Barron’s recently held its 2019 Roundtable, a gathering of 10 of Wall Street’s smartest investors. Here are the stock picks of Scott Black, founder and president of Delphi Management in Boston.
Q: What appeals to you this year, Scott?
Scott Black: We like companies with sustainable earning power, high returns on equity, strong free cash flow, and low valuations. Value investing has done poorly in recent years. Since 2007, large-cap and growth stocks have outperformed mid- and small-caps and value by a large amount. If you stick to the basics, as Benjamin Graham used to say, value will out. I am recommending five companies that should do well, even if the economy slows.
Banks are out of favor, but we like U.S. Bancorp (USB), headquartered in Minneapolis. It is probably the best-run large U.S. bank. The stock closed Friday [Jan. 4] at $46.83. There are 1.62 billion fully diluted shares, and the market cap is $75.9 billion. The company pays a dividend of $1.48 a share, for a 3.2% yield. We do our own earnings models. Revenue should be up about 3.5% this year. Provisions for loan losses are forecast at $1.4 billion. We estimate that U.S. Bancorp will earn about $4.45 a share, up from about $4.10 in 2018. My estimate exceeds the consensus forecast by about a nickel a share. [On Jan. 16, USB reported 2018 EPS of $4.14.]
U.S. Bancorp is the only major bank with a return on equity above 15%. ROE was 15.2% in the latest quarter. It also has the highest return on assets of any major bank, at a recent 1.54%. Net interest margins have been fairly consistent in the past five or six quarters, around 3.15%. Most banks depend on loans; one of the nice things about this bank is that a high percentage–42%–of its revenue is non-interest income.
Q: What are U.S. Bancorp’s major business lines?
Black: There are four: commercial real estate, residential mortgages, credit cards, and other retail banking. Non-interest-bearing deposits are 23% of the total. The company operates in 25 states, and has 3,100 branches. Since 2014, earnings have compounded at 7.5% a year. The stock is selling at 10.5 times our 2019 earnings estimate, and return on equity will be about 14.7% this year. Management would like to get ROE closer to 17% over time, but that is hard to do in this environment. Loans-to-deposit growth is 85%, which means the bank doesn’t have to get wholesale funds to fund its balance sheet. Its securities portfolio is bulletproof, consisting of about $46 billion of hold-to-maturity U.S. Treasuries and government-agency debt. If interest rates go up, U.S. Bancorp will benefit.
I don’t normally recommend pharmaceutical companies, but AbbVie (ABBV) is my next pick. Humira, which is advertised heavily on TV, is a $20 billion-a-year drug, representing 62% of AbbVie’s annual revenue. The stock closed Friday at $89.07. There are 1.5 billion fully diluted shares, the market cap is $134 billion.The dividend is $4.28 a share, and the shares yield 4.8%.
Q: Why does the company advertise Humira so heavily? Wouldn’t doctors already know about it?
Black: Not necessarily. AbbVie wants to create demand because it is a $63,500-a-year drug.
Mario Gabelli: It also has 80% profit margins.
Oscar Schafer: And biologic competitors are coming.
Black: That’s why the stock is so cheap. Humira is used to treat rheumatoid arthritis, Crohn’s disease, ulcerative colitis, and psoriasis. The patient injects it every two weeks. Checking online, the price is about $4,900 per two-needle package at CVS and Walgreen.
Q: Is it covered by insurance?
Black: Sometimes, but not always. AbbVie likely earned $7.95 a share last year, against $5.60 the year before, on a 16% increase in revenue. We expect revenue to rise only 3% this year, to $33.7 billion, while earnings increase 10%, to $8.75 a share. Based on the company’s strategic plan, announced in 2015, management wants to grow annual earnings by about 10% per annum through 2020, and launch more than 20 new products, generating profit margins of close to 50%. Margins are near 40% at this point.
Q: How many new products come from internal research, versus acquisitions?
Black: They are all from internal research and development. Products in the pipeline include Elajolix for treatment of endometriosis, and new drugs for rheumatoid arthritis and psoriasis coming in 2021 to ’23. You might also know Imbruvica, a heavily advertised treatment for non-Hodgkin’s lymphoma. Novartis (NVS) and Amgen (AMGN) are working on biosimilars. In the U.S., Imbruvica has patent protection until 2027. AbbVie generated $9.5 billion in free cash flow in the nine months ended Sept. 30. Net income was $7.5 billion. The company has an authorization to buy back $6.5 billion worth of shares.
Q: Many big pharma companies are buying smaller companies to accelerate drug development and growth. Would AbbVie be interested in doing deals?
Black: It looks like they are going to focus on internal development.
My next stock is controversial. Just kidding; it’s Walt Disney (DIS). The stock closed Friday at $109.61. The market cap is $164 billion, and the dividend is $1.76 a share, for a yield of 1.6%. Disney expects total revenue to rise just 2.5%, to $60.9 billion, in the fiscal year ending next Sept. 30. Earnings will be essentially flat at $7.15 a share, against $7.08 last year. These numbers don’t include the acquisition of 21st Century Fox’s (FOXA) entertainment assets, for which Disney paid $71.3 billion, plus assumption of debt.
