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The Perfect Value Stock for an Overvalued Market
With the incredible returns we’ve seen over the last 18 months it’s easy to ignore stock valuations. Big gains and new index highs inspire confidence that everything is fine, otherwise stock prices wouldn’t be going up so fast. At times, riding the market tailwinds can be an exceptionally profitable investment strategy. So why bother to look at valuation? It hasn’t mattered for years.
One way to think about valuation is that it puts a number on investor expectations. High valuations imply high expectations. If a company is trading above 10x price/sales, expectations for future revenue growth are high. As long as the company delivers on these expectations, and future growth prospects remain vast, the shares can climb higher. But fast revenue growth can’t continue forever – a market segment approaches maturity, competitors emerge, the concept loses appeal – and high expectations lead to disappointment. Few traits are more damaging to a high-expectations stock than disappointment. Look no further than former darlings with dashed growth expectations like Peloton (PTON), down nearly 80% from its peak, Moderna (MRNA), down 40% and QuantumScape (QS), down 80%.
In late August, the total market value of companies with valuations over 10x sales was $14 trillion. Not only is this nearly triple the prior tech cycle peak in 2000, it is seven times higher than only three years ago. Clearly, enthusiastic investors have rosy expectations about the future. One may ask if mega-cap tech stocks like Apple (AAPL), Meta Platforms/Facebook (FB), Alphabet (GOOG) and Amazon (AMZN) bias this data? They do not, as they each have price/sales multiples below 10x.
What should a savvy investor buy at this stage of the cycle – especially as the tailwinds from copious amounts of fiscal and monetary stimulus are fading or possibly reversing?
Consider “Low-Expectation” Stocks
One sensible approach is to begin trimming out of high-expectations stocks while adding to low-expectations stocks. One such stock is Bristol-Myers Squibb (BMY)1. Investors worry about Bristol’s long-term revenue growth, as key products Revlimid, Opdivo and Eliquis have patent expirations over the next several years. But the company is likely to replace the lost revenues with its robust pipeline and sensible acquisitions. The likely worst-case scenario is flat revenues.
Near-term prospects remain healthy: consensus Wall Street estimates project that Bristol will produce 2-3% revenue growth over the next few years following robust 9% growth in 2021.
Investors, however, have low expectations that even this modest scenario will play out. BMY shares trade at only 7.6x estimated 2022 earnings and 7.3x estimated EV/EBITDA. Yet, the company will likely generate $15 billion of free cash flow in each of the next three years – this is the equivalent of 36% of Bristol’s market cap. The investment grade balance sheet carries modest leverage, with its $15 billion in cash offsetting much of its $44 billion in debt (net debt is only 1.3x EBITDA). And the management is shareholder friendly, recently raising the dividend by 10% (producing a dividend yield of 3.5%) and authorizing a new $15 billion share repurchase program.
Shares of Bristol-Myers already assume a disappointing future. It won’t take much good news to beat these low expectations and lift Bristol-Myers Squibb stock.
- Disclosure Note: The author of this article personally owns shares of Bristol-Myers Squibb (BMY).
Do you own any stocks that you would consider “low expectation”?
3 Dirt-Cheap Tobacco Stocks for Value Investors
Perhaps unsurprisingly, tobacco company shares have fallen out of favor in recent years, with some share prices down 40% or more from their 2017 highs even as the stock market has surged. First, the growing influence of ESG-minded investors has weighed on the shares. From a fundamental perspective, a major issue has been the acceleration in the declining rate of domestic cigarette volumes. Typical annual volume declines have been in the 3-4% range, but this rate increased to 4.5% in 2018 and 5.5% in 2019. The federally-mandated increase in the minimum age to purchase tobacco from 18 to 21 may be reducing demand. More recently, the possibility of new menthol regulations and higher taxes has pushed away investors.
An emerging concern is the growth in “next generation” non-combustible tobacco products that are showing signs of developing into threats to cigarettes. The previously rapid growth of vaping products like JUUL, for example, may have contributed to the erosion of traditional tobacco volumes. In some ways, this mirrors the emergence of electric cars and trucks – demand for traditional products remains robust but a transition to new products is seen by investors as inevitable. As such, companies that are in the vanguard of this shift are viewed more favorably than those that lag. Another similarity: most of these initiatives have rapid demand growth from tiny bases but so far remain unprofitable.
All of these issues have created an investment opportunity in tobacco stocks. While a transition to non-combustible products may eventually occur, tobacco companies may continue to generate vast free cash flow for years to come, rewarding shareholders, as the transition won’t likely occur overnight. And the industry has many appealing traits that remain in place. Revenues are remarkably stable with slow but steady growth, as annual price increases more than offset declining unit volumes. Wide profit margins (45%+) and low capital spending requirements translate into steady profits and cash flow, much of which is paid out as dividends.
Supporting near-term fundamentals is that the accelerated volume decline appears to have stopped, with U.S. volumes flat in 2020. Whether this is a pandemic-related rebound in demand – driven by higher stress, higher disposable income, and fewer limits on where to smoke when at home – or a more enduring change is yet to be seen, but early indications are favorable. Several companies have new leadership that are driving a transition to non-combustible products. These managements also bring a greater awareness of investor and societal concerns about their products, which may at least partially alleviate some ESG concerns.
For value investors, a major appeal is that valuations are near long-time lows, while dividend yields are exceptionally high relative to the stock market. These stocks can also offer defensive traits in an overpriced market. Listed below are three tobacco stocks with good value.
3 Dirt-Cheap Tobacco Stocks for Value Investors
Dirt-Cheap Tobacco Stock #1: British American Tobacco (BTI)
Following its recent acquisition spree, including its $30 billion deal for Lorillard in 2015 and its $49 billion buy-in of the remaining 48% of Reynolds American (2017), British American is one of the world’s largest tobacco companies. It has a 40% share of the global cigarette market, although the U.S. generates just under half of its total sales. Led by a new CEO since 2018, the company is accelerating its transition to non-combustible products to expand upon its market-leading position in this segment. Its vapor, oral and heated products already comprise 12% of total company revenues. Initiatives to simplify the company, reduce costs and release unproductive cash should boost core earnings. Once its non-combustible products turn profitable in four years or so, overall earnings growth could accelerate. Management guided to 3%-5% revenue growth in 2021, which, combined with possible widening of its 44% operating margin, should produce faster profit growth. Like its peers, British American Tobacco produces hefty free cash flow, pays a generous dividend and carries reasonable debt (which it plans to reduce further).
Dirt-Cheap Tobacco Stock #2: Philip Morris International (PM)
This company previously was Altria’s international division before its 2008 spin-off, and has essentially no U.S. revenues. The company’s portfolio of top-selling premium, mid-price and discount-price brands includes Marlboro, the #1 selling international cigarette brand that produces 37% of PMI’s total volume. Unlike its domestic peers, the company carries international product liability risk but this is likely to remain readily manageable. Combustible products are a relatively low 76% of total revenues, as its successful IQOS (heated not burned) products, which it sells globally and licenses to Altria for sale in the United States, boosts its alternatives operations. Volumes in 2020 were weak due in part to lower pandemic-related demand at duty-free shops, although operating income rose 5%. PMI expects mid-single-digit revenue growth this year, with an expanding profit margin. The company’s balance sheet is strong, and its generous cash flow provided management with the confidence to recently raise its dividend by 2.6%.
Dirt-Cheap Tobacco Stock #3: Vector Group (VGR)
This tobacco company is the fourth largest cigarette manufacturer in the United States, producing discount-priced brands through its Liggett and Vector subsidiaries. It also owns Douglas Elliman Realty (the fourth-largest residential real estate company in the nation) and holds direct ownership stakes in large real estate projects in four major markets. The company has a unique trait: its tiny cigarette market share at the time of the 1998 MSA exempted it from onerous perpetual liability payments for volumes up to a 1.93% market share. This permanent cost advantage has helped Vector expand its market share to 4.1%, although it retains some medical liability exposure. Its management team has long tenure with the firm, providing stability. Management and directors own a combined 8% of Vector’s shares, providing the incentive to maintain its competitiveness. Revenue and profit trends are favorable, although its real estate business is struggling, and its balance sheet remains sturdy.
Do you still own any tobacco stocks? Tell us about them in the comments below.
3 Micro-Cap Stocks Trading at Value Prices
It seems like the financial markets are in constant conflict over whether growth stock investing or value stock investing is the better pursuit. Growth investors obviously love rapid capital appreciation while value investors like to take advantage of fundamental valuation, more price stability, and the occasional dividend.
For the past 10 years, growth stocks have absolutely clobbered value stocks.
But growth vs. value performance has always been cyclical.
Value stocks crushed growth stocks from 1999 to 2009, and growth stocks have crushed value stocks ever since.
While I do think that value stocks are poised for some solid returns over the next 10 years or so, I prefer to avoid an either-or approach.
Instead, I choose to invest in the best possible (usually growth) companies at value prices.
This seems mutually exclusive, right?
If you are investing in the best possible companies, you are going to have to pay up.
Zoom (ZM), for example, grew revenue 369% last quarter. But you aren’t going to be able to buy Zoom at a “value” multiple. The stock trades at a P/E ratio of 146x.
So how do I find growth stocks at value prices? Micro-cap stocks.
The Advantage of Micro-Cap Stocks
What’s the catch? You have to be “poor” enough to invest in them.
Before Warren Buffett became famous for building Berkshire Hathaway into what it is today, he managed a small hedge fund with initial assets of $500,000.
Over the next 11 years, Buffett generated 31.6% annual returns (25.3% after fees) for his investors.
How did he do it? By investing in micro-caps.
Or take it from Peter Lynch, famed Fidelity portfolio manager who once wrote, “The size of a company has a great deal to do with what you can expect to get out of the stock. How big is this company in which you’ve taken an interest? Specific products aside, big companies don’t have big stock moves.”
Today, Buffett’s Berkshire Hathaway has $139 billion of cash on its balance sheet. Buffett goes “elephant hunting” to deploy that cash. In other words, he’s looking for large companies to buy.
He could invest in micro-caps, but it just wouldn’t move the needle for him.
But if you don’t have billions or even hundreds of millions, then odds are, it might make sense to invest a portion of your portfolio in micro-cap stocks.
Here are three examples of growth stocks trading at value multiples (disclosure: I own all three stocks) that are part of my current recommendations.
Before I share these ideas, I want to emphasize to use limits when buying micro-caps. If you don’t use a limit, a tiny order at the “market price” could move the market!
3 Micro-Cap Growth Stocks Trading at Value Prices
Greystone Logistics (GLGI)
Greystone recycles plastic to manufacture pallets. The company has grown sales at a compound annual growth rate of 30.4% for the past four years yet trades at a value multiple with a P/E ratio of 8.9x. Sales have declined in the past calendar year due to the pandemic but should reaccelerate in 2021. Better yet, insiders own over 40% of company’s shares ensuring we are well aligned.
Medexus Pharma (MEDXF)
Medexus is a Canadian specialty pharma company that grew revenue by 94% the last quarter. It has a tremendous runway for growth as one of its products, treosulphan, is on the cusp of FDA approval and will provide the potential for the company to double its revenue. Despite rosy prospects, the company trades for just 1.4x revenue. Comparable companies trade at 2.5x to 3.0x revenue.
P10 Holdings (PIOE)
P10 is a private equity holding company. It has ownership stakes in a diversified portfolio of private equity management companies. Any time these private equity companies raise new funds, P10 adds to its revenue base. In 2020, P10 grew revenue 50%. P10 looks relatively expensive trading at 28x free cash flow, but if you adjust for several acquisitions that were completed in the last 12 months, the stock is trading at 12.4x free cash flow.
When making investments do you target growth at a value price?
How Catalysts Can Jumpstart Your Stock Performance
Many of the most successful investors are contrarians who buy unpopular stocks at bargain prices. Not only do these stocks offer the potential for strong returns regardless of the market’s direction, their low valuations can dampen the effect of sharp declines in mega-cap popular stocks.
However, buying just any unpopular stock isn’t a great strategy. Many of these stocks are out of favor for a reason – they have fundamental problems that, if left unaddressed, could threaten the company’s existence or at least relegate it to permanent cheap-stock status. Low valuation isn’t enough, especially in a rapidly-evolving economy with aggressive competitors.
You need to find value stocks with catalysts.
How Catalysts Can Jump-Start Your Stock Performance
Successful contrarian investors look for a catalyst to jump-start the fundamentals at otherwise moribund or underperforming companies. A catalyst is a strategic-level change such as new leadership, a spin-off transaction, interest from an activist investor, or emergence from bankruptcy. An effective catalyst can jumpstart a struggling company toward a more prosperous future.
Our investing process emphasizes catalyst-driven value stocks. To help us find these ideas and to organize our analysis, we maintain a catalyst database, currently holding over 3,000 strategic events from the past three years. We publish a listing of the most recent catalysts each month in our Catalyst Report, a proprietary report that is unique on Wall Street.
One highly effective way to use this tool is to pair the catalyst names with weak stocks. Combining these two traits can generate a short list of high-potential turnaround investment candidates. As part of the report, we highlight some of the most interesting candidates.
This past March saw many CEO changes and a ramp-up in activist investor campaigns as the proxy season approaches. While it was a relatively quiet month for spin-offs, we anticipate this type of catalyst will remain a prolific tool for finding attractive contrarian investments. With the worst of the pandemic (hopefully) in the rear-view mirror, companies and shareholders are working to adjust to the new economic and capital markets environment. This will make 2021 a busy year for catalysts.
3 Value Stocks with Catalysts
Three catalyst-driven value stocks that we recently highlighted for subscribers include:
Blucora (BCOR) – Blucora is an $800 million market cap company with two businesses – Avantax (wealth management) and TaxAct (tax preparation software). An activist investor, Ancora, is pressuring for the removal of the CEO, a refresh of the board of directors and a break-up of the company. Ancora published a 73-page slide deck that outlines their rationale and plans.
FirstEnergy (FE) – This otherwise dull electric utility got caught up in an embarrassing bribery scandal last year. While the outcome remains unclear, the ever-present Carl Icahn sent a letter to the board of directors and is acquiring shares as they remain heavily discounted.
Berkshire Hills Bancorp (BHLB) – Previously self-described as “America’s Most Exciting Bank,” Berkshire predictably collapsed under its controversial leadership and strategy. Now under new leadership and pressured by an activist investor, the bank appears to be getting its act somewhat together. The shares have responded but this one still is worth a closer look.
Are organizational catalysts big drivers for your investment decision making?
These Sectors are Benefiting Most from America Reopening
As the growth and tech stocks that drove the equity rally during the pandemic rapidly cool off, investors are eager to put their money to work elsewhere. Increasingly, that destination appears to be “reopening stocks,” companies poised to benefit from widespread vaccination and an end to lockdowns.
Expectations are high for a big economic rebound in the travel and leisure space, and an increasing emphasis on infrastructure development (plus a red-hot housing market) is powering a rally in industrials and materials.
