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Why Emerson Electric's Stock Is Worth Owning

Thursday - 3/28/2013, 9:24pm  ET

The next selection for the Inflation-Protected Income Growth Portfolio is electrical equipment and industrial engineering services giant Emerson Electric . A pretty well-diversified business, yet one that rarely succumbs to the conglomerate discount, Emerson's stock had been priced a little too high to earn a position in this portfolio. Its recent pullback from that peak brings it back into the iPIG portfolio's buy range.

A long-tenured member of the dividend growth club, with over 55 years of increasing dividends, Emerson is a business with a proven history of rewarding investors for the risks they're taking by owning the stock. While the past isn't a guarantee of the future, a track record like that demonstrates an incredibly strong foundation that has been able to withstand wars, recessions, and the recent financial meltdown.

Why it's worth owning in the iPIG Portfolio
To earn a spot in the portfolio, a company has to pass a series of tests related to its dividends, its balance sheet and valuation, and how it fits from a portfolio diversification perspective.

Dividends:

  • Payment: The company's dividend currently sits at $1.64 a share, a yield of about 2.9% based on Wednesday's closing price.
  • Growth history: The company has raised its dividend annually for over 55 years, with increases dating back to 1956 
  • Reason to believe the growth can continue: With a payout ratio of 58%, the company retains better than 40% of its earnings to invest for future growth. That reasonable payout ratio also gives the company flexibility to maintain its dividend if future growth doesn't materialize as quickly as hoped

Balance sheet and valuation:

Balance sheet: A debt-to-equity ratio of around 0.5 indicates that the company does use debt, but it hasn't overleveraged itself to the point where a near-term financial hiccup would derail it.

Valuation: By a discounted cash flow analysis that has been updated to reflect the most recently reported quarter, the company looks to be worth around $42.9 billion. That makes its market cap of $40 billion seem reasonable.

Diversification fit:
The previous picks for the portfolio included:

As a fairly diversified and industry-focused business, Emerson Electric touches many of the same lines of business as several other iPIG portfolio picks, which makes it less than ideal from a diversification perspective. Still, from a diversification perspective, a little overlap in a lot of places is better than owning nearly identical businesses. It may not be perfect diversification, but it's all part of the balancing act needed to manage across risks in investing.

Why pick it over its peers?
Still, as Emerson is only one of several electrical, industrial, and engineering companies out there, it raises the question: Why select this company instead of one of the others?

General Electric , for instance, looks to be available at an even lower earnings multiple than Emerson, and until it cut its dividend during the recent financial meltdown, it also had a multi-decade dividend growth streak. A key issue with adding GE is that its large defense business puts it too close to other iPIG portfolio selections United Technologies and Raytheon.

Emerson's climate division makes air conditioning parts, and thus puts it in the same industry as United Technology's Carrier division. Still, a part maker/finished goods overlap is less of a diversification concern than direct competition, such as between GE's aircraft engines and United Technologies' Pratt & Whitney aircraft engines. 

Johnson Controls , another electrical and industrial engineering services powerhouse was also considered. Unfortunately, though, Johnson Control has both a lower dividend yield, and its dividend growth streak was recently interrupted.  Layer in a slightly higher earnings multiple for Johnson Controls than Emerson, and the nod went to Emerson.

Put it all together, and it means that, among its peers, Emerson looks like the best overall fit for this portfolio.

What are the risks?
Of course, no investment is without risk. In Emerson's case, its internal diversification acts as a buffer that can reduce the upside potential of any one of its business. For instance, this past Tuesday, it reported that overall orders were flat, with strength in its climate control and process automation businesses offset by weakness in its industrial automation and network power businesses.

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