Who doesn’t like to find great deals? Especially in stock picks? Being bargain hunters at our core, we get it. In reality though, there is no broad definition of “the most undervalued stocks”. Even so, we can certainly share some of our current favorite undervalued stocks for 2017, and the process we use to decide whether or not a stock is undervalued.
First, let’s understand the process. Our technology scores over 3,000 stocks multiple times a day to calculate the stocks’ aggregate relative value across a wide range of metrics. These metrics, such as the price to earnings ratio, enterprise value to EBITDA ratio, free cash flow yield, and price to sales ratio are just a few of the important figures we calculate. In the end, a list of stocks that meets our valuation principles is spit out.
Next, we put the technology aside and take a human look at the names that have been suggested. What do we know that a computer cannot figure into the equation? We focus on higher-level qualitative aspects such as product depth, competitive positioning, product breadth, balance sheet strength, capital structure and more, to ensure that the companies we select are the best fit for our mix of strategies.
Keep in mind that these two steps go hand in hand; one cannot be completed without the other, otherwise the decision will be biased. To us, a stock is considered undervalued if it is trading at a price that is meaningfully less than where we believe it will be valued in three to five years. Remember, investors and the stock market tend to be biased. No investor ever has complete information and can succumb to individual emotionally-biased behaviors. This can lead to market-wide overreactions that can result in a stock being over- or undervalued. And we like to capitalize on those potential opportunities where possible; all the while investing in companies that we believe to have a prosperous future, even if others do not see the potential.
We aren’t looking for flash-in-the-pan picks or overnight returns. Time and commitment are essential ingredients in our formula. In a recent Barron’s article1 about our newsletter performance, Mark Hulbert put it this way:
It pays to have nerves of steel That’s the most important lesson to emerge from the Prudent Speculator’s position as one of this country’s most successful investment newsletters of the past four decades.”
Okay, enough about our framework, process and nerves of steel. Now on to the undervalued stock picks.
NOTE: This blog will be updated monthly with a new stock that meets our criteria. Come back each month to find a new featured pick.
Featured stock for January 2017: WSM – Williams-Sonoma is a retailer of cooking equipment, home furnishings and home accessories through retail stores (Williams-Sonoma, Pottery Barn, PB Kids, PB Teen and West Elm), mail-order catalogs and e-commerce. WSM shares took a few beatings in 2016, including a more-than-10% drop since Q3 earnings in November. While those results were better than expected, Williams-Sonoma trimmed the high end of its 2016 outlook to between $3.35 and $3.45 (compared with $3.35 to $3.55 previously). Despite the paring of guidance, analysts expect the company to grow at around 8% per annum over the next three years, driven by the West Elm brand. West Elm continues to expand its footprint, having opened 10 locations in Q3, and will share an expanding “The Key” loyalty program with other Williams-Sonoma family brands. We like Williams-Sonoma’s balance sheet, which includes no long-term debt (though there are lease obligations). The company also has $447 million remaining on its repurchase program, which it intends to execute over the next three years, and the stock yields a rich 3.1%.
Featured stock for February 2017: GM – Auto and truck maker General Motors saw strong sales in December, selling almost 250,000 cars to retail customers nationwide, with an average transaction price of $36,386, more than $4,000 above the industry average and $720 above the company’s 2015 average. For 2017, GM now expects to make $6.00 to $6.50 per share, a nice improvement from the $5.50 to $6.00 range in 2016. The company attributed the guidance increase to stronger-than-expected performance in North America and China, as well as a “strong vehicle launch cadence.” GM also added another $5 billion to its common stock buyback plan and expects to spend $3 billion of the revised $8 billion authorization this year. We see sales growth outside of North America as a long-term catalyst, especially in emerging economies. While we recognize that pensions and union contracts will always be part of the equation, we think the solid balance sheet ($24 billion in cash and short-term investments), improving cost controls, free cash flow generation and capital return initiatives make the ‘new’ GM a buy. (Source: The Prudent Speculator 2/2/2017)
Featured stock for March 2017: DIS – Disney operates one of the largest diversified media companies in the U.S. and is a global leader in producing branded family entertainment. Shares have made quite a recovery since October, after dipping as low as $90.83. In fiscal Q1 2017, Disney earned $1.55 per share on $14.8 billion of sales, compared with analyst estimates of $1.49 and $15.3 billion, respectively. Strength in Parks & Resorts (attendance at the new Shanghai Disneyland topped 10 million in its first year, though domestic park attendance dropped 5%) and the success of Studio (Rogue One: A Star Wars Story was a blockbuster) helped offset a 7% drop in ESPN ad revenue and declining ratings for SportsCenter and Monday Night Football. Additionally, Disney announced plans to raise prices for single-day Disneyland tickets for adults and children between 2.1% and 4.8%. While DIS faced some headwinds in Q1, we like that the company has a solid pipeline of park improvements coming up, including Star Wars Land (2019) and an Avatar-themed resort (May 2017). A new Hulu-based online streaming service has also made it to beta testing (a final testing phase before wide public release) and management expects that upgrades to ESPN mobile will help retain existing TV customers. With unparalleled content and characters, we think DIS should be a core holding. (Source: The Prudent Speculator 3/2/2017)
