In this issue, I present my overall outlook on the investment climate and the economy. I also add two new stocks to the portfolio and give updates on our existing stocks.
Cabot Benjamin Graham Value Investor 280
Benjamin Graham is called The Father of Value Investing. His influence has inspired many successful investors, including Warren Buffett.
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In the last issue, we started with the thesis that the upside potential from investing in stocks is getting increasingly constrained due to the elevated valuation of the market. However, there’s still ample room for growth due to the prevailing low interest rates, as illustrated in the two charts below.
The first graph shows the striking correlation between the 10-year treasury yield and the S&P 500 earnings yield (which is the inverse of price to earnings ratio). And the second graph shows the historical multiples of earnings yield to bond yield.
You’ll note in the second graph that we’ve seen an unusual spike in the earnings yield-to-bond yield multiple since 2010, reaching a peak of 3.41x in 2012, driven by the historically low interest rates since the global recession. This extreme multiple has been normalizing as stock valuations rise and interest rates stabilize. Currently, the earnings yield of S&P 500 is around 4%, and the bond yield is 2.33%, giving an earning yield-to-bond yield multiple of 1.7x.
At this point, I think interest rates will rise and that S&P 500 earnings are likely to grow with GDP and inflation, coupled with the proposed lower tax rate—providing ample room for the market to adjust itself in either direction.
In a nutshell, there is no need to panic. Although the market’s valuation based on a single metric like price-to-earnings ratio may sound alarming, such a myopic viewpoint based on a single matrix would lead us to wrong conclusions. It is not a surprise that the bull market has continued since the recession. In fact, if the liberal monetary policies of the Fed continue, the current bull market may continue for a while yet.
Despite our optimism, I will continue to use high standards in my analysis. Using reasonable diversification is essential to safeguard your portfolio from a downturn. For further details on diversification, please read “Diversification from a Value Investing Standpoint” here.
“... you measure everything against interest rates, basically, and interest rates act like gravity on valuation.” — Warren Buffett
Economic and Market Update
Since the October Issue, we have seen overall positive economic data in the U.S. GDP expanded 3% in the third quarter of 2017, beating the market’s expectation of 2.5%. The inflation rate increased to 2.2% year-over-year in September, led by 10.1% year-over-year increase in energy prices due to the hurricane-related production disruption in the Gulf Coast. The unemployment rate fell to 4.2%, with the private sector hiring 235,000 workers in October. More importantly, the household savings rate decreased to 3.1% in September from 3.6% in August—the lowest savings rate since the global recession—indicating strong consumer confidence.
We have some great news for housing construction market as well, with continued seasonally-adjusted growth in the sale of single-family houses (667,000) and previously-owned houses (5.39 million). The S&P Case-Shiller composite home price index rose 5.9% year over year, nearing its all-time high at the peak of the housing bubble in July 2006. Our recommendation of Toll Brothers (TOL) has seen some great momentum, but increasing consolidation among large players, especially the latest news of the merger between Lennar Group and CatAlantic Group, could create some pricing pressure on smaller players like Toll Brothers.
On the flip side, there have been a couple of yellow flags popping up in auto manufacturing, which could hurt the top-line growth of Magna International (MGA) and Gentex (GNTX). We have yet to conclude whether the reduction in light vehicle production is due to an attempt by automakers to reduce excess inventories or an actual demand shortage.
On the monetary side, the Fed held interest rates steady at 1% to 1.25%. In the U.K., the Bank of England raised its interest rate by 25 basis points to 0.5%—its first rate hike in a decade as the inflation rate stood above 2% for eight straight months.
The S&P 500 is 1.5% up in the past month, mainly due to a 4% increase in the Technology sector, followed by Basic Materials (+2.6%) and Utility (+2.2%). The Healthcare sector performed the worst, down -1.9%, mainly led by a big decline in Biotech (-10%). Fortunately, we had exited Celgene (CELG) and sold part of our Allergen (AGN) shares. However, we are still exposed to Gilead (GILD), though our exposure is based on its current bargain price relative to its free cash flow and a long-term bet on its terrific management.
With the economy in good shape, I have a stable outlook on the market.
New Buy Recommendations
This month, I present two new stocks. The first, Discovery Communications (DISCA), is available at a low price due to the ongoing concern of cord cutting. I selected the second, Signet Jewelers (SIG), based on its strategic initiatives, customers preference for brick and mortar stores over e-tailers, and low stock price.