Return on equity is a high 28%. In fiscal 2018, Disney generated $9.8 billion in free cash flow and $13 billion in net income. Last year was the first in years in which Disney’s parks and studios did better than its media businesses. Parks and studios generated $7.449 billion in operating income, versus $6.625 billion for media. Traditional media companies are losing subscribers as people cut the cable TV cord. ESPN and the Disney Channel have each lost more than 2 million subscribers. Still, ESPN has 86 million subs and the Disney Channel, 89 million. The company recently launched the ESPN+ paid streaming service and signed up more than a million people. Disney has great content. Its movie business produced $10 billion of revenue last fiscal year.
Gabelli: Disney had a 26% market share in the U.S.—much bigger than No. 2-ranked Warner Brothers—and Disney makes only 10 or 11 movies a year.
Black: Disney has The Lion King, Frozen, Toy Story, Star Wars, and many other movie franchises. They know how to ring the cash register, and they’re great at cross-licensing products, including toys and theme-park attractions. Netflix (NFLX) can’t replicate Disney’s franchises.
Henry Ellenbogen: Scott, Netflix will spend $10 billion this year on content, and a lot of Netflix viewership is TV series. You’re focusing on market share in movies, but to have staying power in TV, companies will have to invest aggressively in content.
Rupal Bhansali: Netflix is investing with borrowed money, and doing so because Disney is pulling its content off Netflix as it launches its own streaming media service. Netflix’s move is defensive, not offensive. It isn’t a choice, but a necessity.
Black: After the Fox deal closes, Disney will have a net-debt-to-equity ratio of about 58%. The company is leveraged, but the debt isn’t monstrously high. As an investor, you have to be patient, while [CEO Robert] Iger moves forward with his strategy. In the past four years, earnings have grown by an average 13.1% per annum, yet the stock is down from about $119 to $109.
My next company is defense contractor Lockheed Martin (LMT). Production of the F-35 fighter plane is ramping up in a big way; the company delivered 91 last year and will make more than 130 this year. Lockheed closed Friday at $265.04. The market cap is $75.8 billion. Revenue came in around $53 billion last year, and earnings per share were around $17.55. The company has guided for top-line growth of 5%-6% this year; our estimate is $56.2 billion. Operating profit margins are around 10.7%. Our earnings estimate for this year is $19.65 a share, which means the stock trades for 13.5 times earnings. Return on capital is about 40%, and the company has a stock-buyback authorization of $3.5 billion. Free cash flow for the first nine months of 2018 was $4.04 billion, against $3.8 billion of net income. Over the past four years, earnings per share have compounded at 11.4% annually.
Lockheed has four main segments. Aeronautics includes the F-35, the restarted F-16, and the C130J cargo plane. Aeronautics represents 39% of revenue, with operating profit margins of about 10.7%. The missiles and fire-control business is 15% of the company, and has margins of 14.5%. Rotary and Mission Systems is the fancy name they put on the Sikorsky helicopter unit, acquired in 2015. Margins have improved dramatically since the purchase. The business contributes 27% of revenue and has operating margins of 9.5%. The fourth segment is the space division, funded mostly by the government. The business is 19% of revenue. with an 11.4% operating margin. The company generates a ton of cash and yields 3.3%. You get paid while you wait for the stock to rise.
Abby Joseph Cohen: Rep. Adam Smith is the incoming chairman of the House Armed Services Committee. He has been supportive of increases in the defense budget, especially those aimed at personnel and advanced technologies such as cyber-defense, space, and green awareness.
Q: Scott, when you looked at Lockheed, did you also consider Raytheon (RTN)?
Black: Yes, but two divisions had no earnings growth in the latest quarter; we need to find out what is going on there.
Q: Any other picks?
Black: I also like Hercules Capital (HTGC), a business-development company in Palo Alto. It provides venture growth capital to other businesses. The stock is $11.68, and the market cap is $1.13 billion. The dividend is $1.24, for a 10.6% yield. Hercules covers the dividend from cash flow, not incremental borrowing. In a typical year, about $470 million of loans are paid off, and $700 million of new loans are funded.
We expect Hercules to earn $1.37 a share this year. The price/earnings ratio is about 8.5 times. The stock trades for 1.12 times net asset value, which was $10.38 a share at the end of the third quarter. That’s the lowest multiple in years. The board just authorized a $25 million stock buyback. Hercules generates a 12.7% return on equity, and plans to lift that to 15% over time. Since inception, Hercules’ average annual loan writedown has been just four basis points, meaning 0.04% of loans. The company is almost bulletproof. Hercules has helped fund Facebook (FB), Pinterest, Box (BOX), and Fuze. It currently has 89 portfolio companies. The sweet spot is loans of $20 million to $30 million. The company is asset-sensitive. A rise of 25 basis points in interest rates would add four cents a share to earnings.
Q: Anything else, Scott?
A: I have two more for the faint of heart: the six-month Treasury bill, yielding 2.51%, which I recommended at the midyear Roundtable, or the one-year Treasury note. Both give you liquidity and protect your principal.
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