Featured stock for April 2017: FDX- Memphis-based FedEx is the world’s largest cargo airline and offers door-to-door package delivery services for consumers and businesses in more than 220 countries and territories. FedEx posted earnings per share of $2.35 for fiscal Q3 2017 (vs. $2.62 est.) on revenue of $15.0 billion (matching the estimate), but the company reaffirmed full-year adjusted EPS guidance of $11.85 to $12.35. FDX benefitted from record peak-season volumes and low-single-digit growth in domestic express package volume. FedEx also announced a 16-year express air transportation deal with the U.S. Postal Service and launched FedEx Fulfillment, a distribution service for small- and medium-sized businesses. The integration of TNT Express, a Dutch courier service that FedEx purchased last year to give it a huge footprint increase in Europe, remains on schedule with management expecting an operating income improvement between $1.2 billion and $1.5 billion by 2020. We believe investors should continue to focus on the positive long-term growth from e-commerce, a market that is expanding at 15% or so per annum, and the accretive margins actions currently being put in place. To be sure, giant FedEx customer Amazon has expanded into the delivery business, but FDX CEO Fred Smith explained, They certainly have revolutionized the e-commerce world, and were not sure what Amazons going to do one way or another. But the FedEx system that consists of thousands of facilities has been decades in the making.
Featured stock for May 2017: VZ- Verizon is an integrated telecom company that provides voice and data services to wired and wireless customers. The company provides service to retail customers, businesses and the federal government. VZ shares have been beaten down since the beginning of the year on concerns that customer loss is accelerating and that the wireless data phone market is becoming a race to the bottom as far as profitability. We think that the tough competitive landscape concerns are largely priced in at this point, and believe that Verizon can continue to leverage its vast network to remain competitive over the long term in the wireless market. Although we aren’t betting on a big corporate tax cut, we are optimistic that there is potential for Verizon to benefit from even a small reduction, as the company pays in the 34% to 35% range currently. After the tumble, VZ trades with a current P/E of 12.2, below the 3-, 5- and 10-year averages, and a yield of 5.0%.
Featured stock for June 2017: KIM – Kimco Realty Real estate investment trust (REIT) is one of North Americas largest publicly traded owners and operators of neighborhood and community open-air shopping centers. KIM owns interests in 517 U.S. open-air shopping centers, comprising 84 million square feet of leasable space across 34 states and Puerto Rico. KIMs high quality portfolio of assets are tightly clustered in major metro markets and carry a well diversified stable of tenants. Shares have been crushed over the last year, losing almost 40% as investors decided that continued shifts in consumer behavior and greater adoption of e-commerce will further disrupt tenant profitability, thereby impacting KIMs property performance. While we agree that there will be continued headwinds on this front, we think the sell-off is well overdone and has created an attractive long-term opportunity. Many of KIMs in-place leases are significantly below current market rents, giving the company a potential source of organic growth moving forward, and historically low levels of new shopping center supply should support operating performance. More importantly, perhaps, very few of Kimcos customers are closing stores, while the largest tenants TJX (3.5% of annual base rent) and The Home Depot (2.5% of ABR) are not exactly struggling. We like that KIM has maintained its full-year FFO guidance of $1.50 to $1.54 per share and that the shares currently offer a 6.2% dividend yield.
Featured stock for July 2017: KR – Kroger is one of the world’s largest grocers, operating 2,792 supermarkets in 35 states with a total of 178.1 million square feet of retail space. In mid-June, grocery stocks plunged after Kroger issued a disappointing Q1 earnings report and news broke that Amazon had reached a deal to buy Whole Foods, making investors fearful that supermarkets were the next area of the already-fragile retail sector to feel the intense competitive pressure from the e-commerce titan. The Whole Foods deal has yet to be approved by shareholders, and even Kroger may still be a bidder for the upscale grocer. Certainly, competition has continued to intensify in the grocery biz, with German chains Lidl and Aldi having recently entered the fray, but the difficult backdrop was already well understood and had largely been discounted in our view. We also think that the last-mile of distribution remains the most challenging, and the purchase of stores by an online retailer is a major nod to the difficulty that Amazon is having getting everything to a shoppers doorstep. The number of failed home-delivery grocers is large, and we believe that plenty of shoppers will prefer to pick out their own rations for a long time still. We see KRs plunge as a buying opportunity, given a P/E ratio below 12 and a yield above 2%.
