American Water Works; I’m Raising My Glass to its Growth

Summary

  • American Water Works operates a small monopoly and sells essential products.
  • The water treatment business is highly fragmented.
  • There are lots of room for dividend growth in the upcoming years.

What Makes American Water Works (AWK) a Good Business?

American Water Works sell the perfect product: water. This utility company provides regulated and market-based drinking water, wastewater services and other related services to an estimated 15 million people in 47 states and in Ontario, Canada. The best part of it, AWK still has lots of room for growth as its market is highly fragmented in the U.S.:

Source: AWK website

Revenue & Earnings

Revenue Graph from Y-charts

The company is on solid ground to keep up its growth in the upcoming years. Management aims at a 7-10% annualized EPS growth based on regular investments, regulated acquisitions and organic growth.

Source: Ycharts

How AWK fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rule: I try to avoid most companies with a dividend yield over 5%. Very few investments like this will be made in my case (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment… or that the company has nothing else but a constant cash flow to offer its investors. However, high yield hardly come with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

AWK was once a high yielding stocks but that was right after following the financial crisis. Ever since then, the company has increased its dividend payouts while its yield went ever lower. This is mainly due to the fact that AWK stock price went up by over 125% over the past 5 years (as at October 10th 2017).

AWK meets my 1st investing principles.

Principle#2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything else but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

American Water Works has successfully increased its dividend payments for the pat 8 years. It is only missing 2 more years to become a Dividend Achiever. The Dividend Achievers Index refers to all public companies that have successfully increased their dividend payments for at least ten consecutive years. At the time of writing this article, there were 265 companies that achieved this milestone. You can get the complete list of Dividend Achievers with comprehensive metrics here.

While the company ran into some problems back in the 2000’s the business now seems under control.

AWK meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what happened with a company. As investors, we are more concerned about the future than the past. this is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

While I respect management commitment to keep its payout ratio between 50% and 60%, its cash payout ratio is all over the place. You would think that a water company would be a strong cash flow business. Unfortunately, AWK has to invest massively in its water pipe network to improve its quality. Such significant CAPEX hurt the business cash flow.

AWK meets my 3rd investing principle… but it is still under watch

Principle #4: The Business Model Ensure Future Growth

AWK business model is quite simple: people need to drink water to live. This situation is not likely to change in the future. The water industry in the U.S. is highly fragmented with many cities struggling with their own water treatment system. Once a company manages a water treatment plan, it operates a small monopoly. As the largest player in this industry, AWK is in a strong position to acquire smaller players and benefit from its expertise and economy of scale. There is no doubt this business will continue to grow in the next decades.

Potential downsides

On a more negative note (because not everything is pink in this world), the investment required to upgrade water connections is more than significant. Expenses to improve the water network could get out of control. As I noted in my 3rd investing principle, the company is bleeding cash to improve this network. Therefore, it has to borrow more money to finance its activities (and dividend payments).  Raise of interest rates could hurt AWK profitability has its debt level increased significantly over the past decade.

Source: Ycharts

AWK still shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect timing to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

Unfortunately, according to the PE valuation, there isn’t any deal with AWK at this price. The company has never traded at a higher multiplier in the past decade.

Digging deeper into this stock valuation, I will use a double stage dividend discount model. As a dividend growth investor, I rather see companies like big money making machine and assess their value as such.

Following the company’s previous dividend growth history, I’ve used an 8% growth rate for the first 10 years and reduced it to 7% afterward. I believe there is lots of room for growth in this market and investors will be rewarded accordingly.

Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.66
Enter Expected Dividend Growth Rate Years 1-10: 8.00%
Enter Expected Terminal Dividend Growth Rate: 7.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $233.06 $116.13 $77.17
10% Premium $213.64 $106.45 $70.74
Intrinsic Value $194.22 $96.78 $64.31
10% Discount $174.80 $87.10 $57.88
20% Discount $155.38 $77.42 $51.45

Source: how to use the Dividend Discount Model

In the light of this analysis, I can see that AWK offers some upside potential.  The stock value more than doubled over the past 5 years, but the hype around water utilities is not about to finish. There is definitely a little speculation around such pricing, but the industry is promising.

