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Stocks  | February 22, 2019

Dividend growth stocks are one of the most popular long-term investing strategies, and it's not hard to see why. Over many decades, they have tended to outperform non-dividend stocks and the S&P 500, and with lower volatility to boot.

Given the proven alpha generating power of dividend stocks, it's no surprise that Warren Buffett's (the best investor in history with over 20% CAGR total returns over 53 years) company, Berkshire Hathaway (BRK.B), has dividend stocks as the 14 largest holdings in its $200+ billion portfolio.

While blindly following any investor isn't always the best strategy, given Buffett's famous focus on buying quality dividend blue-chips at fair value or better, I think Berkshire's portfolio can make for a good starting point for income growth investors to start searching for good ideas.

So let's take a look at why Buffett is such a fan of Apple (AAPL), Bank of America (BAC), and Coca-Cola (KO). Specifically, learn the reasons why these three blue-chips likely make up 43% of Berkshire's portfolio, and more importantly why all three companies are likely to deliver not just safe and growing dividends over time, but market-beating total returns as well.

Why Buffett Loves Apple

Buffett is famous for not investing in tech stocks because he considers them to be in his "too hard" bucket due to how quickly the sector changes. So why is Apple now over 20% of Berkshire's portfolio? For the same reason that Buffett has said he'd love to own 100% of the company.

Apple's ecosystem remains sticky and wide moat. Analyst firm Fluent reports that 80% of iOS users plan to remain loyal to Apple, and 70% won't even consider switching to Android. And according to 451 Research, customer satisfaction for the latest generation of iPhones is 99% while 81% of business users plan to buy an iPhone. Analyst firm Kantar says that iPhone loyalty in the US is 90%, 23% above the second highest brand.

Buffett is famous for his love of strong brands and wide moats, and Apple's strength in both is enough to make it more than a hardware company in his eyes (and mine).

Apple has made its fortune through world-changing hardware products like the iPod, iPad, and iPhone but now the company's installed userbase of 1.4 billion(900 million iPhones, up 75 million in the past year) is setting it up to become a more service oriented company.

The company's service revenue has been the fastest growing part of the business (and at 63% gross margins the most profitable), for several years now. In fact, since 2015 service sales have grown at 19% CAGR and the company maintained that historical growth rate in its holiday quarter, despite all its headwinds (see risk section).

Service gross margin was up 1.7% YOY showing that Apple is benefiting from large economies of scale that should only get larger as its user base grows over time. In Q1 2019 service revenue hit a record $10.9 billion, representing 13% of company revenue and an annual run-rate of $43.6 billion. That puts Apple on track to hits its goal of $50 billion in service revenue by 2050.

Morningstar's Abhinav Davuluri expects the company's headwinds to result in a modest revenue decline in 2019 mid-single-digit sales growth to resume in 2020 and beyond, driven by non-iPhone sales growth (mostly services). Given management's Q2 2019 guidance (-7% revenue growth) I consider that a reasonable long-term growth forecast.

Why do I think Apple's relatively terrible 2019 doesn't foreshadow falling sales forever? For a few reasons. First, as Tim Cook pointed out in the most recent conference call, iPhone sales delivered record results in "the United States, Canada, Mexico, Germany, Italy, Spain, and Korea".

And according to CFO Luca Maestri, the company saw double-digit sales growth in "Germany, Spain, Poland, Mexico, Malaysia, and Vietnam."

Also, the large increase in battery replacements Apple made at discounted prices in 2018 means that the refresh cycle was probably temporarily extended in some of its developed markets. This should abate later in 2019.

Second Apple Pay, cloud services and the App Store search ad business are all growing strongly, in addition to App store, showing that Apple's service business is thriving across a diversified business platform (App store is just 30% of service revenue). Cloud services, in particular, saw 40% revenue growth YOY showing that Apple's cloud business isn't nearly as weak as some bears think.

Finally, we can't forget that Apple's bottom line is going to still benefit from the largest buyback plan in history.

