The Valuentum Buying Index, our stock selection methodology, identifies firms that are 1) undervalued on a discounted cash-flow basis (e.g. three-stage fully-populated valuation model with complete financial statements), 2) undervalued on a relative value basis versus peers and the firm’s closest competitors, where applicable, and 3) just starting to show interest by investors as measured by technical/momentum indicators, providing the mechanism to drive a firm’s price to its fair value. Without the latter component, investors have a heightened risk of holding an underpriced stock for an extended period of time, one that may turn out to have little prospects for eventual price-to-fair-value convergence.
Once a firm is added to the Best Ideas portfolio or Dividend Growth portfolio, generally with a Valuentum Buying Index rating of a 9 or 10 (the highest rating, equivalent to a “consider buying” rating), we hold the firm until it registers a 1 or 2 (the lowest rating, equivalent to a “consider selling” rating). We may make a trade in (add/trim) the position (when it scores between a 3 or an 8, inclusive) for valuation considerations and portfolio construction considerations, but we like to capture the entire pricing cycle with our ideas (from a 9 or a 10 to a 1 or a 2 on the Valuentum Buying Index).
Just like a value manager doesn’t include all undervalued stocks in the market in his or her actively-managed portfolios, however, we don’t include all firms that score a 9 or 10 in our actively-managed portfolios. The firms that are added to the portfolios have passed muster with our analyst team and can be considered the best of the best ideas. For example, a firm with a weighting of a 5%-10% in one of the actively-managed portfolios should be viewed as one of our very best ideas, en route to price-to-value convergence or ongoing upward pricing momentum.
Before we dig into the constituents of the Best Ideas portfolio and Dividend Growth portfolio (collectively our best ideas), we think an overview of what investors can expect in 2014 is warranted. Investors don’t have to look too far to find ‘bullish’ sentiment, both in print and across the television waves of CNBC. It’s almost too prevalent. We’re singing a slightly more cautious tune than other investing pundits. Though we acknowledge many of the tail risks (US debt default, concerns about the aggressiveness of tapering, etc.) may be off the table in 2014, we’re not that excited about the broader market valuation and reiterate our opinion that prudence during 2014 will be rewarded.
First, we continue to see many more instances of 1 and 2 (the equivalent of a “consider selling” rating) on the Valuentum Buying Index than we do instances of 9 and 10 (the equivalent of a “consider buying” rating). Second, FactSet notes that S&P 500 firms, as of December 20, 2013, are trading at 15.1 times forward earnings, more than the prior 5-year average of 13.1 and above the 10-year average of 14. We think it’s difficult to argue that the economic growth prospects (and underlying earnings growth prospects) are better today than they were 10 years ago heading into the end of 2004. For example, 2004 marked the third year of the earnings recovery from 2001, but 2014 will mark the fifth year of the earnings recovery from 2009 (see image below). We think it’s probable that earnings multiples will contract to the 10-year average during 2014, despite decent global economic growth, and we wouldn’t think twice about the adjustment. It would be a reasonable move within the probable range of market valuation outcomes.
Image Source: FactSet
Said differently, a target on the S&P 500 of 1681 (14 times the S&P 500 companies’ collective forward 12-month earnings of $120.05) may be more appropriate than talks suggesting the S&P 500 will eclipse 2,000 by the end of 2014 (the S&P 500 is roughly 1,800 at the time of this writing). Though such a view may run counter to the patterns of history (a strong year is typically followed by another strong year), we think investors should know how the valuation parameters stack up heading into 2014 and how far we are into the earnings recovery at this point. In any case, prudence in allocating new capital in 2014 will be paramount.
Our Best Ideas
We cannot recommend that you buy, sell, or hold any stock because we are not aware of your personal financial situation, goals and risk tolerance. This is how our business works. However, the following stocks are our best ideas heading into 2014. They represent holdings in the Best Ideas portfolio and Dividend Growth portfolio. The goals of the Best Ideas portfolio are to outperform the broad market performance every year and to generate a positive return each year regardless of the broader market environment. The goals of the Dividend Growth portfolio are to generate a growing stream of income and deliver a high-single-digit annual rate of return over rolling three-to-five year periods.
