Are you afraid of a stock-market correction or, worse, a bear market?
If so, that fear is well-grounded, as the S&P 500 (.SPX) trades for 14.2 times the consensus 2015 estimate of earnings per share, the highest since 2007, a year before the crash.
Another indicator of an overvalued market is a wave of big-time mergers and acquisitions. There have been 757 deals involving U.S. and Canadian companies announced so far this year, compared with 199 a year earlier, according to FactSet. And the value ascribed to startups is, to put it mildly, absurd. Scrap-booking startup Pinterest, which is just now starting to think about making some sales, is worth $5 billion.
Focus on investing
AT&T Inc. (T) made a big splash Sunday with its decision to pay $48.5 billion for DirecTV (DTV). The telecom giant's move to shore up a much larger TV subscriber base and boost its cash flow follows a deal by Comcast Corp. (CMCSA) in February to acquire Time Warner Cable Inc. (TWC) through a $45 billion stock swap.
Pfizer Inc. (PFE) Monday said its "final offer" for AstraZeneca PLC (AZN) had been rejected. The offer was for an astronomical $120 billion, a 15% premium.
There are other signs that a bear market is coming, but some professional investors with value-based approaches would look forward to the opportunity to make discounted plays.
David Bechtel, one of three principals of Barrow Funds, said in a telephone interview that his firm is "following a private-equity approach to investing in companies. We are not looking at them as pieces of paper to trade, but as economic ownership in businesses."
"We roll up our sleeves and look at cash flow generation and operating margins, and a company's ability and willingness to reinvest cash it generates back into its business profitably," he said. "This tells us the management team wants to do what it is doing, likes the business that it's in, and that it is a good business."
The idea behind this approach is not only to identify companies with strong cash flow, but to use the numbers to pinpoint companies that feel so strong about their prospects for growth that they are plowing most of the cash back into the business, rather than just buying back shares or increasing dividends.
The "value" element to this growth-oriented approach is Barrow's focus on "acquiring them at discounts, because we think they will return to fair value over time," Bechtel said.
The Barrow All-Cap Value Fund (BALAX) investor-class shares have performed quite well, with an average annual return of 21.7% over the past five years, compared with 19.8% for the Morningstar Large Value category and 21.2% for the S&P 500.
The Barrow All-Cap Value Fund (BALAX) is highly diversified, with 186 stocks as of March 31. Nearly 100% of the fund was invested in equity, and the top holding — Smith and Wesson Holding Corp. (SWHC) — made up only 1.5% of the portfolio.
Another buy-side investor with a completely different approach from Bechtel's is Tim Piechowski of Alpine Capital Research. Piechowski is one of three portfolio managers at the firm, which takes a more conservative approach, with an objective to "preserve capital from permanent loss during periods of economic decline while providing a return above the cost of capital and market average in the long term."
According to the company, portfolios managed by Alpine Capital Research achieved an average total return of 19.7%, net of fees, for the five years through March 31.
Piechowski, in a phone interview, said that except for client accounts managed with "long/short strategy," his firm has "a very long-term philosophy."
"Since our firm was founded in 2000, the firm has held 52 stocks. We have very low turnover (holding positions over six years on average) and try to get these numbers very well," he added.
The long portfolios managed by Alpine Capital Research at the end of March held only 20 stocks. Piechowski is leaning heavily toward large-cap stocks. "For the market as a whole, we think stock indices in the U.S. are high relative to underlying economic fundamentals," he said. Alpine Capital Research is so pessimistic about the valuation of the market that the portfolios it manages are 35% invested in cash.
Piechowski said: "We look to stocks as part ownership in a business, just like a gas station or a bakery down the street. We want to buy them inexpensively, have a good team managing them, and exit them at a good price as well."
Both fund managers emphasized this "ownership" aspect of stock selection and referred to the work of legendary value investor Benjamin Graham, who was a major influence on Berkshire Hathaway Inc. (BRK/B) founder Warren Buffett.
