield. But Linde's has grown more quickly in recent years, and with its significantly lower payout ratio, the CAGR gap is likely to widen.     LIN APD   Yield 1.3% 2.8%   Years of Growth 31 years 41 years   5-Year CAGR 13.9% 9.3%   Payout Ratio 35.9% 59.5%   Click to enlarge The second reason, I gather, has to do with valuation. I'll get to that in a moment. A Stable and Diverse Business For those unfamiliar with Linde, they operate in the industrial gas industry, supplying argon, carbon dioxide, helium, hydrogen, nitrogen, oxygen, and a variety of rare and specialty gases. Their largest customers are in chemicals and energy, manufacturing (e.g., automotive, electronics, metal fabrication), healthcare, and food and beverage industries. They also lease equipment such as storage containers and delivery mechanisms related to their gas products. Linde operates in over eighty countries, and their extensive sales operation is able to tailor solutions to a diverse customer base. Aspects of their business model investors will find attractive include:  Consistent demand - industries rely on a steady supply of gases to maintain operations Leasing business - reduces their reliance on product sales Long-Term Contracts - ensures predictable revenue and maintains customer loyalty Supply Chain - integrating production, distribution, and logistics improves margins  Valuation As alluded to, Linde has in recent years traded at a richer valuation than APD. Its P/E, P/S, and PEG are among the most expensive in the sector, but I am more interested in how these metrics compare to the company's own valuation history:     Current 5-Year Avg.   P/E Non-GAAP (TTM) 29.9% 29.5%   P/E GAAP (TTM) 33.8% 43.1%   EV / EBITDA (TTM) 18.5 17.1   Price / Book (TTM) 5.4 3.6  Quant Factor Grade: D-  Click to enlarge Apart from P/E GAAP, Linde grades above its recent historical averages, so this may not be an opportune time to initiate a position. That said, Wall Street analysts currently have a price target of $473, which suggests a discount of around 8.5%. My own DCF fair value comes to around $391 based on a discount rate of 9% (using WACC). This assumes a near-term EPS growth rate of 12% (the five-year CAGR is 13.5%) and 9% terminal rate (the CAGR since 2010 is 10.7%). This DCF valuation suggests Linde is about 10% overvalued. Simple DCF Calculator Stock Performance As Nivesha Investors recently pointed out, Linde's margins have improved since its merger with Praxair in October 2018 while revenue growth has slowed. Combined with the steep valuation metrics, Nivesha concludes \"the share prices have outrun the fundamentals.\" I agree from a short-term perspective, but for buy and hold investors seeking to diversify, I don't quite agree with their Sell rating. LIN has handily outperformed the S&P 500 (SPY) and the Materials Select Sector SPDR Fund (XLB) by total return over five- and ten-year intervals, and it has also outclassed its closest competitors L'Air Liquide S.A. (OTCPK:AIQUY) and APD by wide margins:   Total Return 5Y (annualized) 10Y (annualized)   LIN 26.1% 29.4%   SPY 15.3% 13.1%   XLB 13.6% 11.5%   (OTCPK:AIQUY) 17.3% 16.4%   APD 5.1% 17.3%   Click to enlarge Combining fundamentals' analysis, performance history, and valuation estimates, I rate Linde a Hold. Summary  Linde and Air Products and Chemicals are top companies in the Materials sector. While some investors may prefer APD for its higher yield and others for its promising CAPEX investments, Linde has been the stronger performer over the last decade plus. For those who already own Linde, I see no reason to sell. 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