Despite returning a record $336 billion to shareholders over the past six years, Apple's net cash position (cash minus debt) remains a sky-high $130 billion. Luca Maestri, its CFO, has stated it eventually wants to reach a net zero cash balance implying that buybacks will reach even more epic proportions in the coming years, and the company will be able to deliver on Tim Cook's promise of annual dividend hikes.

In fact, at the Q4 conference call, Mr. Maestri reiterated that plan saying the company knows its dividend "is very important to our investors who value income... and plans for annual dividend increases going forward."

In the future I expect Apple's bigger push into health and new service offerings (like TV and video game streaming) to deliver that modest top line growth. Higher margins from services and a torrent of buybacks should deliver roughly double-digit bottom line and dividend growth, which is more than enough for me to recommend and own the stock myself.

But while I'm an Apple bull that doesn't mean that that I'm not aware of the numerous challenges facing the company in 2019 and beyond.

Risks To Consider

Now some investors are worried that BRK unloaded nearly three million Apple shares in Q4, thinking it might mean Buffett has lost faith in the company. That's not necessarily true given that Buffett's assistant Debbie Bosanek told Reuters that it wasn't Buffett who sold 2.9 million shares of Apple.

"One of the managers other than Warren had a position in Apple and sold part of it in order to make an unrelated purchase." - Debbie Bosanek

But even though Buffett himself isn't actively selling Apple shares (he, Ted Weschler and Todd Combs all manage independent accounts for the company), it's also true that Buffett wasn't actively buying shares either.

That might be due to the real risks Apple is facing, which include the steep iPhone declines in China, which were made worse by the US/China trade war.

The collapse in Chinese revenues (which caused virtually all of the company's 5% YOY sales decline) is going to likely weigh on the company for as long as the trade war lasts, if not possibly longer.

That's because, though it's trying to transition to a services-based company, 62% of revenue is still iPhone related and China was once considered the crown jewel of its growth opportunities.

According to analyst firm IDC iPhone volumes in China fell 20% last quarter, double the decline in Chinese smartphones of 9.7%. There are two troubling indications from IDC's report.

The first is that China's slowing economy, when combined with longer refresh cycles is making China's overall smartphone growth potential far smaller. That's courtesy of the slowest economic growth in 28 years, which the IMF expects to continue for the foreseeable future.

And while Huawei's strong YOY growth might be partially due to nationalism (its CFO was arrested in late 2018 in Canada per American request) the fact remains that China's smartphone market is rapidly changing, and in a way that Apple's new higher price strategy is ill-suited for.

Nicole Peng, a senior director at Canalys, explains in a recent note saying

Apple doesn’t have a good go-to-market strategy that fits the rapidly changing Chinese market...It also seemed to be slow in reacting to China’s economic slowdown and changes in consumption structure...When smartphones became a commodity for Chinese customers, multinationals need to adjust their overall sales and marketing strategies...Apple didn’t seem to change its Chinese marketing plans. ” - Nicole Peng (emphasis added)

IDC's report pointed out that a big reason that Huawei, Oppo, and Vivo managed to deliver positive volume growth in Q4 2018, and thus were able to steal market share, was by delivering a better value proposition including solid hardware specs but at lower price points. Apple has been slow to change its recent focus on higher phone prices which isn't just hurting it in China but other markets as well.

Back in November Apple began asking Japanese retailers to start discounting its iPhone XR, which is supposed to be its lower end entry-level model, to boost weaker than expected sales. In the latest quarter, total Japanese revenue fell 4.5%, largely due to lower iPhone revenue from these weak sales and price discounts. Granted that was largely due to Japanese telecoms greatly curtailing subsidies but that will prove a permanent headwind.

Remember that Apple's strategy has always been brand and moat focused, counting on its status as a premium maker of top tier hardware to achieve the best ASPs in the industry. However, it's now clear that consumers around the world are now reaching their limit on how much they are willing to pay for iPhones which means that Apple might have a tougher time driving long-term sales growth that analysts expect.

Does that mean that Apple's thesis is broken and its time to sell? No, but it does mean that Apple is going to have to switch tactics and likely lower prices in the future which will weigh on iPhone margins.

The good news is that higher margin service revenue should keep the company's FCF margin among the highest in corporate America BUT there is also a risk to Apple's service business that investors need to know about.