AWK meet my 5th investing principle with a potential upside of 15%

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest investor struggles is to know when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is the time to pull the trigger. My investment decisions are motivated by the fact that the company confirms or not my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company are not valid anymore, I sell and never look back.

Investment thesis

The investment thesis in such company is simple: you are buying shares of a monopoly selling an essential product with repetitive purchases. With a highly fragmented industry and the urgent need for massive investment in water connections, a leader with the size of AWK will find a way to grow its business.

Water needs will continue increase as population grows and there are no substitutes for it. It is also a recession proof business. Finally, AWK is real money making machine with constantly increasing cash flow:

Source: AWK presentation

AWK shows a solid investment thesis and meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

While AWK shows consistent growth pattern due to its business model, I would tend to add a position in a more conservative portfolio. The hype around the water industry may fade at one point and what will remain is a strong dividend payment. In a decade from now, this is the type of company that will pay a higher yield, but with limited stock growth perspective.

AWK is a core holding.

Final Thoughts on AWK – Buy, Hold or Sell?

Overall, I like the business model and the company. I think there will be lots of room in the next decade for growth and the demand for water is indisputable. While the PE valuation seems high, AWK still shows enough dividend growth power under its hood to fuel a higher stock price. AWK is a buy.

Disclaimer: I do not hold AWK in my DividendStocksRock portfolios.

 

September & October Are NOT Bad Months for Your Investments

For a strange reason I can’t explain, many investors tend to make stats of anything. Even worse, those same investors trade according to these stats without any fundamentals at all. I have in mind the “seasonality of returns” for examples. Many investors think there is a general bullish market during the holidays or that January will determine if we are going to have a bullish or bearish year. Since we are right in the middle of a great seasonality, I’d like to attack the September & October Effect.

Source: Ycharts

Unless you were living under a rock, you surely remember what happened during the fall of 2008. The worst stock market crash in the history started in August 2008 and finished in November the same year (with a perfect bottom on March 9th 2009). I guess this is enough to give nightmares to a whole generation of investors.

If I pull out the charts from the 80’s, I will find another horror story. The Black Monday occurred on October 19th 1987 when the market fell by 22% in a single day. The bulk of the disaster was attributed to a glitch in program trading orders. But whatever the reason was, investors got hit by a train during another horror story:

Source: Ycharts

If this wasn’t enough, the 1929 market crash happened… on October 1929. Those three events alone marked the imagination of millions of investors. These stories are told like legends and other boggeyman horror tales. But should we really fear those months on the stock market?

Source: Ycharts

The truth is that if you have purposely missed September and October of each year since the last crash, you missed a grand total of 36.63% in total return (including a +2.40% as at October 3rd 2017). The best part is that since 2009, there is only one year where the combination of both months leads to a negative return:

Source: Ycharts

From September 1st 2009 to October 31st 2016, the S&P 500 shows a total return of +147.70%. During this period, the “horror months” shows 34.23% or 23.17% of the total return (34.23% / 147.70%). However, 2 months out of 12 only represent 16.67% of the year. In other words, September & October brought more returns than their weight.

When you take a close look at the above mentioned chart, you can also notice that while the average return is about 4%, there are very strong and very weak periods. In other words; there are absolutely no seasonality trends over the past 8 years!

September & October could be good or bad months on the stock market like any others. It’s because a few catastrophes happened in history that it means something.

Now… what will happen this year?

Source: ycharts

We are already halfway in the “horror months” and the stock market is showing a positive return of 2.40%. Will it go up, will it go down? I don’t know. And I don’t really mind. I recently received the commuted value of my pension plan and I intend to invest it this fall. If I want to retire wealthy, I can’t really wait on the sideline hoping for a market crash. What if October is another good month as it was the last 8 times?