Discovery Communications (DISCA: 17.10)
Discovery Communications (DISCA) is a significantly undervalued stock with conservative growth prospects. The company is a global media company that provides contents such as Discovery, TLC, Animal Planet and The History Channel across multiple distribution platforms. In 2016, revenue from U.S. networks and international networks were $3.28 billion and $3.04 billion, respectively.
Discovery’s two main revenue streams are distribution revenue and advertising revenue. Distribution revenues include affiliate fees charged to the distributors (cable, DTH and telecommunication service providers) of Discovery’s television network’s first-run content, and digital distribution fees charged to digital distributors for licensed contents that was previously distributed to Discovery’s television networks. Advertising revenue came from ads sold in its television networks and digital products. The two graphs show segment-wise revenue and operating profit margin since 2009.
As you’ll note, U.S. Distribution, International Distribution and U.S. Advertising have been steadily increasing, while there was some recent setback in International Advertising revenue though it seems to be recovering in 2017. The operating margin in the U.S has been around 50% to 60%, while the margin from international had dwindled from 40% in 2002 to 20% in 2016, primarily due to increasing sports content costs in Europe. That said, I’m assuming a conservative 2%-3% long-term growth in Discovery’s earnings without accounting for the synergies that will be achieved by its acquisition of Scripps Networks Interactive.
Discovery will acquire Scripps Networks Interactive for $14.6 billion. Scripps provides lifestyle and interactive content on channels like Food Network, HGTV, Travel Channel, DIY Network, the Cooking Channel and Great American Country. Scripps’ annual revenue was $3.4 billion in 2016, with a net profit margin of around 20%. Discovery and Scripps anticipates the merger to provide a $350 million in cost synergy and international exposure to Scripps’ female audience-targeted contents. The combined firm will also allow for better bargaining power with advertisers and distributors due to its sheer size.
I believe that Discovery’s $14.6 billion offer was at a considerable premium. However, the premium will be offset by the significant bargain in Discovery’s stock. The current market undervaluation of DISCA is a result of ongoing concerns on cord cutting and emerging competition from internet-based content providers like Netflix, Amazon, Hulu and YouTube. Even after these considerations, Discovery is a bargain considering its stable and attractive free cash flow, and I foresee stable growth for the company and expect the market to appraise the stock at a reasonable valuation in the future. BUY.
Signet Jewelers (SIG: 67.29)
Signet Jewelers is the world’s largest retailer of diamond jewelry, with retail stores in the U.S., U.K. and Canada. As of January 2017, the company has 3,682 stores located in malls and off-malls principally as Kay Jewelers, Jared, Zales Jewelry, Piercing Pagoda, H. Samuel and Ernest Jones. Signet Jewelers is focused on the middle market with product price points from $50 to $10,000. This market accounts for around half of the $41 billion U.S. market. Signet acquired Zales Corporation for $1.4 billion in 2014, which increased the company’s market share from 9.7% in 2013 to 15.2% in 2017.
Diamond specialty retailers like Signet have experienced increasing competition from supercenters like Walmart and online stores. However, according to a survey by WeddingWire in 2013, around 47.7% of engagement rings were purchased from jewelry chain stores and only 6.5% from online retailers, indicating that diamond retailing is one of those retail business which is not significantly threatened by e-commerce websites like Amazon. Customer experience and expert advice in specialty retail stores is a major factor for consumers’ preference for brick and mortar specialty retailers.
The retail jewelry industry is highly fragmented, with the top three players accounting for only 21% of market share. Currently Signet, Tiffany and Berkshire Hathaway’s subsidiaries, Ben Bridge Jeweler, Borsheims Fine Jewelry and Helzberg Diamonds, are the leading competitors in the space. As consolidation in the industry increases, competition will increase among the large players. And as disposable income continues to rise, diamond retail sales will see reasonable growth in the future.
The sheer size of the company helps Signet increase its bargaining power with suppliers, direct diamond contracts with mining companies and better visibility through its nationwide retail chains and TV advertisements. The company is planning to outsource its capital-intensive in-house credit program for a premium to private-label credit card provider ADS, which will help Signet retain more cash. Signet plans to distribute 70% to 80% of free cash flows in the form of dividends and buybacks.