Reopening Stocks for Your Watch List
You can easily see the renewed optimism with a glance at the Invesco Dynamic Leisure and Entertainment ETF (PEJ). This ETF, which tracks an index of 30 U.S. stocks from the leisure and entertainment industries, is up nearly 20% year-to-date (and was up over 40% prior to the Archegos hedge fund fiasco which caused a massive sell off in ViacomCBS (VIAC), one of the fund’s top holdings).
Shares of restaurant supplier Sysco (SYY), which comprises 4.5% of fund assets, struggled to gain much upside traction throughout 2020, due to restaurant closures. That’s turned around recently; Sysco is up over 7% year to date.
Travel Stocks on the Move Again
Other top holdings, such as travel services provider Booking Holdings (BKNG), struggled amid travel restrictions. After two failed rally attempts in 2020, Booking has notched a year-to-date return of 10%.
Another travel booking firm, TripAdvisor (TRIP), has been on a tear in recent weeks.
The company’s business went nowhere in 2020, and it reported a yearly loss of $1.27 per share. Wall Street analysts expect that to turn around this year, with earnings of $0.07 per share.
Although many stocks began the long, slow process of rebounding last spring, TripAdvisor stock only began rallying in November. The stock is working on its fifth month in a row of upside trade, with some big monthly advances.
In February, for example, TripAdvisor was up a whopping 60.2%, to 49 a share.Trading volume has been above average as the stock races higher. That’s a good sign of conviction among institutional investors.
Optimism Abounds for Materials and Industrial Stocks
While stocks of consumer-facing companies poised for an economic rebound are showing strength, the not-so-glamorous sectors of industrials and materials are also rotating into leadership.
With optimism on the rise over an improving economy, institutional investors are taking a fresh look at prospects for industrial production. The materials sector, of course, is relevant to that viewpoint because its components produce the inputs used in production.
Meanwhile, the new $1.9 trillion economic stimulus package will give Americans more money to put back into the economy.
In addition, materials and industrials may have more room to run, as the Biden administration hopes Congress will pass an even larger spending bill later this year. As of now, the intention is to wrap trillions of dollars in infrastructure spending into that bill.
That may benefit stocks of companies that would have a role in new infrastructure projects.
For example, Caterpillar (CAT) just crawled through 2020. The company remained profitable, but earnings growth decelerated. Analysts are eyeing earnings per share of $8.20 this year, which would mark a 38% year-over-year increase. For 2022, Wall Street pegged earnings expectations at $10.67 per share, a 30% increase. Both those forecasts were raised recently.
Not coincidentally, Caterpillar shares are trading near all-time highs.
Meanwhile, fellow machinery maker Terex (TEX) is trading at its best levels since 2018. The company reported losses in the first and second quarters of 2020, a reflection of the challenging business environment. However, Terex plowed through the bad quarters, ending the year with earnings of $0.13 per share.
Analysts expect that to grow an almost astonishing 1,600% this year, to $2.26 per share.
These are just a few of the top reopening stocks to keep on your watch list as America’s economy gets back in gear following a nightmare year. All of them are off to strong starts in 2021, and could soar much higher by year’s end.
Have you been investing in anticipation of a travel boom as lockdowns end?
The Last Place You Thought You’d Find Value: Chip Stocks
When you think of value investing, most don’t associate semiconductor stocks. The companies that develop the chips that drive all of our technology are rarely “on sale” and in fact, they usually range from “expensive” to “extremely expensive.”
What keeps them expensive? The answer to that is easy:
- Rapid near-term growth
- Strong forward visibility provided by the inexorable increase in demand for smarter and faster computing power
- The barriers to entry keep rising – not just anyone can design a leading-edge semiconductor, let alone build a factory that can produce them
Today, despite continued expansion of the industry’s production capacity, there is a surprising shortage of semiconductors. Automobile makers are but the most visible example of companies being squeezed as they can’t get enough chips.
Value investors have benefitted from the strong rebound in out-of-favor stocks in recent quarters. At some point, this upcycle will fade, leaving bargain hunters wondering where they can yet again produce strong returns.
For those yearning to ease their value constraints, one place to look is among the weakest of the major semiconductor companies. While not obviously out-of-favor, we list two that have some “issues” yet may offer a value-oriented way to participate in the industry’s growth.
Intel Corporation (INTC)
Intel is the iconic producer of chips for personal computers, servers and a wide range of other computation-intensive applications. Due to strategic and operational blunders, the company is struggling to catch up to leading-edge chip production capabilities. Taiwan Semiconductor (TSM) is now widely recognized as having a one- or two-generation lead – while not insurmountable the gap presents Intel with a severe challenge.
However, Intel has new and exceptionally capable leadership and at least one attentive activist investor (along with legions of passive investors) closely monitoring its turnaround. And, its strategic value to the United States’ technology security is a highly valuable intangible asset. The shares have been stagnant for nearly three years, despite their recent surge, and trade at only 12.8x estimated 2021 earnings, while also offering an above-market 2.3% dividend yield.
Cirrus Logic (CRUS)
Cirrus Logic produces a wide range of semiconductors that connect the digital and analog worlds. In the past, investors were pleased to participate in the company’s close and prosperous relationship with Apple, which produces over 80% of Cirrus’ revenues. However, as Apple appears to be taking more control over its semiconductor procurement, CRUS shares have slipped in investors’ regard.
The recent profit slowdown hasn’t helped, either. The company is now more aggressively working to reduce its reliance on Apple. New initiatives include developing and shipping chips to Android-based smartphone producers, expanding its chips’ usefulness in other devices, and developing chips for new but adjacent segments. While the shares have recently been strong, they have lagged other chip stocks. Trading at 18x forward earnings, they still remain a relative bargain in the industry.
Do you invest in chip stocks? Have you ever gotten them at a bargain price?
As the U.S. Dollar Weakens, These Stocks Should Benefit
Since last April, the U.S. Dollar Index, which measures the currency’s price relative to other major currencies, has declined about 10%. The current 90.51 price marks a 3-year low. While this level remains about in the middle of the index’s 30-year band, there are credible risks that could push the dollar lower. Standout risks include vast new fiscal spending, aggressive Federal Reserve monetary policy, a recovery in emerging markets, and a less appealing investing environment due to potentially higher corporate taxes and regulations.
With so much going on, it’s easy to have missed the slip in the value of the U.S. dollar. But there are ways to take advantage of the weaker U.S. dollar.
Investors who want to capture potential further dollar weakness, or hedge their dollar-based holdings, have a wide range of vehicles. Currency futures contracts provide the most direct exposure, but these can be difficult to access by most investors and carry considerable risks.
Several ETF families offer a more conventional approach, including the Invesco CurrencyShares securities like the FXE (Euro), FXY (Japanese Yen) and others. While these ETFs may provide near-direct currency exposure, stock investors may instead be more comfortable holding equities of public companies with high international revenues. Also, as equities, these can be backed by companies that have enduring value, allowing investors to hold larger positions for longer, and receive a dividend along the way.
While technology companies generally have a high mix of international sales, their stocks currently are expensive. As such, the shares may move more with market sentiment than with the dollar.
Investing in lower-priced, less cyclical companies with stable revenues and high international sales may offer an appealing option. The three companies outlined below also have considerable emerging market exposure, which could provide a more potent hedge against a weaker U.S. dollar.
3 Value Stocks for a Weaker U.S. Dollar
One of the most widely recognized global brands, McDonald’s (MCD) generates nearly 62% of its revenues from outside of the United States. Of its 38,700 global locations, nearly 25,000 are spread across 118 developed and emerging countries. McDonald’s sales have remained relatively sturdy during the pandemic. Third-quarter global comparable-store sales recovered from earlier weakness to decline only 2.2%, showing that the company is adapting to the pandemic environment relatively well. Surprisingly, McDonald’s shares have been nearly flat since the beginning of 2020. The stock trades at a 25x multiple of forward earnings, comparable to its average over the past few years, and offers a solid 2.5% dividend yield.
Philip Morris International (PM) generates 100% of its revenues from outside of the United States, with nearly 45% produced in emerging markets. Formerly the international tobacco operations of the original Philip Morris company, now named Altria (MO), PM International was spun off in 2008. The company produces over $29 billion in revenues and holds a leading 28% share in international markets outside of China. Aware of the shift to smokeless products, PMI is investing heavily in this category, which now generates 23% of its total sales. Profit margins and cash flow are generous, while the debt balance is strong, particularly given the stability of the company’s business. Trading at a modest 14x forward earnings, with a 5.9% dividend yield, PM shares offer an attractive way to participate in a weak U.S. dollar.
Chicago-based Mondelez International (MDLZ) produces some of the world’s most popular chocolate bars, chewing gums, crackers and related snacks, including Oreo’s, Cadbury and Toblerone. About 75% of its revenues are generated outside of the U.S., with a sizeable 37% of revenues from emerging markets. Snacks are a secular growth industry, and Mondelez is well-positioned to participate as the #1 or #2 player in the major categories. Its renewed focus on better execution is helping the company drive further revenue growth and margin expansion. Mondelez shares have hardly budged since mid-2019. At 20x forward earnings, the shares aren’t expensive and may not fully recognize the value of its 11% stake in KeurigDrPepper (worth ~$5 billion) and JDEPeets (worth ~$4 billion). MDLZ shares pay a 2.2% dividend yield.
All three of these stocks, which held steady during the pandemic, should be safe bets for the future.
2 Stocks that Could Be Saved by Activist Investors
Activist investors buy stocks of undervalued companies that need outside pressure to help turn them around and make improvements. They do this in a variety of ways.
- The most successful activists emphasize changes in company leadership, as that is the most effective route for making improvements. The CEO, overseen by the board of directors, determines how the company uses its resources, including its people, factories, intangible assets like technology and brands, and other assets. If the strategic and tactical application of these resources is headed in the wrong direction, the company will struggle. Once resource usage becomes more productive, corporate prosperity usually returns.
- The other component of a successful campaign is starting with an undervalued stock. Low investor expectations provide a margin of safety, as the shares already likely discount a dour future. And, any improvements will likely restore at least some faith in the company’s prospects, helping drive the stock higher.
Two well-known companies fit the activist investor target checklist but have yet to see any meaningful activist involvement:
- IBM (IBM)
- Walgreens Boots Alliance (WBA).
IBM (IBM) – IBM was once the dominant technology company, providing the critical hardware as the world shifted from manual calculating to computers. In the early 1990s, after losing much of its relevance, new outsider CEO Lou Gerstner engineered a major turnaround by shifting IBM’s focus to the software and services that surrounded its hardware. This turnaround was legendary: Gerstner had little technology experience, yet under his guidance IBM restored its prominence, leading to a 6x gain in its share price over the next decade.
Today, IBM again struggles with relevance. Its revenues have continued to fall for the better part of a decade despite numerous acquisitions. IBM’s new CEO, Arvind Krishna, is aggressively working to turn around IBM’s fortunes. His focus on the cloud, partly by removing via spin-off IBM’s Managed Infrastructure Services segment, may lead to new growth. But IBM clearly has major challenges, as competitors Amazon (AMZN), Microsoft (MSFT), and others have huge advantages. No activists currently have a meaningful stake in IBM, but given its strategic crossroads, the opportunity seems ripe for a major activist investor stake.
Walgreens Boots Alliance (WBA) – Walgreens is a cheap stock. It is also among the worst-performing large cap stocks over the past decade, offering some contrarian appeal. Its 4.9% dividend yield appears sustainable, paying investors to wait. However, the company is strategically adrift, and earnings estimates continue to slip. Amazon’s recent announcement that it will be entering the mail-order pharmacy business adds a new and potentially debilitating competitor to the industry.
In an encouraging sign, Walgreens’ CEO recently announced his retirement, providing an opening for activist investors. The company clearly needs the fresh perspective that an outside CEO can provide, and an activist investor could be instrumental in guiding the board of directors in their selection process.
Walgreens’ yet-to-be-named CEO must produce a clear and sound plan that is crisply executed at both the strategic and store levels. The new leadership will need to determine the fate of its nearly 19,000 retail stores, the ongoing merits of its 27% stake in pharmacy wholesaler Amerisource Bergen, the plan for its mail order joint venture, and whether to pursue a health care insurance strategy like competitor CVS or some other approach.
Turnaround investors should put both of these companies on their watch list.
Why You Should Buy Bank Stocks in 2021
It might feel like all the bargains from the pandemic have been snapped up, but a potentially historic opportunity is upon us, and there are a number of undervalued bank stocks out there.
Over the past year, financials have underperformed the market. However, the Federal Reserve recently announced that it would allow the nation’s big banks to resume share repurchases. Dividends will be capped and the sum of a bank’s dividends and share repurchases in the first quarter cannot exceed the average quarterly profit from the four most recent quarters.
Nonetheless, it’s a significant positive, should put a floor on valuations, and all big banks have significant room to buy back stock. Below are three examples worth paying attention to.
One Big Bank and Two Regional Banks
Of all the big banks, I like Citigroup (C) the best as it’s trading at a mere 0.7x book value and 12.0x earnings, yet should benefit from a recovering economy in 2021.
Separately, regional banks look attractive.
A financial stocks investor that I closely follow is Derek Pilecki, Managing Member and Portfolio Manager at Gator Capital.
He only invests in financial stocks and can go long attractive names or short the ones that are overpriced. His performance is incredible. Since inception in 2008 he’s generated a compound annual return of 21.1%, crushing the S&P 1,500 Financials Index, which has returned 6.8% annually over the same period.
What is even more impressive is that his performance has also crushed the tech heavy S&P 500, which has returned 11.1% annually over the same period.
In his most recent letter, he makes a compelling case to invest in regional banks. The last time regional banks were this cheap was in 1990—during the Saving & Loan Crisis!
Of the regional banks, Pilecki details two that look attractive: ConnectOne Bancorp (CNOB) and Flushing Financial Corp (FFIC). Let’s dig into these two regional bank stocks a bit more.
ConnectOne Bancorp (CNOB) is a $7 billion bank with 28 branches in New Jersey. Historically, it has grown loans per share by ~14% while also maintaining a history of good loan underwriting (minimal loan losses). Further, it acquired a competitor (Bank of New Jersey), which was a savvy acquisition because the company was able to acquire all of its deposits but eliminate almost all of its expenses. Finally, the micro-cap stock($780 million market cap) looks cheap, trading at only 85% of tangible book value and 7.2x 2021 earnings. By comparison, its peer banks in the New York metro area trade at 110% of tangible book value and 9.2x earnings.
Flushing Financial Corp (FFIC) is a bank with 20 branches on Long Island. It is an underfollowed stock, with only two analysts providing coverage. Nonetheless, it has a long history of solid underwriting and is in the process of closing an acquisition (of Empire Bancorp) which will be 20% accretive to 2021 earnings and improve the bank’s return on equity from 8% to 10%. Meanwhile, the stock is only trading at 78% of tangible book value and 8.4x 2021, a discount to peers. Better yet, it pays a 5.3% dividend that is well covered.
While it may feel like all the easy money has been made in the market, financial stocks look like a cheap way to play the improving U.S. economy in 2021 and beyond. These bank stocks are a good place to start.