Best Ideas Portfolio
Altria
We continue to prefer Altria (MO) on the basis of its hefty annual dividend yield. The company continues to raise the dividend at a nice clip and holds a prized 27% ownership stake in SABMiller, which continues to perform well. SABMiller currently sports a ~R800 billion market capitalization (or about $80 billion USD at current exchange rates), which means Altria is effectively sitting on $21.6 billion in potential cash (about 30% of its market capitalization) at current price levels. We think this hidden asset within Altria’s portfolio is the primary difference between our fair value of Altria and its market price. Altria remains a core holding in the portfolios of our Best Ideas Newsletter and Dividend Growth Newsletter. We think Altria’s shares are worth $40 each.
Apple
We think consensus estimates for Apple’s (AAPL) earnings through the middle part of this decade are too low (on the basis of the recent China Mobile transaction), and the company’s committed entrance into China bolsters the sustainability of the firm’s long-term earnings stream, offering support for our estimate of its cash-flow based intrinsic value. We like the company’s track record of innovation and its extremely healthy balance sheet that will pave the way for significant dividend growth and opportunistic share buyback opportunities. We continue to believe Apple’s shares are worth north of $600, with upside to over $750 on the basis of the high end of our fair value range.
Baidu
Though we continue to be cautious on the economic environment in China, Baidu (BIDU) will benefit from the ongoing boom in China’s Internet space. The country has the world’s largest Internet user population—and a long way to go to reach penetration levels of developed countries. We think Baidu will remain at the forefront of such secular expansion for many years to come. We think its shares are worth $193 each.
Buffalo Wild Wings
Buffalo Wild Wings’ (BWLD) business model continues to be tremendously successful with revenue surging 28% year-over-year to $316 million in its third quarter, results released in October. Diluted earnings per share jumped 65% year-over-year to $0.95 during the quarter thanks in part to lower chicken wing costs. Buffalo Wild Wings is only in the “fifth inning” of its expansion efforts. With 959 locations, the company sees the opportunity to nearly double its restaurant count to 1,700 units. For 2014, the firm expects to achieve 20% net earnings growth and open its 1,000th store during the year. At the high end of the fair value range, we think shares are worth over $170 each.
DirecTV
DirecTV’s (DTV) large subscriber base, leading brand name, and substantial programming content are key competitive strengths. The company remains a holding in the portfolio of the Best Ideas Newsletter, and we didn’t see anything in its third-quarter results, released early November, that would challenge our valuation thesis on the company. We’d like to continue to see the firm gobble up its undervalued stock in the periods ahead and expect valuation upside to $80 per share on the basis of our fair value estimate. The company continues to be included in merger rumors in the telecommunications space, and we would not be surprised to see it as a part of a large deal in the coming years.
eBay
We continue to be very pleased with online consumption so far this holiday season, and in particular, ongoing strength at Best Ideas portfolio holding eBay (EBAY). eBay uniquely benefits from both a network effect in its auction business and a secular trend toward consumer online consumption in its payments business, PayPal. We think shares of the e-commerce giant are worth $79 each, offering investors a very attractive long-term valuation opportunity.
We estimate Facebook’s (FB) intrinsic value to be roughly $80, and the shares have rocketed higher towards that level in recent months. The company continues to roll out endeavors that represent new revenue streams (e.g. video advertisements), and thus far, it has been able to recover from its very rough start as a public company. Though the call options on Facebook’s shares in the Best Ideas portfolio may expire worthless, we’re expecting further upside in shares and are levered to that expectation. Facebook could be a stock that reaches the highest of market valuations on overly optimistic market expectations, regardless of whether they come true or not.
