Markets

Weather Market Volatility: A 2.3% Yielder With 35% Upside Potential

When uncertainty reigns in the global economy, you can count on stocks to be even more volatile.

That has been the case recently as investors try to simultaneously get a handle on a range of complex issues: crashing oil, possible interest rate hikes in the United States, slowing growth in China and central bank stimulus in Europe, to name a few.

By keeping investors so on edge, these and other worrisome signs of instability are clearly influencing the CBOE Volatility Index. This popular measure of investor expectations for stock market volatility during the next 30 days is often referred to as the fear index or VIX, after its ticker symbol.

As you can see, the VIX has been elevated since early December. And it's now regularly topping the historical norm of 20, suggesting investors think rougher-than-usual times are ahead.

That doesn't necessarily mean it's time to bail on the market, but a thorough portfolio review is wise at this point. Depending on your risk tolerance, consider reducing more speculative positions and make room for safer, dividend-paying stocks. A stable favorite: Automatic Data Processing, Inc. (Nasdaq: ADP ) , by far the world's largest provider of payroll and other HR outsourcing services (by revenue).

As volatility picks up, investors will increasingly flock to ADP because it's a dividend aristocrat -- a firm with a market value of $3 billion or more and at least 25 years of consecutive dividend increases. ADP easily meets that definition with a $40 billion market value and 40-straight years of dividend raises. Its payout, $1.96 a share, represents a solid 2.3% yield based on a recent stock price of $86.50.

From 2005 through 2014, ADP grew its dividend at an impressive 13% annual pace. And look for continued solid payouts in coming years for one simple reason: ADP is the go-to player in its field, servicing 80% of the companies in the Fortune 500 and processing paychecks for 1-in-6 of all U.S. workers (about 24 million).

It's the top provider of outsourced HR functions in Europe, too, serving 30,000 clients with millions of employees in the region. Globally, the firm boasts 600,000 accounts encompassing 34 million workers.

While its size is an obvious an advantage, ADP also dominates through broad expertise. Although best known for payroll processing, the firm offers services addressing everything related to employment including recruitment, benefits administration, retirement, HR management, employee communications and regulatory and tax compliance.

ADP also wisely keeps abreast of key technological trends influencing how customers would like their services delivered. For instance, 72% of ADP clients use the firm's cloud platforms. Approximately 2.5 million clients use ADP mobile applications.

This sort of one-stop shop capability encourages client retention, with the typical customer staying on board for 12 years. In 2014, retention reached an all-time high of 91.4%.

In coming years, ADP should generate overall top-line growth in the high single digits. However, analysts project continued double-digit expansion in the Professional Employer Organization ( PEO) services division, which currently accounts for 21% of revenue.

Employers, especially smaller ones, are increasingly adopting a PEO business model because it's cheaper and more convenient. When a client agrees to a PEO setup, its workers become employees of ADP, which assumes all of the HR and payroll-related tasks for those workers. The client remains in charge of the workers' daily activities, but is spared a large and costly administrative burden that ADP can handle more efficiently. ADP's fee for PEO services is typically a percentage of gross payroll.

The PEO segment has been expanding at a double-digit pace and currently generates around $2.3 billion in annual revenue. The division generates more than $200 million in annual cash flow, a figure which has also been rising at a double-digit clip.

As the leading payroll services provider, ADP could also benefit soon from what is probably a widely overlooked tailwind -- the imminent rise in short-term interest rates. Economists currently expect the Federal Reserve to start raising rates as early as June 2015.

When rates go up, ADP will start earning more interest on its substantial float, basically free short-term loans resulting from the brief lag between the time when the firm takes control of payroll money and the time when it must apply those funds to customer payroll. A mere 50-basis-point increase in ADP's yield on the float would boost operating profits by about 5%, analysts at Morningstar estimate.

ADP is well-positioned to grow the bottom line 11.6% annually, as analysts project. Such growth would boost per-share profits to $5.32 over the next five years.

This suggests ADP's dividend could rise about 10% annually to $3.19 during that time, assuming the firm maintains its 60% payout ratio. It also implies solid-looking 35% upside to $117 for ADP's stock, based on an earnings multiple in the historic range of 22.

Risks To Consider: Excessive dollar strength because of the European Central Bank's huge new stimulus program could force the Federal Reserve to put off raising interest rates or cancel rate hikes indefinitely, delaying or perhaps even eliminating a significant tailwind for ADP. Also, the firm's management warns that it's not yet clear how health care reform will ultimately affect the ability of the PEO business to attract and retain clients .

Action To Take --> Investors seeking shelter from risk should consider payroll and HR outsourcing giant Automatic Data Processing. Its global scale and attractive dividend should translate to greater price stability in rocky markets. Since volatility is likely to persist, consider waiting for opportunities to buy on the dip. There should be plenty throughout 2015.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.