The first investment book I ever read was "The Five Rules For Successful Stock Investing: Morningstar's Guide To Building Wealth and Winning in the Market," by Pat Dorsey. Dorsey advocated a value-investing approach to stock investing, which I gravitated to instantly. Morningstar's research reports had a value-investing approach back then (a bit less now, it seems) as opposed to the more prevalent earnings and guidance focus so I enjoyed reading them, even if I rarely acted on them.
Investors are advised not to put too much stock into analyst opinions and for good reasons (some of which can be found here). Stock analysts aren't any better at stock-picking than most investors. Investors need to understand that stock-picking is not an analyst's job -- that's what portfolio managers are for. What they do offer is a wealth of knowledge about the industries they follow, knowledge most investors simply don't have the time or ability to glean on their own. If we are cognizant of analyst biases toward short-term results, accounting earnings (as opposed to free cash flow) and growth (vs. sustainable profitability), investors can gain much insight from analysts' reports.
For this screen, I decided to leverage two well-known research firms: Morningstar and Standard & Poor's. Both rate stocks from 1 star (strong sell) to 5 stars (strong buy). As of 9/16/2011, Morningstar listed 124 5-star stocks while S&P rated 93 similarly strong buys. 5-star ratings by these two firms should not prompt automatic buying but simply provide a base for further research. Only nine stocks made both lists:
Prices as of 9/19/2011
View all financial metrics for this screen, including my estimated intrinsic value, in spreadsheet format.
Applied Materials, Inc. (AMAT) provides manufacturing equipment, services and software to the global semiconductor, flat panel display, solar photovoltaic (PV) and related industries. AMAT is one of the strongest prospects revealed by this screen. Morningstar accords it a wide economic moat (meaning it has competitive advantages vs. industry peers) due to its scale and puts a fair value of $19 per share. S&P is high on the stock, targeting a 12-month share price of $14, even though it forecasts sales dropping 14% in FY 2012. They view that as the cyclical trough for the company and are positive on long-term demand for flash memory due to smart phones and tablets as well as synergies from the Varean Semiconductor (VSEA) acquisition. I rate the stock at $15 per share -- its free cash flow track record is impressive and it will still have a solid balance sheet even after VSEA deal closes. The biggest risk here is the extreme cyclicality of its business cycle. Applied Materials generated over $9B revenue every year since 2006 except for 2009, where revenues crashed to $5B and FCF was barely positive. The company may be the best positioned in the industry but the possibility of such business volatility is a big concern and I would look for a larger margin of safety to buffer against such possibility. An entry point around $9-$10 would be attractive.
Apache Corporation (APA) is an independent energy company which explores for, develops and produces natural gas, crude oil and natural gas liquids in seven countries including the United States, Canada, Egypt, Australia and the U.K. Both research firms are fans of Apache's disciplined acquire-and-exploit approach as APA sports one of the strongest balance sheets among independent E&P companies. S&P expects shares to reach $145 in a year and approves of the company's move into deepwater drilling in the Gulf of Mexico. Morningstar projects fair value at $150 per share and assigns the company a narrow economic moat, though this seems to be derived from the commodities more than the company as many oil and gas companies are credited with having narrow moats. My analysis for energy companies generally focus on reserves, not cash flow and on such a basis, I rate APA fair value at $90 per share, substantially lower than Morningstar and S&P.
Covidien Public Limited Company (COV) is engaged in the development, manufacture and sale of healthcare products for use in clinical and home settings. Morningstar values the former Tyco subsidiary at $76 and states the company has a narrow economic moat, citing market-leading position in niche segments as well as established position in the heavily regulated pharmaceutical segment. S&P is slightly less optimistic, seeing shares trading at $64 in 12 months, but foresee double-digit EPS growth over the long term as the company focuses its product line and benefits from aging populations. My conservative free cash flow analysis values the stock at $42 per share, near its current trading price.
Express Scripts, Inc. (ESRX) is a North American pharmacy benefit management offering a range of services to its clients. Express Scripts is interesting in that it is currently in the approval process for its proposed merger with rival PBM Medco (MHS). Both Morningstar and S&P think the move, if allowed by antitrust authorities, would significantly bolster ESRX's market position, possibly even transforming Express Scripts into a wide-moat company with much leverage over its suppliers. In its current state, Morningstar values shares at $61 while S&P has a $65 12-month target price. I value the shares around $42, which means I would need an entry price considerably lower, around $32, for an adequate margin of safety.
