Tuesday, April 3, 2018

Recent Sell: Northrop Grumman

In my latest Pulse article, I presented a yield channel chart of Northrop Grumman (NOC) that clearly shows that the stock is trading at an overvalued yield when looking at historical yield patterns.

Furthermore, NOC is trading at a 30% premium to my fair value estimate and yields only 1.3% at $349.12 per share. The stock's premium price is one reason that it is ranked #32 of 47 dividend growth (DG) stocks in my portfolio.

As one of my home run stocks, it is tough to sell NOC when it is performing so well, but my yield channel chart suggests that now is a good time to do so. This article presents a short summary of the trades and dividends received as well as a net profit analysis.

Yield Channel Analysis

Yield Channel Charts provide a tool for dividend growth investors to assess market valuation relative to historical yield patterns.

Yield channels can be seen as safety zones for stock prices. As long as the stock price stays in the yield channel, the stock is fairly valued. If the stock price moves outside the yield channel to the upside, the stock is overvalued and the yield is low, historically. Conversely, if the stock price moves outside the yield channel to the downside, the stock is undervalued and the yield is high, historically.

The following yield channel chart shows that NOC is trading at overvalued yield levels:

The chart is an updated version of the one I published in the March Pulse article. I now use a log scale and I include an overlay of the 5-year undervalued yield as a dotted line. I think the overlay is quite useful, as it shows the tighter yield channel that results from a shorter history of yields. (The 5-year overvalued yield is very close to the 9-year overvalued yield, so it is less useful to include).

It is pretty evident that NOC is trading at overvalued yield levels. The stock yields 1.3% at $349.12 per share. I think the capital I'm freeing up by closing my NOC position can be invested more effectively elsewhere.

Other Considerations

My latest fair value analysis indicated that NOC is trading at a premium of about 30%. The stock ranked #32 of 47 DG stocks in my DivGro portfolio and earns a 4-star rating:
The stock's relatively poor ranking is mostly due to its premium price. However, as noted in my latest Pulse article, there are a few additional concerns. NOC has uncomfortable debt levels and a rather high price to book ratio, while the company's latest quarterly EPS dropped 8% from the prior quarter.

A recent article argues that NOC is a highly cyclical company that could lose a lot of value in the event of a downturn. Given the congressional budget deal that recently increased defense spending, it is not clear that the defense sector would experience a downturn anytime soon. From that perspective, selling now may not be the smartest move. But I'm long General Dynamics (GD), Lockheed Martin (LMT), and Raytheon (RTN), which provides ample exposure to the defense sector.

Finally, in selling NOC I'm not saying the stock isn't a quality dividend growth stock anymore. I do think that NOC is trading at a significant premium, though, especially relative to the other defense stocks in my portfolio.

Trade Summary

I transferred NOC to DivGro in 2016 as part of a consolidation process. The stock has performed exceptionally well and became DivGro's ninth home run stock in October 2017. The following five-year price chart shows my buy prices and average cost basis of $152.50:

Here is a summary of trades and dividends, along with a net profit analysis:

2014-01-03  Bought 8 shares of NOC at $114.06 per share:$912.48
2014-03-19Dividend on 8 shares at 61¢ per share:$4.88
2014-06-18Dividend on 8 shares at 70¢ per share:$5.60
2014-09-17Dividend on 8 shares at 70¢ per share:$5.60
2014-12-17Dividend on 8 shares at 70¢ per share:$5.60
2015-03-18Dividend on 8 shares at 70¢ per share:$5.60
2015-06-17Dividend on 8 shares at 80¢ per share:$6.40
2015-09-16Dividend on 8 shares at 80¢ per share:$6.40
2015-12-16Dividend on 8 shares at 80¢ per share:$6.40
2016-02-19Bought 8 shares of NOC at $190.93 per share:$1,527.44
2016-03-16Dividend on 16 shares at 80¢ per share:$12.80
2016-06-22Dividend on 16 shares at 90¢ per share:$14.40
2016-09-14Dividend on 16 shares at 90¢ per share:$14.40
2016-12-21Dividend on 16 shares at 90¢ per share:$14.40
2017-03-22Dividend on 16 shares at 90¢ per share:$14.40
2017-06-21Dividend on 16 shares at $1.05¢ per share:$16.00
2017-09-13Dividend on 16 shares at $1.05¢ per share:$16.00
2017-12-20Dividend on 16 shares at $1.05¢ per share:$16.00
2018-03-21Dividend on 16 shares at $1.10¢ per share:$17.60
2016-03-28Sold 16 shares of NOC at $342.49 per share:$5,479.76
Capital Gain: $3,039.85

Dividends Received:$182.48
Commissions/Fees/Taxes: $0.00
Net Gain: $3,222.32

I made a net gain of 132% on the original amount invested, which is a gain of 46% annualized.

Closing my NOC position reduced DivGro's projected annual dividend income by $70.

Concluding Remarks

I'm very happy with NOC's performance and the fact that my investment returned 46% on an annualized basis. While I'm a little sad to close one of my home run stocks, I believe doing so while the stock is trading at a significant premium to fair value is a good move.

With NOC yielding only 1.3%, it shouldn't be hard to deploy the capital I'm freeing up in a way that would increase DivGro's yield. But the total returns that NOC delivered in four years will be hard to beat!
    What do you think of this sell? Do you think basing sell decisions on yield channels is a sound investment strategy? Please share your thoughts in the comments section below.


    1. i like the sell. NOC is very much overvalued like you mentioned

      1. Thanks, Fiscal Voyage -- we'll see how it goes. Maybe I'll buy back the stock when it goes to undervalued yield levels sometime in the future.


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