Why You Shouldn’t Expect Another Big Decade from Amazon.com
Do you invest in Amazon, or are you considering it? They certainly have no shortage of business, especially given the last year of interrupted in-person shopping. Amazon.com (AMZN) is among the most popular and widely held stocks. With a market cap of $1.7 trillion, it is the third-largest holding among the $4.6 trillion of investments indexed to the S&P 500 (behind Apple (AAPL) and Microsoft (MSFT)).
Amazon.com stock is also a top holding in a vast pool of other indexed and actively managed funds including the $131 billion Fidelity Contrafund, where it is the top holding at about 10% of assets, and the $144 billion Invesco QQQ ETF, where AMZN is the #2 holding at almost 11% of assets. It is also likely held by most pension funds and 401(k) accounts as well as in many individuals’ separate accounts.
In a self-reinforcing cycle, this popularity is helping drive the shares higher. Year-to-date the shares have gained 82%, and over the past decade the stock has appreciated at a compound annual rate of 35%, for a total return of 19x. As amazing as this return has been, the five-year 43% compound annual rate is even more impressive.
Not surprisingly, Wall Street is enthralled with Amazon.com stock. Of the 48 analysts that have ratings on Amazon, 46 rate it as Buy/Outperform, according to Capital IQ. Only two analysts assign a lower rating (Hold), with no Sell ratings.
What are the buyers of the 5 million AMZN shares that are traded every day assuming about their future returns? Many buyers have short-term or quant-driven motivations and therefore care little about time horizons longer than a few weeks. If these were the only buyers, then AMZN shares would be precariously balanced on daily news flow and momentum.
Assuming that there are long-term investors buying the stock, what are they expecting for their future returns? Perhaps they see the impressively strong fundamentals and assume that something like the 30%-40% rates of return of the past will continue. Let’s look at the math behind these assumptions.
Should You Buy Amazon.com Stock Now?
Since the company is valued not on current results, but on future results, we looked out seven years, to 2027 prospective results.
Let’s assume that Amazon can increase its revenues at a 15% rate each year, roughly in line with analysts’ estimates. In 2027, it would generate about $1 trillion in revenues. Let’s also assume that it can double its net profit margin to 10% of sales from the current 5%, so it would earn about $100 billion in profits in 2027, or about $200/share. If the market puts a 30x P/E multiple on the stock, the shares would trade at about $6,000 in seven years. This 80% increase from today’s $3,339 price may seem appealing, but produces a pedestrian 9% annual compound return.
Being more optimistic, if the shares could earn a generous 50x P/E multiple, the resulting $10,000 share price would yield a 17% annual compound return. While falling well short of the historical rate, this prospective return has understandably clear appeal.
Yet, how likely is Amazon to achieve these assumptions to reach even the $6,000 price? At $1 trillion in sales, Amazon would be larger than the $900 billion in estimated 2027 sales of Walmart and Microsoft combined. And, to continue to grow at a 15% rate and earn the premium valuation, Amazon would then need to add an incremental $150 billion in sales in 2028, and more each year thereafter. That would be the equivalent of two Target Corporations, or nearly one Google, each year. Amazon probably would have to expand successfully into a spread of new markets to even attain the $1 trillion revenue mark.
Can Amazon double its profit margins? Wider margins depend on pricing power and cost controls – difficult when its faces a vast roster of well-funded and aggressive competitors in its core retail and cloud businesses. And, Amazon is already widely recognized as stingy on expenses.
This outlook also assumes that the company won’t face any meaningful regulatory barriers or higher taxes, and that interest rates don’t increase (which could reduce the appeal of growth stocks). Meeting all of these requirements to reach even a $6,000 share price in 2027 may be a real challenge in a competitive and changing world. Any meaningful shortfall could result in a more dismal return.
With a rosy future already built into Amazon.com stock, it’s a tall order to justify new investments into the shares. And, for investors who are already loaded up on AMZN, either directly or indirectly through various investment products, it probably wouldn’t hurt to lighten up a bit.
2 Bargain Stocks that Should Surge as the Pandemic Fades
No matter who you are, the coronavirus pandemic has impacted you in some way.
While we’ve certainly seen our share of negative outcomes, we’ve also seen people rise to the occasion to help their neighbors, change their lifestyles, and support each other.
Even so, I think it’s safe to say that, at the least, we are all tired of it. It’s important to remember, however, that this is still a very temporary situation. In the grand scheme of things, this pandemic will be just a minor blip in history. In a year, we’ll forget all about these “new normal” restrictions. This virus will assume its rightful place as a bad memory, and a trivia question for future generations of Jeopardy.
As investors, it’s time to look past this pandemic. Think of your investment career as a 26-mile marathon. The virus is only part of the first mile or so. It makes sense to position yourself for the post-pandemic world by targeting the stocks that will benefit most in the “old normal.”
The fact is that all this misery creates investment opportunities. Great companies have been crushed in the pandemic. But the damage is temporary and it creates a fantastic opportunity to buy some of the very best companies at dirt cheap prices.
Here are two cheap stocks that fit the bill…
I don’t know how you feel about this coffee house place. But one thing is for sure: They know the young generation and modern society, and how to make money from it. And they sure know how to get inside the wallets of today’s hipsters.
Starbucks took the simple idea of a coffee house and turned it into one of the largest and most profitable companies in the world. The stock has been phenomenal. It’s returned an average of 22% per year for the last 10 years. It’s been one of the best growth stocks on the market and it still has a lot of running room going forward.
But the company is in the crosshairs of the lockdowns. People stopped going to work and public places. Sales were down 38% in the second quarter and the company reported a loss. While the market index is back near new all-time highs, SBUX is still more than 20% below the 52-week high.
But the pandemic will end and people will go out again. And they will surely come back to Starbucks. But the story is even better than just that. Starbucks has been expanding its drive-through and delivery business. These areas were part of future growth even without the pandemic. Starbucks adapted to the new situation quickly and has broadened its business for the future. And it will be a future that includes less competition after this disaster.
SBUX stock isn’t as cheap as many companies because Starbucks is adapting well. But it will surely come back strong.
Las Vegas Sands (LVS)
You guessed it—this company is in the gambling business. Gambling is one of the most cyclical of all businesses. And you don’t want to own stocks in the sector ahead of a recession.
I could just say that it is very good timing to buy a cheap cyclical stock ahead of an inevitable economic recovery. And that’s true. I could say that people will surely flock back to the gambling tables as soon as the lockdown restrictions subside. And that’s true too. But the situation is even better than that for Las Vegas Sands.
It is a truly international company, and the largest resort and casino operator in the world. About 85% of revenues are generated in China and Singapore. And those countries are way ahead of us in terms of easing lockdown restrictions. The virus hit Asia first and their time table is months ahead of ours.
Casinos in China and Singapore have already reopened. The pent-up desire to go out for a night on the town is massive. Business is already back and will continue to get better in the quarters ahead.
The company has a strong cash position and can easily weather the storm. And for the next several quarters, this should be a company with skyrocketing earnings growth.
It can be tough to look toward a brighter future when we’re in the middle of a crisis, but to find success in the stock market, you have to look ahead. That’s where the money is.
How Value Stocks Can Outperform Growth in the Next 10 Years
Growth investing is the darling of investor imagination. Buy a stock at a low price, and hang on while it skyrockets in value. But growth eventually comes to an end. Meanwhile, value investing takes a backseat. It’s not as cool or “fun” and it takes patience. Some might even say that the days of value investing are over.
Is that true? Is value investing dead? The financial media has long proclaimed its demise, backed by strong outperformance of growth stocks compared to value stocks. The numbers are clear: over the past decade, growth stocks have produced a 17.4% annualized return, vastly higher than the 10.6% returns from value stocks.
Further illustrating the gap, an investor starting with $100 and focusing only on growth stocks would have earned almost $400, more than doubling the $173 earned by the value investor over this period. So, what has happened to value investing?
Value Investing: A Lost Decade
At its core, value investing focuses on paying a bargain price for an asset. We believe that there is a widespread misperception about what value investing is, that value investing is not dead and is increasingly likely to emerge as a successful strategy.
First, index providers including FTSE Russell, which is the source of the above-mentioned returns, use an outdated definition of value investing. According to their definition, value stocks are those with low price/book value multiples. This purely statistical method has diminished relevance in a world where company value is driven by intellectual assets (which aren’t recorded by accountants the same way as a factory or other hard assets). Nor is it meaningful when book value is reduced by aggressive borrowing and share repurchases.
Further, low-multiple definitions ignore the growing secular risk from the digital revolution underway, in which nearly all businesses must adapt or fail. In many cases, low-multiple stocks reflect secular losers that will fail, not undervalued bargains.
Also, value investing itself has evolved. In the late 19th and early 20th century, when public equity markets were rife with schemes, frauds and near-zero corporate transparency, traders like Jesse Livermore, immortalized in the 1923 classic Reminiscences of a Stock Operator, made profits using momentum and ticker-tape watching. Investing based on fundamental analysis and valuation, pioneered by Benjamin Graham and outlined in his 1934 investing bible Security Analysis, offered a way to sort through the jumble to find quality companies that could survive and prosper – often available at bargain prices in a market that had neither the patience nor the skill to find them.
In the decades following the Second World War, as disclosure, management practices and investor sophistication improved, value investing evolved toward buying quality companies at prices temporarily beaten down by recessions or temporary dislocations like the 1963 Salad Oil swindle. Legendary value investor Warren Buffett prospered in this period, shifting from the “cigar butt” approach to “great companies at good prices.”
Today, value investing involves the same basics – paying a bargain price for an asset. It involves understanding the intrinsic value of companies, including the effect of secular change regardless of industry or capital base, and seeking to buy them at bargain prices. Value investing includes bargains produced by temporary dislocations and cyclical downturns but certainly isn’t limited to these traditional definitions.
The Secret Ingredient to Value Investing
The value vs growth debate has another element: time. In the post-war period, recessions and booms were frequent, arriving every 3-7 years. This produced growth/value cycles of about the same duration. However, since the 1982 recession (almost 40 years ago), economic growth cycles have lasted about a decade. This provides fewer bargain-producing opportunities and gives true growth companies a longer runway to increase their earnings – and see unfettered gains in their stock prices.
Aiding this cyclical extension is the Federal Reserve Bank. Starting with the 1987 market crash, the Fed began shifting its policy from inducing recessions to mitigating them. No longer removing the punch bowl, the Fed is now spiking it. The effect on value investing? Prolonging investor enthusiasm for growth stocks at the expense of traditional value stocks.
Growth and value cycle lengths have expanded with the economic cycle lengths. Growth investing performed well in the 1990s, ending with the Dot-com bubble. Value investing produced much stronger returns in the 2000-2010 decade (+3.64% annualized rate compared to a ‑2.25% annualized loss for growth). The past decade, of course, has been a growth cycle.
With the digitization of the economy being accelerated due to the COVID-19 pandemic, investors have accelerated their valuation assumptions in response, rivaling the run-up at the end of the Dot-com era. Perhaps the growth style of investing has reached its limit.
Value investing is about finding companies with enduring value, at bargain prices.
Buy this Gun Stock Before the Election
It’s an election year, and you can pretty much count on people buying more guns up until the 2020 election. Whenever there is a strong Democratic candidate, gun-owners stock up.
The gun industry historically has had significant booms and busts. Currently, the U.S. is experiencing a boom given unprecedented demand for guns and ammo; Smith & Wesson stock is the perfect gun stock to play the boom.
Smith & Wesson (SWBI) is a stalwart name in the firearms industry, delivering firearms and firearm-related products to consumers for over 160 years. The bulk of their revenue is derived from selling long guns and handguns, with additional ancillary revenues coming from their Gemtech Suppressor brand and their Precision Components manufacturing arm. The company does not sell these products directly to consumers, but rather to retailers who eventually sell the products to end users.
The last boom occurred leading up to the 2016 U.S. election, when Hillary Clinton was the heavy favorite. Many thought her election would result in increased gun control laws.
As a result, consumers rushed to their gun stores to stock up on guns and ammo, and Smith & Wesson saw its business and stock price boom.
As we all know, Donald Trump won the 2016 election, and gun sales plummeted. To make matters worse, Smith & Wesson had made several acquisitions in the previously booming market and had taken on debt to do so.
2017, 2018 and 2019 were not kind to Smith & Wesson, as sales declined by 29%, inventory ballooned, and free cash flow declined by 83%.
However, recent events have switched the outlook for the gun and ammo industry from bust to boom in a matter of weeks.
COVID-19 Lockdown Leads to Gun Sales
Gun sales started to pick up during the COVID-19 lockdown as individuals feared that law enforcement would not be able to help them or their family in the case of an emergency.
Demand for guns surged even higher following national protests following the killing of George Floyd.
“Almost, you couldn’t even keep up with it. That’s how crazy it was,” said Joe Hawk, owner of Guns & Roses in New Jersey. “After Memorial Day, it spiked again. It just went crazy again.”
A Democratic Lead Results in Gun Sales
One benefit to Smith & Wesson is that its business isn’t necessarily economically sensitive. However, it is closely tied to the economic cycle.
If a Democrat appears likely to win the Presidential election and implement stricter gun control laws in America, consumers rush to buy guns before more regulations come into place. If a Republican is then elected afterwards, much like the result of the 2016 election, sales slow considerably.
Sales ramped higher in both 2012 and 2016. In 2012, President Obama (a Democrat) was re-elected and sales continued to grow. In 2016, President Trump was elected and sales stalled as fewer worried about tighter gun restrictions.
Gun Sales Go Up in Election Years
Given that 2020 is a Presidential election year and Joe Biden has a reasonable chance of winning, consumers will likely continue to buy guns leading up to the election.
In light of the factors discussed above, SWBI stock has been strong in 2020.
Nonetheless, there still could be significant upside ahead. Smith & Wesson stock typically performs well in election years. As such, the stock could be a great trade into the second half of the year.
4 Retailers that are Benefiting from Social Distancing
Experts predict the pandemic has acclimated consumers to the idea of online shopping, a trend that’s projected to continue well beyond the U.S. economy’s complete reopening. U.S. retail sales just had their biggest jump in history despite the recent economic shutdown. With this in mind, let’s take a closer look at some of the companies that should benefit from this trend.
Amazon.com is the name that perhaps first comes to mind when most people think online shopping, and for good reason: Amazon is the largest e-commerce retailer by online revenue, surpassing even Walmart as the largest retailer in the world last year. Just when it looks like the firm has saturated all the most important retail channels, it keeps finding new ways to grow. It generated $280 billion in sales last year, and analysts anticipate $346 billion in revenue (+24%) for 2020, thanks largely to the massive increase in online sales related to the pandemic. It also continues to expand into new areas, including healthcare, and the growth trend is expected to continue for the next several years. Needless to say, AMZN stock should be a staple of any long-term growth investor’s portfolio.
Big Lots (BIG)
E-commerce stocks aren’t the only ones making bank in today’s post-COVID economy. In what came as a surprise to many, a few brick-and-mortar retailers actually outperformed during the shutdown, as well. Among them was Big Lots (BIG), which kept all its stores open during the pandemic and reported strong online business (+45%) and higher comparable-store sales in April.
