PORTFOLIO NOTES: FINAL ISSUE
In recent months, I’ve helped investors unwind some of their Benjamin Graham Value stocks, while keeping those with sound fundamentals and good earnings growth prospects. We’ve talked about how to assess stocks based on earnings growth, value (as represented by price/earnings ratio and debt), and price chart activity. Today we’re wrapping up this stock coverage with some basic guidelines for how to handle the remaining portfolio stocks.
If there were just one stock investing lesson that I would want to impress upon you, it’s that over time—meaning one-to-five years—share price performance tends to follow earnings growth. That’s why I make a big effort to find companies with strong earnings growth, so that I can increase the odds of achieving good capital appreciation.
Stock investing can get unnerving at times, so when in doubt, go look at the earnings projections for your stocks. Do the consensus earnings estimates indicate that Wall Street expects the company to see profits grow at least 10% both this year and next year? If so, relax a bit. It might not be necessary to worry about tariffs or bond yields or the strength of the U.S. dollar. But if earnings aren’t expected to grow very well, you might consider trading out of that particular stock and instead buy one of the stocks on your “waiting in the wings” list.
What? You don’t have a “waiting in the wings” list?? Well, that’s your stock wish list! There are lots of great stocks on the major U.S. stock exchanges. You can’t own them all, but you can certainly line up your next five favorites so that if it seems wise to sell one of your current portfolio stocks, you have a couple of good investment ideas at the ready.
I hope that you’ve found my guidance to be beneficial this year. As always, please send questions and comments as they arise to Crista@CabotWealth.com.
PORTFOLIO STOCKS
Apple (AAPL – yield 1.4%) manufactures a wide range of popular communication and music devices, and many services as well. The highly touted news last week focused on AAPL reaching a $1 trillion market capitalization. That’s an intimidating number, and might make you wonder, how can a $1 trillion stock not be overvalued? One trillion is a big number, so it naturally evokes thoughts of excess.
There are a variety of ways that investment professionals measure value, but I assure you, market cap is not one of them. (Frankly, share price is not a measure of value either.) Price/earnings ratios (P/Es) and PEG ratios are common valuation measures, as are cash flow and debt ratios. I like to focus on P/E and debt, but AAPL’s PEG ratio is quite low as well.
Generally speaking, I want to see a P/E that’s lower than an earnings growth rate. Bigger picture, I might also consider the stock’s historical average P/E, the current average industrywide P/E, dividend yields, and next year’s expected earnings growth rate when looking at the current raw P/E number. It’s important to me to eliminate as much obvious stock market risk as possible, so that you and I are less likely to have a horrendous investment experience. Believe me, there’s enough risk in stock investing that we don’t need to voluntarily ask for more!
AAPL has been undervalued for well over a year now, and we’ll get to the current numbers in just a sec. But I also want to point out that the company spent $20 billion on share repurchases during the recent quarter, and had $243 billion in cash and marketable securities as of June 30, representing about 26% of the stock’s market value. That’s an awful lot of liquidity! For comparison, Procter & Gamble (PG) had $11.8 billion in cash and marketable securities at the end of the quarter, representing just 5.7% of its $206.2 billion market cap. I picked PG randomly, but you get the idea. Market cap does not tell us anything about value until we know more about the other moving parts of the company’s balance sheet.
Analysts now expect EPS to increase 27.4% and 15.8% in fiscal 2018 and 2019 (September year-end). The corresponding P/Es are 17.7 and 15.3. The stock is moderately undervalued based on 2019 numbers.
AAPL is my favorite stock for long-term investors. I believe almost every stock investor should own some shares. AAPL began reaching new highs again last week. I think the best price you’re likely to get will be on a brief pullback below 200.
Berkshire Hathaway Class B (BRK.B) reported attractive second quarter results last week. Analysts proceeded to raise their earnings estimates, although 2019 earnings growth remains weak. Berkshire Hathaway is expected to transition from a year of 65% earnings growth in 2018 to just 4.3% growth in 2019. The 2019 P/E is high at 20.7. The stock remains overvalued based on 2019 numbers.
The stock is recovering nicely from its big downturn this year, but there’s no reason to believe that it will surpass its January high of 217 this year. I would take the opportunity to sell near 217 when that day arrives, and reinvest my capital into an undervalued growth stock, thereby increasing my capital appreciation potential. Long-term buy-and-hold investors still own shares in a thriving company.
Discovery Communications (DISCA) reported second quarter results that reflected big gains in U.S. and international ad revenue and improved operating results that were offset by higher restructuring and other charges associated with the acquisition of Scripps Networks. The company continues to deliver robust free cash flow generation and is paying down debt ahead of schedule. Its networks currently capture a huge market share of women’s programming, including HGTV, Food Network, Animal Planet and the Oprah Winfrey Network.