What follows is a breakdown of three stocks favored by Bechtel, and two by Piechowski:
Myriad Genetics Inc. (MYGN) of Salt Lake City is the top holding of the Barrow All-Cap Value Fund (BALAX). The company develops diagnostic tests to help doctors make care decisions. Some of the tests help predict the likelihood of various forms of cancer or that a patient will respond well to certain medications.
The stock closed at $37.58 Monday and is up 79% this year, following a 23% decline during 2013. The shares trade for 17.5 times the consensus fiscal 2015 EPS estimate of $2.15, among analysts polled by FactSet. The consensus 2014 EPS estimate is $2.38.
For its fiscal third quarter ended March 31, Myriad Genetics reported earnings of $36.8 million, or 48 cents a share, compared to $37.9 million, or 46 cents, a year earlier. Net income was down because of a one-time non-cash charge of $12.6 million from the acquisition of Crescendo Bioscience and a $1.2 million non-cash amortization of acquired assets. EPS rose despite the lower net income, because the company's continued buybacks have lowered the share count. Third-quarter buybacks totaled $41.9 million.
Sales per share grew by 26% to $2.40 from $1.90 a year earlier. The company also expects its revenue to grow at the same rate for all of fiscal 2014.
"It is an interesting firm with an exceptionally attractive cash flow yield," Bechtel said, adding that the year-over-year growth of sales per share has been "tremendous."
Another name favored by Bechtel is GNC Holdings Corp. (GNC) of Pittsburgh, which was founded in 1935 and operates 8,600 stores selling nutrition and diet products worldwide.
The stock closed at $37.17 Monday, down 36% this year, following a 78% return during 2013. The shares trade for 10.6 times the consensus 2015 EPS estimate of $3.50. The consensus 2014 EPS estimate is $3.06. Based on a quarterly payout of 16 cents, the shares have a dividend yield of 1.72%.
The recent weakness reflects the company's lowering of its guidance for 2014 when it reported first-quarter earnings on May 6. Earnings came in at $69.9 million, or 75 cents a share, compared to $72.6 million, or 73 cents, a year earlier. Revenue totaled $677.3 million, up 2% from $664.7 million a year earlier, but well shy of the consensus estimate of $710.4 million. Same-store sales in the U.S. were down 0.7% and "were negatively impacted by severe weather patterns in January and February," GNC said.
The company now expects 2014 EPS to range from $3.05 to $3.10, down from its initial guidance of $3.18 to $3.24 in February. GNC earned $2.85 a share during 2013. The company also expects a "mid-single-digit increase in consolidated revenue," down from its previous estimate of a "high-single-digit increase."
"In March, U.S. same-store sales were positive and exceeded the January-February period by several hundred basis points after adjusting for the Easter shift," CEO Joseph Fortunato said during the company's earnings call.
Despite the disappointing sales results, GNC generated cash flow of $1.31 a share during the first quarter, up from 96 cents a year earlier, according to FactSet. Free cash flow — cash flow less capital expenditures — was $1.18, up from 86 cents.
The recent disappointment in sales growth, poor performance of the shares and the low forward P/E ratio could signal a buying opportunity for long-term investors. According to Bechtel, the stock now has a "very attractive valuation compared to historical."
Ferro Corp. (FOE) of Mayfield Heights, Ohio, was founded in 1919 and produces specialty chemicals, including pigments, powders, performance coatings, polymer additives, porcelain and many other products used in manufacturing.
Bechtel described the firm as "a classic American industrial company," and said, "we really like their ability to generate cash flow. Those cash flow dollars can be bought inexpensively."
The stock closed at $12.44 Tuesday, down 3% this year after more than doubling in 2013. Despite last year's runup, the shares trade for a relatively low 12.1 times the consensus 2015 EPS estimate of $1.03 a share. The consensus 2014 EPS estimate is 73 cents.
Ferro reported first-quarter net income available to common shareholders of $17.2 million, or 20 cents a share, increasing from 883,000, or a penny, a year earlier. Both periods included a large number of special items, including charges for exited business lines and $4 million in restructuring and impairment charges during the first quarter, down from $9 million a year earlier.