The closeout consumer goods retailer also said comparable-store sales were “up strongly” in the current quarter and have exceeded the firm’s expectations through mid-June; it also saw its biggest e-commerce volume ever in Q1. Management attributed recent growth to increased demand for home furnishings during the lockdowns, though it warned that sales will likely slow this summer. But analysts anticipate more growth in furniture and online sales (the firm recently partnered with Instacart to provide same-day delivery from nearly 1,400 stores in 47 states), and 13% revenue growth is expected in Q2. As an off-price retailer in a rebounding economy, we think Big Lots still has room to grow.
When most people think of retailers, they don’t typically think of automobiles. But Carvana (CVNA), the nation’s fastest-growing auto retailer and the leading e-commerce platform for buying and selling used cars, is among the retailers that drastically outperformed during the shutdown. Although its sales fell around 30% in early April, it rebounded to around 25% growth (year over year) by April’s end due to the pandemic. Millennials in particular are drawn to the firm’s unique online car sales platform, and analysts estimate 29% revenue growth this year and 45% top-line growth in 2021. Carvana’s growth prospects make it a worthwhile consideration for longer-term-oriented investors.
Millions of Americans experienced cabin fever during the shutdown, and with the extra time on their hands, many turned to home improvement projects and gardening. Lowe’s (LOW) experienced strong sales growth in the first quarter, with total company comparable sales growing 11% and online sales increasing an incredible 80%! The pandemic also resulted in increased demand for COVID-related products, such as cleaning supplies and appliances like refrigerators and freezers. Now that the economy is reopening, the company should see increased sales for building supplies, as well as home consumer-related products. Earnings are estimated to increase 17% this year from a year ago, while revenue is expected to rise 6%. All told, there appears to be growth potential ahead for LOW.
The companies discussed here are among the top performers in the retail sector and should be able to benefit from additional improvements in U.S. economic conditions. With a new bull market now underway, investors should expect that retail stocks—particularly those with a solid e-commerce business—will continue to show relative strength and forward momentum in the months to come.
You Just Got a Stock Spin-off. Now What?
If you have large-cap stocks in your portfolio, you will eventually end up with shares of a stock spin-off. You won’t look for them. You won’t call the company asking when you can get yours. They just magically show up in your portfolio, and you won’t even know what it is. At least, it sometimes seems that way.
Take, for example, United Technologies, which spun off two separate companies, Otis Worldwide (OTIS) and Carrier Global Corporation (CARR). The remaining aerospace division of United Technologies was merged with Raytheon to create an aerospace and defense juggernaut. To further confuse the issue, it kept the Raytheon (RTN) name.
But let’s take a step back.
What is a Stock Spin-off?
A stock spin-off occurs when a publicly traded company separates part of its business into a second public company and distributes its shares in the new business on a pro-rata basis to existing investors.
Spin-offs occur because management thinks their business is undervalued by the market, and believes (with good reason) splitting the business up into a simpler structure will force investors to re-value the spin-off and parent more in line with comparable companies.
How Do Spin-offs Perform?
In short, they perform well and many famous investors advocate for investing in spin-offs.
Peter Lynch, who famously generated 29.2% annual returns while managing Fidelity’s Magellan Fund, wrote in One Up on Wall Street, “Spin-offs often result in astoundingly lucrative investments.”
Joel Greenblatt, a lesser-known but equally impressive investor who generated 50% annual returns while managing Gotham Capital, was also a proponent of spin-off investing. He wrote in You Can Be a Stock Market Genius, “You can make a pile of money investing in spin-offs. The facts are overwhelming. Stocks of spin-off companies significantly and consistently outperform the market averages.”
While spin-offs won’t outperform every year, numerous studies show that over the long term, stock spin-offs do quite well.
For example, Credit Suisse found that U.S. stock spin-offs outperformed the market by 13.4% in the first 12 months of trading.
What to Do When You Receive a Spin-off
When you receive shares in a spin-off, it’s difficult to find information related to the new company or companies that you now own. But given the long-term performance of spin-offs, it’s usually a prudent decision to hang on to the shares of any spin-off that you receive.
Take Otis Corporation and Carrier Global Worldwide, the two spin-offs that we discussed above. Both of these companies have solid businesses, will continue to grow with the global economy and trade at reasonable valuations. They have cyclical exposure (especially Carrier), but over time, they should both perform well.
Nonetheless, there are two questions to consider when deciding whether to sell a spin-off:
- Is the spin-off paying exorbitant high interest on its debt?
- Is the spin-off’s business in secular decline?
If the new spin-off has debt and its cost of interest is at 10% or higher, bond holders have expressed serious concerns about the staying power of the business. This is a serious red flag.
Take Quorum Health (QHCCQ), a 2016 spin-off from Community Health Systems (CYH). Bond holders priced Quorum’s debt at 11.6%, an incredibly high interest rate, especially considering how low rates were (and continue to be) around the world. Investors would have been smart to sell their spin-off shares of Quorum Health as the company performed poorly and eventually declared bankruptcy.
The second question relates the outlook for the business.
If the spin-off’s business is in secular decline, it’s usually a good decision to sell the stock, even at a cheap valuation.
Take CBS Radio, which was spun off and merged with Entercom Communications (ETM) in November 2017.
The radio business generates good cash flow but is in secular decline. Again, investors would have been wise to sell ETM after the CBS Radio spin-off as shares are down 83% since the transaction.
Usually, however, it pays to hold onto your spin-offs or buy more.
Consider PayPal (PYPL), a 2015 spin-off from eBay (EBAY). PayPal is up 318% since its first day of trading!
Or Zoetis (ZTS), a 2013 spin-off from Pfizer (PFE), up 344% since.
Or Bioverativ, a 2017 spin-off from Biogen (BIIB), which was acquired by Sanofi (SNY) a year after its spin-off for 138% higher than its spin-off price
Those are the kinds of returns that make investing in stock spin-offs worth the risk.
3 Stocks Capitalizing on an Unusual Summer
Summer is the time to enjoy the sunshine. Invite friends and family to a backyard barbecue, pop open a cold beverage, or take in a baseball game. We hop in our cars for road trips, crank up the tunes, and stop at roadside ice cream stands. And there’s nothing like an outdoor concert on a summer evening, watching the sunset and listening to your favorite band with hundreds or thousands of your best friends.
This summer will be the best we’ve ever...(Record scratch…) Or not. Not this year, thanks to COVID-19. Instead, Americans are having to get creative with their summer planning, mostly limited to their homes or at least their own states. To make the best of it, people are purchasing items some probably never thought they’d buy. And a new breed of alternative summer stocks is capitalizing.
Never thought of yourself as an RV (recreational vehicle) person? Thousands of people are starting to make the plunge, shelling out for the safety and space of a camper or Winnebago to do a bit of sightseeing at a time when hotels aren’t much of an option.
Always dreamed of putting in a pool, but never found the right time to do it? Now’s the time! With many beaches still closed, and the fear of being around other people still lingering, Americans are using the summer vacation money they’ve saved and putting in a swimming pool instead.
And of course, the boom in home projects, gardening and landscaping continues. After being stuck at home for two and a half months, your yard has probably never looked better. Now it’s time to tackle those in-home restoration projects you’ve been putting off for years—or vice versa.
How to play the sudden, unexpected boom in RV purchases, at-home pools and home and garden improvements? Try Thor Industries (THO), Pool Corporation (POOL) and Home Depot (HD).
Three stocks that will brighten up your summer
Alternative Summer Stock #1: Thor Industries (THO)
Bloomberg recently published a detailed article on the concept of “Covid Campers,” outlining the noticeable uptick in RV purchases—particularly among first-time buyers. An RV dealer in Austin, Texas reported sales being up 30%. Camping World Holdings Inc., a retailer of outdoor equipment and RVs, was one of the rare U.S. companies to beat first-quarter sales estimates. Bookings at Outdoorsy, which is essentially Airbnb for RVs, allowing consumers to rent recreational vehicles, have “skyrocketed,” according to the company’s co-founder.
As RV purchases/rentals have ramped up, production is up too. And that’s why I like Thor Industries, the largest publicly traded RV manufacturer in the U.S. While sales and earnings for 2020 are expected to fall thanks mostly to the six-week hiatus the company had to take at its manufacturing plants, the recent surge could have the company beating estimates.
Meanwhile, the stock is flourishing, on the brink of breaking out above its February highs…
With plenty of upside left (the stock traded as high as 156 in January 2018), the rebound in THO stock likely isn’t over.
Alternative Summer Stock #2: Pool Corporation (POOL)
According to MarketWatch, the 25 biggest pool builders in the Pool and Hot Tub Alliance have had more consumer inquiries year over year. That’s pretty remarkable considering that 38 million people are out of work.
Sabeena Hickman, the Alliance’s president, said, “With COVID, and the trepidation with travel, people are taking that money and investing it in a backyard pool. Most of the industry had shut down for a period of time. Now they’re saying their phones are ringing off the hook.”
Shares of Pool Corporation, a wholesale distributor of swimming pool supplies, equipment and related products, are soaring accordingly. POOL stock is trading at new all-time highs, blowing past its February highs.
It’s a mid-cap stock, but a reliable one of late (beta of a mere 0.74). Buy on dips and keep position sizes relatively small.
Alternative Summer Stock #3: Home Depot (HD)
Like grocery stores and gas stations, hardware stores and home improvement chains remained open during the pandemic. And with people at home more than ever before, the demand for home and garden products has rarely been higher. Two wit: Home Depot – the nation’s largest home improvement store chain – reported a 7.3% year-over-year increase in sales, including a 6.4% uptick in same-store sales—its biggest year-over-year jump since the second quarter of 2018.
As a result, Home Depot stock has crawled out of the big hole it dug for itself in March; it’s trading just under February highs.
Add in the 2.5% yield and long history of dividend growth, and HD is a perfect all-weather stock that is thriving during these tumultuous times.
REITs to Buy for the Eventual Retail Rebound
Shopping is a national sport. For proof, look no further than the lines of people camping out at their favorite retailers before Black Friday. Or visit the gift shops of any beach town in the middle of summer. But that was before. Now?
Who needs the big name brick-and-mortar retailers? Well, I have to tell you, with the exception of Lowe’s, Home Depot, and the grocery stores, not me!
It’s amazing how much time (and money) I save by not going shopping. That’s one thing for which I can thank the coronavirus pandemic. But, unfortunately, the pandemic has been devastating for a group of businesses that have long been struggling. It will be the death knell for many of them. But not all…which is why shopping center REITs could be good long-term, bounce-back investments. More on my favorites in a bit.
The short-term state of retail is ugly, but there are investment opportunities if you know where to look.
According to GlobalData Retail, 60% of overall U.S. retail square footage has closed its doors since the pandemic. Total online and store purchases fell 8.7% in March. Best Buy announced it is furloughing 125,000 employees. The Gap has laid off tens of thousands and has burned through $1 billion in cash since February. Nordstrom’s sent more than 300,000 employees home.
The beneficiaries have been Amazon (AMZN), as well as retailers that had already been building their online presence. E-commerce sales had already doubled over the same period last year by February. And since the pandemic started, they were up another 38% in March.
Some retailers have gotten into the online game, creatively. Nike and Lululemon have upped their online activity by offering exercise classes. Several retailers have been allowing customers to order online and pick up curbside.
But those who had not established a robust online presence before the coronavirus—retailers like the Gap, Kohl’s, and Macy’s—are hurting. Prices are being discounted as much as 70% at some stores. And we’re suddenly seeing bankruptcy filings from J. Crew and luxury department store retailer Neiman Marcus Group, who both filed for Chapter 11 bankruptcy protection. Forever 21 filed in September 2019 and closed 100 stores. It’s amazing that J.C. Penney is still in business, after years of struggles, and rumors have it that the company is hoping to skip liquidation, perhaps by filing for bankruptcy. Same with Sears and Kmart; I just can’t see them holding on. Pier 1 filed for bankruptcy in February.
It’s going to get worse. S&P Global Ratings says that some 30% of retailers have at least a 1-in-2 chance of defaulting on their debts and more than 2,100 retailers in the U.S. have permanently closed this year, and another 9,700 store locations are shuttered. Experts say that 20%-25% of all U.S. stores could close in the next two to three years.
As for what to buy now, here are the companies that I think are going to be the losers: big department stores like Macy’s (M), boutique retail establishments like The Gap (GPS), and shopping center REITs that are anchored by big department stores. If you have those in your portfolio, it’s probably best to take your losses now.
The winners at this point have been Walmart (WMT), Costco (COST), Kroger (KR), Lowe’s (LOW), Home Depot (HD), and, of course, Amazon. Lowe’s shares have almost doubled; the others are all up. But before coronavirus, Walmart and Kroger had had their ups and downs. Costco has been a perennial investor favorite. And both Lowe’s and Home Depot have benefited by being two of the few stores you could actually visit since coronavirus concerns shuttered many storefronts. The boost may be temporary for most of them—with the exception of Amazon. Amazon has found new audiences with its streaming and Amazon Web Services, in addition to its e-commerce gains.
But not everyone wants to buy a stock priced at more than 2,400 a share.
Take the long view on retail by investing in shopping center REITs
Instead, thinking longer-term, why not consider some of the real estate investment trusts (REITs) that own shopping centers anchored by stores that are not the big department retailers?
Here are a few ideas:
National Retail Properties, Inc. (NNN) owns 3,125 properties over 48 states covering 37 lines of trade. Its top tenants include: 7-Eleven, Mister Car Wash, Camping World, LA Fitness, Flynn Restaurant Group (Taco Bell/Arby’s), GPM Investments (Convenience Stores), AMC Theatres, Couche-Tard (Pantry), BJ’s Wholesale Club, Sunoco, Chuck E. Cheese’s, and Mavis Tire Express Services.
Slate Retail REIT (SRRTF) is a Canadian-based REIT that owns 76 properties totaling approximately 9.9 million square feet. Tenants include Kroger, Publix, Ross Stores, PetSmart, and Rack Room Shoes.
Realty Income Corporation (O) owns 6,500 properties. Its top 10 tenants include: Walgreens, 7-Eleven, Dollar General, FedEx, Dollar Tree / Family Dollar, LA Fitness, AMC Theaters, Regal Cinemas (Cineworld), Walmart / Sam’s Club, and Sainsbury’s.
It may be a bit before these shares start to recover, but they are long-term ideas. And they all pay decent dividends while you wait for appreciation. So, why not go shopping?
Think Credit Cards to Get Income
Visa, Mastercard or AMEX: Which One is the Best Investment?
Most people don’t carry cash anymore, and when they do, they often still use a credit card or debit card to avoid another trip to the ATM. If this sounds like you, you’re not alone.
Cash is fading as the currency of choice. The world is moving rapidly in the direction of cashless transactions. In the U.S., about a quarter of all transactions are not even made in person and cash can’t be used. Cash is now used in only 39% of in-person transactions, according to a recent Federal Reserve study.
According to the same study, about 30% of all U.S. transactions are cash. While cash still remains the single largest payment source, credit cards and debit cards together account for 48%. And the U.S. only ranks fifth among nations with the most cashless transactions. In fact, electronic payment volume exceeded cash transactions globally for the first time a couple of years ago.
The growing popularity of cashless transactions has given rise to crypto currencies like Bitcoin. Digital currencies provide a lot of the convenience of cashless transactions while retaining anonymity. And these currencies will likely continue to grow and gain traction in the future. But investing in them is like the Wild West. You can lose your shirt in a hurry.
