Monday, June 27, 2011

Are Large Cap Stocks on Sale?

A follow up to this post:

Buffett: Waiting For The Fat Pitch

If not quite fat pitches yet, many big cap stocks seem not at all expensive.

Last week I noted that many stocks among the Dow 30 are, on the surface, very reasonably valued.

Some, of course, more than others. I'm wary of businesses that may be benefiting from cyclical tailwinds that make them look cheap now but on a normalized long-term basis they end up not such a bargain.

In general, I wouldn't take the bat off the shoulder for most commodity businesses unless they have a clearly sustainable low cost advantage, a conservative balance sheet, selling at a price that reflects a weak business outlook. In other words, a much larger than average margin of safety is needed.

In fact, I wouldn't go near something like Alcoa (AA) no matter how inexpensive it was.

For most businesses, especially the capital intensive/cyclical ones, current earnings doesn't help much in estimating intrinsic value. Cyclical stocks often look cheap when they are most expensive. The use of what ends up being near peak earnings to value a cyclical business, a common mistake, can be very costly*.

In my view, earnings produced on average over at least a full business cycle (much longer if recent bubble conditions have caused distortions) must be used with quality of earnings carefully checked.

To me, this is not the case for the great consumer franchises. For those businesses, recent annual earnings is usually sufficient given the resilience of their earning power.

Dow 30
3M (MMM), AT&T (T), Alcoa (AA), American Express (AXP), Bank of America (BAC), Boeing Co (BA), Caterpillar Inc (CAT), Chevron Corp (CVX), Cisco Systems (CSCO), Coca-Cola (KO), Disney (DIS), Du Pont (DD), Exxon Mobil (XOM), General Electric (GE), Hewlett-Packard (HPQ), Home Depot Inc (HD), IBM (IBM), Intel (INTC), Johnson & Johnson (JNJ), Kraft Food Inc (KFT), McDonalds (MCD), Merck (MRK), Microsoft (MSFT), J.P. Morgan (JPM), Pfizer (PFE), Procter & Gamble (PG), Travelers (TRV), United Technologies (UTX), Verizon (VZ), Wal-Mart Stores (WMT)

The focus here is always on purchasing shares of good businesses, with an appropriate margin of safety, then allowing the economics of the business itself, the drivers of growth in intrinsic value, to do the heavy lifting over a long period of time. No special ability to trade or time the market required.
(I never have an opinion when it comes to the trading of any stock. Fortunately, nor is some unusual talent for trading required if price vs value is frequently judged well.)

Many large tech stocks, pharma stocks, and integrated energy stocks currently sell at single digit price to earnings ratios. A low multiple isn't enough. Ultimately, what matters is whether the business has durable competitive advantages that allow it to produce a high return on capital** over a very long period of time. Durable high return on capital is useful for gauging 
how intrinsic value may grow over time (though there is no precise method to predict long-term growth in value, of course).

Again, the durable high return on capital is what drives long-term investment returns not some kind of superior trading skills.

It's often better to pay a slightly greater multiple (maybe more than slight) for a business that's positioned to produce a high return on capital for years to come.

Return on capital for tech stocks often looks pretty solid but the question is not usually how attractive current or near term return on capital happens to be for most tech stocks.  The question is how sustainable those seemingly favorable economics will be in a constantly changing competitive landscape with evolving future threats. That's why I'm not comfortable with most tech stock investments unless the discount to likely value is very large.

The single digit multiples found among some of the above stocks appear to be pricing in a future not likely to happen. I have no idea what the stocks will do in the short-to-intermediate run but, for me, quite a few of these do have a decent margin of safety. 


They seem as strangely cheap today as they were strangely expensive roughly a decade ago. Yet, I wouldn't describe any as being along the lines of what Buffett calls a fat pitch.

A decade ago prices reflected a rosy future that didn't happen. For many of the better businesses here with prices that reflect a lousy expected future, I suspect things will end up being a bit better than lousy and long-term investors will do okay.

Most big banks also sell at a single digit multiple of likely normalized earnings (some are already at single digit multiples even with earnings depressed well below potential).

As far as banks go, for me, something like Wells Fargo (WFC) still looks very reasonable even if the regulatory and systemic risks remain significant. The long-term economics of Wells is exceptional. Even as the rules of the banking game change I'm of the opinion they will continue to have an advantage.

I may, of course, be proven wrong about Wells. The question is whether any bank is worth the trouble when considering all the other reasonably valued assets available. Many things can go wrong for a bank, some beyond its control, that simply cannot for other businesses.

As always, some of this comes down to how comfortable an individual investor is with the inherent risks of one asset versus another asset. Buy an asset where you don't understand the inherent risks and potential and the conviction required to hang in there if the market price starts to break down probably will not be there.

For my money, adjusted for risk the best businesses to own long-term remain the great franchises (Diageo: DEO, and Pepsi: PEP and Johnson & Johnson: JNJ among many others) when bought at the right price. These all have huge and durable economic moats. The durability of their economics come primarily from a combination of strong product, brands, distribution, and scale. Each are very difficult to dislodge from their unique positions of strength and have proven economics to back it up.

These stocks may lack characteristics that those involved in hyperactive trading are looking for but the merits of their long-term effects, especially on a risk/reward basis and when bought at the right price, are real.

"...why should such an owner care if at any time most other investors are faring somewhat better or worse. And particularly so when he rationally believes, like Berkshire, that his long-term results will be superior by reason of his lower costs, required emphasis on long-term effects, and concentration in his most preferred choices." - Charlie Munger in a speech to the Foundation Financial Officers Group

The problem is most of these are not particularly inexpensive (though certainly not overvalued) at this time so some patience is required.

Adam

Accumulating, or planning to accumulate, long positions in some of the above stocks as they hopefully drop further in value. Previously have established long-term positions in KO, PEP, DEO, PG, JNJ, AXP, and WFC. Many of these were established at much lower prices. Technology positions require a larger margin of safety.

* That it was bought near the cyclical peak of earnings is often only obvious after the fact...when it's already too late to sell.
** Return on capital measures how well a company employs its resources to generate profits. The best business has durable competitive advantages yet needs little capital relative to the profits it produces. The durability characteristics make it likely that not only can a business earn a nice return now, but that those favorable economics are sustainable for a long time. A business that needs modest capital compared to earnings power (whether financed by equity, debt or the future free cash generated) has lots of options that benefit shareholders. Capable management can either return excess cash to shareholders (dividends or buybacks depending on attractiveness of the share price) or use it to produce high returns on capital when the opportunity to deploy incremental capital presents itself. The problem for shareholders begin when management uses capital to pursue growth for its own sake regardless of return. 
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