I’d rather focus on dividend growth stocks to build my retirement portfolio. Regardless where the market will end on Halloween, I know my dividend payments won’t end-up in a horror story!

Buy the Dip on Canadian National Railway

Summary:

#1 Canadian National Railway is back on track for future growth.

#2 The stock jumped by 10.67% over the past 12 months, but lost 5% in the past 30 day. , It’s time to buy the dip.

#3 Meanwhile, the dividend has jumped by 120% over the past 5 years.

 

Canadian National Railway (CNI) has been on a great stock ride over the past 12 months. As the TSX decreased by 2%, CNI stock is up 10.67% as at August 19th. This creates another interesting entry point for this strong dividend grower.

Revenue

Revenue Graph from Ycharts

As you can see, the railroad industry cycles up and down. The latest down cycle happened during the oil bust, but CNI’s great diversification helped it weather the storm

 

Source: CNI Q2 presentation`

Now that the Canadian economy seems to be more resilient than expected, Canadian National Railway has started to see signs of recovery faster than expected.

How CNI fares vs. My 7 Principles of Investing

We all have our methods for analyzing a company. Over my years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. Let’s take a closer look at them.

Source: Ycharts

Principle #1: High Dividend Yield Doesn’t Equal High Returns

My first investment principle goes against many income seeking investors’ rules: I try to avoid most companies with a dividend yield over 5%. I will make very few investments like this (you can read my case against high dividend yield here). The reason is simple; when a company pays a high dividend, it’s because the market thinks it’s a risky investment, or because the company has nothing else but a constant cash flow to offer its investors. However, high yields hardly come with dividend growth and this is what I am seeking most.

Source: data from Ycharts.

CNI hasn’t been one of the most generous companies in term of yield. It has maintained a very cautious approach by steadily increasing the dividend but also keeping enough money for its capital intensive business model. After all, taking care of thousands of kilometers of railroads has a price! Overall, CNI’s yield isn’t incredible at 1.57%, but it surely doesn’t raise a red flag.

CNI meets my 1st investing principle.

Principle#2: Focus on Dividend Growth

Speaking of which, my second investing principle relates to dividend growth as being the most important metric of all. It proves management’s trust in the company’s future and is also a good sign of a sound business model. Over time, a dividend payment cannot be increased if the company is unable to increase its earnings. Steady earnings can’t be derived from anything but increasing revenue. Who doesn’t want to own a company that shows rising revenues and earnings?

Source: Ycharts

While CNI’s dividend yield isn’t impressive, its dividend growth history is. CNI shows a dividend growth streak of 22 consecutive years. If it were an American company, it would even be part of the Dividend Achievers. On top of that, CNI’s annualized growth rate for the past 5 years is 17.08%. The company has more than doubled its payouts during this period going from $0.188/share to $0.415/share (Canadian dollar).

CNI meets my 2nd investing principle.

Principle #3: Find Sustainable Dividend Growth Stocks

Past dividend growth history is always interesting and tells you a lot about what has happened with a company. As investors, we are more concerned about the future than the past. This is why it is important to find companies that will be able to sustain their dividend growth.

Source: data from Ycharts.

After this impressive dividend growth period, you would expect the company to show a relatively high payout ratio. Well, think otherwise. Both CNI’s payout and cash payout ratios are under 40%. The company has already been known for its stellar operating ratio in its industry and this reflects on earnings and cash flow.

CNI meets my 3rd investing principle.

Principle #4: The Business Model Ensures Future Growth

Looking at past metrics tells you a story about a company. Unfortunately, this doesn’t mean history will repeat itself in the future. A good way to make sure it does is to understand how the company makes money. CNI owns and operates one of the largest and most efficient railroads systems in North America. Railroad transportation is one of the best ways to move commodities and other goods across such a large continent. Since it is virtually impossible for a new company to build railways these days, CNI will continue to generate cash flow year after year.