There’s a safer and easier way to play the trend. In fact, you can do it with Dow stocks. Established blue chip companies are benefiting greatly from the proliferation of credit card and debit card usage and making money like crazy. Take a look at the ten-year returns of these boring old credit card stocks:
- Visa (V) 1,156%
- Mastercard (MA) 1,651%
- American Express (AXP) 536%
The S&P 500 return over the same period was just 310%. A $10,000 investment in the market index ten years ago would be worth about $41,000 today, not bad. But a $10,000 investment in the above mentioned stocks over the same period would be worth $125,000, $175,000 and $64,000 respectively.
The future for these credit card giants looks pretty good. Sure, there will be increasing competition from mobile apps and other payment methods. But there’s still plenty of opportunity to go around. About 85% of transactions globally are still conducted in cash.
Let’s dive deeper into these three stocks:
Visa (V) is king in the U.S. with a 51% market share of the credit and debit purchase volume. In fact, Visa is the largest payment processor in the world. It operates in 200 countries. Here’s the beautiful thing about Visa. It doesn’t loan money. It just collects a fee every time a card is swiped. There is zero concern about rising delinquencies in a declining economy. The company just rings the register every single time the card is used. Visa company continues to enjoy double-digit earnings and revenue growth with no end in sight.
Mastercard (MA) is no slouch either. It’s the second largest payment processor in the world, operating in 200 countries. It has the same business model as Visa except it’s smaller. It has actually been outperforming Visa in terms of growth as its smaller size enables some leveling of market share. Like Visa, Mastercard still has lots of potential growth opportunities throughout the world.
American Express (AXP) is a different animal than Visa and Mastercard. It also sells for less, but the main difference is that Amex actually loans money. Customers maintain balances for their transaction and pay a considerable interest rate. The thing that separates Amex from other credit card companies is the elite quality of its clientele, who have the best credit risks and lowest delinquencies in the business. Amex also generates fees every time the card is used. As well, it has tremendous relationships with corporations and their business travel expenses. The company has relationships with 60% of fortune 500 companies. It also has partnerships, most notably with Delta Airlines.
The future is bright for these credit card companies; you can buy them at any time. They also have strong momentum at this point. However you may not want to pay up for the credit card giants with the market at all time highs. That’s okay. V and MA are ideal stocks to target for buying in the next down market or bear market. At some point in the future, there will be a huge opportunity to pick up these juggernauts on the cheap. Don’t forget them.
Estate Planning - Uncle Sam Hopes You Won’t Do It
No one wants to talk about dying. But, as the quote often attributed to Ben Franklin says, “nothing is certain but death and taxes.”
And if you don’t make plans for what happens to your assets after you die, Uncle Sam, as well as several state governments will reap a good portion of the assets you’ve accumulated from working, saving, and investing. Your first goal should be to protect your estate from taxes, so you can maximize the monies that you pass on to your heirs and beneficiaries.
But you may have other goals, too, including:
- Protecting your business and making sure there is a plan in place so that it will continue after your death. You’ll want to ensure it is incorporated properly to minimize taxes and you’ll want to ensure that you have enough insurance to keep it going, at least in the short-term.
- Providing for long-term care for yourself and your spouse.
- Allocating assets to care for minor or disabled children, or your pets.
- Supporting a non-profit or charitable organization.
- Directing the use of assets for your children’s or grandchildren’s education
- Protect your wealth against creditors.
Consequently, it’s time to make a plan!
Let’s start very simply—with information. There are two primary taxes you have to worry about:
- Estate Tax. As of this year, your estate must file a U.S. estate tax return if your individual estate is valued at $11,580,000 (if single) and $23,160,000 (if married) or more upon your death (which is why this is also sometimes referred to as the Death Tax). For the vast majority (99.8%) of Americans whose estates are below that level there will be no estate tax from Uncle Sam. Here is a link to current estate tax rates: https://smartasset.com/taxes/all-about-the-estate-tax. If you live in Connecticut, Delaware, Hawaii, Illinois, Massachusetts, Maryland, Maine, Minnesota, New Jersey, New York, Oregon, Rhode Island, Vermont, Washington State, and Washington, D.C., your state also has an estate tax, and some of those are applicable to estates much smaller than $11,580,000. Make sure you check the threshold in your state.The Executor—not the beneficiaries—of your estate will be responsible for paying your estate tax—before any proceeds are paid out to your heirs.
- Inheritance Tax. Also sometimes referred to as a Death Tax, this is a state tax that your heirs (the beneficiaries of your property) pay on the assets they inherit from your estate. It is calculated separately for each beneficiary. Currently, six states levy inheritance taxes: Iowa, Kentucky, Maryland, Pennsylvania, Nebraska and New Jersey. Here’s a link to current rates: https://www.jrcinsurancegroup.com/states-with-an-inheritance-tax-2020/. It’s important to note that spouses are exempt from inheritance taxes (federal and state). And if your children and grandchildren live in Iowa, Kentucky, Maryland, or New Jersey they won’t pay an inheritance tax either.
How to Avoid or Reduce Estate and Inheritance Taxes
At the most basic level there are three things you can do to reduce the estate and inheritance tax when you die:
- Give your money away before you die
- Write a Will.
- Set up a Revocable or Living Trust
Let’s delve into each one of these methods that can help you avoid or reduce the death taxes.
Gifting: For 2020, you can help your heirs to pay less taxes by gifting them up to $15,000 each and every year (up to $30,000 if you are married and hold the property jointly). However, there is a lifetime gift exemption. For this year, it is $11.58 million ($23.16 million for married couples), which means you can give away up to those amounts during your lifetime, without having to pay gift tax on them.
A couple of caveats: 1) Even if you don’t go above the exempted amount, you may still need to file a gift tax return with the IRS. Consult your accountant; and 2) Your state may also levy a gift tax. Right now, it looks like Connecticut is the only one to do so, but again, consult your accountant or attorney.
And one more important thing to know. There are some gifts that are always exempt and for which you do not need to file a gift tax return, including:
- Gifts to charities approved by the IRS (these can also be deducted from the total amount of gifts you make, for exemption purposes)
- A gift to your spouse (as long as he or she is a U.S. citizen)
- A gift to cover someone’s education tuition, if paid directly to the educational institution (does not cover gifts to cover room and board, books or supplies)
- Gifts to cover someone’s medical expenses, if paid directly to the medical facility
- A gift to a political organization
Wills: This legal document stipulates how you want your assets to be distributed among your heirs, and if you are responsible for minor children, it will set forth the terms of their care.
There are three primary types of wills:
Joint wills are executed by two people, usually a married couple, and take the place of separate wills for each partner. Usually, they stipulate that when one spouse dies, the estate passes to the other. And then when the last spouse passes away, the entire estate goes to their children. And while this seems simple, some states don’t recognize them and most attorneys advise against them, as they are very inflexible.
Mutual wills are usually set up by a married or committed couple. These are very common, especially in this day of blended families, as they bind the surviving partner to the terms of the will. For example, you may want your property to pass to your children, not those of your spouse’s, and a mutual will can ensure that. Note, a mutual will is not the same as a joint will.
Pour-over wills are used in combination with creating a trust, and are recommended if you have minor children. It will name your children’s guardian and make sure that all the assets you want in the trust are there, even if you fail to retitle some of them before your death.
Wills are not the be-all and end-all of estate planning. Certainly, they allow you to select the distribution of you bank balances, property, or prized possessions, as well as businesses or investments. You can also name how assets are to be directed to your favorite charities or organizations and who should become the guardians or caretakers for minor children.
But…wills do not address what can make up the majority of your estate, such as life insurance policies (they have specified beneficiaries), ‘transfer on death’ titled investment accounts, or even some jointly-owned assets. Every state but Georgia has elective-share or community property laws that regulate the ownership and inheritance of your marital assets. Elective-share simply means that the surviving spouse may ‘elect’ not to accept the share of property dictated by your will, and instead, require a more equitable split.
In the U.S., there are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. And Alaska is considered an opt-in community property state, which means that both spouses have the option to make their property community property. In a community property state, both spouses equally own all marital property.
Bottom line, this means that in an elective-share or community property state, your will can be overruled. Naturally, there are plenty of exceptions as to which assets constitute marital property, so please consult a professional to determine your specific requirements.
And even if you do create a trust, a will is recommended. Your trust will deal with specific assets, and your will can cover the miscellany.
As you can see, a will should be the first step in your estate planning process. Unfortunately, most people (some 60% of Americans) do not have a will. And that is not a good thing, because, if you die without a will (intestate), your state gets to determine how your assets are disbursed. Most of the time, that means your spouse gets one-half of your estate and the other half goes to your children. And that can create havoc.
What if your children want to cash out by selling the family home, which can leave your spouse with nowhere to live? Or you have a minor or disabled child, and no one is appointed to look after him? Or you have children that don’t get along and spend years in court fighting each other over your assets?
Lastly, let’s not even think about the taxes! A good, executed will can help you avoid or reduce estate taxes (especially on large estates) or the inheritance taxes that your heirs will have to pay.
So, let’s agree you need a will. I know it sounds overwhelming to think about, but now’s the time! And if your break the process down, step-by-step, it will go much easier.
Here’s the Financial Freedom Federation 6-Step Process to Creating Your Will
Step 1: Write down a list of all your assets and debts.
This will include the contents of safe deposit boxes, family heirlooms (especially jewelry and antiques), art, furniture, collectibles, real estate, vehicles, business ownership/interests, health savings accounts, intellectual property, bank accounts, investment accounts, life insurance policies, retirement accounts, and other assets that you wish your heirs to inherit.
Step 2: Write down which of your heirs get what.
You may also want to write a ‘letter of instruction’ to keep with your will. The letter should include a list of accounts and numbers, passwords, and burial instructions. By itself, please be aware that the letter of instruction may not be valid in some states; so, make sure you also include these items in your will. While your making your list, also consider a power of attorney or living will (medical directive), and who you would want to be responsible for financial and/or medical decisions should you become mentally or physically incapacitated (more on these later). And don’t forget about providing caretaking for your pets.
Step 3. Prepare and validate your will.
You don’t need an attorney to prepare your will; there are plenty of tools available on the internet, but I would strongly recommend an estate planner or attorney, just to make sure you close all the loopholes.
However, should you decide to go it alone, your will needs to be witnessed by two adults of ‘sound mind’, with whom you are well-acquainted. And to prevent trouble ahead, those witnesses should be ‘disinterested’ people—those who have no financial or personal stake in your estate. If your attorney prepares your will, he should not serve as a witness. And lastly, your state may require that your will be notarized, which can help ease your heirs through the probate process (if you don’t manage to avoid that!)
Step 4. Choose an executor.
Choose wisely. You may want your best friend, but if you two are the same age, your best friend may not be around when you die. And your executor should be willing and able to administer your estate, even if it takes several years to be closed.
You can name pretty much whomever you desire—your spouse, an adult child, a trusted friend or relative, or your attorney. And you can name joint executors. But if your estate is large and/or complicated, consider a professional to manage its disbursement. And make sure your executor is empowered to pay your bills and deal with debt collectors and any related issues that may arise.
Step 5. Store your will in a safe, but accessible place.
People often first think of a bank safe deposit box, but if you die and your heirs do not have access to the box, it may take a court order to open it, which can delay the processing of your estate. A good, water- and fireproof safe can solve that problem. Make sure to give your executor and attorney a copy of your will and tell him where the original is located. Otherwise, trying to locate the original will can hold up the settling of your estate.
Step 6. Review your will every couple of years.
Life changes: beneficiaries die, people divorce, children are born, more assets are acquired. Any of those scenarios may prompt a change in your desired asset distribution. If that happens to you, you can either write a new will or add a ‘codicil’, witnessed by two people and notarized, outlining your change of heart.
- No will—no control over the disbursement of your estate.
- You can prepare a valid will yourself, but you must have it witnessed to decrease potential challenges.
- Review your will—and revise, if necessary—every few years.
- Oral wills are not widely recognized as valid.
- While holographic wills (written, signed, but not witnessed) are recognized in some states, they often lead to challenges of their validity.
- Life insurance proceeds, investment accounts, and jointly-owned assets are generally excluded from wills.
Don’t Forget about a Living Will
A Living Will has nothing to do with your Will or how your assets are distributed. Instead, it’s a legal document in which you express your wishes for any medical care that you may need in case you’re are incapacitated and cannot direct your own care. It tells your medical professionals whether or not you agree to resuscitation or life support to prolong your life. A living will may be attached to your will as an addendum; that way, in case of a medical emergency, it will be easily accessible.
If you become incapacitated and don’t have a living will, it will be up to the medical professionals to determine what life-prolonging care you will receive. A living will may also be called a declaration regarding life-prolonging procedures, an advance directive, or, a declaration.
The requirements for a living will vary by state so many people hire a lawyer to prepare their living will. Most people can create this simple document - along with the other typical estate planning documents - without incurring legal fees by using a quality software application that accounts for their state’s laws. Like your regular will, in most states, your living will must also have two witnesses and be notarized. Please consult your own state regulations for exact requirements.
A living will is often accompanied by a Durable Power of Attorney (DPOA) for healthcare. The DPOA appoints an ‘agent’, ‘healthcare proxy’, or ‘attorney-in-fact’ to carry out your directives in your living will.
You may revoke your living will, and DPOA, at any time. The living will generally terminate at your death, unless it allows your agent to make decisions about organ donation or autopsy. The DPOA is only effective while you are alive.
Trusts are legal documents that can be set up prior to death and they survive a person’s death. They can also be created by a will and formed after death. A trust is a fiduciary relationship, in which one party, the trustor (also called trustmaker or grantor), gives another party, the trustee, the right to hold title to property or assets for the benefit of a third party, the beneficiary. The primary reasons to form a trust are to:
- Ensure your assets are distributed as you desire
- Provide legal protection for your assets
- Save your heirs time and streamline the paperwork of the estate
- Avoid or reduce estate and inheritance taxes.
Once your assets are placed in the trust, they belong to the trust itself, not the trustee. There are lots of different types of trusts, but the two basic and most common types are revocable and irrevocable.
Revocable Trusts are created during your lifetime, and you can change them or revoke them at your pleasure. They may also be called Living Trusts. The mechanics are this: You establish the trust, put in the assets you desire, and you serve as the initial trustee.
You are the only person designated to add or remove property from the trust during your lifetime. The big advantage: any assets you transfer into the trust during your lifetime are not subject to probate (more on that in a little while), which can save you and your heirs a lot of money.
However, asset protection is not a major advantage, as with a revocable trust, your creditors may possibly still access your assets within the trust (with a court order)
When you die, typically, your revocable trust becomes an Irrevocable Trust.
An Irrevocable Trust cannot be changed or revoked after you create it. It’s permanent—until you die, and your assets are given to your heirs.
An Irrevocable Trust has a couple of advantages: 1) It protects the assets in the trust from lawsuits and judgments. Often used by business owners, doctors and attorneys, the assets in the trust cannot be removed by court orders and judgments; and 2) If you have a large estate and you have already reached your lifetime tax-free gift limit, and you are leaving additional funds (above the limit) to your heirs, the trust will exempt your estate from the 40% federal tax levy that it would normally be subject to for gifts above the exempted amount.
