By Rick Higgins:
It's tough to find stocks to buy in a bullish market, because very few are cheap. You can buy on momentum, but you'd have to be good at timing when to sell. Or you can buy stocks that you can depend on performance over the long-term, stocks you don't need to look at every day!
If I were picking these stocks, what would I look for?
1. Dependable earnings growth into the future.
These are companies that have a strong position in growth sectors, are not at risk with fickle consumer tastes and ideally enter into long-term contracts with their customers.
Looking through the ocean of stocks, two stocks seem to fit this description: Wabtec Corporation (NYSE:WAB), a $2.4b supplier of products and services for rail and transit industries worldwide, and Stericycle (NASDAQ:SRCL), a $2b biohazard disposal company.
2. Reasonably valued in terms of price-earnings ratios.
The projected earnings growth needs to be able to offset any decline in price-earnings ratios.
As we shall see, when we layering in a second criteria though, WAB seems a better stock than SRCL. There are reasons why SRCL has a higher P/E ratio than WAB which we discuss below, and if you believe them, both stocks are worthy of buying and holding.
But is it always a bad idea to buy high P/E stocks? Let's find out.
How has these two stocks performed?
Since 2006, both stocks have delivered remarkably similar performance in earnings growth and stock performance. Both stocks have delivered over 20% in stock return driven largely by over 20% in earnings growth. Other than the softness for WAB in 2010 and 2011, both stocks have delivered consistent earnings growth. Interestingly, between 2006 and now, both stocks have maintained their respective P/E ratios, for WAB approximately 21-23x and for SRCL approximately 36-28x.
Why do I like these two stocks?
Both companies are leaders in their respective niches with healthy long-term growth prospects.
WAB is the market leader in North America for braking-related equipment at 50% market share. Global marketplace is more competitive with a small number of cost-conscious customers. However, sales growth continues to be driven by growth in U.S., U.K., Australia and Mexico, driven by continued growth in passenger transit. Both Specialty Products & Electronics and Remanufacturing / Overhaul & Build continue to drive bullish growth. As of Dec 31st, 2012, the company's backlog was $1.6b, ensuring a baseline for revenue for 2012, yet over 50% of total sales typically came from aftermarket orders, which provide a steady stream of cash flow for WAB. With a healthy cash balance, M&A has been a strong driver of growth. In 2012 alone, WAB acquired 4 businesses with revenues of about $150M.
|WAB (in $'000)||2010||2011||2012||2010-11||2011-12|
|Specialty Products & Electronics||516,595||880,030||1,094,148||70.4%||24.3%|
|Remanufacturing, Overhaul & Build||272,527||331,787||496,883||21.7%||49.8%|
SRCL is a global leader in handling and disposal of regulated waste which includes items such as medical waste (needles, syringes, gloves, cultures, blood and blood products), hazardous waste and pharmaceutical waste (expired or recalled pharmaceuticals). SRCL competitive advantage lies in a broad range of services and a diverse customer base. Growth in the industry is driven by aging population, which drives medical attention and testing, regulation and increasing pressure to outsource to reduce costs. Europe has been a strong drive of growth. Global M&A has been a strong driver of growth. Since 1993, SRCL has completed 299 acquisitions globally.
|SRCL (in $'000)||2010||2011||2012||2010-11||2011-12|
Both companies have had consistent ROE and healthy growth expectations. ROE for WAB has fluctuated between 15 and 25% while for SRCL it has remained steady around 20-25% for most part. In terms of growth estimates, analysts are bullish on both, and slightly more bullish on SRCL than for WAB.
|WAB EPS Estimate||Dec 2012A||Dec 2013E||Dec 2014E||2012-2013||2013-2014||2012-2014|
Source: Yahoo Finance
|SRCL EPS Estimate||Dec 2012A||Dec 2013E||Dec 2014E||2012-2013||2013-2014||2012-2014|
Source: Yahoo Finance
What are their fair values and expected returns?
For WAB, the stock is fairly valued if we assume 12% earnings growth, 18% RONE, 16.5x future P/E and 1.1 beta. Current earnings and near-term earnings growth account for over 75% of current share price. 16.5x future P/E seems conservative given the historical range from 13x to 26x. If we assume future trailing P/E remains closer to 18x compared to 21x today, fair value is closer to $120 compared to $110 today, with an expected returns of around 10%.
For SRCL, the stock is fairly valued if we assume 13% earnings growth, 19% RONE, 24x future P/E and 0.7 beta. Current earnings and near-term earnings growth account for only 69% of current share price. 24x future P/E is close to the low end in its recent history of 25x to 37x. If we assume future trailing P/E remains closer to 30x compared to 36x today, fair value is closer to $136 compared to $110 today, with an expected returns of around 10%.
Why does SRCL enjoy a higher P/E ratio than WAB?
Because it has a lower beta and cost of equity. A company with zero earnings growth is expected to have a price-earnings ratio of 1/cost of equity, so the lower the cost of equity, the higher the "normal price-earnings ratio". Yet, from a conventional value investor point of view, SRCL seems over-valued with its high P/E and the margin of safety seem small, given that current and near-term earnings account for less than 70% of current stock value, and even lower if we pick a higher cost of equity.
I argue WAB has a higher risk operationally, given its exposure to the construction and maintenance of railway, but a lower market sentiment risk given a lower P/E ratio. SRCL has a lower risk operationally, given its highly defensible business and exposure to the recession proof healthcare service industry, but a higher market sentiment risk given a much higher P/E ratio.
Both stocks are fairly valued stocks you can buy and hold without having to worry about every day. Over the next 5 years, I expect them to deliver at worst annualized returns in the 6-8% range, but probably 10% or even more. Currently, 5 analysts rate WAB a buy, 1 hold and none sell whereas for SRCL, 9 analysts rate a buy, 4 hold and none sell.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. This article was written by Rick Higgins, one of our contributors. Neither CandidMarkets nor Rick Higgins received compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.