If you ever want to put yourself in the situation to make an investment that delivers total returns better than the S&P 500 at large over the medium-term, here is something I do that could be a useful technique to add to your arsenal when considering an investment: I try to find situations where stock market analysts are (1) predicting lower growth than I anticipate, or (2) predicting a lower market valuation multiple than I estimate.
Usually, these situations are hard to find, because most stock market analysts predict both rosy growth and rosy long-term valuations for stocks that are well above my own estimates.
But I will share with you two examples that I have recently encountered wherein I have found a decent-sized mismatch between what the analysts are predicting and what I am predicting.
The first one is McDonald's (NYSE:MCD). Most stock market analysts predict that the fast food giant will trade at 15-16x earnings over the long term. I'm a little more optimistic than that. McDonald's is one of the few large caps in the country with a good chance of growing earnings and dividends by 9-11% annually over the next five to ten years, and doing it in a high-quality way at that.
For much of the 1990s and early 2000s, McDonald's stock traded at over 20x earnings, meaning that investors were willing to pay at least $20 for each unit of McDonald's profit that their ownership stake represented. Personally, I am targeting a long-term P/E ratio for McDonald's stock of between 17-18x earnings because the company has high-quality earnings (i.e. in Europe where everything is falling apart, McDonald's profits on the continent are holding steady) that are growing by 9-10% annually and giving shareholders dividend increases of roughly that amount.
Knowing that I place more of a premium on the earnings quality and growth prospects of McDonald's (compared to what many analysts are predicting) can be a useful way to find stocks with outsized potential relative to the current market price.
An example where I anticipate more growth than what analysts estimate is with a company like ConocoPhillips (NYSE:COP). I see plenty of analysts calling for Conoco to post annual profits around the $6 per share figure, and my guess is that Conoco will hit $7.50 within the next five years barring a steep decline in commodities pricing. From a risk perspective, it seems that a lot of commentary is focusing on the fact that Conoco is transitioning into a pure exploration and production company following the spinoff of Phillips 66 (NYSE:PSX), whereas I'm focusing on the growth at Bakken and Eagle Ford to see earnings per share growth increases. My big picture view of Conoco is that the company is not only increasing its volume, but will be earning greater margins on its projects--and since the potential earnings per share growth (which will eventually trickle over to dividend growth) is not adequately covered in the price of the stock, I buy.
A similar story plays out across the other high-yielding oil companies (and are only moderately applicable to Exxon (NYSE:XOM) and Chevron (NYSE:CVX). In the case of Royal Dutch Shell (NYSE:RDS.B), the valuation is beaten down because investors are regarding temporary headwinds as permanent (i.e. the refining and chemical arms of Shell's business are posting weak results in Europe, and on the North American front, even though the natural gas availability has increased over 30% in the past 5+ years, the lower prices of natural gas have caused earnings to temporarily stagnate, making some investors impatient).
In the case of BP (NYSE:BP), it is a mixture of both techniques mentioned above that are at play-the market is placing a much lower multiple on BP's earnings that I anticipate over the long-term, and the future earnings per share growth potential of the firm are not adequately priced into the stock. BP is a company that, absent a litigation threat, has a realistic possibility of trading at 10x normalized earnings. Similarly, the company seems poised to earn over $7 per share in the next five years barring a commodity price decline. It will not take a whole lot of things going right to get the price of BP above $40 over the next five or so years, plus investors get paid about 5% of their initial investment to wait for full value to be realized.
At the end of the day, the most important thing for me to do is find an excellent company that is offering the greatest amount of future profits (some of which will be retained, and some of which will be paid out to me as a dividend) at the lowest price I can find, adjusted for the conviction of my predictions. But it can also be helpful to find out where I am situated in relation to other analysts.
I happen to think that McDonald's will have a higher long-term earnings multiple than what some of the analysts think, and I also think that the big oil companies will increase earnings per share faster than the analysts think. I'm not trying to sell you on either of those viewpoints. Instead, I wanted to give tangible examples of how I situate myself when trying to find investment opportunities-a great starting place is finding companies that will trade at higher long-term multiples than analysts imagine, or will grow faster than predicted. The successful exploitation of that discrepancy can be a great way to add a margin of safety to your portfolio holdings.