Here are a few more types of trusts:
Asset Protection Trusts insulate your assets from your creditors. They can be set up in the U.S. or in a foreign country. They are generally created as irrevocable trusts.
Charitable lead trusts (CLT) and Charitable Remainder Trusts (CRT) convey assets into a trust, which will then pay income to one or more parties during the lifetime of the trust (no more than 20 years), and then distributes the remaining assets of the trust to one or more parties at the end of the trust’s term.
In a CLT, your selected charity benefits from the first part of the trust—the lead. And at the end of your trust’s term, the remaining assets are distributed to you or your beneficiaries. In a CRT, the income from the assets in the trust is first distributed to the trust’s beneficiaries for a specific period of time, and then any monies remaining are donated to the designated charity
Special Needs Trusts are created on behalf of a beneficiary who receives government benefits. It allows the beneficiary (for example, a disabled person) to receive luxuries, dental and vision benefits, transportation, education, rehabilitation, insurance, special dietary needs, spending money, vacations, payments for a companion or other items, without reducing his eligibility for government benefits. The primary stipulation is that the beneficiary may not have any control on the amount or frequency of the trust’s distributions, and he cannot revoke the trust. Ordinarily when a person is receiving government benefits, an inheritance or receipt of a gift could reduce or eliminate the person’s eligibility for such benefits.
Spendthrift Trusts do not allow the beneficiary to sell or pledge away interests in the trust, so it offers protection from the beneficiaries’ creditors, until such time as the trust has distributed all property to the beneficiaries.
Tax By-Pass Trusts enable a spouse to leave money to the other spouse, reducing the federal estate tax when the second spouse dies. Normally, at that time, the remaining assets that are more than the exempt limit will be taxable to the couple’s children, up to a whopping 55%. With a tax by-pass trust, that amount is substantially reduced.
Totten Trusts cover accounts and securities in financial institutions, not property. They are set up during your lifetime by depositing monies in a financial institution in your name as trustee for someone else. They are revocable trusts which are not ended until your death and then the monies (gifts) are transferred to your individual or entity beneficiaries, without going through probate.
Lastly, if you do create a trust, fund it promptly. Otherwise, if you die before it is funded, it will be useless.
A will and a trust go hand-in-hand, whereas a will generally covers the totality of your assets, and a trust provides for dealing with specific assets, such as life insurance or a particular piece of property. Make sure all the assets that you want to be in the trust are put into it. Any asset that is not retitled in the name of your trust are subject to probate.
I’ve mentioned probate several times, so let’s tackle exactly what that means to your estate.
Probate is a court of law whose purpose is twofold:
1) It verifies your will is legal and that your wishes are carried out; and
2) If you don’t leave a will, a probate court will decide how to distribute your assets. Probate can take a few weeks or months, if your estate is small, or for larger estates, it can take years. Probate is where anyone who wants to contest a will files a petition. And the legal fees can quickly add up. Not only that, but once probate is filed, those records are available to the public.
Not every asset is subject to probate—bank accounts, retirement funds, and life insurance usually name beneficiaries, so those assets can go directly to your heirs.
But probate is a pain—tons of paperwork for your executor to wade through and file, including an inventory of every one of your assets. Creditors can come out of the woodwork with their claims. The estate can’t be settled until the court makes sure any potential heirs are notified.
Consequently, you probably want to avoid probate—at all costs. And you can do that by creating a will, establishing a trust, and/or making sure all your assets are titled properly.
Make Sure your Assets Are Titled Properly
How the title to any property you own is held can make a big difference on the tax implications and who controls the property. There are many ways to title your assets. Which one is best for you depends on your circumstances and your objectives. This is an area where you may well want to seek legal advice.
Here are a few of the most common types of title methods:
Joint Tenancy is when two or more people hold title to real estate with equal rights to the property during their lives. If one dies, ownership reverts to the surviving owner. The owners do not need to be married or even related. Properties entitled this way cannot be transferred by will if one owner dies. One disadvantage: if one of the owners dies and has debts, the creditors can secure a judgment to collect from the other party.
Tenancy In Common (TIC) is when two or more people hold title to real estate jointly, with equal rights to enjoy the property during their lives. Either owner can pass his ownership onto his heirs (or sell it if he desires), but any outstanding debts on the property for which the deceased owner signed are the responsibility of his heirs.
Tenants by Entirety (TBE) is only for legally married couples. The couple, for legal purposes, is one entity. This method conveys ownership to them as one person, with title transferred to the other in entirety if one of them dies.
Sole Ownership is when one person or entity owns the property. That may include single or married persons, or businesses. This type of ownership would need to be included in a trust and/or will to be properly passed on to your heirs.
Community Property is when a husband and wife—during their marriage—own property together. Under this title, either husband or wife may dispose (or will) of one-half of the property to someone other than their spouse. Generally, property acquired during marriage (except real estate) is community property. Real estate acquired during a common-law marriage is also community property. In that case, I would recommend consulting an estate attorney.
Corporation Ownership is property by a corporation which is owned by its shareholders but having an existence separate from those shareholders.
Partnership Owners are two or more people who share ownership of a business. They may be equal or limited partnerships. If limited, the limited partners have ownership benefits but no management rights, and the general partner is responsible for all business decisions.
Trust Ownership in which real estate is owned by a trust and is managed by a trustee on behalf of the beneficiaries to the trust.
Calculate your Life Insurance Needs
Not everyone needs life insurance, but most people will have at least some type of term insurance policy. A full review of the types of insurance you may want or need is a much longer discussion, one we will cover in a future issue. For now, here are just a few reasons why you might want to include insurance as part of your estate plan:
- Your family is dependent upon your income
- You have a mortgage which could be paid off at your death
- Your business partners could use insurance to pay your heirs to buy out your ownership
- You have a minor or a disabled child who will need extended care or expensive education if you die
- You have debts that could be paid with the proceeds
- Your heirs can use it to pay your burial expenses
You can name a beneficiary to your life insurance policy. That beneficiary can also be a trust you set up, which would be the likely course of action if you have a minor or disabled child who is unable to make financial decisions.
Granting Power of Attorney
A power of attorney allows a person you appoint—your “attorney-in-fact” or agent—to act in your place for financial or other purposes when and if you ever become incapacitated or if you can’t act on your own behalf.
You can have your attorney create the necessary documentation to name your attorney-in-fact and there are many forms and online tools to enable you to do it yourself.
Here are the four types of Powers of Attorney you can confer:
Limited—allows someone else the power to act in your place for a very limited purpose and is usually valid for a specified time period. For example, to sign a deed to property for you on a day when you are out of town.
General—is comprehensive and gives your attorney-in-fact all the powers and rights that you have yourself. For example, you can have a Financial Power of Attorney which enables your representative to sign documents for you, pay your bills, and conduct financial transactions on your behalf. It ends on your death or incapacitation unless you rescind it before then. You can also create a Medical, or Healthcare, Power of Attorney which designates a representative to make medical decisions on your behalf. The Healthcare Power of Attorney goes further than a living will, which is only valid if you are incapacitated.
Durable—can be general or limited in scope, but it remains in effect after you become incapacitated. If you become incapacitated, no one can represent you unless a court appoints a conservator or guardian. A durable power of attorney will remain in effect until your death unless you rescind it while you are not incapacitated.
Springing—can allow your attorney-in-fact to act for you if you become incapacitated, but it does not become effective until you are incapacitated. Be sure to specifically detail the standard for determining incapacity and triggering the power of attorney.
Finally, once you have created an estate plan, make sure your executor has a copy of your will and trust documents, as well as a list of your assets, credit cards, any loans, insurance policies, investment and bank accounts, account numbers, recent home appraisal, the location of your assets (i.e., safe deposit boxes, storage facilities), and instructions regarding your desires for burial, cremation, funeral ceremonies, and organ donation.
And don’t forget to regularly review and update your estate plan, beneficiaries on your accounts (as well as contingent beneficiaries), and include all items in your trust that should be in there.
Please note, while I have tried to make sure all of the information in this article is up-to-date laws and regulations are constantly being added or amended, so don’t use it as a substitute to consulting the professionals—lawyers, trust officers, investment advisors, and accountants—who can give you specific information on the state and federal laws that will govern your plan.
What Warren Buffett Knows that You Don’t
You would have thought you were at a rock concert! More than 35,000 excited people standing in line on a dreary day in Omaha. Then milling into an auditorium at the convention hall, ready to sit for 5-6 hours to hear a CEO speak. Yes; a CEO!
That’s the kind of crowd that Warren Buffett, Chairman and CEO of Berkshire Hathaway, Inc. draws to his annual meeting each year. I’ve been a Buffett fan my entire career, and I was delighted to join his other ‘groupies’ to attend one of his meetings a few years ago. And I was not disappointed. In his folksy style, he and his right-hand man, Charlie Munger, spent most of the day answering questions from the crowd, and then roaming the exhibit hall where every subsidiary of Berkshire Hathaway displayed its wares (even stepping aside once to play his ukulele!). Added to that, the company offered tours to several of its subsidiaries, and provided a barbeque for meeting attendees.
It’s almost unheard of for a CEO to be so deeply involved with his investors. But it’s all part and parcel of Buffett’s ‘folksy’ style.
Buffett is commonly referred to ‘the world’s greatest investor’. His nickname is the ‘Oracle of Omaha’ because investors and money managers parse his every action and comment to try and determine his thoughts on the markets and individual stocks.
And why wouldn’t they? Buffett began buying shares in Berkshire Hathaway in 1962. Berkshire Hathaway began life in 1888, as the Hathaway Manufacturing Company, a cotton miller, founded by China trader, Horatio Hathaway. In the 1950s, the business merged with Berkshire Fine Spinning Associates, another milling company that had been in business since the early 19th century. But the combined company—along with the rest of the U.S. textile sector—fell on hard times, closing a number of plants and laying off workers by the end of the decade. The stock price didn’t fare so well, either, and in stepped Buffett, who thought the company was severely undervalued, and began loading up on shares at an average price of $7.60 per share.
Over the next three years, Buffett continued accumulating shares, and by 1965, he held a majority stake in the company. And while retaining a foothold in the textile industry, began buying stakes in other businesses. He bought into his first insurance companies in 1967, and then used their cash flow to gradually turn Berkshire Hathaway into an investment vehicle, purchasing significant numbers of shares in other companies.
As the U.S. textile industry faded, Buffett had to finally admit defeat in that sector, discontinuing that segment by 1985. But the remaining company thrived. and took over management and control of the company in 1965. His total average cost per share by this time was $14.86. Today, Berkshire’s class A shares closed at $ 329,799.00—not bad!
Buffett’s investing prowess has served the company well, and himself, as well, enabling him to build his personal fortune to about $86 billion.
He’s made his share of mistakes, which I’ll talk about in a little while, but he is one of the most astute investors of all time. The types of companies in which he invests have not changed substantially since he first took control of Berkshire. Most are consumer-driven companies whose products could be found in the supermarket or the local mall.
So, what does he know that you don’t?
As it turns out, the answer to that question is, a lot. You see, Buffett has said that he reads 5—6 hours a day, perusing five newspapers and up to 500 pages of corporate reports. Most of us don’t have that kind of time, and even if we did, we probably wouldn’t be interested in spending it in that way.
But you don’t have to turn yourself into a Buffett clone to benefit from his wisdom. That’s because over his 78 years of investing (he started at age 11, with the purchase of stock in oil service company, Cities Service—now Citgo, at $38 a share), he hasn’t shied away from sharing his thoughts and processes that are the foundation of his success as an investor.
But before I share that specific checklist, let’s talk about Buffett’s background, so you can understand more fully his strategies.
Graham and Buffett—Legendary Value/Fundamental Investors
Buffett learned about investing from his Columbia University teacher, Benjamin Graham, the father of security analysis.
In 1934, at merely 40 years of age, Benjamin Graham (with his colleague, David Dodd) co-authored Security Analysis, the primer for Value Investing. Many editions later, the book has become the bible of security analysts nationwide.
Graham felt that too many investors were speculators—buying or selling simply because a stock or the market went up or down, investing in “hot” stocks, and margin buying—all trends of the era in which he grew up. He saw—with his own eyes—the debacle of the ‘29 crash, the bank closings, and the utter loss of confidence in Wall Street. He knew that investors had lost sight of the reason that the stock market was established: To fund corporate expansion. He decided that to restore confidence, investors would have to change their thinking, and advised that, “if an investor wanted to enjoy a reasonable chance for continued better-than-average results, he must follow policies which are inherently sound and promising and are not popular on Wall Street.”
His definition of an investment: “Upon thorough analysis, an investment promises safety of principal and an adequate return.” Anything else was mere speculation.
In other words, Graham proposed that the foundation of sound investing should not change with the whims of trends or the winds of time, but should be altered only as a result of important economic and financial changes. Such events might include changes in interest rates, inflation, the trend toward conglomeration of corporations, or significant bankruptcies—all occurrences which might alter the way a stock is to be valued. That’s quite a different train of thought than what was then espoused by the “professionals.” You might imagine how popular that advice was with the Wall Street crowd!
Graham further stood the investment community on its head when he stated that “the rate of return should not depend on the old and sound principle that it should be more or less proportionate to the degree of risk an investor is ready to run. Instead, it should be dependent on the amount of intelligent effort the investor is willing and able to bring to bear on his task.” Heresy on Wall Street — Graham was actually telling investors they could figure it out for themselves—they didn’t need the pros!
And Graham was most definitely not a market timer. He stated that “the only principle of timing that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear, or at least no longer cheap, by analysis.” In other words: It’s the company that counts, period.
He felt that a good investment should be a company that was worth considerably more than what its stock was selling for. He calculated this “value” of a company by estimating its future earnings as well as taking into account the worth of its assets; in other words, what the value of this business would be to someone interested in buying it.
And even though there were analysts (then as now) building mountains out of molehills with reams of ratios to analyze a single company, Graham felt that just a few—the most important— criteria would do the job.
Graham especially liked to invest in companies whose earnings were reasonably stable, with good growth prospects. Additionally, he required that they be conservatively financed, large companies that paid dividends, with price-earnings ratios of less than 25. And he found legions of such companies—many selling for less than their net working capital (current assets – current liabilities). But for some reason, the stock market and the market pros were underestimating, or undervaluing, the potential of the companies’ earnings, resulting in an “undervalued” stock price.
Graham’s success was legendary. During his most active years—from 1936 to 1956—he consistently posted annual returns of 20% plus, while the S&P 500’s performance ran around 14%.
And his legend lives on in Warren Buffett. While Benjamin Graham introduced Value Investing to the investment community, his student Warren Buffett actually formed a company whose sole purpose is to “value invest.” Buffet’s Berkshire-Hathaway is essentially a portfolio of the stocks of businesses he has bought over the past 57 years. As shown in the box below, you can see that his stock picks are widely-diversified, but almost to a company, easy to define and to understand.
Companies Owned by Berkshire Hathaway
But Buffett wasn’t satisfied that he had learned everything he needed to know about investing from Graham. So, along the way, he has expanded on Graham’s version of Value Investing.
