By Brian Nelson, CFA
“’I believe you have to be willing to be misunderstood if you’re going to innovate.’ You can’t outperform the market if you are the market. Similarly, you must adopt a non-consensus view and be right about that view to beat competitors.” CEO of Amazon Jeff Bezos with ‘Source: 25iq’ commentary
Many members have expressed to me that they just can’t believe investors select stocks in a different way than the Valuentum style (absent dividend growth investors, which have carved out a unique niche in their own right). Some of our new members think the Valuentum process is the principal and dominant framework for investing – or how the majority of investors look at things. This view may be true if we consider some of the very best investors that combine methodological frameworks, but it’s certainly not true not across the board. Valuentum has a nice economic moat in the investment industry, and since we’re a boutique research firm (without broad sell-side distribution), members benefit greatly from our non-consensus view. The savviest investors understand that if everybody else is doing what they’re doing (or if they’re doing what everyone else is doing), the best they can ever hope for is average – and that’s if they don’t make any mistakes.
To many of our members, the Valuentum way is just a natural extension of common-sense investing: selecting underpriced stocks that are just starting to garner market interest via stock-price appreciation. After all, to them, highly-rated ‘Valuentum’ stocks have strong valuation support and a solid or improving investor/technical foundation (value+momentum), significantly reducing the likelihood of catching a ‘falling knife’ while substantially improving the probability of ongoing price-to-fair value convergence.
Value investors don’t need to catch falling knives — they don’t need to buy an underpriced stock immediately as it falls below the margin of safety threshold (and is still going down). Being even more patient often leads to scooping up that same stock at an even better price. By buying it immediately at the margin-of safety-threshold, investors are, by definition, trying to time the market. Buying that underpriced stock (below the margin of safety threshold) shortly after it turns up is a much better approach. In this case, the market lets the investor know when that stock is ready to converge to its intrinsic value. The Valuentum style, which favors underpriced stocks that are just starting to converge to intrinsic value, is a whole new way to view investing. Yet, to many, it is just common sense.
The Valuentum process – in its transparent form – may not be easy to understand, however, and sometimes it’s misunderstood. The process is not a rapid trading program, but instead, it is one grounded in discounted cash-flow analysis, relative value analysis, and timeliness indicators. As the CEO of Amazon (AMZN) Jeff Bezos noted in the introductory quote, it’s okay that we’re sometimes misunderstood, as we remain completely focused on innovating and making a difference for the individual investor. In the stock market, most participants can’t beat a broad market index consistently. So, they resort to conventional market wisdom. But it is that same “conventional market wisdom,” which we don’t find to be wise at all, that leads most to underperformance and others to mediocrity — indexing. As with our members, we are very comfortable applying the Valuentum process. We simply know it works — not because it has significant academic back-testing and empirical evidence, but because at its core, it is simply common sense. We believe – in no uncertain terms – that the Valuentum process is the correct way to think about investing, and ‘adopting a non-consensus view and being right about it’ is all that we strive for at Valuentum.
So, where do investors get started? Well, there are a number of ways that existing members use the Valuentum Buying Index rating system. First and foremost, most members consider buying constituents in the Best Ideas portfolio and Dividend Growth portfolio – these are our best ideas at any given time. The constituents in these actively-managed portfolios, which are inserted in each edition of the monthly newsletters, have previously registered high scores (9 or 10 = “we’d consider buying”) on the Valuentum Buying Index and won’t be removed until they register a 1 or 2 on the index (equivalent to a “we’d consider selling” rating), or for other qualitative considerations.
We may tactically trim/add to their positions in the portfolios over time, but because we seek to capture the entire pricing cycle in the Valuentum framework, we like to hold stocks from the time they register a 9 or 10 to the time they register a 1 or 2. We have a qualitative portfolio-management overlay (and don’t include every stock that registers a 9 or 10 in the portfolio, either due to sector weighting considerations or due to overall market valuations), but for the most part, this is the core of the process. In its transparent form, the work behind the Valuentum style is somewhat intimidating, but we like to provide all of the 16-page reports and dividend reports in our coverage universe so members have confidence that the ‘methodology engines’ are running behind the scenes. For example, the discounted cash-flow models we use for each company include thousands of inputs, just to arrive at a fair value estimate and a fair value range in each report.
