Another year has come and gone and 2013 was a fantastic year for almost all investors with the average stock gaining around 20% for the year. Most of the gains this year were from P/E expansion and not driven by earnings gains for most companies. The average P/E ratio went from around 14 at the beginning of 2013 to just over 16.4 by mid-December 2013. The market I believe is now fairly valued if not slightly over valued.
Given that I believe that most of the gains we saw this year in company share prices were driven by investor sentiment turning positive and new money flowing into the stock market as investors found renewed faith in equities.
Now I'm not a market timer but when most people are running into the market and the market starts to froth with enthusiasm it makes me want to run the other direction. Finding excellent companies selling for a steep discount to their fair value becomes increasingly difficult. This presents the value investor with a dilemma. Do you start pulling money out of the market and going more to cash or do you start reallocating capital to less than excellent companies that are in a difficult industry or are themselves a turn-around story.
When finding relative value becomes difficult I believe that the prudent investor should dig deeper to find value in companies that may not hit you in the face and start to move a little more to cash instead of being fully invested in the market. This is a very unusual market at present because the market is rapidly rising and the role rising interest rates play in reigning in the markets expansion are nowhere to be found because of the Fed's actions. That also leaves the smart investor that wants to lock in some gains very few options to safely reallocate funds. Bonds and money market funds are not an attractive alternative because they are not returning enough interest at this time. The other downside to bonds are that when the Fed allows interest rates to move higher instead of being artificially depressed bonds will take a hit given the inverse relationship between bond yields and interest rates.
Given all of these factors here are my investment picks for 2014. I'm personally investing in solid companies that I believe still offer a margin of safety or are a turn-around story that will likely have a happy ending. I believe that the companies I have chosen will be strong in the next 5-10 years and even if the market declines these companies offer some protection in a declining market and a dividend that should soften and decline. Then if the market does reverse itself in 2014 I will have a cash cushion to ease the pain of a drop and some ammunition to purchase shares in companies that offer a compelling value. I'm approaching 2014 with some caution and a defensive value approach.
2014 Company Picks
|Yield||Value||DCF||Rate||Value||Profit||on Equity||on Capital|
|Bank of NY Mellon||BK||$31.52||14||$0.58||1.90%||$35.00||12%||10%||$2.25||$31.00||N/A||8%||10%|
|National Oilwell Varco||NOV||$69.40||13||$0.91||1.50%||$113.00||61%||11%||$5.50||$52.70||11%||11%||10%|
|KKR & Co.||KKR||$22.71||8.6||$1.62||8.00%||$39.00||77%||9%||$2.75||$8.45||N/A||32%||2%|
1. Wells Fargo (WFC)
Wells Fargo is the best banking investment going right now. Wells Fargo has the best banking franchise and the strongest balance sheet of any major bank. Wells Fargo is dominating other banks both financially and on their market strategy. Wells Fargo also has the best management team in the banking industry. Wells Fargo is leading all other banks in the three key areas of mortgages, commercial/business mortgages, and business lending. With over 9,000 retail branches Wells Fargo is second in the US for deposits which fuel the lending side of the business. Cross selling existing customers additional services is one of the key factors that sets Wells Fargo apart from other banks. On average Wells Fargo cross sells 6 additional services or products to each customer.
Financially Wells Fargo is the largest bank in the US based on market cap but I believe the company can still grow as it takes business from other banks. Wells Fargo has delivered impressive 6% earnings growth over the past 10 years and 14% return on equity(ROE). In addition, the P/E of Wells Fargo is reasonable 11.4 and the company pays a dividend of 2.7% annually. The only downside I see to owning Wells Fargo is that the consumer mortgage business is softening as interest rates rise and that the company seems fairly valued on a discounted cash flow basis(DCF). The DCF I calculate for Wells Fargo is $46 per share and it is currently trading at $44 per share. I feel comfortable holding this bank given its growth prospects and its impressive ROE.
2. Discover (DFS)
Discover Financial has been on a tear the past 2 years by doubling in value since 2012. Discover's increase in price has been supported by a strong earnings increase. Discover has a P/E ratio of only 10.3 based on its latest price and a 1.5% dividend. Among credit card companies Discover is more like American Express than Visa or Master Card. Discover not only processes the credit transaction but they also extend the credit to the card holder. This difference is both a positive and a negative. The positive is that Discover makes money both on processing the transaction and on the interest on the loan to the consumer. The negative is that Discover is open to credit risk in the event the consumer defaults on their credit card debt. Discover has been rebounding nicely since 2008 as loan default rates fall. Discover has an excellent current ROE of 20% that is expected to level off to around 15% over the next five years. Discover is growing nicely and is expected to grow earnings at around 9% per year over the next five years. Discover has an economic moat based on its position in the credit card industry. Imagine the difficult task of competing with established credit card processors or trying to launch a new credit card company from scratch. Discover is poised for growth while offering some protection based on its current price to earnings.