 

CNI shows a strong business model and meets my 4th investing principle.

Principle #5: Buy When You Have Money in Hand – At The Right Valuation

I think the perfect timing to buy stocks is when you have money. Sleeping money is always a bad investment. However, it doesn’t mean that you should buy everything you see because you have set some savings aside. There is a valuation work to be done. In order to achieve this task, I will start by looking at how the stock market valued the stock over the past 10 years by looking at its PE ratio:

Source: data from Ycharts.

Looking at the past 10 years, you can see the PE ratio is getting closer to a 10 year high. This usually doesn’t look good.

Digging deeper into this stock valuation, I will use a double stage dividend discount model. As a dividend growth investor, I rather see companies like big money making machine and assess their value as such.

Here are the details of my calculations:

Input Descriptions for 15-Cell Matrix INPUTS
Enter Recent Annual Dividend Payment: $1.65
Enter Expected Dividend Growth Rate Years 1-10: 10.00%
Enter Expected Terminal Dividend Growth Rate: 7.00%
Enter Discount Rate: 9.00%
Discount Rate (Horizontal)
Margin of Safety 8.00% 9.00% 10.00%
20% Premium $276.46 $136.89 $90.42
10% Premium $253.42 $125.48 $82.89
Intrinsic Value $230.39 $114.07 $75.35
10% Discount $207.35 $102.66 $67.82
20% Discount $184.31 $91.26 $60.28

Source: how to use the Dividend Discount Model

Note: this section has been done using CAD metrics.

Looking at the dividend discount model, I can see CNI is still offering potential.

CNI meets my 5th investing principle with a potential upside of 14%

Principle #6: The Rationale Used to Buy is Also Used to Sell

I’ve found that one of the biggest struggles an investor faces is  knowing when to buy and sell his holdings. I use a very simple, but very effective rule to overcome my emotions when it is  time to pull the trigger. My investment decisions are motivated by the fact that the company either does or does not conform my investment thesis. Once the reasons (my investment thesis) why I purchase shares of a company  are not valid anymore, I sell and never look back.

Investment thesis

Canadian National Railway is the most productive railroad company with the best operating ratio in the industry (55.1%). At a 1.64% yield, we can’t talk about a “strong” dividend payer. However, after digging further, I realized how strong the company’s fundamentals are. CNR has a very strong economic moat since railways are virtually impossible to replicate. Therefore, you can count on increasing cash flow coming in each year. Plus, there isn’t any better way to transport most commodities than by train.

Potential Risks

There isn’t much risk when you invest in a steady cash earning company where virtually no new competitors could enter. This is a privileged market where CNI is dominant.

CNI shows a solid investment thesis and meet my 6th investing principle.

Principle #7: Think Core, Think Growth

My investing strategy is divided into two segments: the core portfolio built with strong & stable stocks meeting all our requirements. The second part is called the “dividend growth stock addition” where I may ignore one of the metrics mentioned in principles #1 to #5 for a greater upside potential (e.g. riskier pick as well).

Canadian National Railway will offer great entry points from time to time as it evolves within in a cyclical industry. However, CNI will not show incredible stock price growth overtime. This is a steady earning company that will show more dividend growth than anything else.

CNI is a core holding.

Final Thoughts on CNI – Buy, Hold or Sell?

In short, CNI is definitely a BUY. The company shows a 14% upside and a strong dividend growth potential. Plus, in the event of a market crash, you can count on CNI and its 22 years of dividend growth history to continue raising your “waiting payment”.

Disclaimer: I do hold CNI in my DividendStocksRock portfolios.

The opinions and the strategies of the author are not intended to ever be a recommendation to buy or sell a security. The strategy the author uses has worked for him and it is for you to decide if it could benefit your financial future. Please remember to do your own research and know your risk tolerance.