Like Graham, Buffett looks for those companies that are undervalued, in terms of today’s numbers. He certainly looks at future earnings but doesn’t rely solely on them to make a buying decision. He expresses this concept by saying, “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.” His secret to Wall Street riches is simple: “You try to be greedy when others are fearful, and you try to be very fearful when others are greedy.” Alternatively stated: Don’t follow the crowd.
As I said above, Buffett feels that research is the key; nothing beats old-fashioned elbow grease and he spends hours every day doing just that. He disregards “hot tips,” sets his goals and targets for the company at the time he buys the stock, and believes that too much diversification—what he calls the Noah School of Investing, or buying two of everything—is not prudent. In fact, Buffett tends to take rather large positions in the companies that he owns in his Berkshire-Hathaway group, and keeps his portfolio fairly lean, in terms of the number of companies.
That focus on a smaller group of investments led to one additional criteria that Buffett added to Graham’s model and ultimately made his trademark—he believes in really getting to know the companies in which he invests. That means personal visits and conducting ongoing communication with the decision-makers. But Buffett takes that step even further. He also gets to know the company’s customers, suppliers, and its competitors.
Another expansion of Graham’s strategy is Buffett’s addition of qualitative factors to the investment equation. While Graham certainly considered whether or not management was strong, efficient, and cost-conscious and that the company’s products seemed worthwhile, Buffett also looks at more intangible qualities, such as franchise or brand name value. For example, before he bought Disney stock for the first time, he factored in the value of Disney’s huge movie library, which did not show up in Disney’s financial statements at that time.
This led to Buffett changing Graham’s concept of the worth of a business, by adding such intangibles to a company’s book value, which is basically defined as a company’s assets minus its liabilities, or the capital that has gone into a business, plus retained profits. Together, the actual balance sheet figures plus the intangibles add up to the “intrinsic value” of the company.
And lastly, Buffett enlarged Graham’s definition of risk to include the risk of paying more than a business would prove to be worth.
Buffett has often been maligned in the media for his conservative investing practices. In the late ‘60s, he was attacked for staying out of the “hot” electronics sector and retaining his old-line retail stocks. But he had the last laugh then, just as he had during the recent technology boom.
And Buffett has the juice to back up his strategy. Since he took control of Berkshire Hathaway in 1964, the stock has generated 24.9% annualized returns—more than double that of the S&P 500, as you’ll see in his annual returns in the box below.
Berkshire Hathaway Yearly Returns
Buffett’s Winning Ways
Buffett’s investing strategy is well-known, and you don’t have to be a rocket scientist to understand it. It consists of a handful of investing maxims that have served him well for 78 years. Let’s talk about them.
Invest in Yourself First
This is Buffett’s #1 tip, and why he is a life-long learner. As a child, Buffett has commented that he read every book on investing in the Omaha public library—some of them twice. He has said, “One easy way to become worth 50% more than you are now at least is to hone your communication skills—both written and verbal.” As Buffett notes, this is an investment that “you can’t beat, can’t be taxed and not even inflation can take away from you.”
As a young man, Buffett was so terrified to speak in public that he would throw up beforehand. So, he set out to rectify that by spending $100 to enroll in a Dale Carnegie course. And he has claimed the course changed his life: “If I hadn’t done that, my whole life would be different. So, in my office, you will not see the degree I got at the University of Nebraska. You will not see the master’s degree I got from Columbia University; but you’ll see the award certificate I got from the Dale Carnegie course.”
His advice to all: “Address whatever you feel your weaknesses are, and do it now. Whatever you want to learn more, start doing it today. Don’t put if off to your old age. You’ll have a more rewarding life not only in terms of how much money you make, but how much fun you have out of life. You’ll make more friends the more interesting person you are.”
When you Buy a Stock, you are Buying Part of a Business
When Buffett buys a stock, he thinks of it as buying the entire company, at its enterprise value—the price you would pay for it if you could buy the whole company at current prices.
He adopted that concept from Benjamin Graham. As Graham reasoned in “The Intelligent Investor,” “buying stock makes you a part owner of a business, someone who should not be concerned about short-term fluctuations in stock prices.”
Buffett even goes so far as to include thirteen owner-related business principles in his Berkshire Hathaway “Owner’s Manual” for shareholders: berkshirehathaway.com/ownman.pdf. In his first tenet, he notes, “Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners.”
Invest in Companies that you Understand
Buffett is often quoted as saying, ‘Don’t buy any stock you can’t explain to your grandmother’. That fits into his strategy of only buying businesses or stocks that are ‘within his circle of competence’—companies he can easily and fully understand and that have stable or predictable products for the next 10–15 years. He wants to know how a business operates, how it makes money, and if its business model and profits are sustainable far into the future, before buying its stock.
He took a lot of heat during the technology heyday, when he was called a ‘has-been’ for not jumping on the technology bandwagon. But we know who got the last laugh, don’t we?
Buy a Wonderful Company at a Fair Price, not a Fair Company at a Wonderful Price
This rule relates to Buffett’s intrinsic value proposition, buying stocks with a large “margin of safety”—investments that currently sell significantly below their intrinsic value. When you buy companies for less than you think they are worth, it helps to limit any potential losses in case you overestimated intrinsic value (a value trap), or some unforeseen circumstances dims a company’s potential.
Buffet has this to say about intrinsic value: “Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover—and this would apply even to Charlie and me—will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.”
To put it into a more usable format, here is how Buffett explained his formulation for intrinsic value at his 2007 annual meeting: “Let’s say you decide you want to buy a farm and you make calculations that you can make $70/acre as the owner. How much will you pay [per acre for that farm]? Do you assume agriculture will get better so you can increase yields? Do you assume prices will go up? You might decide you wanted a 7%, so you’d pay $1,000/acre. If it’s for sale at $800, you buy, but if it’s at $1,200, you don’t.”
Clear as mud, right? Many analysts have spent years trying to figure out exactly how Buffett determines intrinsic value. We do know this: to determine intrinsic value, Buffett analyzes a variety of business fundamentals including earnings, revenues, and assets. If the intrinsic value is at least 25% higher than the company’s market cap, Buffett views that as a value proposition.
Buffett’s Favorite Holding Period = Forever
That’s not exactly true, as Buffett does occasionally sell some—or all—of a stock, but he continues to adhere to the long-term investing principles he learned from Ben Graham, and, for the most part, Buffett remains a buy-and-hold investor.
His strategy is to search for businesses with competitive advantages—not just today—but for decades into the future. He looks for companies with pricing power, strategic assets, and powerful brands, that have the ability to not only weather—but outperform in good and challenging times. Last year, in a CNBC interview, he likened long-term investing to buying a farm: He said, “Nobody buys a farm based on whether they think it’s going to rain next year; they buy it because they think it’s a good investment over 10 or 20 years.” And he famously told his shareholders in 1996, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
He has held his top 10 holding for an average of 7 ½ years. And he’s had his shares of Coca-Cola, Wells Fargo & Company (WFC), and American Express Company (AXP) for more than 25 years.
Compounding is the Key
Buffett doesn’t play short-term. He keeps his money invested as he understands the power of exponential growth—in share appreciation and in rising and accumulated dividends. And that means that instead of taking his dividends when they are paid, he just reinvests them. Buffett bought his first stock at 11, but he has said that some 99% of his wealth has been earned since he turned 50 years old. That’s because the accumulation of dividends has accelerated his earnings; he is earning money not just from the appreciation of the original shares he purchased, but also from the additional shares that his reinvested dividends have purchased.
Let’s look at an example:
Warren Buffett bought more than $1 billion of Coca-Cola (KO) shares in 1988, about 6.2% of the company, which made it the #1 position in his portfolio. He added to his position in 1994, bringing his total share count to about 100 million, and he hasn’t sold even one share since then. He has let the dividends accumulate and the share price appreciate. His cost basis for his shares is $1.299 billion. Today, he owns 400 million shares and his stake in Coke is equal to about $21.7 billion, now his third largest holding. That’s a $1,570% return!
Don’t be Reactionary; Focus on the Right News
He’s often said he doesn’t pay attention to the news or current events when making his investment decisions, thereby avoiding knee-jerk reactions. Instead, he focuses on price and value, believing in ‘staying the course’ and ‘trusting your original plan.”
He advises investors to avoid reacting emotionally. It’s easy to get overwhelmed with the constant barrage of information being thrown at us every day, soothsayers spouting off every minute on television and radio, encouraging short-term trading, and often inciting panic in investors. It’s not always easy to filter out if they are saying anything important to your investing strategy. Most of it is just noise that causes investors to be afraid or to get greedy. Buffett says don’t be either.
Learn from your Mistakes, and Move On
As I said earlier, even Buffett makes mistakes. But he makes sure that he learns from them to keep from making the same error again. A company can recover from a mistake, he says, but “you gotta make sure that it’s still a fundamentally good business” if you decide to stay with it.
Overpaying for Kraft, now Kraft-Heinz (KHC). After a dividend cut and an SEC probe were announced near the beginning of 2019, his holdings in the stock were down $4.3 billion. That investigation is still ongoing, and the stock remains in the doldrums. However, Buffet says he has no intention of selling his shares, as he continues to believe in the company’s long-term value.
Buying Berkshire Hathaway. Buffett calls it “the dumbest stock he ever bought”. It was a failing textile company when he got his hands on it, and he thought he would profit when more mills closed. The company tried to cheat him; he got mad and took control; tried to run it for 20 more years; and finally gave that part of the business up—but at a cost he estimates of $200 billion.
Investing in Tesco and holding the shares too long. At the end of 2012, Berkshire owned 415 million shares of this grocer in the United Kingdom. In 2014, Tesco overstated its profits and its shares tanked. Buffett sold some shares that year, pocketing $43 million, but held the rest, which cost Berkshire $444 million, after-taxes.
Buying too much ConocoPhillips Stock. Buffett admits his biggest mistake here was not consulting any of his oil experts, including Charlie Munger, before jumping into this stock. In 2008—near peak oil and gas prices—he spent $7 billion, which decreased in value to some $4.4 billion at the end of that year.
Purchasing US Airways Stock. Although the company was saved by merging, and it looks like Buffett eventually recouped his investment, he still regrets buying $358 million of US Airways stock in 1989.
But, by far, Buffett says his biggest mistakes were the opportunities he passed up, like:
- Amazon (AMZN). Although he now owns the stock, he regrets not buying it sooner.
- Not Buying the Dallas-Fort Worth NBC Station. He could have had it for $35 million in the early 1970’s, but he passed. It was valued at $800 million, he told his shareholders in his 2007 letter.
- Google, now Alphabet (GOOG and GOOGL). He says he should have bought it when his Geico subsidiary was paying Google $10 per click
He admits to many more mistakes, which led him to establish these two tenets about mistakes: 1) If you have cash, never invest for the sake of investing, and 2) don’t regret your mistakes. You’ll only know if you missed out on a great investment opportunity once that opportunity has unfolded.
Is Management Rational and Candid with Shareholders?
You can’t really define or analyze quality, but seeking quality of management in his investments is one of Buffett’s cardinal rules. Here is how he does it:
First, he asks: “Is management rational?” Does it spend shareholders’ money rationally, making the right decisions when it comes to reinvesting (retaining) earnings or returning profits to shareholders as dividends? This goes against the grain of most people, managers or not. It’s easy to take the usual route, be greedy; keep the profit for yourself; and build a nice empire. But the smart tactic is to maximize shareholder value by properly and efficiently utilizing the company’s cash flow. Buffett likes companies that give money back to their shareholders in the form of dividends and share buybacks.
Second, is management honest with their shareholders? You can learn a lot by just reading the Letter to Shareholders at the beginning of a company’s annual report. Most companies are great at bragging about their successes in this letter, but the letters that separate good versus excellent managers will also admit their mistakes. Buffett says they should also report their financial results “in a way that helps investors make smart investment decisions.” They must answer three key questions: “1) Approximately how much the company is worth; 2) What is the likelihood that it can meet its future obligations; 3) How good a job are its managers doing, given the hand they have been dealt?”
And lastly, Buffett wants to know if management resists the institutional imperative. He doesn’t want companies that take action just so they look like they are doing something. And he shies away from those that do nothing but imitate their competitors’ strategies and tactics. He’s looking for stand-outs—innovators.
Focus on ROE and High Profit Margins
Most analysts’ primary focus is on a company’s earnings per share, but Buffett likes return on equity (ROE) better. Here is his reasoning: Companies, generally, retain some portion of their previous year’s earnings as a way to increase their equity base. He doesn’t think there’s anything special, “about a company that increases EPS by 10% if, at the same time, it is growing its earning base by 10%.”
ROE is simply net income divided by shareholder’s equity and compares a company’s financial performance (over time) with that of its competition, in order to determine if it has a sustainable competitive advantage. When Buffett calculates ROE, he focuses strictly on performance, excluding all capital gains and losses and extraordinary times from earnings.
He also likes companies who generate high ROE’s but are not leveraged to the hilt. And that depends a lot on what’s normal for the industry in which a business operates, so it will vary from company to company.
In general, a sustained high rate of return on capital, the better the business.
Extending Buffett’s definition of ROE gets us to what he calls Owner Earnings, specifically “the value of a company is simply the total of the net cash flows (owner earnings) expected to occur over the life of the business, minus any reinvestment of earnings.”
His definition of owner earnings: “These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges...less (c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume.”
Fortunately, these numbers can all be found in a company’s financial statements. And Buffett adds this, “All of this points up the absurdity of the ‘cash flow’ numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b)—but do not subtract (c).”
Buffett also insists on a company with healthy profit margins (net income divided by revenues). Profit margins illustrate if a company is being run efficiently, keeping its costs in line so that more money flows through to the bottom line.
Buffett is known to be pretty strict about his managers’ containing costs. He says, ‘The really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.’”
Lastly, Buffett talks about the One-Dollar Premise, or his premise that “every dollar of retrained earnings should, over time, generate at least one dollar of market value.”
It all comes down to making a profit and reinvesting that profit over time to build value and maximize shareholder returns. After all, return on capital and reinvesting drive future earnings, which—all other things being equal—should boost long-term stock performance.
And one last thought on investing from Buffett: “Generally speaking, if you get a chance to buy a wonderful business—and by that, I would mean one that has economic characteristics that lead you to believe, with a high degree of certainty, that they will be earning unusual returns on capital over time—unusually high—and, better yet, if they get the chance to employ more capital at—again, at high rates of return—that’s the best of all businesses. And you probably should stretch a little.”
These tenets comprise the strategy behind Warren Buffett’s investing success. I’ll leave you with some more of his ideas—the companies that he doesn’t own outright, but in which he has significant holdings.