3. Bank of NY Mellon (BK)
I'm choosing Bank of NY Mellon based on its enviable position as a commercial banking service provider and asset custody manager for trusts. The moat is based customer switching costs and scale. Bank of NY Mellon looks like it will continue to win business in the asset custody market and the overall business is expected to grow earning at a 10% rate per year for the next 5 years. Today Bank of NY Mellon trades at a reasonable P/E ratio of 14.2. Bank of NY Mellon's competitive advantage in the custody asset business gives the bank an opportunity to earn profits in excess of their cost of capital.
4. KKR & Co. (KKR)
KKR is a solid value and dividend investment. KKR has an amazing dividend yield of 8%. I estimate the DCF value of KKR at $40 per share which gives a margin of safety of almost 50% and an upside of almost 100% from its current price. KKR has very little debt compared to its market cap. The dividend seems fairly safe at a 58% payout to earnings. KKR is quickly growing its assets under management which gives it a more ammunition to make smart investments. Given KKR's track record of increasing general partners return on their investment and of finding excellent investments I am adding this company to the portfolio. Investing in KKR allows the opportunity to invest in a number of private businesses. KKR earns money by investing assets under management in various businesses in many countries. KKR offers businesses they invest in direct lending, special situation investing, and secured mezzanine loans. One note of caution is that KKR can be rocky ride, but I believe the positives outweigh the negatives for KKR.
5. Dollar General (DG)
Dollar General is a value oriented retailer with a defensible moat of 10,557 stores placed in both urban and rural areas. Many of these locations offer convenience for the customer and Dollar General faces limited competition based on the remoteness of these stores because of their rural locations or from a lack of retailers in urban blighted areas. Dollar General is expected to grow earnings at an annual rate of 16% per year for the next 5 years and the company is selling at a slightly elevated P/E ratio of 17%. This P/E ratio is not so concerning when factoring in Dollar General's expected growth rate. Dollar General's sustained ROE is an impressive 19% which is much higher than the company's cost of capital. This wide spread between cost of capital and ROE creates excess shareholder value. Another reason I'm buying Dollar General is because I like that it serves discounted merchandise to lower income people. Even in the event of a recession Dollar General should maintain strong sales based on its value oriented products and its loyal customer base. Dollar General is currently selling for around $59 per share. My estimate is that on a DCF basis the company is worth $80 per share so that incorporates a margin of safety of 33%.
6. American International Group (AIG)
As I have written before here I'm a big fan of insurance companies and their valuations. Since I wrote about the extreme values presented by both life and P&L insurance companies in January 2013 many companies have dramatically increased in value with several doubling in the past 10 months.
I'm still on board with AIG as an attractive long-term value. AIG presents investors with decent values and long-term growth. On a DCF basis AIG is trading at a 45% discount from its fair market value and its book value. In addition all insurers as well as AIG should see a nice increase in revenue as interest rates start to rise once the Federal Reserve starts to allow interest rates to return to normal market rates. AIG is trading at a low 9.8 P/E ratio and I predict earnings to rise at 10% per year for the next 5 years. AIG is also tightening underwriting requirements to ensure profitability for both its P&L and life business.
I'm extremely bullish on AIG's future prospects and its ability to increase its underwriting profits and their fixed income investment profits increasing as interest rates are allowed to return to normal.
7. National Oilwell Varco (NOV)
National Oilwell Varco is often referred to as No Other Vendor in relation to its economic moat based on the lack of available alternatives to their products and services. National Oilwell Varco is well positioned to capitalize on the growing subsea market. National Oilwell Varco is trading for a reasonable P/E ratio of 15 with earnings expected to grow at 12% per year for the next 5 years. At that growth rate National Oilwell Varco's earnings should double by 2018. If the P/E ratio holds this would put National Oilwell Varco at around $160 per share. National Oilwell Varco doesn't offer much of a dividend payment but it does offer some security by buying a quality company with a defensible moat at a reasonable valuation.
8. Aetna (AET)
Aetna recently purchased Coventry which significantly added to their membership. Aetna trades at a moderate P/E ratio of 13 and a 16% discount to its fair value of $74. This provides an attractive entry point into a national healthcare provider that will benefit from the recent industry changes due to Obamacare. In health care membership and size are the attributes that benefit health maintenance organizations. With the Coventry purchase Aetna did dilute shares to finance the purchase, but the addition of 5 million new members from Coventry adds to Aetna's ability to demand lower costs from both care providers and drug providers. Aetna's earnings should advance 10%per year for the next 5 years. Challenges are present and there are some uncertainties regarding changes from Obamacare, but Aetna is well positioned to take full advantage of these changes and capitalize on increased membership.
9. Visa (V)
Visa is expensive but this company is one of the best companies in the world. If you could build the perfect business for profits and security it would be difficult to not have many of Visa's attributes. Visa is a world-wide toll collector taking a piece of all transactions on its very popular network. How many times per day do you use your Visa card or Visa branded debit card? Visa makes money every time you pull out the ubiquitous Visa credit card. Visa is accepted by almost every merchant in every corner of the planet. Visa has little to no risk since they just process transactions and they don't have any of the consumer's credit risk. Visa generates an impressive profit margin of over 50% and is positioned to grow in the US and abroad as the world moves from a cash to credit society. This is a company that an investor can purchase and hold for 20 years. Paying over 20 time's earnings is tough for a value investor but if one waits for Visa to drop to a reasonable valuation you might wait forever. Buy now and hold onto this great business forever.