FedEx Corporation (FDX) provides a portfolio of transportation, e-commerce and business services under the FedEx brand. Obviously, both research firms view FDX favorably, with Morningstar assigning the firm a narrow economic moat and pointing to DHL's failed effort to crack the US market as evidence of the substantial barriers to entry in this business and foresees a possibility that only two global shipping firms will be operating. Morningstar and S&P have similar price targets on the stock at $112 and $120 per share respectively, a considerable amount higher than its current trading price around $75. Of all the companies on this list, FedEx was the one where I most diverged from the research firms. Despite impressive scale and some pricing power, FedEx throws off relatively little free cash flow. It is a mature $24B market cap company but generated less than $500M FCF annually over the last 5 years with little indication it can boost those levels significantly. Even if the economy turns up and package volume boosts considerably, rising commodity costs and labor issues may limit FDX upside. In my book, a company's worth is measured by how much cash it can deliver to its owners while still maintaining its business, i.e. free cash flow, and by that measure, I don't see FDX worth anywhere near its current share price, much less the targets offered by the two research firms.
General Motors Company (GM) is a global automotive company which develops, produces and markets cars, trucks and parts worldwide as well as provides automotive financing services through General Motors Financial Company, Inc. (GM Financial). A recent ward of the state, GM shed much of its debt and labor obligations in its recent bankruptcy, much to the liking of Morningstar, which sees shares worth double its current trading price. However, GM is one of the few stocks on this list doesn't have an economic moat, according to Morningstar. S&P sees shares selling for $40 in 12 months as they say GM's new financial structure strong enough to ward off cyclical and competitive threats to its business. Keep in mind, these high ratings take into account GM's still unfunded $22.2B pension obligation as well as the government's 27% ownership overhang. Due to those factors as well as the new company's lack of history and operating track record, I passed on assessing GM for investment.
Lazard Limited (LAZ) is a financial advisory and asset management company serving a diverse set of clients around the world, including corporations, partnerships, institutions, governments and high-net worth individuals. The boutique investment firm is regarded favorably by S&P, which likes the mix of Lazard's advisory business (57% revenue) and asset management (41%) and regional diversification. Even though M&A volumes are down, S&P believes LAZ's earnings potential is not reflected in the stock, which it says should be trading at $44. Morningstar is similarly positive on the stock, valuing shares at $42 and foreseeing good times even if the economy remains in the dumps due to Lazard's restructuring business. I agree that shares look under-priced but not as much. Based on free cash flow analysis, I judge LAZ to be worth $29 per share though one could argue that a firm like Lazard should be valued differently, perhaps on a sum-of-parts valuation based on its advisory business and asset management business.
Rio Tinto plc (RIO) is engaged in minerals exploration, development, production and processing of materials including aluminum, copper, diamonds, energy, iron ore and other minerals. Morningstar views Rio Tinto's low-cost assets favorably as they are situated mainly away from sovereign risk, Australia's proposed mining profit tax aside. It assigns RIO a fair value of $84 per ADR, with two-thirds of that value derived from its copper and iron ore assets. S&P see RIO shares trading at $92 as they envision an economic recovery combined with limited supply capacity growth leading to higher demand for raw materials. I value RIO at $45 per share strictly on FCF. While miners are rarely evaluated on a cash flow basis but rather on resources still in the ground, Rio Tinto's large and diverse portfolio set makes that approach less optimal as there would be many different commodity pricing inputs in that model but it may be more beneficial to perform that exercise.
Exxon Mobil Corporation (XOM) is the largest publicly-traded integrated oil/gas company in the world as well as a manufacturer and marketer of commodity petrochemicals. XOM is universally regarded as the top-in-class operator of the Big Oil set, a view with which S&P concurs, stating that the company enjoys superior earnings and dividend growth as well as stability, which is amazing given an industry as volatile as oil and gas. They think shares are worth $103. Morningstar values the shares similarly high at $99 and accords XOM wide moat status due to its superior capital allocation and developed expertise, which makes it more attractive than its peers to partner national oil companies. However, due to Exxon Mobil's sheer size, production growth is hard to come by. Excluding the XTO acquisition, XOM's replacement ratio would have been around 25% and given the increasing scarcity of big oil and gas fields to discover, future production growth may be dependent on acquisitions. That said, I own XOM and value it at $90 per share, taking into account reserves, free cash flow and its substantial refinery and chemicals operations.
Of this list of 9 5-star stocks, three stand out as prospects: AMAT, LAZ and XOM. All three pay similar dividends, yielding above 2%. Since I established my initial position in XOM around $60, I would wait until that level before considering buying more. As mentioned previously, Applied Materials is attractive except for its susceptibility to the cyclical nature of the semiconductor industry but even so, with a large enough discount and margin of safety, such volatile results could be tolerated. I would strongly look at AMAT if it approaches $10. LAZ might be the most interesting. While it had the lowest discount as suggested by FCF analysis, it may be useful to examine the company further and evaluate the components of its business separately.