In this month’s issue, I introduce two new stocks, recommend selling two stocks and change one position from Buy to Hold. I’m consciously changing the portfolio into more defensive stocks to guard against inflationary fears.
Cabot Benjamin Graham Value Investor 284
Benjamin Graham is called The Father of Value Investing. His influence has inspired many successful investors, including Warren Buffett.
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As value investors, we have ample reasons to believe that investing in stocks today is not as easy as it was a few years ago. This is by and large due to three major reasons: 1) economic uncertainties due to changes in global political policies, 2) the U.S. economy nearing close to its full potential and 3) high market valuations.
One could debate forever on the merits and demerits of the current U.S. administration’s economic policies, such as the new tax code, deregulatory activities and some protectionist trade policies (such as the recent increase in steel and aluminum import duties). My or anyone else’s opinion on such matters would not add much value—if it were obvious what the economy and earnings will do, we’d all be rich. However, it’s worth noting that regardless of such policies, their uncertainties create massive ripples in the market due to the prevalent high valuations of most stocks and sectors.
Secondly, the U.S. economy has almost reached its full growth rate potential with the personal savings rate close to an all-time low, although there is ample room to grow in capacity utilization. Much of this growth rate can be attributed to the prevailing low interest rates—akin to low gravity which creates a buoyant economy. If one believes that the current low interest rates are sustainable in the long-term, then one may see ample room for growth in economy and market. However, I have a more conservative viewpoint and think rates will move back to more normal levels over time.
Thirdly, the current market valuation gives almost no room to find even a reasonably good, large company at a reasonable price. Warren Buffett echoed this view in his recent letter to shareholders, and it is also evident from the huge pile of cash that Berkshire is holding. Thus, we are left with three options: small companies at reasonable valuations, declining large companies at a very low valuations and turnaround companies.
There are obvious risks associated with these kinds of opportunities, though with enough digging, value investors can still uncover some enticing opportunities.
A small business may not have the market power to defend itself from competitive pressures of the leading players. Acknowledging this risk, I recommended small-cap companies like Nautilus (NLS) in the last issue.
A declining large business could be attractive if its free cash flow, including its liquidating net asset value, could be milked out or the company has the potential for recovery in the long run. One such example in our portfolio is Gilead Sciences (GILD).
Turnaround stocks are a bet on management, the subjective nature of which is itself a risky proposition. In our portfolio, Signet Jewelers (SIG) and Lowe’s (LOW) are two examples. Many other stocks with buy and hold ratings in our portfolio are of moderate valuations with reasonable growth expectations.
“The disciplined, rational investor neither follows popular choice nor plays market swings; rather he searches for stocks selling a price below their intrinsic value and waits for the market to recognize and correct it’s errors. It invariably does and share price climbs.” — Benjamin Graham
Economic and Market Update
Although the overall economy continues to grow, the trade imbalance in the U.S. is nearing a 10-year high. U.S. exports increased 1.8% to an all-time high of $203 billion, while imports grew at 2.5% to $256.5 billion, creating a trade gap of $53.1 billion as of December 2017. In 2017, the trade gap widened 12.1 % to $566 billion. Such an increase in the trade gap, coupled with the current administration’s protectionist policies, will continue to affect the manufacturing sector’s gross margins.
Consumer inflation rate increased 2.1% YoY as of January, surpassing the market’s expectation of 1.9%. I have discussed in detail the role of inflation on stocks in my article, “How Does Inflation Affect Stocks?”. In a nutshell, there are more reasons to be conservative than not as inflation and interest rates are expected to rise.
New Buy Recommendations
STORE Capital (STOR)
Since the last issue, I introduced Store Capital (STOR), which is a REIT ?(Real Estate Investment Trust) that manages hundreds of restaurants, retailers and other business properties. STORE, which stands for Single Tenant Operational Real Estate, has a comprehensive business model which identifies financially strong businesses for STORE’s net-lease solutions. The current occupancy rate is more than 99% and has been right around that level for many years!