While App store revenue is indeed high margin and more stable than hardware sales, according to App Annie games are expected to account for about 60% of total app spending in 2019. What's more App Annie estimates that 40% of total app spending worldwide is from China, where smartphone video games have been red hot in recent years. But that's in terms of all app spending and Apple's exposure to China's gaming market might be even larger.

That's what Macquarie analyst Ben Schachter warned about back in December 2018 when he pointed out that 75% of Apple's App store revenue is from gaming and 60% of it from the Asia-Pacific region (mostly China).

In 2018 Chinese regulators cracked down on video game approvals due to concerns over users being addicted. Should those regulations end up slowing new game releases, and Apple continues to face rising pressure from developers (2.5 million in China) to lower its 30%/15% App Store fees (for new and old apps, respectively) then Service revenue growth might end up slowing significantly in the coming years. What's more, in China, third-party app platforms are becoming increasingly popular meaning that the App store might end up losing pricing power and lowering overall service revenue growth in the future.

Basically, Apple's biggest risk is that its long-term core strategy of service growth converting it from a pure-play premium hardware maker might end up failing, or at least not generating the kind of long-term growth analysts and investors expect.

One final warning I feel is appropriate pertains to 2019 specifically. In Q1 2019 Apple bought back just $8.2 billion in stock, during the worst market correction in 10 years. That's less than half the over $20 billion average of Q2 through Q4.

In fairness to the company fiscal Q1 is not normally a strong buyback quarter, and given that Apple was planning on its first pre-earnings guidance cut in 16 years (in early January over collapsing China sales) management may have been saving up dry powder for fiscal Q2.

However, if the next earnings release doesn't show a major increase in buybacks that might be a warning sign to investors that management believes its growth headwinds in 2019 might get worse, not better. After all, if your goal is to maximize the value of over $100 billion in future buybacks then you'll want to deploy most of that money when the share price is the lowest.

Apple's shares fell to $142 in January, which was the lowest valuation in years. If Apple didn't jump at that opportunity then it might signal management expects the valuation to potentially fall even lower sometime this year.

While I'm not a market timer and thus don't pin my recommendations on such speculation, it's prudent for income investors with limited capital to always try to get the best price possible for their money.

What am I doing personally with Apple? Well, I'm holding it in my retirement portfolio with no plans to sell. And as for my new Deep Value Dividend Growth Portfolio (beating the market by 10% so far), I have Apple on our watchlist but with a 2% target yield, because I'm aiming for a 13% or higher long-term total return potential.

For most investors, who aim for double-digit total returns over time, I can still recommend the company today. However, I will be watching its 2019 results closely. Specifically, how its iPhone revenues appear to be doing outside of China and especially whether or not the company's service growth remains near its 19% historical norm.

Why Buffett Loves Bank Of America

Roughly 40% of Buffett's portfolio is in bank stocks and it's not hard to see why. Fundamentally it's a simple and highly profitable business. Use low-cost deposits to fund higher interest long-term loans, and as long as a bank's risk management is strong (conservative underwriting) banks will mint money that can be returned to shareholders as buybacks and dividends. That's especially true for mega-banks who are unable to grow through M&A due to strict regulation by the Federal Reserve.

In Q3 2018, Berkshire invested $13.3 billion in bank stocks, including nearly $6 billion in Bank of America. In Q4 2018 Buffett bought around $500 million more Bank of America, showing continued faith in that bank's remarkable turnaround under CEO Brian Moynihan.

It also doesn't hurt that Bank of America continues to benefit from very strong growth in both its top and bottom line.

MetricQ4 2018
Net Income+39%

Operating profits (which excludes corporate tax cut) were up 22% and 6% revenue growth is very impressive for such a massive bank this late into the economic cycle.

Those impressive results are mainly due to two factors. First, was strong growth across its various business lines

  • commercial loans up 2%
  • consumer loans up 4%
  • total loans up 3%
  • deposit growth (what funds the loans) up 4%
  • Merril Edge client inflows of $25 billion (impressive for the worst S&P 500 quarter in 10 years)
  • Full-year Global Wealth and Investment Management inflows of $56 billion (during the worst year for stocks since 2008)

All told BAC was able to grow its total assets by 3.2% ($73 billion in Q4 alone) and its tangible book value per share (objective intrinsic value) by 5.6%. For a bank of its size (second biggest US bank by assets), that is very impressive growth.

