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Characteristics of a Successful Value Investment

I will use Algonquin Power & Utilities Corp. (TSX:AQN)(NYSE:AQN) as an example to discuss potential characteristics of a successful value investment. Algonquin shares have returned about 24.7% in the last 12 months. These results beat the average market returns of 10% per year. Let’s explore why that may be the case.

Safe dividend

Not all value stocks offer a dividend, but when they do, the dividend can only boost shareholders’ overall returns. Even after the nice price appreciation, the stock still offers an above-average yield of 4.4%. This dividend is supported by the utility’s growing earnings and operating cash flow.

Growing dividend

Paying a dividend is nice, but a stock that offers a growing dividend is even better. Over time, a stock becomes more valuable to its shareholders solely by the growing income they receive.

Early in the year, Algonquin hiked its dividend per share by 10%, representing its seventh consecutive year of dividend growth. Management expects the company to grow its dividend by 10% per year through 2021. This means that without relying on price appreciation, shareholders can get a yield on cost of about 6.5% by 2021.

Good execution

Management has shown it can execute. Since 2010, it has grown the company nicely. That’s why Algonquin started offering a growing dividend to increase shareholder value.

Its recent achievements include the successful acquisition of Empire, a regulated electric, gas, and water utility serving customers in four states: Missouri, Kansas, Oklahoma, and Arkansas. So, Algonquin now serves about 780,000 customers and has a net capacity of more than 1,400 MW for its ~263,000 electric customers.

In Q1, Algonquin had some wind and solar facilities come into service. As a result, the utility now has over 1,500 MW of renewable power-generating capacity, of which 88% have long-term power-purchase agreements with a weighted average term of 16 years remaining.

Reasonable valuation

Management does its part by running the company well. Then it’s up to investors to buy at a reasonable valuation. If they overpay for the shares, it’ll take time for earnings and cash flows to catch up.

At about $14 per share, Algonquin trades at roughly a price-to-cash-flow multiple of 11, which is still reasonable for its growth potential.

Share price cooperation

If management continues to execute, shares should continue on a steady climb, barring any major market corrections. However, no one can guarantee that share prices will cooperate.

For a stable utility, such as Algonquin, I think it will. Since 2010, Algonquin shares have delivered total returns of 313%, or annualized returns of 21.1%. This more or less matches its 12-month returns.

One last characteristic

Typically, smaller companies have a better chance of outperforming their bigger peers, given the former group has good management and shareholders pay a reasonable valuation for the shares.

A $500 million company can more easily double to $1 billion than for a $5 billion company to double to $10 billion. Algonquin is categorized as a mid-cap utility, and it will have higher growth potential than large-cap utilities.

Is Algonquin a good buy now?

There’s no margin of safety in Algonquin’s shares. However, it’s reasonably priced. Investors looking for a stable, growing dividend can consider buying some shares now or wait to add on any dips.

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*returns as of 5/30/17

Fool contributor Kay Ng owns shares of ALGONQUIN POWER AND UTILITIES CORP.

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