STORE is well diversified, with 1,921 properties leased to 397 customers across 100 industries. No single tenant contributed more than 3.4% of revenues, while the top 10 tenants combined made up only 18.5% of total revenue. During 2017, 87% of the leases originated by STORE Capital were master lease agreements with an average lease term of 17 years.
My primary thesis in investing in STORE is its inherent hedge against inflation—75% of its leases and loans have annual escalations adjusted to the Consumer Price Index (CPI), while almost all of STORE’s debts are at fixed rates. Thus, if inflation picks up, the firm’s revenues will do the same, while its financing costs will stay the same.
As of year-end 2017, the company had $1.89 billion in land and improvements and $3.95 billion in building assets. Rental revenue in 2017 was $427 million, with a rental yield of about 8% of the net property, a figure that rises every year with the aforementioned inflation adjustment. The company has around $2.7 billion of debt, the majority of which is facilitated through STORE Capital’s master funding conduit. The average current interest rate on the debt is about 4%.
The spread between the rental yield of about 8% and the borrowing rate of 4% allows STORE Capital to expand by prudent leveraging. Mainly, what is to be noted is that the majority of leases (income) are hedged against inflation, and borrowing is hedged against interest rate hikes. Thus, the 4% spread with a rental escalation of 1.8% gives STORE enough room to increase its equity. Based on this assumption, I believe STOR’s intrinsic value to be about 30 per share. BUY.
McKesson (MCK)
McKesson Corporation is the global leader in healthcare supply chain management solutions, retail pharmacy, community oncology and specialty care, and healthcare information technology. McKesson partners with pharmaceutical companies and healthcare providers to ensure quick delivery of medical services, products and medicines.
McKesson offers more than 25,000 national brand and surgical products across its extensive distribution network, which serves more than 40,000 customers in the U.S. Internationally, McKesson distributes to 13 countries in Europe through its network of about 110 branches serving more than 50,000 pharmacies.
The healthcare distribution industry is basically anything but fragmented—AmerisourceBergen, Cardinal Health and McKesson have a combined market share of about 90%. Their extensive distribution networks, coupled with their slim profit margins, creates a huge barrier of entry to new entrants.
Two significant risks associated with McKesson are volatility in drug prices (and product mix), which could affect its thin profit margin, and the company’s dependence on large customers. During fiscal 2017, CVS Health accounted for 20.2% of McKesson’s total revenue, and McKesson’s 10 largest customers accounted for? made up about 54.2% of its total revenue. If the CVS-Aetna deal happens and the combined entity opts for a different distribution company, McKesson will lose a significant customer. A convergence of healthcare industries (like the CVS-Aetna deal would be) would decrease the strong moat McKesson and other drug distribution companies have been enjoying for years.
However, McKesson hasn’t just been sitting around waiting for competition or sector changes to take hold. Led by 58-year-old CEO John H. Hammergren, McKesson has developed and acquired highly efficient proprietary distribution software and technologies to prevent a threat by Amazon from creating a lot of value in the industry. For example, the company’s inventory management software, Acumax Plus, has order quality and fulfillment in excess of 99.9% accuracy.
In the long run, I expect McKesson to provide stable and (importantly) reliable cash flow growth, in the low- to mid-single digits. The company is one of the least leveraged firms in the industry and has the capacity to borrow more if it needs additional capital for a large acquisition. In fiscal 2017 (ended March 2017), the company had annual revenue of $198 billion with a net income of around $5 billion. McKesson currently has a free cash flow yield of more than 8%, a very attractive figure for such a well-situated operator. After reaching the peak of 175 per share in January 22, the stock price has fallen to about 150 per share during the market’s correction and consolidation. At the current price, MCK is a solid value investment here, and while charts don’t factor directly into my advice, I would note there’s plenty of price support in this area, a sign big investors see this as a value area as well. BUY.