Featured stock for August 2017: ZBH – Zimmer Biomet is a global leader in orthopedic implants (hips, knees, spine, trauma and dental) as well as related orthopedic surgical products. ZBH is by far the king in hip and knee implants and we believe favorable demographics, which include aging Baby Boomers and increasing obesity rates, will drive solid demand for large joint replacement. Additionally we like that Zimmer has a history of strong relationships with the orthopedic surgeons that use its products. The doctors in this specialty have frequently shown resistance to efforts by hospitals or health systems to limit their ability to choose their brand. While shares have performed well in 2017, ZBH has pulled back since reporting Q2 revenue and earnings that were in line with expectations as near-term growth remains somewhat subdued. We think growth will pick up over time and we like that ZBH consistently generates strong free cash flow, while management now forecasts 2017 adjusted EPS of $8.20 to $8.30. Shares are trading at less than 15 times the midpoint of guidance, with that multiple only 60% of the average of its peer group.
Featured stock for September 2017: ALK – Alaska Air provides passenger, mail and freight air service to more than sixty cities in three countries through its Alaska Airlines, Virgin America and Horizon Airlines subsidiaries. ALK operates a fleet of 156 Boeing 737 and 65 Airbus A320 single-aisle jets for mainline service, while Horizon operates 52 turboprops and 7 regional jets for feeder or thinner routes. Alaska shares, and airlines in general, have plunged since March, as low-cost carrier competition, weather, fuel price and capacity concerns have been worrisome. We appreciate the headwinds, but we think that in the last decade, airlines have operated in a way that is a substantial departure from history (and that is sustainable!). Capacity continues to wax and wane, but new, fuel-efficient and more-capable airplanes afford the ability to right-size capacity on routes. Although Alaska paid a high price, we think the acquisition of Virgin America is working out well, even as fleet synergies wont be fully realized for years, given that many of the A320s are locked in lease contracts. We think that the combined entity will remain the premier airline in the Pacific Northwest, offering travelers low fares and a top-level customer experience. ALK trades for 9.4 times NTM earnings.
Featured stock for October 2017: XOM – Exxon is the world’s largest integrated oil and gas company, but the stock is down more than 9% in 2017, despite oil prices rebounding to more than $50 per barrel recently. Business conditions will remain pressured, but we still subscribe to the long-term global-energy story that usage in emerging economies will continue to rise. We like that the company is well-run and that management is focused on operating fundamentals in this lower price environment. Exxon generates strong cash flow from operations and is comfortably able to cover the investments in the business and dividend payments. Additionally, XOM is the only energy player with a Aaa credit rating (issued by Moodys) and its fortress balance sheet and capital discipline gives it the financial flexibility to selectively invest in higher-value products and potentially acquire assets at a discount. We are constructive on XOMs cost-control initiatives and the value that its upstream and downstream operations achieve due to a high level of integration. We also like the research and investment in reliable alternative energy sources for the future. XOM yields 3.8%.
Featured stock for November 2017: AXAHY – AXA is an insurance company that provides life and non-life insurance, savings and pension products, and asset management services to more than 100 million customers. According to CFO Gerald Harlin, AXA is focused on top-line growth in the Health and Protection business, while the Life Insurance business remains an area that has room for improvement, particularly in Italy, Japan and Hong Kong. AXA grew EPS 5% overall in the first half of the year, with a 3% gain in Life & Savings, a 6% improvement in Property & Casualty and a 10% increase in Asset Management. Looking ahead, the company plans to keep a tight lid on expenses and acquisition costs in order to meet the stated underlying EPS growth rate target of 3% to 7% per annum for 2015 to 2020. We like that AXA maintains a solid balance sheet, which includes global investments that seek to lower risk and volatility via diversification, and it is a top scorer in our proprietary valuation algorithm. AXAHY has a solid yield (especially compared to many U.S. insurers) of 3.4%, while trading near book value and for a forward P/E ratio of around 10.
Featured stock for December 2017: SCGLY – Paris-based Societe Generale SA (SocGen) offers commercial, retail, investment and private banking services. The bank has more than 3,000 branches in France, plus an additional 4,000+ branches in nearly 70 other countries. At the companys recent Investor Day, management noted multiple points of reform to combat deep and long-term transformations in the European banking industry. Among the areas of improvement, SocGen is focusing on improving customer banking experiences via digitalization, decreasing office costs (including the elimination of some retail bank positions and branches) and jettisoning non-core subsidiaries. While some analysts have cautioned that the transition may be slow and painful, we think that the strengthening European macroeconomic environment will serve as a tailwind for the bank. We believe that the 2020 strategic plan is on the ambitious end of the spectrum, and that the company will need to execute strongly on multiple fronts to achieve goals like 3%+ revenue growth per annum, cost reduction to below 17.8 billion euros (fiscal 2016 non-interest expense was 20.2 billion euros) and EPS above 6.50 euros per share (2016 was 4.55 euros). Despite the challenges, we think SocGen adds geographic diversity to a broadly diversified portfolio and trades at reasonable valuation levels, including a forward P/E of 11.2 and net dividend yield of 4.0%.
1 Hulbert, Mark. “The Little Newsletter That Crushed the Market”. Barron’s, 23 February 2017. Web. 27 February 2017.
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