Valuentum members like to conduct their own due-diligence, examine the 16-page stock report on the firm’s landing page on our website, evaluate the corresponding dividend report for health and safety (if applicable), and read through the Valuentum commentary and corporate press releases. There is a wealth of information for every stock on our website, and members take advantage of this unrestricted access – in addition to gaining access to the portfolios and email transaction alerts. The fact that we offer an independent, unbiased view is par for the course for most of our readers, while others like that we say and do what we mean. If a company is in one of our portfolios, we like it a lot. If a company has a high Valuentum Buying Index rating or is undervalued on a discounted cash-flow basis and not included in the portfolios, we like it but not as much as the portfolio holdings. If a company is overvalued and has a low Valuentum Buying Index rating, we don’t like it that much.
With all of this said, we wanted to put the following 8 companies on your radar (if they are not already). Some of them are included in the Best Ideas portfolio, while others are worth watching closely. If dividend growth investing is more your style, please look at this earnings update here. Let’s now dig in!
Stocks Highlighted: BRCM, BWLD, F, PPG, SYNA, USG, UNP, V
Broadcom (BRCM) — Valuentum Buying Index: 6 — Fair Value Estimate: $41
Broadcom is a firm that gets a lot of attention in our coverage universe because of its frequent high rating on the methodology. Before its most recent update, the company had registered a 9 on the Valuentum Buying Index. We like the firm’s valuation opportunity, but because we are quite tech-heavy in the portfolios at present, Broadcom has never garnered an allocation in either the Best Ideas portfolio or Dividend Growth portfolio. That didn’t stop the company from posting solid first-quarter results recently, however. During the quarter, management noted strength in its Broadband and Infrastructure segments, better-than-expected gross margins and improved expense discipline. Revenue and net income continued to face pressure during the period, but Broadcom indicated that improvement progressed into the current June quarter. In any case, the company’s operating results have fluctuated significantly in the past, and we would expect fundamental volatility going forward. We think there are better technology-sector ideas for consideration (hence why it’s not a portfolio holding), and we would point investors that are interested in mid- or big-cap tech exposure to either Apple (AAPL) or Microsoft (MSFT), the latter two paying excellent dividends with healthy valuation potential.
Buffalo Wild Wings (BWLD) — *Best Ideas Portfolio Holding*
Buffalo Wild Wings is our favorite idea in the restaurant space for good reason, and its first-quarter results showed why. During the period, total revenue advanced more than 20% on same-store sales growth of 6.6% at company-owned restaurants and 5% at franchised restaurants. Net earnings soared an impressive 70%+, to more than $28 million, in the period, as earnings per diluted share increased at a similar pace. Earnings growth benefited from a 440-basis point improvement in cost of sales thanks to lower wing prices. We believe the company is only in the “fifth inning” of its restaurant expansion efforts. With 1,010 locations, the company sees the opportunity to grow its restaurant count to 1,700 units over the long run. For 2014, the firm expects to achieve 25% net earnings growth (was 20%), and we think there may be upside if wing costs stay mild. At the high end of the fair value range, we think shares are worth nearly $200 each.
Ford (F) — *Best Ideas Portfolio Holding*
Ford has come a long way since the doldrums of the Financial Crisis that saw the global automotive industry shaken to its core. The first quarter of 2014 represented the automaker’s 19th consecutive quarter of profitability. Ford retains the significant operating leverage of yesteryear, but its financial leverage is now much more manageable. The firm ended the quarter with automotive gross cash of $25 billion, exceeding debt by $9.5 billion. Ford’s liquidity position is now a healthy $36.6 billion. 2014 will see the launch of 23 new global vehicles (the most in a single year in history), and full-year pre-tax profits in the range of $7-$8 billion (even after reflecting that heavy investment). Though Ford will see Mulally leave at the end of this year, we think COO Mark Fields is highly capable of running the automaker as the next chief executive. The middle of the decade is looking quite bright for Ford Motor. We think shares are worth north of $20 each.
PPG Industries (PPG) — Valuentum Buying Index: 6 — Fair Value Estimate: $195
PPG is a major global supplier of coatings for customers in a wide array of end markets. PPG’s aerospace coatings business supplies sealants and coatings to many commercial and military aircraft, its architectural coatings are used by painting and maintenance contractors for decoration and maintenance of residential and commercial buildings, and its industrial coatings are used by automotive OEMs. The firm isn’t too capital-intensive, has pricing power, and its top-market share position in a consolidating industry is hard not to like. The company’s EBITDA margin is the best among peers, and its dividend track record is among the best we’ve seen (it’s an Aristocrat). During the company’s first quarter, PPG reported its highest sales volume growth (5%) in three years, as total revenue cruised 17% higher. Management noted that adjusted earnings per share leapt 40% versus the prior year, with improvement across every region. PPG is one of our favorite ideas in the chemicals industry, but its valuation leaves much to be desired (even as it upped its dividend to $0.67 per quarter). We’re still waiting for a better price at a larger discount to intrinsic value. Shares are trading at roughly $190 each at the time of this writing.
