“A significantly “undervalued stock” that is dropping like a rock is a huge red flag, and the Valuentum system offers a methodological overlay to incorporate the very valuable information contained in share prices.” – Brian Nelson, CFA
What a day for Michael Kors (KORS)! At the time of this writing February 2, shares of the aspirational brand are soaring 20%+. Yes, it is a holding in the Best Ideas Newsletter portfolio, “Valuentum’s Best Ideas Portfolio,” and yes, we added to the position in Michael Kors November 5, 2015, “Email Transaction Alerts.” The email transaction alert, which included some profit-taking in Altria and additions to the positions in Buffalo Wild Wings and Michael Kors, can be downloaded here. Prior to the surge today, Kors’ shares held a ~1.5% positon in the portfolio, and while the impact of this jump may not pack the “punch” as that offered by Google’s (GOOG, GOOGL) and PayPal’s (PYPL) recent quarterly results (given the high weightings of the latter two), we really can’t complain. Shares of the company are approaching $50 each, and we’re sticking with our $62 per share fair value estimate for now, “.”
As it relates to the report, Michael Kors’ fiscal third-quarter (calendar fourth-quarter) release showed a company that is still growing revenue at a nice clip (~10% on a constant-currency basis) and one that put up $1.65 per share in earnings on a constant-currency basis during the period. For fiscal 2016, Michael Kors expects total revenue to advance at a “low-double-digit” pace, with the current quarter the last of the fiscal period, despite pressure on comparable store sales (+2% in Q3, however). Diluted earnings per share is expected in the range of $4.38-$4.42 for fiscal 2016, implying the company is trading at roughly ~11 times soon-to-be trailing twelve-month earnings with a ~$700 million net cash position! Given some of the exorbitant multiples (i.e. 20+ times) placed on “slow-growing,” debt-heavy equities in this market, it’s very easy to see why we liked the company from a valuation standpoint, and why we felt the time was ripe to add to the position in November when shares nudged modestly upward. Technically speaking, shares can close the “gap down” to $60, in our view, but it’s likely it will take some time for the market to digest the big gains today. Dividend Growth Newsletter portfolio holding Coach (COH) is also showing relative strength on the news.
We received another reminder today of the benefits of incorporating the information held within stock prices as an overlay to a robust valuation context, as in the Valuentum methodology. Rent-A-Center (RCII), a stock trading at just 5 times forward earnings with a dividend yield of 7%, reported nothing short of a horrible quarter February 2, with shares now trading down 24% at the time of this writing from its February 1 close. Our latest report update on Rent-A-Center, “,” made the case that our estimate of its intrinsic value was higher, but a lackluster 6 on the Valuentum Buying Index helped us to keep things in context. Where traditional valuation approaches may have been scooping up shares rapidly on account of the company’s traditional “undervaluation,” the Valuentum Buying Index helped to keep us away from Rent-A-Center, which turned into a “falling knife.” A significantly “undervalued stock” that is dropping like a rock is a huge red flag, and the Valuentum system offers a methodological overlay to incorporate the very valuable information contained in share prices.
But let’s talk more about a 6 on the Valuentum Buying Index because after all we just added Johnson & Johnson (JNJ) to the Best Ideas Newsletter portfolio, and it was a 6. On page 14 of every company’s 16-page report, you can view the flow chart of how we arrive at each Valuentum Buying Index rating, and you’ll see that a 6 isn’t fantastic, but it’s not terrible either – but “constructive.” In Rent-A-Center’s case, we viewed the prospect of its “undervaluation” on both a discounted cash-flow basis and relative-value basis as more red flags than anything else, in the context of its very poor industry, risky leasing business model with inventory obsolescence risk in a tightening credit market. To a large degree, Rent-A-Center’s share-price action was telling us something was very wrong with the company, not necessarily with respect to our long-term valuation assessment, but with respect to the market’s appetite in eventually assigning it our estimated intrinsic value. This situation is what we are hoping to avoid when we ditched shares of Alibaba (BABA) and Gilead (GILD), “Google..Ahem…Alphabet.”
On the other hand, in the case of newsletter portfolio holding Johnson & Johnson, we’re huge fans of its industry backdrop (consumer/pharma/medical devices) and cash-rich business model, not to mention that we get a nice yield to hold shares. Johnson & Johnson’s strong technical outlook coupled with what we describe to be a “fair valuation” means that we picked up a great company to fill the needs of healthcare exposure in the Best Ideas Newsletter portfolio, a place that became absent once Gilead’s shares were removed. High Valuentum Buying Index ratings have been shown to outperform low Valuentum Buying Index ratings over large sample sizes, “Why Valuentum Buying Index Ratings Matter,” but individual stock-selection, as in that of the Best Ideas Newsletter portfolio or Dividend Growth Newsletter portfolio, requires a portfolio-management overlay and subjective evaluation. This is why we may shun companies like Rent-A-Center but adore companies like Johnson & Johnson, for example, with both registering a 6 on the index.
We had outlined the “carry trade” and its impact on US interest rates, “Dividend Growth ‘Bubble’ To Continue But For How Long?” and the financials sector (XLF) is getting pummeled February 2. Schwab (SCHW), Bank of America (BAC), Citigroup (C) and Goldman Sachs (GS) are among the sector’s biggest loses, and while we were expecting continued pressure on rates, we’re not against holding financials sector exposure in the Best Ideas Newsletter portfolio, even as we say we’re not jumping to add to our positions. A potential flattening yield curve, slowing economic growth, hiccups in the housing market, and concerns over energy loan losses are a few areas that will trouble the Big Banks for the foreseeable future, “Our Comprehensive Report on the Banks & Money Centers Industry.” Though we never like to see positions face pressure, we’re keeping our banking exposure low at no more than just a few percentage points of aggregate portfolio value.
Sometimes members forget all of the “land mines” we’ve avoided in both the newsletter portfolios. It’s easy, for example, to forget how we avoided the “crash” in biotech (IBB) through most of last year and into this one (practically nil exposure in either portfolio), but we were reminded of how we avoided the continued pain in the energy sector (XLE) February 2. Oil giant BP’s (BP) fourth-quarter showed a 90%+ drop in fourth-quarter earnings, and the upstream and downstream behemoth is cutting capital spending to the bone. BP’s Dividend Cushion ratio is a serious 0.1, “,” and its payout may not make it at present levels. With crude oil prices dipping back below $30 per barrel, the banks are starting to get really nervous, and we doubt many will continue to allow unsustainable dividend/distribution payments in light of credit quality deterioration. Even the strongest Exxon Mobil (XOM) is facing a bloated net debt position as it scales back capital spending and buybacks to navigate this tumultuous energy-resource price environment.
We’re not the only ones expecting a surge in high-yield defaults in coming years. Moody’s, for one, expects “junk bond” defaults to a hit a six-year high in 2016 from failing commodity-tied entities, and from our perspective, the outlook for 2017 may not get much better as the slow cash-flow bleed comes to a head for many. High-yield bond spread of ~800 basis points (HYG, JNK), as of January 27, means debt funding could become prohibitively expensive for even some of the “better” speculative grade entities. The banks have already taken some heavy hits to their energy bond portfolios, and appetitite for risk taking is no longer. Be careful out there.