10. DaVita (DVA)
DaVita has a tremendous retail presence across the US. As America ages and Type II diabetes becomes more prevalent DaVita stands to dramatically increase sales. Demographics and health trends are definitely in DaVita's favor. DaVita's earnings should increase by 15% per year for the next 5 years. DaVita's return on equity(ROE) is an impressive 20% and they have maintained that level of ROE for the past 10 years. DaVita has also had 10 years of increasing earnings in the 15-20% range. DaVita is selling at a 30% discount to their discounted cash flow value so there is a margin of safety on a fast growing company. The main danger for DaVita is if the government slashes reimbursement payments for dialysis treatment. My view is that DaVita will continue to grow and benefit from Obamacare.
11. Phillip Morris (PM)
Phillip Morris has an extremely loyal following among its tobacco brands. Phillip Morris is also globally diverse which helps insulate them from any regulatory changes in a specific country. Phillip Morris is also well positioned in developing markets where most tobacco use rate are growing. Phillip Morris has great brands, a good valuation, and sells at a 22% discount from its discounted cash flow value. Phillip Morris is well positioned to take advantage of growth from developing countries. Phillip Morris has an excellent return on capital of 51% and a 4.4% dividend. Phillip Morris has a wide economic moat that allows it to earn more than its cost of capital. Phillip Morris is a steady choice for the year ahead and will offer some downside protection while still having room for solid year ahead gains.
12. NCR (NCR)
National Cash Register is selling for around 25% below fair value on a discounted cash flow basis. NCR is selling for a reasonable P/E ratio of 14.5 and has no dividend. On the positive side NCR has addressed its sizable pension liability and NCR is moving into higher margin software and payment processing services. With NCR's strategic moves I see earning advancing 15% per year over the next 5 years. NCR boasts a very respectable return on equity of 24%. NCR is immersed in the banking and retail segments and is creating new streams of reoccurring revenue. NCR is moving from just a provider of cash registers to a payments processor and software provider. This change will drive profit margin expansion and a majority of this revenue is reoccurring.
13. Coca-Cola- (KO)
Coca-Cola is currently selling for around $40, but its discounted cash flow value is $45 which is a slim margin of safety. What Coke lacks in margin of safety it more than makes up for as a solid steady growth and a growing dividend that has been raised every year for over 50 years. Coke has a diversified beverage line that compensates for declining soda sales in developed countries. Coke has added various lines of water, juices, and energy drinks to maintain growth. Coke is a great long-term holding with a rock solid balance sheet. This defensive pick for 2014 should weather any financial turbulence in the year ahead.
14. Citigroup (C)
Citigroup has a forward P/E ratio of 9.8 and has great price recovery potential. Earnings should advance around 14% for the next 5 years. Citigroup's earnings grew 21% from 2012 to 2103. Another good thing for Citigroup investors is that the book value is $63 per share and is currently selling for $50 per share. Citigroup has been shedding noncore assets to trim debt and the company has strengthened its customer credit quality. Citigroup will also start paying a dividend in 2014 of around 1%. While this isn't a stellar dividend it goes a long way to get Citigroup back on the right track. I see Citigroup as an investment in a recovering banking giant at a reasonable valuation.
15. Berkshire Hathaway (BRK-B)
One reason to own Berkshire Hathaway is that it is essentially a cash generating machine built by one of the world's best investors. The swath of companies both public and private that Berkshire Hathaway has swallowed is impressive in their diversity and profit creating ability. The insurance holdings are the fuel that propels this conglomerate. Mr. Buffett is able to take the float from the premiums the insurance business collects and invest them in quality companies that deliver impressive returns for shareholders. I like the fact that Berkshire Hathaway continues to deliver solid returns at a reasonable valuation. This is long-term holding and a defensive choice for 2014.
16. General Motors (GM)
General Motors is on track for a record year following their rebound from the financial crisis. GM is set to post $3.41 in earnings for 2013 which puts its P/E ratio at around 12. Earnings are set to grow around 10% for the next 3-5 years. The biggest catalysts for GM are the facts that the government will soon exit its investment stake in GM and that GM will then be able to tap into its $27 billion reserve to start paying a dividend. GM's core brands are all showing renewed vigor and growing customer satisfaction ratings. Customers have been flocking to GMC, Cadillac, Chevy, and Buick dealerships with sales rising 30% since 2010. GM is also well positioned in emerging markets with brands like Buick and Cadillac being very popular in Asia. GM has sold 3 million vehicles in China this year and sales are up around 12% over 2012.
GM has a return on equity of 14% GM's margin of safety is 30% based on its discounted cash flow (DCF) value. GM is selling for around $41 per share and its DCF value is $53 per share. Right now GM offers growth at a reasonable valuation.