Part I of this series focused on the high valuation of the stock market and the fact that returns over the next decade most likely will be quite low and the probability of a bear market is high. The next series of articles will focus on individual stocks that I believe are attractively priced to deliver a return above the stock market. I believe these ideas also have relatively little downside risk.
I believe valuation is a prime driver of returns and investment success. Individual stocks and the stock market trade in a valuation range. They are attractive at a low valuation and unattractive at a high valuation. Investors who pay attention to this fact will have a significant advantage over other investors and the market. Paying attention to valuation is akin to paying attention to your cards when playing poker. You only want to put your money into the pot or market when the odds are in your favor and you have an advantage. If not, you pass and fold.
To recap my thoughts on the stock market, below is a chart of the S&P 500 Index's cyclically adjusted P/E ratio since 1960:
You will notice, based on the dashed lines (outside of the tech bubble of the late 1990s), the S&P 500 Index has traded at a valuation range between 8 and 20 times earnings. With the current P/E ratio at 17.7, the upside potential to a 20 P/E ratio is 13%. The downside risk, to a P/E ratio of 8, is 55%. This is not a very favorable risk/reward proposition. With the market trading much closer to a peak valuation than a trough valuation, I believe this is where individual stock picking can make a huge difference in a portfolio.
A key component associated with successful stock picking is flexibility. Flexibility is a key attribute associated with long-term investment success. Successful valued based investors such as Warren Buffett, Ben Graham, Michael Price, Seth Klarman and John Templeton have posted very attractive long-term returns by maintaining a flexible investment style. Each individual stock will be evaluated with a flexible mentality with an emphasis on valuation.
Elements of flexibility include:
1. Owning a wide range companies regardless of size. Good investment opportunities can be found in large blue chip stocks and obscure small companies.
2. A willingness to not mimic the indices. If a particular sector is overvalued, like tech companies in the late 1990s, an investor should avoid the sector.
3. Owning both "growth" and "value" companies. The key point to remember is that growth is a component of a company's value. High quality companies that can grow at 10 to 15 percent a year, and sell at 13 to 17 times earnings, can be attractive. Conservatively financed "deep value" companies which have little growth potential but sell at extremely cheap valuations of three to six times earnings and/or near liquidation value can be attractive.
When investing in individual companies it is paramount to view each stock purchase as if you were buying the whole business. As a result, I like to look at each potential purchase from a risk standpoint. There are three primary elements of risk with owning the business of a publicly traded company: business risk, balance sheet risk and valuation risk.
Expeditors International (EXPD) is a company that I think rates very favorably on each element of risk. Expeditors International is one of the largest U.S. based cargo freight forwarders with much of its business focused on the growing Asian markets. The best way to explain their business is to characterize them as a broker between companies that want to ship products and companies that provide the shipping service. As a middle man, they take a commission for each transaction.
Business Risk - Low
Among the factors that makes EXPD an attractive business include:
· The company earns a consistently high return on invested capital. Free cash flow return on invested capital has averaged 45 percent over the past decade - ranging between 39% and 50%. (Note: The average company earns about 15 percent. A company that consistently returns above 20 percent usually has an outstanding business.)
· The business requires no inventories. This can be a major cost of running a business. This is one of the reasons why EXPD's returns on capital are so high.
· Very little capital expenditures are needed to maintain the business. Capital expenditures have averaged 22 percent of operating cash flow over the past decade. (Note: This is much lower than the average company which spends about two-thirds of its operating cash flow on capital expenditures.)
· The company has consistently expanded it operating margins. Operating margins last year were 8.9%. This is higher than the 8.1% in 2007, 7.4% in 2002 and 4.4% in 1992. This is a sign the business has an economic moat and pricing power.
· The business has exhibited solid and consistent growth characteristics. This is evident by the fact that it has grown at 9.0 percent per year over the past five years and at 13.2 per year over the past 10 years. It has grown its intrinsic value in 24 of the past 25 years. The only year it did not grow its intrinsic value was in 2009 when it fell 13 percent.
· The company has a focus on the Asian trade routes. The Asian markets have much greater growth prospects than the U.S. and Europe, which is in an economic malaise. This is a positive for the future growth potential of the business.
Balance Sheet Risk - Very Low
· The company is debt free and has $1.3 billion in cash - equal to about 17 percent of the company's market cap.
· The company has a culture of not embracing debt. During its history it has never had positive net debt.
· Since the business is sensitive to the economy, this strong balance sheet will allow the company to endure a prolonged economic downturn.
Valuation Risk - Low
Lastly, and most importantly, the company has relatively low valuation risk. Below is a valuation chart of Expeditors International based on its trailing Enterprise Value/Cash Earnings Ratio. (Note: Enterprise Value is a better valuation measure than the P/E ratio because it takes into account how the company is financed. Enterprise value is calculated as the market cap of the company plus debt less cash. Since EXPD has no debt, $1.3 billion in cash and a $7.5 billion market cap it rates more favorably on an EV/Cash Earnings basis than on a P/E basis. A P/E ratio only focuses on the equity of a company and earnings after interest payments. As a result a highly leveraged company can look artificially undervalued on a P/E ratio basis.)
The stock has historically traded at an EV/Cash Earnings ratio of between 15 and 30. My intrinsic value estimate for the stock is 25 times cash earnings or $51.92. This is 47 percent above its most recent closing price. My estimated downside price for the stock is an EV/Cash Earnings ratio of 14 or $31.70, 10 percent below its most recent price. In contrast to the stock market, which offers upside potential of 13% and downside risk of 55%, EXPD is a much more attractive risk/reward proposition.
One last way to look at EXPD is to compare its stock price to its intrinsic value over time. Below is a chart that illustrates EXPD's stock price against its intrinsic value since 1988.
My intrinsic value estimate is the implied stock price from an EV/Cash Earnings multiple of 25. Every time over the past 25 years when EXPD's stock has traded below this estimate the stock price has reverted back towards its intrinsic value. Given the very attractive valuation, I think investors in EXPD should be amply rewarded over the next 5 to 10 years in what I think is going to be a difficult stock market environment.