Financial Select SPDR Fund & SPDR S&P Bank ETF
We prefer general operating corporations to any banking entity, all else equal. The history of the banking sector has witnessed three significant banking crises in the past three decades alone: the savings and loan crisis of the late 1980s/early 1990s; the fall of Long-Term Capital Management and the Russian/Asian financial crisis of the late 1990s; and the Great Recession of the last decade that not only toppled Lehman Brothers, Bear Sterns, Washington Mutual, and Wachovia but also caused the seizure of Indy Mac, Fannie Mae and Freddie Mac. We don’t want to take on the individual risks of any one bank, but we do think broad exposure to the financials sector via low-cost ETFs can be an attractive idea. We have modest banking exposure in the portfolio of our Best Ideas Newsletter via the Financial Select Sector SPDR (XLF) and the SPDR S&P Bank ETF (KBE), primarily for diversification and valuation reasons.
Ford Motor
“2014 is expected to be another solid year for Ford (F) and a critical building block in the One Ford Plan as Ford moves forward in building stronger global brands, a growing business based on outstanding products and a better balanced business in terms of source of sales and profitability. This is supported by a strengthening balance sheet that will continue to enable the company to reward shareholders with attractive returns (source).” Though cost pressures related to new investment will weigh on 2014 earnings at the automaker, the fundamental trajectory of global auto sales is positive, and we think the potential for earnings upside relative to lowered expectations is great. We think shares of Ford are worth north of $20 per share.
General Electric
General Electric (GE) has transformed itself from the days it had to slash its dividend back in 2009, as GE Capital is much smaller and poses less risk to the overall financial health of the organization. It’s hard not to like the pace of the industrial conglomerate’s orders, the size of its backlog, and the trajectory of industrial segment margins. We see valuation upside in GE’s shares to the mid-$30s per share under our optimistic case.
We think Google’s (GOOG) shares look undervalued. We don’t expect mobile or Google+ to propel the company to higher profitability, but we think the firm will likely maintain market share on the traditional web for a very long time. Given the innovative nature of the company, we wouldn’t be surprised to see Google as a leading glasses maker, car-software innovator, internet provider or anything else in the next ten years. We continue to hold the company in the portfolio of our Best Ideas Newsletter. Shares are worth north of $1,200 per share, in our view.
Health Care Select Sector SPDR ETF
There are few ETFs that give you broad equity exposure to the trend toward increased spending on healthcare. The Health Care Select Sector SPDR (XLV) includes Johnson & Johnson, Pfizer, Merck, Gilead Sciences, Bristol-Myers, Amgen, AbbVie, UnitedHealth Group, Celgene, and Biogen. We like broad exposure to healthcare and view this ETF as a long-term holding. We think it offers a nice balance to the Best Ideas portfolio. See more here.
Intel
According to data released by the International Data Corporation (IDC) Worldwide Quarterly PC Tracker on December 2, personal computer (PC) shipments will drop more than 10% in 2013, the most severe yearly contraction on record. However, this news isn’t the key takeaway. Instead, it is expectations for stabilizing demand by 2015 that we expect to provide a shot of optimism to the PC supply chain. We view the news as particularly positive for Intel (INTC), offering further support for the long-term growth and sustainability of its dividend. We think shares of Intel are worth nearly $30 each.
Intuitive Surgical
Intuitive Surgical (ISRG) is the global leader in the field of robotic-assisted minimally invasive surgery. The company generates as much as $170k/year in customer annual service agreements and as much as $2.2k per procedure. We love its razor/razor-blade model. Sentiment on the company’s shares, however, is terrible at the moment. The company is worth more than $420 per share, in our view, but we’re watching its risk profile closely. Intuitive Surgical has been the target of well-publicized criticisms of the efficacy and cost-savings of its surgical applications, and we note the firm is one of the riskiest in the Best Ideas portfolio.