But growth in its businesses is just half the reason for Bank of America's record 2018 results, and the reason Buffett is such a fan of the company. The second is an impressive track record of cost-cutting.

A key banking metric is the efficiency ratio (non-interest expenses over revenue) and a good rule of thumb is you want to see this below 60%.

BAC's efficiency ratio was elevated through 2014 as it worked through the various regulatory fines connected to the sub-prime housing fiasco (which totaled $76 billion or about 31% of all Financial Crisis related fines). Those record legal fines were due to former CEO Ken Lewis's disastrous acquisitions of Merrill Lynch and sub-prime mortgage lender Countrywide Financial just before the financial crisis.

Since those fines ended the bank's efficiency ratio has been steadily declining each year and Brian Moynihan has spent much of the past decade selling off riskier business units and cutting costs, which is expected to continue in the coming years (thanks to leveraging lower cost digital banking). By the end of 2022 Morningstar's Eric Compton expects BAC's efficiency ratio to fall to an industry leading 53%, making it not just one of the most efficient banks in America, but the entire world.

Bank of America has been able to reduce operating expenses for 15 of the last 16 quarters and thus generate positive operating leverage for 16 consecutive quarters.

This has led to some of the best profitability in the banking industry, and well above the quality benchmarks investors typically look for.

MetricBank Of AmericaIndustry MedianQuality Bank Benchmark
Net Interest Margin2.48%NA2.0%

And thanks to Bank of America being the largest retail bank in the country (over 12% national market share) it enjoys a large deposit base of low-cost checking accounts that helps boost its net interest margin (average loan interest rate minus average deposit rate). This is the core of what drives its impressive and steadily rising profitability.

That's what's allowed BAC's net interest margin to rise over the last two quarters, despite a sharp decrease in long-term interest rates. Should long-term rates rise by 1% (and the yield curve remain stable) that would boost the company's net interest income by $2.7 billion per year or 5.7%.

But as we've just seen, thanks to its growing deposit base (much of it near zero interest checking), BAC doesn't actually need rising rates to prosper.

And when combined with steady cost-cutting and an inability to buy other banks, management has pretty much no choice but to return its fast-growing profits in the form of rapidly growing dividends and buybacks.

Last year BAC authorized $20.6 billion in buybacks (scheduled for mid-2018 to mid-2019) and just boosted that by another $2.5 billion. Ok, so maybe BAC is raking in record profits now, but that was also the case in 2007 before the Financial Crisis blew up its balance sheet and nearly bankrupted it. What's to keep the same thing from happening during the next recession?

That would be the fortress-like balance sheet and the bank's focus on super safe lending standards. For example, gone are the days of BAC "reaching for yield" with shaky and speculative subprime loans. According to Morningstar, the bank's average consumer loan is to people with FICO scores over 750, which is over 50 points higher than the average American's score (itself at record highs).

But safer lending is just one reason that Bank of America has become one of the safest big banks in the country. The other is that it's made sure its capital ratios have vastly improved in the coming years.

There are two important bank balance sheet metrics to know, CET1 and SLR.

MetricBank Of AmericaRegulatory Minimum
Fully Phased CET1 Ratio11.9%9.5%
Supplementary Leverage Ratio6.8%6.0%

CET1 measures a bank's capital (shareholder net assets, retained earnings and Tier 1 assets like highly liquid risk-free Treasury bonds) against risk-weighted assets (loan book). The supplementary leverage ratio or SLR measures a bank's equity against its total risk-weighted assets, including off-balance sheet ones.

The regulatory minimums for these ratios are not just set by the Federal Reserve but by the Basel 3 global banking accords and are designed to ensure a "too big to fail" bank can survive a severe recession without a high risk of failure or need for future bailouts.

To test that resiliency to a downturn the Fed conducts annual stress tests which simulate an even worse recession than 2008-2009, to model how a bank's CET1 and SLR would hold up in the face of mounting defaults and loan losses.