Credit quality of receivables is a risk not to be ignored. However, considering management’s recent strategic initiatives to outsource the in-house credit business and close Zales’ underperforming in-mall stores will yield better margins in the coming years.
Signet’s current revenue of $6.26 billion and net profit of $325 million is expected to grow conservatively at around 5% anually over the long term. With a current valuation of nine times earnings and an expected free cash flow yield of 10%, the company is a bargain for long-term investment. BUY.
Prudent Portfolio
Stocks in the Prudent Portfolio are ranked based on various factors, including the prospect of appreciation, maximum downside risk and expected annualized yield. I suggest that you allocate more capital to the stocks with the better rankings.
Updates on Current Recommendations
Current Buys
Magna International (MGA: 53.40)
Magna International is a global auto supplier that designs and manufactures automotive systems and parts. The company also assembles complete vehicles for OEMs (original equipment manufacturers). Magna has 317 manufacturing plants worldwide. Magna’s revenue grew 12% and cash flow grew 20% annually over the past five years. I expect revenue to grow at 8% in the long term with a net profit margin of 5.6%. With a current price-to-earnings ratio of 9, MGA is a good bargain. Uncertainty in NAFTA agreement could be a concern because Magna is a Canadian company. However, out of 149 manufacturing facilities, 55 are in U.S. while only 50 are in Canada and 30 are in Mexico. Out of 27 development and sales centers, 13 are in the U.S., one is in Mexico and 11 are in Canada. So Magna has a significant presence in U.S. and its presence in the Asian market is rising at a much faster rate than in North America—which will provide some cushion in case there’s a revamp of NAFTA.
In the grand scheme of how the auto industry is moving, I think the industry will become very commoditized when self-driving cars penetrate the ride-sharing space. In other words, brands would matter less, and tech companies may outsource to Magna to build complete vehicles. BUY.
Williams-Sonoma (WSM: 48.30)
William-Sonoma is a specialty retailer of kitchen and home products with an established e-commerce and retail business. The company has almost no long-term debt and a clean balance sheet. Its Pottery Barn line sales are slightly declining, while its other brands like Williams Sonoma, West-Elm and Rejuvenation are growing strongly. The stock is trading at a historically low price-to-earnings ratio and is reasonably priced compared to its healthy free cash flow. BUY.
Updates on Other Stocks
In the October issue, in an attempt to consolidate the Value and Enterprise models into the more focused Prudent Portfolio model, I recommended selling many stocks. Some of the stocks have since fared well, while others had sharp declines, notably Celgene (CELG -26%), GNC Holdings (GNC -25%) and Priceline (PCLN -15%). Sometimes, not losing is winning!
Allergan (AGN)
Allergan experienced a setback when a Federal judge ruled against the company’s plan to use Native American sovereignty to protect six patents associated with its blockbuster dry eye drug, Restasis. The new court decision will clear the way for generic manufacturers to produce drugs similar to Restasis at much lower cost. Restasis contributes around 9% of Allergan’s $15 billion sales, and due to the drug’s relatively higher profit margin, Restasis contributes around 15% to the bottom line. Should Allergan’s appeal to the Federal Court not succeed, I expect near- and long-term competition from generic drug manufacturers. In the worst case, there would be a $1.5B hole in two years’ revenue due to the disappearance of Restasis. I recommended that you sell a portion of AGN on October 19, and reiterate that advice now. SELL.
Alliance Resource Partners (ARLP)
Total revenue was down 17.9% year-over-year to $453.2 million, due to adverse geological conditions encountered at the Hamilton mine, leading to a 9.1% decline in the average price to $45.12 per ton and a 31.8% decline in net income to $61.3. Year-over-year cash distribution increased 15.4% to $0.505 per unit. Potential export revenue, particularly to India and Europe, could improve the top line in the long run. Note that ARLP pays a dividend yielding close to 10% with good distribution coverage. HOLD.
