Listeners of the most recent Dividend Talk podcast may have heard that I’m selling my 3M shares over the summer. In a nutshell, 3M is having too much litigation risk which, in my opinion, puts their dividend at risk.
As an example,
- they haven’t been growing their free cash flow over the last 5 years
- their payout ratio is already on the high-end
- their debt/equity ratio will get worst after the settlements
What I really mean to say is this; they already own 19 billion in debt and I expect at least an additional 30 billion due to litigations (which is very optimistic. There are even estimates of up to 143 billion).
At the same time, they currently have a 4 billion Free Cash Flow and a dividend payment of 3.3 billion. This leaves 700 million left for interest payment expansion due to litigation.
However, the math doesn’t work here, because let’s assume that 3M will be able to borrow those 30 billion at a very attractive 3% interest rate. This alone would mean a 900 million additional annual interest payment.
Take on top of that the annual additional down payments and BOOM, there goes your free cash flow and any wiggle room the company has.
But hey, 3M’s management is a bit more optimistic, because they are forecasting a 5.5 Billion Free Cash Flow for 2023. Honestly, I find that number very stretched, but they might be able to achieve it after their severe cost-cutting exercise.
Still, it would mean hardly any cash flow left to grow the dividend or to buy back shares.
Knowing this, I simply have to start my selling process by making rational decisions. Although, taking a 50% loss always hurts and it won’t be easy to recover my invested capital.
On the other hand, that’s also what a diversified portfolio means. You win some, you lose some.
My strategy to replace 3M
Honestly, I don’t mind the loss of capital as much as I hate losing dividend income. That’s why my first and foremost goal is to replace 3M’s dividend income with at least the same amount of dividend income by investing in other stocks.
This automatically means that I will need to reinvest the money in some high-yielding stocks because 3M is yielding 6% at the time of writing.
At the same time, “someone’s death is someone’s bread” as the saying goes in the Netherlands. Therefore I would also like to allocate some money back into an industrial with clear tailwinds (i.e. Siemens?).
That’s why my strategy to replace 3M will be in a mix of 2 or 3 stocks with an average yield of 6%. In practice, this means buying a high-yield, low-growth stock to make place for a decent-yielding stock with a proper growth profile.
Last but not least, taking a capital loss on my 3M shares allows me to tax-harvest my options income and profits gained by selling some stocks in my growth portfolio.
Where I reinvested the first 3M funds
It may not come as a surprise, but European insurance stocks continue to provide very attractive risk versus rewards profiles combined with very juicy yields.
The main reason for lower share prices is the increased interest rate environment. This puts short-term pressure on insurance companies because they will need to account for lower bond portfolio values via their income statement. Hence, this directly impacts their earnings per share numbers.
However, in the long term, insurance stocks are known to perform well in rising interest-rate environments. This is due to something called float, a concept popularised by Warren Buffet.
Having said that, I consider myself a long-term investor with a healthy dose of patience. That’s why I have decided to reallocate my 3M funds into NN Group NV at an 8.3% dividend yield.
I hear you think now: again NN Group, how boring…
Yes, you are right! Actually, dividend growth investing is supposed to be boring and that’s what makes this investing style so difficult.
In my opinion, the stock market is like a candy store and there are so many interesting stocks available to us. That’s why it’s so easy to get caught up in the moment and slip away from your core investment strategy.
I have learned and I’m still learning to embrace boredom as part of my investment strategy.
But let’s get back to NN Group NV. The reason why I continue to reallocate money to them is the following:
Firstly, their dividend seems safe and it derives the points mostly for their balance sheet strength, dividend commitment, and healthy payout ratios.
Going forward, I also believe that their EPS growth numbers will look better as international expansion is one of their main growth drivers.
Secondly, I believe there is a strong margin of safety compared to their current share price.
Let me show this via 2 different valuation models.
Fair Value – Dividend Discount Model
The dividend discount model helps you estimate the intrinsic value of a company based on its future dividend prospects.
Sometimes this is an easier valuation model to value stable dividend growers because their dividend policies are all about predictability. Especially when you combine this with a quick check on their balance sheet and dividend payout numbers to assess dividend safety.
Having said that, let’s use the Gordon Growth model which assumes a constant dividend growth. The formula for that is:
P0 = D1 / (r−g)
P0 is the fair value price, D1 is the expected dividend per share next year, r is the required rate of return, and g is the constant growth rate of dividends
In other words, 2.79 / (12.5% – 6%) gives a fair value of ~43 Euro per share.
Let me repeat this in simple language, if NN Group will continue to grow their dividend by 6% on average over the next 10 years, then buying the shares for 43 Euro should provide you with a 12.5% annualized return.
The shares are trading at ~33.5 Euro right now, so there’s also a ~30% margin-of-safety in case my assumptions are wrong.
Not a bad deal, don’t you think?
Fair Value – Discounted Cash Flow
Let’s also look at it from a discounted cash flow point of view. This one is typically a bit harder to understand, but it comes down to taking a sum of all expected future free cash flows and discounting it to its value today.
Money costs money and that’s why I use a 12.5% discount rate as my personal required rate of return in this high-interest rate environment.
However, in NN Group’s case, I’m using their Net Income numbers as this is a more reliable figure than Free Cash Flow.
To understand why, Bing Chat is able to explain this very well (Long $MSFT 💪):
For calculation purposes, I’m using 1.2 billion in Net Income as a basis. This is below their 5-year average, but that’s because I expect some short-term headwinds in their bonds portfolio.
Having said that, I’m expecting a 5% net income growth in the first 5 years and 3% thereafter.
As you can see in the below stock-on-a-page overview, this gives the company a fair value of 47.5 euros per share.
To me, it’s clear that NN Group shares are quite significantly undervalued. Both the DDM model and the DCF model provide similar results.
I neither feel that my assumptions are very aggressive. To the contrary, I rather find them very conservative.
However, I’ve shared them transparently with you to allow you to judge whether you agree with this. If you don’t, please let me know, because I might have a blind spot or missed something.
Investing can lead to significant losses of capital. Hence, it’s always important to have at least a thought about what can go wrong.
In NN Group’s case, you can start by reading the risk section in its annual report, page 75. Actually, I would always recommend familiarizing yourself with those if you are considering investing money in a stock. Most often, all that can go wrong is already explained there.
Having said that, the main risk I see is that management makes poor investment decisions in their investment portfolio. There is a lot of net income sensitivity to decisions made in that section of the balance sheet.
As an example, I already mentioned that I’m expecting some headwinds as a result of their bond portfolio. This can even get worst if countries continue to increase interest rates to combat inflation.
But all in all, I consider NN Group NV a boring and stable business that will still exist 20 years from now. People simply need insurance and management has so far proven to be decent capital allocators.
Selling a stock at a loss is never easy. Especially not when it entails a dividend king with a very rich dividend growth history.
However, sometimes the writings are on the wall and that’s how I feel about 3M.
Luckily though, it’s a market of stocks and not a stock market, so there’s always another opportunity to invest. In this case, my money has been spent on NN Group.
Reallocating my money into the stock at an 8.3% yield will give me some space to buy a lower-yielding stock next time.
Stay tuned to learn whether this will be Siemens or something else 😉
That’s it from my side. Let me know what you think about my actions in the comment section below this article.
Of course, I’m also curious to learn from you and what you are doing with 3M. Are you adding, holding, or selling 3M?
And if you are selling, what are you buying for it in return?
Have a great week ahead and C U around next time!
European Dividend Growth Investor
PS: this post has been sponsored by the following people that bought me a coffee 🙏