Synaptics (SYNA) — Valuentum Buying Index: 6 — Fair Value Estimate: $68
Synaptics most recently registered a 9 on the Valuentum Buying Index in August 2012 at $28 per share. Clearly, we’re not very happy that we didn’t add the company to the Best Ideas portfolio at the time, but at the same time, we like the continued affirmation of the Valuentum process in stock-selection. Synaptics provides custom human interface solutions (cursor control) and generates half of its revenue from mobile smartphones. The tablet market and its fingerprint ID business represent new opportunities for its intellectual portfolio, and while the company’s valuation opportunity has closed, we were impressed with its fiscal third quarter results. The company now expects fiscal 2014 top-line growth of 37%-40%, up from expectations of about 20% at the beginning of the year, thanks to a stronger outlook for its fingerprint ID operations. We’re not putting new money to work in the company, but Synaptics has been one of the best innovators over the past 5-10 years, and we encourage investors to keep a close eye on its intellectual portfolio. Shares are trading at roughly $62 each at the time of this writing.
USG Corp (USG) — Valuentum Buying Index: 6 — Fair Value Estimate: $51
USG may have the highest incremental margin on new revenue of any firm in our coverage universe. Incremental operating profit margins following cyclical economic troughs at the company have been 35% during 1982-1985, 56% during 1992-1995, 33% during 2001-2004, and roughly 60% since 2012. Said differently, for every new dollar of revenue, 60% of it falls to the operating profit line, working wonders on profitability – this relationship is often called operating leverage. USG makes wall, ceiling, flooring and roofing products for the residential/nonresidential construction markets and repair/remodel construction markets. The firm boasts the well-recognized SHEETROCK wallboard brand name. In its first quarter results, sales advanced 4%, while operating profit surged 35% — not quite as strong operating leverage as in recent quarters, but still impressive. Operating leverage is the area that most analysts get wrong, and our forecasts for future profits at USG indicate upside potential. Shares are trading at roughly $30 each at the time of this writing. The company’s large debt load, however, may keep us on the sidelines indefinitely.
Union Pacific (UNP) — *Best Ideas Portfolio Holding*
Union Pacific reported record first-quarter results that showed diluted earnings per share increasing 17% and its operating ratio advancing 2 percentage points to 67.1%. 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 nearly $190, in our view, roughly in line with where they are trading. Our ‘consider selling’ discipline is not only valuation-based, but we’d also have to see confirmation in the technicals (pricing information) as well. Said differently, we’d be waiting for its technicals to turn lower for us to consider trimming the position in the Best Ideas portfolio. This patience allows our winners to run higher (without taking on undue capital risk) and the portfolio to capture the “momentum” aspect of the Valuentum process (a key lever of outperformance). In any case, Union Pacific remains our favorite railroad idea.
Visa (V) — *Best Ideas Portfolio Holding*
Visa benefits from two fantastic competitive advantages: a network effect and costly initial investment. The network effect is incredibly strong for Visa. As of its last update, the firm has more than 2 billion cards outstanding accepted by retailers across the world. The number is roughly double the number of Mastercards (MA) and over 20 times the amount of American Express (AXP) cards outstanding. This network effect took years, as well as billions of dollars to create—something that won’t easily be replicated by any new entrant. Adjusted earnings per share in Visa’s first quarter advanced 15% thanks to a 9% constant-currency increase in net operating revenue, which itself was driven by solid growth in service revenues, data processing revenues, and international transaction revenues. Though the firm said revenue growth would slow as a result of sanctions imposed on Russia (RSX) and a stronger dollar, we think this is merely transient and immaterial to the long-term trajectory of Visa’s franchise. We especially like that Visa does not take on credit risk, and while that may disqualify it as financials exposure, we’re considering its position in the Best Ideas as exposure to the sector. Our fair value estimate is $235 share.
Wrapping Things Up
The Valuentum Buying Index continues to be the key driver behind adding or removing firms from the Best Ideas portfolio. We continue to believe the Valuentum style of investing offers significant opportunities to those who are tuning in to its outperformance. Our best ideas continue to reside in the portfolio of the Best Ideas Newsletter.