On an adjusted basis, first-quarter earnings from continuing operations came in at $17 million, or 20 cents a share, increasing from $9 million, or 11 cents. The company expects to earn between 68 cents and 73 cents a share this year, compared to 83 cents in 2013.
J.P. Morgan Chase
J.P. Morgan Chase & Co. (JPM) is the first of two picks discussed by Tim Piechowski of Alpine Capital Research. The stock closed at $53.83 Monday, down 7% this year, following a 37% return during 2013. The company pays a quarterly dividend of 40 cents, and the shares have a yield of 2.97%.
J.P. Morgan's stock trades for 8.9 times the consensus 2015 EPS estimate of $6.04. That's the second-lowest forward P/E ratio among large-cap U.S. banks. The consensus 2014 EPS estimate is $5.43. Only Citigroup Inc. (C) is cheaper, trading for 8.5 times the consensus 2015 EPS of $5.50.
Last year was particularly difficult for J.P. Morgan Chase, with several large settlements, including $17.5 billion in fourth-quarter mortgage-backed securities settlements with various government authorities and investors. Looking ahead, the company's goal is to improve its operating performance to achieve returns on tangible common equity (ROTCE) ranging from 15% to 16%. The reported ROTCE for 2013 was 11%, but J.P. Morgan CFO Marriane Lake said during the company's fourth-quarter conference call that it would have been 15% if "significant items" had been excluded, and that it was 15% for each of the previous three years.
The company had a disappointing first quarter, with revenue down 8% from a year earlier to $28.86 billion, mainly because of weak fixed-income trading volume. The ROTCE was 13%, and expected weakness in second-quarter trading revenue makes it appear quite difficult for the company to achieve a 15% ROTCE this year.
But the stock trades more cheaply on a forward P/E basis than many other large-cap banks, with much weaker performance, including Bank of America Corp. (BAC) -0.26% , which closed at $14.67 Monday and trades for 9.6 times the consensus 2015 EPS estimate of $1.53.
"Over time, JPM should be able to grow its franchise by a couple percent each year. We would expect them to grow mostly in the asset management business going forward, and if loan demand increases, grow the loan portfolio as well," Piechowski said.
When asked if he was concerned about the weak trading revenue, Piechowski said: "Our view is trading revenues are exceptionally volatile form quarter to quarter and year to year. We are very concerned that if interest rates stay very low, there is unlikely to be a pickup in fixed-income trading volume. We discount that in our valuation."
What many investors may not realize when they see so many headlines lamenting the doom of Microsoft Corp. (MSFT) is that "today, 70% of operating income comes from Office, and servers and tools," according to Piechowski. "These are predominantly geared toward the enterprise. The consumer is not that big a driver for the company today."
Microsoft's stock closed at $39.75 Monday, returning 8% this year, following a 44% gain during 2013. The shares trade for 13.7 times the consensus 2015 EPS estimate of $2.89. The consensus 2014 EPS estimate is $2.70. With a quarterly payout of 28 cents, the shares have a dividend yield of 2.82%.
The company's sales per share have grown for each of the past 10 years, according to FactSet. Not bad for a company that has missed out on the smartphone and tablet businesses.
Some of the worry over Microsoft springs from the perception that the Microsoft Office suite of products is threatened by cheaper, or even free, rivals. But among corporate customers, there's quite a bit of "stickiness," because of the linkage between other systems and Office products. For example, if you are using FactSet, Bloomberg, Thomson Reuters or some other financial data provider, data downloads are linked to Excel. It will take plenty of time and investment for companies to make new modules available to integrate with products that compete with Excel.
Another hidden gem for Microsoft, believe it or not, is patent royalty revenue on smartphones paid by manufacturers of phones that run Google Inc.'s (GOOG) Android operating system. "If you look at the Windows Phone revenue stream, and assume it is mostly patent royalties, you can use the figures in the 10-Q to back into a an annual run rate of $2.3 billion coming from the segment," Piechowski said. "Gross margin dollars for the consumer segment are running at about $16 billion. Our opinion is that the patent revenue will continue to grow."