2018 Stress Test Severe Scenario Assumptions

The Great Recession was literally the worst downturns since the Great Recession (the average peak recession GDP decline is just 1.7% according to JPMorgan Asset Management) and so the stress test can be thought of as a realistic "worst case scenario".

MetricBank of America
CET1 Minimum7.8%
CET1 Minimum Requirement4.5%
SLR Minimum5.1%
SLR Minimum Requirement3.0%
Peak Pre-Tax Losses (Over 9 Quarters)$46.3 billion

The Fed's 2018 stress test, the most severe recession yet modeled (with a peak GDP decline of 9%) showed that Bank of America's core balance sheet metrics would not come close to breaching safe levels.

Basically, Bank of America has turned into Buffett's favorite bank (#2 in his portfolio) because of one of the most impressive turnarounds in corporate American history

  • it's transformed itself into one of the safest banks in the country
  • costs have been falling steadily for years
  • profits are soaring
  • returns on capital are steadily rising
  • its core businesses are thriving despite some of the industry's most conservative underwriting standards

But while Bank of America is now firmly a blue-chip bank that both I and Buffett consider worth owning, it still faces plenty of risks, most notably an inevitable recession.

Risks To Consider

Bank of America, like all banks, is highly sensitive to the health of the US economy. Back in December, I recommended investors ignore plunging stock prices (which were collapsing due to fears of a recession in 2019) and focus on the "3 Bs". Those would be

  • Big macro (economic fundamentals that affect corporate earnings growth)
  • Bond yields (10y-3m yield curve, which banks use to predict recessions and adjust lending policies)
  • Buffett (look at how much and what BRK is buying each quarter because BRK's subsidiaries participate in nearly all parts of the US economy and so give him relatively good insights into when a recession might be coming)

While I'm confident that Bank of America's new conservatism and fortress balance sheet will allow it to avoid dividend cuts in a recession, it's still important for investors to know whether or not an economic downturn is coming.

To judge the fundamental health of the economy I like to track 19 leading indicators via David Rice's (aka EconPI) baseline and rate of change grid. In recent months the number of indicators pointing to slowing economic growth has increased from three to 11. The mean of coordinates or MOC has also been sharply moving to the left (into the deceleration quadrant).

And currently, the leading indicators are the most leftwards they've been since 2009, confirming that US economic growth is likely decelerating at a rapid pace. I then confirm this by looking at real time GDP growth models from two Federal Reserve banks.

The Atlanta Fed's real-time GDP growth model has recently been cut by over 50% to just 1.5% due to several major troubling reports (including the weakest retail sales growth since 2009).

While that model is typically more volatile than most (the New York Fed's Nowcast is still predicting decent 2.2% growth for Q4), those weak reports from last week have caused its Q1 GDP growth estimate to fall to a worrisome 1.1%.

The good news is that even much slower growth isn't necessarily a sign that a recession is coming in 2019. Jeff Miller's weekly economic update offers a meta-analysis of several macro models and estimates that the risks of a recession starting in the next three months is 7.8% and just 20% over the next nine months. While that short-term recession risk is up almost eightfold over the past quarter, it's still low. Combined with the still positive yield curve, that means investors shouldn't panic over the fundamentals.

However, it's worth watching the yield curve, (the most accurate recession predictor ever discovered) and one in particular.

According to the October 2018 Dallas Fed banking survey, the 10y-3m curve is the yield curve being closely monitored by most banks that affect their lending decisions (and creates the causal link between a 10y-3m inversion and the recession it predicts).

As of February 15th's market close, the 10y-3m curve was 23.4 basis points, and it's spent the last 106 months declining rather steadily (especially since the Fed ended QE and started normalizing rates and rolling off its balance sheet).

While the curve's recession predicting power only applies to when it's inverted (negative) should the current trend line hold then the "banker's yield curve" will invert in seven months (mid-August 2019). At which point a nine to 16-month recession clock will start counting down as banks start reducing credit to lower quality borrowers, and thus likely creating the negative economic growth they will fear is coming (a self-fulfilling prophecy).