While there’s often a slew of changes in Wall Street’s ratings and price targets when a high profile company reports quarterly results, in this case the only obvious change was that RBC increased their price target on DISCA to 30. However, analysts are lowering their profit projections for this year, while next year’s consensus earnings estimate remains unchanged. The current expectation is that Discovery will achieve EPS growth of 26.3% in 2018 and 48.8% in 2019. There will invariably be additional changes to those estimates in the coming days as analysts rework their figures and publish new research reports. The 2019 P/E is very low at 7.2.
As I’ve mentioned in the past, the company carries debt levels that are higher than I would prefer. However, I recommend that investors keep their shares and consider adding to their position in DISCA, due to the high quality of the company’s entertainment franchise, very strong earnings growth and very low price/earnings ratio.
LKQ Corp. (LKQ) is a distributor of vehicle products in the U.S. and Europe. Management reported a good second quarter in July, and increased full year guidance on revenue, adjusted EPS, cash flow and capital expenditures. The company acquired five European wholesale businesses during the quarter, and opened 17 European branches. Debt levels are rising, though not in a danger zone. Wall Street now expects full year EPS to grow 21.3% and 15.4% in 2018 and 2019. Corresponding P/Es are 15.1 and 13.1.
The price chart is bullish, and the stock will likely cease its run-up at price resistance at 37. (It could advance again after several months of rest.) Traders should sell near 37. Longer-term investors will still own an attractive growth stock, although keep in mind that auto-related companies are affected by the cyclical nature of the economy.
Lowe’s Companies (LOW – yield 1.9%) is a home improvement retailer with a new CEO and management team. Consensus estimates project strong full-year earnings growth of 24.1% in fiscal 2019 (January year-end), followed by 12.3% EPS growth in 2020. The stock is overvalued based on fiscal 2020 earnings, and the long-term debt-to-capitalization ratio is high at 69%, so there are reasons to be cautious. While LOW is a fine choice for a long-term buy-and-hold stock portfolio, it does not provide compelling opportunity for value investors today. I recommend investors sell near the January high near 107 in favor of an undervalued growth stock.
Magna International (MGA – yield 2.4%) is a Canadian global automotive supplier. The company disappointed the market with lower-than-expected second quarter profits yesterday. In addition, the company guided Wall Street lower on full year 2018 and 2020 earnings estimates. Magna is experiencing lower-than-expected income from transmission joint ventures in China and Europe, in addition to the negative effects of currencies and tariffs.
MGA is a mid-cap growth & income stock. Earnings estimates will change in the coming days, likely reflecting moderate growth in the next few years. While the P/E and debt level are low, it appears that earnings growth will not be strong enough to generate much enthusiasm on Wall Street. The dividend is likely safe. Investors will probably earn more money by selling MGA and buying a stock with stronger earnings growth prospects.
Stifel Financial (SF – yield 0.9%) – Full year 2018 earnings estimates rose again last week. The problem is that the 2019 estimate has not risen at all. The earnings outlook is now a bit lopsided, with EPS expected to rise 30.3% in 2018, but then just 7.5% in 2019. My next problem concerns analyst coverage. There were five Wall Street analysts contributing to earnings estimates when I began following Stifel, and now there are just two. I shy away from companies with just a couple of analysts providing research reports, because the audience of potential buyers is then very small.
In my assessment, with single digit earnings growth next year, SF is fairly valued. The stock is rising, with upside resistance around 60-62. My recommendation is that shareholders plan on exiting the stock above 60, in favor of a more undervalued growth stock.
Thor Industries (THO – yield 1.7%) is a maker of recreational vehicles. The market expects EPS to grow 21.2% and 13.4% in 2018 and 2019 (July year-end). (Those numbers have been slowly declining.) The 2019 P/E is low at 10.0. In addition, the long-term debt-to-capitalization ratio is very low at 4.1%. If you want an undervalued growth & income stock with a low debt burden, THO is a great candidate. The stock fell below its trading range in late July, and is now recovering nicely. There’s upside resistance at about 104. I think it will take a while for THO to surpass that price.
Toll Brothers (TOL – yield 1.2%) – Demand for residential new home construction remains strong. Most homebuilders are experiencing big increases in revenue and profits this year. Wall Street expects Toll Brothers’ profits to rise 40.1% in fiscal 2018 (October year-end) and 11.6% in 2019. Corresponding P/Es are 8.1 and 7.3. The stock is rising toward short-term price resistance at 38. While the fundamental numbers remain highly attractive, there’s a decent chance that TOL will not rise any farther until 2019, simply because year-end tax-loss selling will suppress the share price.