Alphabet (GOOG)
Alphabet reported third-quarter revenue of $27.8 billion, up 24% from last year. Operating income was up 35% to $7.8 billion, led by a lower rate of increase in operating expenses of 11%. Cash is at $100.1 billion, with around 60% of it is overseas. Traffic acquisition cost (TAC) was $5.5 billion, up 32% from last year indicating that TAC in high growth mobile advertising is higher than the rest of the advertising platforms. Subscription-based YouTube Red and YouTube TV are seeing rapid growth, further strengthening the profit from other revenues, which include hardware, cloud and play, to $3.4 billion, 40% year-over-year growth. Under advertising revenue of $24 billion (+21%), revenue from Google-owned websites was $19.7 billion (+23%), and $4.3 billion (+16%) from network members. Such a disparity in growth between the advertisement revenue growth in Google-owned websites and network members may indicate increasing competition by other ad services. Should Alphabet’s other bets like Waymo realize, the stock could be highly undervalued, otherwise, it seems fairly valued. Adding the speculative element with the expected growth in Asia-Pacific and the Americas, GOOG appears undervalued. HOLD.
Biogen (BIIB)
Biogen reported quarterly revenue growth of 13% to $3 billion excluding Hemophilia, which was spun off last year, with a diluted EPS of $5.79, a 23% increase over the prior year. Biogen partnered with Elsai to jointly develop and commercialize Aducanumab, an Amyloid-related immunotherapy drug for Alzheimer’s disease which is in Phase 3 trials. Multiple sclerosis (MS) sales stood at $2.3 billion, with $1 billion revenue contributed by oral MS prescription drug TECFIDERA. Under Spinal Muscular Atrophy, SPINRAZA enjoyed robust growth to $271 million, led by its launch in global markets. Biogen also recorded healthy growth in biosimilar products from $31 million in Q3 2016 to $101 million in Q3 2017. Sales of TECFIDERA and Tysabri seem to have plateaued with hopes remaining on the FDA approval of Aducanumab. In the near future, there’s still room for growth for SPINRAZA with expected annual sales of $1.5 to $2 billion. There seems to have been no immediate impact on the top line from Biogen’s Parkinson’s and other neuroimmunology/neuromuscular disorder drugs, which are in Phase 1 and Phase 2 trials. Although Biogen looks cheap compared to its historical price-to-earnings ratios, there is a fear that market will value it at a lower price-to-earnings ratio due to less promising growth expectations. I recommended selling a portion in October, and now I am recommending to sell the rest. SELL.
Blackstone (BX)
Blackstone’s third-quarter earnings climbed to $384 million from $313 million, due to increased interest on private equity funds by institutional investors. EPS beat the street estimates by a wide margin. Assets under management (AUM) rose to $387.4 billion from $361 billion a year earlier. Importantly, performance-based fees rose 33% this quarter. Blackstone’s infrastructure fund has got additional traction from a $20 billion infusion from Saudi Arabia’s Public Investment Fund. I recommend that you hold this stock. HOLD.
EQM (EQT Midstream Partners)
EQT Midstream Partners reported a third-quarter EBITDA of $170 million, with a distributable cash flow of $150 million. $0.98 per share of cash distribution was announced, a 20% jump from Q3 2016. However, the distribution growth of EQT GP Holding (EQGP), which holds around 30% in the total partnership interest, increased to 38%. Although EQM and EQGP look attractive with a reasonable credit rating and high return on invested capital, I’m worried about the ongoing support from parent EQT Corporation (EQT), which is likely to take over Rice Energy (RICE) by the end of this year. Downward pressure on natural gas prices would likely affect the credit quality of EQT (and RICE), at which stage the pricing pressure from EQM’s parent will push the margins of EQM lower. On paper, this is not likely to happen because most of the revenue is from capacity reservation charges from long-term contracts. However, the terms of the agreements will likely change due to their shared management interests. Its structural complexity as a two-tiered MLP further adds to the uncertainty of making a sound value-based decision. SELL.
Gentex (GNTX)
Gentex released its third-quarter earnings which were in line with Wall Street estimates. However, the price has declined nearly 5% this month, mainly due to a decrease in sales in North America and management’s reduced growth forecasts. Sales of its rear view mirrors were down 7% in North America because of an 8% quarter-over-quarter decrease in light vehicle production in North America. The reduction in light vehicle production could be a result of an attempt by automakers to reduce excess inventories or a cyclical demand shortage. However, the drop in North American sales was offset by a 12% increase in international sales of its rear view mirrors and a 6% increase in sales of other products. Gentex’s full-display mirrors are getting an overwhelming response from OEMs but Wall Street is skeptical about Gentex’s competitive advantage in the full-display category.