That basically means that should current economic and bond yield conditions not improve in the coming months (they still could), then a recession could begin in 16 to 23 months or May 2020 to January 2021.

As for Berkshire's buys in Q4 2018, it's important to note that while BRK was a net buyer of stocks, including plenty of economically sensitive banks, Buffett's company was far less aggressive in Q4 than Q3, despite the sharpest correction in ten years.

Combined with the deteriorating fundamentals and very flat yield curve, that might indicate that Berkshire's subsidiary data is telling Buffett that it's possibly time to store up more dry powder ahead of a future bear market.

Basically, the US economy is showing troubling weakness in 2019, potentially indicating we'll experience slower growth this year than most economists/analysts initially expected (2% or less is possible). Should these trends continue, then investors in not just Bank of America but all stocks might want to make plans for becoming more defensive. I've outlined my own long-term recession plan in this article.

Why Buffett Loves Coke

Buffett loves strong brands and stable business models and Coca-Cola, at 133 years old, has proven it has both. That's courtesy of its portfolio of over 500 brands sold in over 200 countries and produced in more than 900 facilities around the world.

The company has 21 mega-brands generating over $1 billion each. While about 70% of sales is still from sodas, the company has been focusing on diversifying into water, energy drinks, and juices for about 20 years, in which time its soda concentration has fallen from 90% to 70%.

In 2018 alone the company introduced 500 new products (bringing its total offerings to 3,900) in an effort to continue diversifying into as many growth markets as possible. 40% of those products were low or now sugar, which is part of Coke's plan to get "on trend" with changing consumer tastes.

The dividend king (56 consecutive years of dividend growth to its name) is incredibly diversified with about 80% of revenue coming outside of North America. That includes a strong presence in the fastest growing emerging markets including in Asia and Latin America (mid to high single-digit sales growth in recent years).

The company expects its future growth to come mainly from emerging markets as well as non-soda sales. That's courtesy of having a relatively small market share in its non-carbonated segments, allowing for a long growth runway.

Coke's long-term non-soda focused strategy isn't just due to the fact that soda is a secularly declining industry in the developed world, but also because non-soda beverages are the fastest growing part of the $150 billion global beverage market.

How does Coke plan to actually deliver stronger top and bottom line growth in the future via this focus on healthier drinks?

Well, a core part of its strategy is strategic M&A. Over the decades the company has taken full or partial stakes in various global beverage makers including: a 16.7% stake in Monster Beverage (MNST), Fuse, Vitamin Water, Honest Tea, A large stake in Keurig Green Mountain, (which was later bought out by a private company for $13.9 billion), Zico Coconut Water, Innocent fruit smoothies and juices, AdeS plant-based beverages, Topo-Chico (Mexican mineral and water brand), De Valle (juices, now a $1+ billion mega brand), Ciel (Latin American water brand)

When Coke buys a brand it's not just to gain immediate sales. It's to plug that brand's products into its world-class marketing and distribution machine which involves 27 million global retailers, and its $4 billion advertising budget.

In mid-2018 the company announced it was buying Costa Coffee for $5.1 billion, gaining its first presence in the $485 billion coffee market via that leading UK based (but global) brand's 4,000 retail locations. Cost's sales are growing at 12% annually (off a base of $1.7 billion in 2018), which Coke believes it can continue by increasing the company's distribution and marketing muscle.

Basically, Coke's plan is to keep adding new brands and products until it's playing in every part of the global hot and cold beverage market which analyst firm NRTD estimates is worth $1.5 trillion per year. But growth in none soda's and emerging markets is just one part of Coke's long-term strategy for delivering safe and dependable dividend hikes for the foreseeable future.

The other is the completion of its four-year plan to re-franchise its bottling operations to significantly boost its margins and free cash flow. That plan will be complete in 2019 and so far it's been working with Coke reporting a 14% boost to FCF in 2018 despite decreased revenues due to both currency headwinds and re-franchising.

That plan, already completed in North America, Europe, and China, is expected to save the company $3.8 billion and boost operating margins from 23% to 34% by the end of this year. More importantly, free cash flow margin (due to lower capex) is expected to hit 27% by the start of 2020.

The company is well on track to hit that target, with 2018 FCF margin coming in at 24%.