Berkshire Hathaway Investments (as of September 30, 2019)
|American Airlines Group Inc||AAL||43,700,000||$27.24||$1,190,388,000||10.0%|
|American Express Company||AXP||151,610,700||$118.28||$17,932,513,596||18.5%|
|Axalta Coating Systems Ltd||AXTA||24,264,000||$30.05||$729,133,200||10.3%|
|Bank of America Corp||BAC||947,760,000||$33.09||$31,361,378,400||10.5%|
|Bank of New York Mellon Corp||BK||80,937,250||$49.27||$3,987,778,308||8.8%|
|Charter Communications Inc||CHTR||5,426,609||$467.27||$2,535,691,587||2.5%|
|Costco Wholesale Corporation||COST||4,333,363||$293.10||$1,270,108,695||1.0%|
|Delta Air Lines, Inc.||DAL||70,910,456||$55.88||$3,962,476,281||11.0%|
|Globe Life Inc||GL||6,353,727||$102.09||$648,651,989||5.9%|
|General Motors Company||GM||72,269,696||$35.31||$2,551,842,966||5.1%|
|Goldman Sachs Group Inc||GS||18,353,635||$217.14||$3,985,308,304||5.2%|
|Johnson & Johnson||JNJ||327,100||$139.56||$45,650,076||0.0%|
|JPMorgan Chase & Co.||JPM||59,514,932||$133.06||$7,919,056,852||1.9%|
|Kraft Heinz Co||KHC||325,634,818||$31.25||$10,176,088,063||26.7%|
|Liberty Global PLC Class A||LBTYA||19,791,000||$22.21||$439,558,110||10.9%|
|Liberty Global PLC Class C||LBTYK||7,346,968||$21.11||$155,094,494||1.7%|
|Liberty Latin America Ltd Class A||LILA||2,714,854||$17.08||$46,369,706||5.4%|
|Liberty Latin America Ltd Class C||LILAK||1,284,020||$17.15||$22,020,943||1.0%|
|Liberty Sirius XM Group Series A||LSXMA||14,860,360||$48.08||$714,486,109||14.4%|
|Liberty Sirius XM Group Series C||LSXMK||31,090,985||$47.84||$1,487,392,722||15.3%|
|Southwest Airlines Co||LUV||53,649,213||$55.53||$2,979,140,798||10.2%|
|MONDELEZ INTERNATIONAL INC Common Stock||MDLZ||578,000||$53.81||$31,102,180||0.0%|
|M&T Bank Corporation||MTB||5,382,040||$165.06||$888,359,522||4.1%|
|Occidental Petroleum Corporation||OXY||7,467,508||$37.98||$283,615,954||0.3%|
|Procter & Gamble Co||PG||315,400||$124.62||$39,305,148||0.0%|
|PNC Financial Services Group Inc||PNC||8,671,054||$152.20||$1,319,734,419||2.0%|
|Restaurant Brands International Inc||QSR||8,438,225||$66.31||$559,538,700||1.6%|
|Sirius XM Holdings Inc||SIRI||136,275,729||$6.86||$934,851,501||3.1%|
|Store Capital Corp||STOR||18,621,674||$40.02||$745,239,393||7.9%|
|Suncor Energy Inc.||SU||10,758,000||$30.96||$333,067,680||0.7%|
|Teva Pharmaceutical Industries Ltd||TEVA||43,249,295||$9.82||$424,708,077||4.0%|
|Travelers Companies Inc||TRV||5,958,391||$134.31||$800,271,495||2.3%|
|United Airlines Holdings Inc||UAL||21,938,642||$87.86||$1,927,529,086||8.7%|
|United Parcel Service, Inc.||UPS||59,400||$115.01||$6,831,594||0.0%|
|Wells Fargo & Co||WFC||378,369,018||$53.23||$20,140,582,828||8.9%|
Intriguing Bets in the Financial Sector
During the recent stock market downturn, investors sold shares of any company that has a connection to the life insurance industry, because they’re likely assuming that this market downturn is similar to the one in 2008. At that time, shares of famed global insurer American International Group (AIG) did a spectacular crash and burn due to tremendous corporate problems. Fortunately AIG – and companies throughout the financial sector – learned some hard lessons about financial management. AIG changed corporate leadership, divested businesses and dramatically strengthened their balance sheet.
Fast forward to the year 2020, and we’re presented with another big stock market downturn that fortunately bears no similarity in causation to the 2008 financial meltdown. Companies that sell life insurance – wholesale and retail – are in far stronger financial positions than they were in 2008. The market is now recognizing the quality among these modern companies, as evidenced by the fact that financial stocks have begun recovering from fire-sale prices.
I maintain a Buy List of companies that are producing strong earnings growth that currently have low valuations, as measured by their price/earnings ratios (P/Es). The list contains stocks from a wide variety of sectors, with the highest representation in the financial sector—most specifically among investment management, life insurance and annuity companies.
If you’re familiar with fundamental analysis, you know that a P/E ratio that’s down in the single digits could represent quite a bargain, as long as a company’s revenue and profits are also attractive. The 2020 P/Es at Ameriprise Financial (AMP), Athene (ATH) and Brighthouse Financial (BHF) fit those requirements. And those are just the first three excellent financial stocks as I go down my list alphabetically. There are more!
Is Ameriprise Financial (AMP) about to Do a Takeover?
Ameriprise Financial (AMP) just issued $500 million in senior 3.00% notes due April 2025. The company already had an impressive amount of excess capital, so the question becomes, “What does Ameriprise plan to do with this new influx of capital?” The two answers that quickly come to mind are (1) repurchase their own stock or (2) attempt to acquire an industry peer in the area of life insurance, annuities, retirement benefits and/or investments.
Ameriprise has a $12.7 billion market capitalization. All of the following industry peers have a significantly lower market cap (most below $5 billion), and they’re also experiencing multi-year earnings growth: Athene (ATH), Brighthouse Financial (BHF), CNA Financial (CNA), CNO Financial (CNO), Equitable Holdings (EQH), Lincoln National (LNC) and Voya Financial (VOYA).
While we’re sitting here debating whether to buy AMP for their potential share buybacks vs. any of their smaller peers for their potential acquisition, there’s a third possible scenario. A large financial company – possibly including a major bank or Berkshire Hathaway (BRK) – could swoop in and buy Ameriprise or any of these other companies.
Merger and acquisition (M&A) activity tends to be somewhat cyclical, often concentrated in a specific industry for a little while, then another industry the following year. Back in 2016, both chemical stocks in my Cabot Undervalued Stocks Advisor portfolios received buyout offers: Axiall (AXLL) and Chemtura (CHMT).
There’s been significant M&A action among investment and insurance companies this year. In February, mere days before the current market downturn commenced, investment banker Morgan Stanley (MS) announced the acquisition of discount broker E*TRADE (ETFC), and global investment manager Franklin Resources (BEN) announced the acquisition of Legg Mason (LM), a smaller investment peer.
The Most Likely Financial Stock Takeover Targets
If there’s any additional M&A activity within the investment/insurance space in 2020, it’s my assessment that the companies I mentioned herein are the most attractive potential takeover targets. After all, if you’re the CEO at a big company who’s looking to buy a smaller company that can add to your product lines and profits, which do you buy: a company that’s financially struggling, or a company that’s growing their profits each year? You buy the company with the attractive business model and growing profits!
I’m not surprised at this spate of financial industry consolidation, and I expect more M&A activity among investment management, life insurance and annuity companies. That’s because the multi-year trend toward lower asset management fees, expense ratios and sales charges is causing financial companies to search for additional ways to generate profit growth.
Investors should also be aware that CEO Warren Buffett of Berkshire Hathaway (BRK) has publicly stated his intention to buy another company. Berkshire has accumulated $125 billion in cash, up to $105 billion of which is available for M&A activity. Knowing that Mr. Buffett is already quite experienced with owning insurance companies, there’s a decent chance that his next buyout could be focused on the cheap valuations within this industry.
I continue to recommend that investors own stock in investment, life insurance and annuity companies because the shares are incredibly cheap, their balance sheets are strong and growing, and there’s already a current trend in place of increased M&A activity within this industry group.
How to Pick Value Stocks like Benjamin Graham and Warren Buffett
Chances are you know who Warren Buffett is.
If not, the very short version is that Buffett is the world’s most successful value investor.
The longer version is this: Warren Edward Buffett, born 91 years ago in Omaha, Nebraska, is the “Oracle of Omaha.” He grew up in Omaha and Washington, D.C. before attaining his bachelor’s and master’s degrees from the University of Nebraska and Columbia University. Mr. Buffett became interested in investing at an early age and attended Columbia in part because a pair of well-known securities analysts taught there.
Buffett then went to work for Buffett-Falk, his father’s brokerage company, before joining Graham-Newman for three years. Mr. Buffett then ventured out on his own and formed several investment partnerships, which purchased a company called Berkshire Hathaway, a textile manufacturing firm. In 1962, Buffett liquidated his partnerships to focus on Berkshire, and the rest is history.
Warren Buffett made one successful investment after another using Berkshire Hathaway (BRK-B) as his conduit. Buffett became adamant that his stocks provide a wide margin of safety. The intrinsic value of a company must outweigh the company’s stock price. He learned that strategy from one of his stock market-savvy Columbia professors, Benjamin Graham.
You might not be quite as familiar with that name. Let me familiarize you.
Who Is Benjamin Graham?
Benjamin Graham was born in London in 1894. (His original name was Grossbaum, but he changed it as a young man, the better to fit into the Wall Street environment.)
His parents moved to New York City when he was a year old. Graham was a brilliant student and won a scholarship to Columbia University. In 1914, he graduated second in his class, at age 20, and was invited to teach at the school. But he refused. His father had died, the family was poor, and Graham needed a larger income to support the family.
So he went to Wall Street and worked for the firm of Newburger, Henderson and Loeb for $12 per week.
His early duties included being a runner, delivering securities and checks, writing descriptions of bond issues, and later writing the firm’s daily market letter. Before long, he began to analyze companies, and at the age of 26 he was promoted to full partner.
In 1923, he left to set up his own partnership, and in 1928 he began teaching investment classes at Columbia. Over time, working with former student David Dodd, the lessons of his classes were gathered into his first book, titled Security Analysis, which was published in 1934.
The book has sold over a million copies. Warren Buffett says he’s read it at least four times. I’ve only read mine once (it’s the second edition, published in 1940, with 851 pages), but it remains a valuable reference. You can buy a fancy new leather-bound sixth edition on Amazon for $132. Or you can get a used one for $31. Or buy the Kindle electronic version for $42.53.
Or, you could simply read Graham’s second book, the more user-friendly The Intelligent Investor, which was published in 1949 and is less than half the size of its predecessor.
I recommend them both.
Benjamin Graham passed away in 1976 at the age of 82.
So what is it that made Graham’s work so special?
In short, he systematized the entire process of evaluating companies, all with the goal of finding low-risk (or no-risk) investments that would reward over the long run.
Graham liked to analyze and quantify a business according to six factors:
3. Growth in earnings
4. Financial position
6. Price history
More precisely, he required that a potential investment have the following:
- An earnings-to-price yield at least twice the AAA bond yield
2. A P/E ratio less than 40% of the highest P/E ratio the stock had over the previous five years
3. A dividend yield of at least two-thirds the AAA bond yield
4. A stock price below two-thirds of tangible book value per share
5. A stock price below two-thirds of “net current asset value”
6. Total debt less than book value
7. Current ratio greater than two
8. Total debt less than twice “net current assets”
9. Annual earnings growth in the prior 10 years of at least 7% annual compounded
10. No more than two declines of 5% or more in year-end earnings in the prior 10 years
And this was all in the days before calculators! Granted, Graham was a whiz with a slide rule, and no doubt he did a lot of the calculations in his head. Nevertheless, that’s a lot of work.
But let’s simplify Graham’s strategy a bit, boiling it down to the seven criteria he used for picking value stocks.
How the Benjamin Graham Strategy Picks Value Stocks
The objective of Graham’s strategy is to identify unappreciated stocks and show you how to find undervalued stocks that meet certain criteria for quality and quantity … stocks that are poised for stellar price appreciation.
Here are Benjamin Graham’s seven time-tested criteria to identify strong value stocks:
Look for a quality rating that is average or better. You don’t need to find the best quality companies—average or better is fine. Benjamin Graham recommended using Standard & Poor’s rating system and required companies to have an S&P Earnings and Dividend Rating of B or better. The S&P rating system ranges from D to A+. Aim for stocks with ratings of B+ or better, just to be on the safe side.
Graham advised buying companies with Total Debt to Current Asset ratios of less than 1.10. In value investing, it is important at all times to invest in companies with a low debt load, especially now with tight lending in a lukewarm economy. Total Debt to Current Asset ratios can be found in data supplied by Standard & Poor’s, Value Line, and many other services.
Check the Current Ratio (current assets divided by current liabilities) to find companies with ratios over 1.50. This is a common ratio provided by many investment services and is especially important now, because you want to make sure a company has enough cash and other current assets to weather any further declines in the economy.
Criteria four is simple. Find companies with positive earnings per share growth during the past five years with no earnings deficits. Earnings need to be higher in the most recent year than five years ago. Avoiding companies with earnings deficits during the past five years will help you stay clear of high-risk companies.
Invest in companies with price to earnings (P/E) ratios of 9.0 or less. Look for companies that are selling at bargain prices. Finding companies with low P/Es usually eliminates high growth companies, which should be evaluated using growth investing techniques.
Find companies with price to book value (P/BV) ratios less than 1.20. P/E ratios, mentioned in criteria #5, can sometimes be misleading. P/BV ratios are calculated by dividing the current price by the most recent book value per share for a company. Book value provides a good indication of the underlying value of a company. Investing in stocks selling near or below their book value makes sense.
Invest in companies that are currently paying dividends. Investing in undervalued companies requires waiting for other investors to discover the bargains you have already found. Sometimes your wait period will be long and tedious, but if the company pays a decent dividend, you can sit back and collect dividends while you wait patiently for your stock to go from undervalued to overvalued.
One last thought. It’s helpful to find out why a stock is selling at a bargain price. Is the company competing in an industry that is dying? Is the company suffering from a setback caused by an unforeseen problem? The most important question, though, is whether the company’s problem is short-term or long-term, and whether management is aware of the problem and taking action to correct it. You can put your business acumen to work to determine if management has an adequate plan to solve the company’s current problems.
Benjamin Graham’s Mr. Market
One of Benjamin Graham’s favorite parables is that of Mr. Market, who Graham often referred to in his classes at Columbia as well as several times in his book, The Intelligent Investor.
Graham’s Mr. Market is a fellow who turns up every day at the stock holder’s door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but often it is ridiculous. The investor is free to either agree with his quoted price and trade with him, or to ignore him completely. Mr. Market doesn’t mind this, and will be back the following day to quote another price.
Graham’s point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that the investor owns. He should profit from market folly rather than participate in it. The investor is best off concentrating on the real life performance of his companies and their dividends, rather than being too concerned with Mr. Market’s often irrational behavior.
Here’s an excerpt from The Intelligent Investor by Benjamin Graham, Revised Edition 2005, page 204-205:
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
“If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
“The true investor is in that very position when he owns a listed common stock. He can take advantage of the daily market price or leave it alone, as dictated by his own judgment and inclination. He must take cognizance of important price movements, for otherwise his judgment will have nothing to work on. Conceivably they may give him a warning signal which he will do well to heed—this in plain English means that he is to sell his shares because the price has gone down, foreboding worse things to come. In our view such signals are misleading at least as often as they are helpful.
“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”