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Why High-Yielding Dow Inc. Could Outperform in a Market Downturn

When stock investors are picking companies for their portfolios, a key consideration is often volatility. This is defined simply as the magnitude of movement in the price of a security, such as a stock, over time. Generally, we measure volatility against some sort of benchmark, which is typically an index like the S&P 500. By measuring volatility against an index, we can derive a stock's beta value, which is a comparison of volatility between the stock in question and the index.

Most stocks have a positive beta value, which means that the stock and the index generally move in the same direction; both go up in bullish periods and down in bearish periods. A beta value of 1.00 means that the stock and the benchmark index move exactly the same amount in the same direction. Conversely, a handful of stocks in the S&P 500 have negative betas, meaning they tend to move in the opposite direction of the benchmark. That is, these stocks tend to rise when the S&P 500 is falling and fall when it is rising. Taking advantage of this can provide a diversification component to an investor's portfolio.

One such stock is Dow Inc. (NYSE:DOW), and in this analysis, we'll take a look at the company's business and its prospects for shareholder returns in the coming years.

Business overview

Dow is a newly-formed standalone company that used to be part of the former DowDuPont business (now broken up). DowDuPont no longer exists as its former parts now form Corteva (NYSE:CTVA), DuPont (NYSE:DD) and Dow. Dow is the former material science business of DowDuPont and began trading on its own on April 1. The new company produces about $50 billion in annual revenue and currently trades with a market capitalization of $38 billion.

Dow is heavily involved in high-growth areas like packaging, consumer care products and infrastructure. Its plastics have a strong reputation worldwide and we see this as a competitive advantage in the niche markets where it competes. Even though Dow Inc. is a new company, the Dow name has been around since 1897, and its reputation remains solid.

Growth prospects

We see Dow as struggling somewhat to produce meaningful growth in the coming years as the company has reported somewhat lackluster results since being spun off. Indeed, we expect just 3% annual earnings per share growth in the coming years, as Dow has faced some significant margin issues in 2019.

Management believes pricing will improve in the latter part of the year and into next year, which should help with shrinking margins. In addition, Dow is in the midst of a robust cost savings campaign, which it is continuing from the DowDuPont days. The company recognizes it had some margin opportunities in its cost structure, and is working to take advantage of them.

Dow's third-quarter results showed tremendous progress toward margin improvement via cost savings, and we expect that lean structure to carry forward. Total savings came to an outstanding $1.37 billion in the third quarter, with $40 million being added to the tally during the quarter. This is a key driver of earnings growth in the future as Dow continues to find its way as a standalone company. At the point when the company achieves some measure of revenue growth in the future, operating leverage should produce meaningful earnings growth.

Dow is also returning essentially all of its earnings to shareholders via dividends and share repurchases. The company has begun buying back stock after the spinoff and has reduced the float by nearly 1% in just a few months. As margins improve, driving better earnings, we believe Dow will increase the rate of share repurchases.

While we see somewhat muted growth for Dow, we like its diverse product portfolio and the fact that we see demand holding up in just about any economic environment. We see Dow producing $3.50 in earnings per share this year.

Valuation and dividend analysis

The recent rally in the stock has the price-earnings ratio up to 14.6, which is higher than our fair value estimate of 12 times earnings. We see the valuation as introducing an approximately 4% headwind to total shareholder returns in the coming years as it moderates. Dow's relatively uncertain future in terms of growth means investors likely will be willing to pay less for the stock, particularly if the margin inflation story doesn't play out in 2020.

Certainly, Dow's appeal for investors is its sizable dividend yield. The company has the stated goal of providing a best-in-class yield, and it has done so in the early days of being a standalone company. The current dividend of $2.80 annually works out to a yield of 5.5%, which is roughly three times that of the broader market and is on par with or better than many traditional income vehicles such as real estate investment trusts.

However, the dividend is consuming 80% of current earnings, and we see that very high payout ratio continuing. Dow has made it clear it intends to pay the vast majority of its earnings in the form of dividends, so dividend safety may come into play in the case of a severe recession. Dow would be able to borrow to pay the dividend during a short downturn, and it could obviously cease share repurchases if needed to conserve cash. Overall, we see dividend safety as a potential problem only in the case of a recession; barring that, Dow offers investors a terrific yield.

Final thoughts

In total, we expect Dow to produce 4.4% total annual returns in the coming years. We like the company's steady demand for its products and its likely resilience to downturns. However, the stock is trading for 122% of its fair value, which will partially offset the dividend yield of 5.5%. Muted growth means we rate Dow shares as well in excess of fair value, but the company's enormous dividend yield is highly attractive. Its very low beta value also provides a diversification component to investors' portfolios, as Dow will likely move inversely to the broader market.

Disclosure: No positions.

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This article first appeared on GuruFocus.