In total management believes that it will be able to achieve about 5% long-term sales growth (it achieved it in 2018) and 8% FCF/share growth, via its strategic plan. If it's able to deliver on that guidance then dividend investors will enjoy roughly 7% to 9% long-term dividend growth as well.

That makes Coca-Cola a potentially great low-risk income growth investment for anyone looking for a low volatility (50% less volatile than S&P 500), defensive company, that can help you sleep well at night during a recession and bear market. Coke fell just 31% during the Great Recession, compared to the S&P 500's 57% crash.

But while Coke is a great low-risk income investment that doesn't mean it doesn't face its share of challenges in the coming years.

Risks To Consider

It can't be overstated just how powerful the negative trend is for coke in developed market soda sales. For example, US soda consumption has been falling steadily and rapidly due to changing consumer preferences and rising soda taxes.

With 70% of sales still from soda, that will create strong growth tailwinds that will mean Coke's growth needs very strong execution on strategic M&A and cost-cutting.

According to the Harvard Business Review, about 80% of M&A fails to deliver long-term shareholder value. Coke's M&A track record is far better than most as seen by its above average and steady ROIC, a proxy for good capital allocation.

However, in September 2018 Kent Landers, a company spokesman told Bloomberg the company was potentially looking at investing in a cannabis company, as part of a future effort to sell cannabis-infused drinks.

Fortunately, the company later said it had decided against such a move, at least for now. That's a smart decision but the risk is that Coke will eventually follow in the footsteps of Constellation Brands (STZ) who invested $4 billion to acquire a 51% stake in Canopy Growth (OTC:CGC). That $8 billion valuation has already led Constellation to take a $160 million write-down on the deal, just two quarters after it closed. The point is that if Coke does ever decide to pull the trigger on cannabis then it has a high risk of overpaying for any deals it makes.

Finally, we can't forget that long-term guidance is not a promise just a plan, and in any given year the company can disappoint investors expecting that 7% to 9% long-term EPS/FCF growth.

Coke's 2019 guidance sent shares crashing up to 7% the day of its latest earnings release thanks to 4% organic growth guidance but flat adjusted EPS growth guidance. The company is still expecting operating profit growth of 10% to 11% on a constant currency basis, but foreign exchange headwinds, combined with rising commodity and transportation costs are expected to make for a relatively weaker 2019.

With 80% of sales outside the US, currency swings are a major risk Coke investors' face in the short-term, though over the long-term currency fluctuations tend to cancel out.

Dividend Profiles: Safe And Growing Dividends And Market-Beating Return Potential

What ultimately drives my recommendations (and portfolio buys) is the dividend profile which consists of safety, yield, and long-term growth potential. Combined with valuation, this tends to determine total returns and whether or not a stock is a good buy at any given time.

CompanyYieldTTM Dividend FCF Payout Ratio

Simply Safe Dividend Safety Score (Out of 100)

Apple1.7%22%96 (Very Safe)
Bank Of America2.1%21%83 (Very Safe)
Coke3.5%80%89 (Very Safe)
S&P 5001.9%33%NA

Apple and BAC are offering roughly the same yield as the S&P 500, while Coke's dividend is far richer. More importantly, these dividends are very safe, courtesy of modest payout ratios relative to safe levels for their respective industries.

Note that Coke's FCF payout ratio is adjusted for one-time restructuring costs in 2018. Management has a long-term FCF payout target of 75% which it will need to slow dividend growth a bit to achieve.

The other half of the safe dividend equation is the balance sheet.

CompanyNet Debt/EBITDAInterest Coverage RatioS&P Credit RatingAverage Interest Cost

Return On Invested Capital

Bank Of AmericaNANAA-NANA
Safe/Good Level3 or Less8 Or MoreNANA8% or More

Fortunately, all three companies have very strong credit ratings courtesy of manageable debt levels, and solid interest coverage ratios. This allows them to borrow at low-interest rates far below their returns on invested capital.

As for growth potential, analysts currently expect solid bottom line growth from Apple and Bank of America while Coke is expected to miss its long-term guidance.

