Note: This is a post from our weekly stock selection email published by InvestorPlace Media. If you like it – you can sign up for email alerts like this each week. We will also be publishing them on our site here.

Trade: Buy VW in the $25-28 range; maintain long term position for dividend yield or until valuation reaches 8-9x earnings.

Today’s investors have often neglected the impact dividends have on total performance over the long term. Depending on the data set being analyzed, dividends are credited with contributing between one-third to over half of the S&P’s total return since 1926. However, this is not a consistent relationship, as dividends have made up a larger share of the total return pie in challenging economic periods and relatively less in strongly expanding ones (even though the yields on an absolute basis are higher during bull markets). During strong bull markets, investors can be forgiven for turning a blind eye to dividends as the bulk of performance comes from steadily increasing share prices. But dividends are a crucial ingredient during range bound markets. And there is plenty of evidence to suggest that we may be in for a challenging environment for quite some time to come, suggesting that dividends will likely be a deciding factor in market returns when the textbooks are written on this chapter in market history.

Hence, finding quality dividend yields at good valuations is a necessary strategy when markets keep treading back on themselves and allow inflation to sneakily eat away at invested capital.

The contribution of dividend yield to total performance has been just as pronounced across the pond. Over an 86 year time frame, total European CAGR is 9.4% with only 5.0% coming from pure price returns. So dividends play as significant a role in the European slice of portfolio diversification as they do for US equity returns. And currently, the dividend yield/bond yield in Europe is near its highest ratio in over 90 years (since the 1920s).

So with dividend yields at multi-generational highs right now, it may be a good time to profit from the Euro crisis and look at picking up quality European dividend plays on the cheap. Of course, there is risk in doing so but if your time horizon is sufficiently long to ride out short term uncertainty and volatility, current dividend yields could turn out to be a boost to your long term performance.

VW: a German Powerhouse

In the US market, it is understandable if you are not overly enthusiastic about the VW brand. But take a closer look. The company that produces the rather pedestrian Jetta also makes the Bentley GT and the pavement-devouring Lamborghini Aventador. But their biggest brand has been mounting an ultra-serious challenge to German luxury rivals BMW and Mercedes Benz. Audi currently makes up over 36% of total earnings, while vehicles with the VW plating account for 25%. VW’s truck brands (MAN and Scania) make up another 13%, and financial services contribute 9%. A production run of 8+ million cars in 2011 gives VW unparalleled economies of scale and technological prowess. And the Audi/Bentley/Lamborghini trio commands a pricing power in the luxury car market that would make even Porsche blush.

Many investors feel it prudent to steer clear of any exposure to Europe until the Union can figure out how to either break up the Euro or create a fiscal and political union in addition to the monetary pact. However, waiting for either of these outcomes a) will likely require a tremendous amount of patience, and b) will forego many rewarding opportunities in the meantime that can be had with a bit of discipline and selectivity. Risks certainly remain. Europe may very well see further deepening to the recessions rippling throughout the continent and China, its largest single market, could see slower growth. But with VW trading at only 5.8x this year’s earnings, it is likely that these scenarios are already priced into the stock.

Euro Crisis Giving a Boost to VW?

It is a commonly received piece of conventional wisdom that it may be salutary for the European Union to let Greece exit and allow fiscally healthier countries to go their way without the drag of bailouts and emergency funds. What is often overlooked, however, is the value that the presence of Greece, Spain, and other debt-laden countries are bringing to Germany. Without them, the Euro would rise in value, putting brakes on Germany’s export-centric economy. This is not to say that Greece’s and Spain’s problems are a ray of shining light for Germany; but the depression of the Euro has undoubtedly been a boon to the continent’s largest economy and continues to be an important driver for its exporting companies, especially its carmakers – a silver lining that is often disregarded in the economic turmoil.

VW’s performance and valuation certainly reflects “recessionary pricing” and it will likely stay near these levels while Europe slogs through its difficulties. However, VW has also traditionally traded near 10x current year earnings. At a 42% discount to that historical average valuation, the springs are more tightly coiled toward upside potential than down.

Selling to the Right Places

VW is geographic-diversity-in-a-stock. It has a presence in virtually every country on the planet where cars are driven. And with nearly 42% of sales coming from the BRIC countries and 50% in total from emerging markets, they are well positioned to take advantage of burgeoning middle classes and expanding discretionary incomes in the most populous corners of the globe, a decided advantage with European economies suffering. (However, it should be noted that of the nearly 30% of European sales, 19.5% comes from relatively stronger and more stable northern Europe and only 10.2% from southern Europe. In comparison, 6% of sales derive from the US.)

While VW is sensitive to credit cyclicality, the market prices their debt very conservatively. The cost of VW’s CDS is only 60 bps higher than German bunds themselves with a much more attractive yield: 3.2% on 2012 dividends vs. 1.4% on the German 10 year. Financing, of course, is integral to a car manufacturer’s sales growth and this happens to be a noteworthy competitive advantage for VW as their cost of debt for financing customers is on average 400 bps below their peers.

Ideal Entry Point at Lower End of Trading Range

VW has traded between $25 and $35 for most of the last year and a half, finding consistent support in the $25-28 range. This has typically marked an attractive entry point in the stock, especially at the valuations and dividend yield previously mentioned. If VW continues to trade in this range, it will likely see a 4 – 4.4% dividend yield in 2013. With any clarity that comes out of Europe, VW should easily trade up to its $35 resistance and possibly beyond it, given its superior competitive edge, extremely strong balance sheet and cash reserves, and positioning in growth markets.

It takes some resolve to buy into a European equity here but VW stands as an example of a high quality, high dividend staple that is uncharacteristically cheap for macroeconomic reasons.

Chart courtesy Finviz. Click to open in larger window.

Additional Image Provided by John Jagerson:

This is not investment advice. Learning Markets, LLC is not responsible for errors or omissions. Please be sure to read our disclaimer.