Sell Recommendations
Blackstone (BX)
I recommend selling BX, which is a private equity firm with significant real estate exposure. My addition of STORE Capital pushes our exposure to real estate higher than I’d prefer. Blackstone’s net accrued performance fee from real estate in 4Q 2017 was $1.8 billion, while the contribution from its private equity division was only $1.1 billion. With the recent promotion of its former head of real estate to the position of COO, I expect the company will increase its focus on its real estate business. Furthermore, the company’s growing complexity makes it hard to arrive at an appropriate valuation. Bottom line: I think STOR is a much better real estate play at this time. SELL.
Malibu Boats (MBUU)
MBUU was on our December watch list when it was trading at 29.5 per share. In February, the stock had a quick surge in price after a stellar earnings result and is currently trading at 36.47 per share, up 23%. I advised MBUU only from a short-time view because of concerns regarding an $80 million tax liability for its pre-IPO private equity owners. The unusual liability will continuously erode Malibu’s future free cash flows even while the company maintains its current growth. If you bought MBUU, the current level is a good exit point for a solid short-term gain. SELL.
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
Home Depot (HD)
Home Depot reported a 7.5% increase in comparable-store growth, a solid result that indicates that the company’s focus on store renovation rather than store expansion is paying off. Together with a healthy housing market, Home Depot is enjoying the fruits of its years of aggressive expansion ahead of Lowe’s. At this stage, Home Depot is the clear winner in execution and strategy and the market is giving HD a slight premium over LOW. Home Depot’s sales were $23.9 billion in the fourth quarter of fiscal 2017, with a small increase in operating margin from 14.19% to 14.54%. HOLD.
Magna International (MGA)
MGA is a strong Buy at the current level. The company has terrific management, excellent customer penetration and good free cash flow. Magna’s fourth-quarter earnings surpassed analyst expectations, and its $10.39 billion in revenue was up 12.3% from a year ago. Annual sales in 2017 were $38.9 billion, up 7% from 2016, despite a 5% dip in North American light vehicle production. Adjusted EBIT increased 7% to $3.11 billion on an annual basis. Complete vehicle production increased 129% as Magna launched a BMW 5-Series and Jaguar E-Pace assembly facility in Graz, Austria. The operating margin also showed some improvement. The stock is an excellent bargain, and the company is well positioned to take advantage of the industry shift toward autonomous driving. BUY.
Lowe’s (LOW)
As mentioned above, Home Depot is the clear winner over Lowe’s regarding management execution and strategy. However, since D.E. Shaw showed activist interest in Lowe’s, the market expected an improvement in its fundamentals, causing LOW to rise faster than HD. But Lowe’s fourth-quarter results disappointed, with its operating margin contracting from 9.6% to 8.99%, which caused LOW to plunge to multi-month lows. D.E. Shaw’s activist role, if it succeeds, may improve the operating margin of Lowe’s. Obviously, the signs are the most promising, but at this point, we think LOW isn’t overvalued (the corporate tax cuts are expected to boost the bottom line by 26% this year) and any good news/progress from Shaw could bring in some buyers. I advise holding on. HOLD.
Thor Industries (THO)
I was concerned about the high inventory level in the RV industry (which led to our sale of LCI Industries), but it appears that RV demand remains brisk enough to absorb that inventory. Thor’s backlog looks considerable, up 33.9% from the previous quarter to $2.80 billion. Thor recorded a net income of $79.8 million in the Q2, compared to $64.8 million in the prior year. With the stock’s trailing P/E down at 15 and a modest yield of 1.2%, I continue to recommend Thor as a Hold. HOLD.
Hanesbrands (HBI)
Although Hanes has been performing well, with prudent acquisitions and organic growth, particularly in the Champions brand, I’m changing my recommendation from Buy to Hold in light of the macroeconomic trend. Hanesbrands has excellent free cash flow, which could continue to allow the company to pay its long-term debts, but if interest rates go higher, there is a risk that the firm’s debt load could be an issue. I will stay cautious about such a scenario and change my recommendation from Buy to Hold. HOLD.
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Cabot Benjamin Graham Value Investor • 176 North Street, Salem, MA 01970 • www.cabotwealth.com
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