Precision Castparts
Precision Castparts (PCP) makes metal castings for every jet aircraft engine program in production or under development by its key customers—GE, Pratt & Whitney, and Rolls Royce. The proliferation of new aircraft builds and aircraft deliveries across the globe will result in increased profits for parts suppliers like Precision Castparts to the airframe makers themselves, Boeing and Airbus. We very much like the long-term growth dynamics of the aerospace (not airline) industry, and the potential margin expansion associated with Precision Castparts’ Titanium Metals acquisition will be significant. CEO Mark Donegan is perhaps the most talented CEO in our coverage in extracting efficiencies from newly-acquired entities. Shares are worth more than $300 at the high end of our estimated fair value range.
Republic Services
We’re huge fundamental fans of the garbage hauling industry and hold Republic Services (RSG) in the portfolio of the Best Ideas Newsletter. The US non-hazardous solid-waste services industry generates annual revenue in excess of $50 billion, and Waste Management (WM), Republic Services, and Waste Connections (WCN) dominate the market, generating greater than 60% of industry revenues and controlling an equal percentage of valuable disposal capacity. The top line for the group can be expected to expand at a nominal-GDP rate, with pricing growth in the industry adding an additional tailwind thanks to recent consolidation (Republic Services/Allied Waste), a rational focus on return on invested capital, and cost pressures facing independent mom-and-pop trash companies and municipalities. We’re not expecting significant valuation upside from Republic, but the firm continues to be an anchor position in the portfolio.
Rio Tinto
In a highly-uncertain commodity price mining environment, we continue to like the prudent moves taken by Best Ideas portfolio holding Rio Tinto (RIO). The company noted that it has already exceeded its target of operating cost cuts of $2 billion by the end of 2013 and is on track for $3 billion by next year. We’re big fans of the operating cost cuts, which coincide with capital spending declines and an ongoing focus on shoring up the balance sheet. 2014 will be a year focused on de-leveraging (paying off debt) to preserve its comfortable investment-grade credit rating. The moves by Rio Tinto speak volumes of its focus on shareholder returns, and the firm continues to be our favorite mining idea on the basis of valuation.
Teva Pharma
We first added Teva Pharma (TEVA) to the portfolio of the Best Ideas Newsletter in July 2013 at just over $41 per share, and the company continues to hover around those levels today. We’ll never pick the exact bottom of a firm’s shares (nobody can), but the resiliency of companies that have registered a 9 on the Valuentum Buying Index in the face of unexpected bad news is astounding. Bloomberg reported rumors that, if the company can’t find a new CEO soon, a merger with fellow generic-drug makers Mylan (MYL) or Valeant (VRX) may be in the cards. The possibility of the emergence of an activist shareholder that would push for change at the generic pharmaceutical giant is even more likely. Teva is worth at least $50 per share, in our view, even after considering mid-cycle declines in revenue and operating profits as a result of patent expiration of Capaxone. If Teva replaces a significant portion of lost profits from Capaxone over the next five years, shares are worth much more.
Union Pacific
Union Pacific (UNP) reported its “best-ever quarterly results” when it posted third-quarter performance mid-October. The company’s operating ratio came in at a record 64.8% (the firm’s best ever—1.8 points better than the year-ago period), as the railroad offset lower coal and grain volumes with strong pricing and productivity improvements. We expect the firm’s operating ratio to be among the best in the railroad group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast. The firm is levered to coal, though we note its mix is more of the PRB (Powder River Basin) variety, which should continue to take share from CAPP (Central Appalachian) coal in the domestic market. Shares are worth $170, in our view.
Visa
It’s hard to find anything wrong with Visa’s (V) business model. The company offers a secure payment network that is accepted virtually everywhere in the United States. The firm makes money every time a Visa user swipes his or her debit or credit card. The only competition Visa faces is cash and mobile payment solutions, which V.me will address and has yet to take a stranglehold. Visa benefits from two fantastic competitive advantages: a network effect and costly initial investment. Visa continues to possess valuation upside and is one of the most shareholder-friendly companies in our coverage universe.
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