I believe Gentex will be able to continue to maintain its monopoly in the rear view mirror category because of its in-depth market penetration and strategic R&D. I would hold this stock and patiently wait until Wall Street gives it a proper appraisal. HOLD.
Gilead Sciences (GILD)
Gilead’s Yescarta is approved in the U.S. for adult patients with lymphoma, and Solvadi is approved for hepatitis C (HCV) in China, where 10 million people are estimated to be living with HCV. Quarterly revenue is down 13% from $7.5 billion to $6.5 billion year-over-year, while diluted EPS is down 17% from $2.75 per share to $2.27 per share. This is primarily due to a 34% year-over-year fall in revenue in HCV sales. HIV drugs Genvoya, Odefsey and Descovy have had good growth of 14% to $1.6 billion of the total $3.6 billion in HIV Sales. There’s still room for growth in the HIV category as HIV diagnosis improves, but stiff competition in the HCV space will add pressure to Gilead unless the decline in the HCV drug sales is offset by growth in Kite Pharma’s Yescarta or Galapagos’ filgotinib (if Gilead successfully acquires Galapagos). This stock is not a conventional value stock, as there are a lot of uncertainties in its ability to increase revenue in future. The company has around $13 billion in free cash flow now and it could erode to $10 billion in five years due to the loss of HCV market share. At the current market cap of $94 billion, it’s reasonable to hold with the hope of additional cash flow from Galapagos or other strategic acquisitions.HOLD.
LKQ Corporation (LKQ)
LKQ Corporation reported Q3 2017 revenue of $2.4 billion, an 11.7% increase from Q3 2016, driven by 4% organic growth and ongoing acquisitions (+6.5%) especially in Europe, and favorable foreign exchange gains (+1.2%). Income from continued operations increased to $122 million compared to $110 million in Q3 2016. Expansion in North America seems to have become saturated, but there is sufficient room for top-line growth in Europe. I foresee overall profit margin pressure as growth is driven by relatively less profitable business in Europe than in North America. The current valuation would not be justified unless the EPS growth stays at around 18%, which is doubtful based on its recent trend. I maintain my previous recommendation to SELL A PORTION.
Spectra Energy Partners (SEP)
Spectra Energy is another MLP like EQM (which we sold last week) and ARLP (which we currently hold). Spectra is involved in transportation and storage of natural gas liquids, natural gas and crude oil through interstate pipeline systems. Continued high capital expenditures funded by heavy borrowing resulted in negative free cash flows for the past few years and is expected to continue. Although the distribution coverage ratio is good, distribution growth is only around 5%, with the current dividend yield of 7%. In light of the possibility of interest rate hikes, I would be a bit conservative on this stock. Sell after the ex-dividend date of November 10. SELL.
Stifel Financial (SF)
Net revenue increased 12% year-over-year to $721 million, driven by investment banking and asset management fees which were partially offset by a reduction in brokerage fees. Net interest income almost doubled to $100 million, driven by higher net interest margin. Stifel, with its strong book value growth, stays attractive even at reasonable growth expectations. HOLD.
T. Rowe Price Group (TROW)
T. Rowe Price reported net revenue of $1.2 billion, an increase of 11.8%, with a net profit of $390 million, an increase of 19.2% from the Q3 2016. The average assets under management (AUM) increased 15.4% to $927.4 billion. In the past three months, the company received an inflow of $6.5 billion to its bonds, money market and stable value accounts, while $600 million flowed from its stock accounts. The net inflow of $5.9 billion was the highest inflow since the first quarter of 2014. However, capital appreciation in equity portfolios seems to have boosted total AUM. Blackrock (BLK) seems to be sucking most of the money from the market with its passive funds, leading to stiff competition for mutual fund managers like T. Rowe to attract capital and fees. HOLD.
Ulta Beauty (ULTA)
In last quarter, ULTA’s net sales increased 20% and EPS increased 28%, with strong growth in e-commerce sales. However, its valuation of 26 times earning and a very low free cash flow yield makes it hard to be considered as a Ben Graham style value stock. I like the business model of Ulta and its unique audience. However, even with a high long-term growth expectation, I find it hard to include as a fairly valued company. I may reconsider this stock later. SELL.
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THE NEXT CABOT BENJAMIN GRAHAM VALUE INVESTOR WILL BE PUBLISHED DECEMBER 14, 2017
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