CompanyYield5 Year Expected EPS (Analyst Consensus)Expected Total Return (No Valuation Change)

Valuation-Adjusted Total Return Potential

Apple1.7%10.0%11.7%11.7% to 14.9%
Bank Of America2.1%9.0%11.1%12.3% to 13.6%
Coke3.5%5.5%9.0%9.7% to 10.6%
S&P 5001.9%6.4%8.3%3% to 8.3%

While all forecasts are merely educated guesstimates if these companies deliver on current growth expectations then each should still deliver solid market-beating returns of 9% to 11.7% assuming no valuation changes.

Factoring in each stock's valuation that long-term (5 to 10 year) total return potential increases a bit to make each even more attractive, especially relative to the conservative total return targets most analysts have for the S&P 500 over the coming 5+ years.

Valuation: Now's A Good Time To Buy All 3 Buffett Dividend Stocks

Thanks to two corrections last year, neither the S&P 500 nor any of these companies have posted impressive gains. But on the plus side that makes each a decent buying opportunity right now, especially given the quality nature of each of these Buffett owned dividend blue-chips.

My two favorite valuation methods are dividend yield theory and a conservative discounted cash flow model. DYT is what I primarily use in my own portfolio decision making because since 1966 that's the sole approach asset manager/newsletter publisher Investment Quality Trends has used on dividend blue-chips to deliver decades of market beating returns.

DYT simply compares a stock's yield to its historical norm, because assuming the business model and growth rates haven't changed much, yields are mean reverting and approximate fair value.

CompanyYield5 Year Average YieldEstimated Discount To Fair ValueUpside To Fair Value

Long-Term Valuation Boost

Bank Of America2.1%1.3%35%55%4.5% to 9.2%
Coke3.5%3.2%7%7%0.7% to 1.4%

In the case of Apple and Coke, DYT says that both are relatively close to fair value, making them "buys" for anyone looking for a safe and growing dividend as well as market-beating potential.

BAC appears to be a screaming buy BUT we can't forget that most banks were forced by the Fed to slash their dividends during the Great Recession. Thus highly rapid dividend growth in recent years might make that super deep discount rather noisy so to confirm I also consider Morningstar's conservative discounted cash flow models.

CompanyMorningstar Fair Value EstimateUpside To Fair ValueLong-Term Valuation Boost

Valuation-Adjusted Total Return Potential

Apple$20017%1.6% to 3.2%11.7% to 14.9%
Bank Of America$3313%1.2% to 2.5%12.3% to 13.6%
Coke$498%0.8% to 1.6%9.7% to 10.6%

While no DCF model is perfect (it requires a lot of assumptions including a discount rate that's different for everyone) Morningstar's conservative analysts tend to assume growth rates that are far below that of most Wall Street firms or even management teams themselves.

Thus I consider them a generally reliable source of fair value estimates that blue-chip investors can use to ensure they are paying fair value or better for a quality dividend stock. As you can see Morningstar estimates that all three Buffett owned blue-chips are indeed undervalued, though BAC isn't nearly as much of a deal as DYT would have you believe.

Overall, given each company's strong fundamentals and safe and steadily rising dividends, I'm happy to give each a "Buy" recommendation at this time, assuming you're comfortable with their respective risk profiles.

Bottom Line: Buffett Loves These 3 Dividend Growth Stocks And So Should You

Warren Buffett has made countless investors rich over the years by investing in quality dividend blue-chips at good to great prices over the decades. Today Apple, Bank of America, and Coca-Cola represent 43% of Berkshire's portfolio, indicating the greatest investor in history remains highly bullish on the long-term prospects of each company.

While no company is risk-free, and all three of these large caps face very real challenges in the coming years, ultimately I agree with Buffett that they are sound long-term income growth investments.

At today's modest discounts to fair value (7% to 15%), I consider all three to be great choices for low-risk income growth investors. Just keep in mind each company's risk profile (and size your position accordingly) as well as the rising recession risk which points to a potential economic downturn coming in 2020 or 2021 (if current trends hold).

During a bear market, it's proper asset allocation (mix of cash/stocks/bonds) that will help you sleep well at night, in addition to owning safe dividend blue-chips like these.

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