Nick's Picks 2016: Introduction And Core Positions

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Includes: AAPL, DIS, JNJ
by: Nicholas Ward

Summary

I know I'm a little late here, but the market has been volatile and keeping up with research has been taking up a lot of my writing time lately.

In this piece I discuss my outlook for 2016 and begin discussing my favorite individual companies to buy right now.

I will update this Nick's Picks portfolio throughout the year. There will be no trading... picks made in January are meant to last the year.

At the end of December, we'll see just how well I've done.

In late December when I began thinking about putting this piece together if you would have asked me whether or not 2016 would turn out to be a volatile year, my answer would have been an assured "yes." I saw the market facing several, potentially significant, headwinds which worried me moving forward in the short term. I thought that many of the issues that caused fear in the markets last August and September, especially those pertaining to valuations, corporate earnings, and the current elephant in the room, China, weren't really solved, but rather overlooked as the market improved off of the recent "flash crash" lows. Because of this, I've been selectively raising cash within my portfolio for months. In August when panic struck in the markets, I was sitting on 3% cash. Today, I'm at roughly 24%, a level I feel much more comfortable with due to market volatility and my own worries regarding a global economic slowdown. But, even with worries like these sitting much closer to the front of my mind today, than they have in years, I would have never expected to see the year start off in such a negative manner.

Because of recent market volatility, writing this piece and several others pertaining to 2015 year end reviews and 2016 picks has been put on the back burner with much of my stock market related time being dedicated toward market research and individual stock due diligence as prices fall and companies potentially going on sale. Hopefully, for all of our sakes, things will settle down on Wall Street - I'd love to have more time to write instead of checking and rechecking target price data as the markets fluctuate. But, either way, I hope to find time in the coming days to knock my year end pieces out soon, because New Year's picks for 2016 being published in February or March just doesn't seem right. Needless to say, I need to get these pieces done soon. I say all of this as an apology of sorts - in my own mind I had a time table for a series of upcoming pieces. Obviously now, that time line is busted. However, I hope that you all will find this series, which will be focused on my favorite investing opportunities for 2016 entertaining, even though I'm technically a week or two late.

So, when it comes to 2016, due to my wider market concerns and anxiety, my focus is on value names, especially those with abnormally high yields. I will be focusing on healthy balance sheets and positive cash flows. I will be looking for well diversified companies with defensible moats and premiere market positions. Simply put, I will be attempting to reduce speculation to a minimum using fundamentals to target value rather than focusing on top line growth (which has worked well for investors in recent years). I think eventually we'll get to the point where the F.A.N.G. phenomena will come to an end - these are obviously great, innovative, disruptive companies, though as risk assessment and management shifts more in line with global economic conditions I expect that capital will flow into more reliable business operations based on the fundamentals rather than speculative future growth. I know that proponents of value investing have been saying that momentum type valuations will come back down to earth for years now. I can't say for certain that 2016 will be the year, though I feel much better right now putting new money into highly profitable value names rather than companies with sky high valuations, solid top line growth, but nothing to show for it in terms of earnings.

I'm expecting 2016 to look a lot like 2015 with regard to market volatility and lacking growth. I think that once again this will be a stock picker's market. I wouldn't be surprised to see the major averages flat or down for the year again - simply put, I just see more headwinds and tailwinds right now. I worry about commodity and credit cycles winding down and potentially bottoming out. With that being said, I don't think investors are doomed by any means. I was able to generate a respectable positive return in 2015 which was a down year for the major indexes and I hope to achieve the same thing in 2016, regardless of market conditions.

Obviously this portfolio will be managed different from my own. Here I plan on selecting stocks now, in January, and letting them sit through the year. In my personal portfolio I will be much more active when managing positions. However due to the apparent value I see in the market right now, I think investors who are comfortable with a more passive buy-and-hold approach can be successful as well. Only time will tell however. I will re-visit this "Nick's Picks" portfolio throughout the year on a quarterly basis to track performance.

I will admit that a lot has changed since I began thinking about this piece and putting together my favorite picks list for 2016 in late 2015. Obviously 7% or so being hacked off of the major averages has created a lot more value than there was before. What was a list of a handful of companies whose valuations were intriguing has grown in recent weeks and because of this I've decided to break my 2016 picks down into sections rather than post one interminably long piece.

I've decided to break down this list down by sector and/or industry, though this first piece will be a bit different. When thinking about my picks I've decided to create a portfolio of sorts which will enable us all to look back at my January picks in late December and see how well I did prognosticating one year out. I hope to make this "Nick's Picks" a bit of a tradition - I think it has a nice ring to it. It will be fun to compare y/y performance and I invite others to do something similar…a friendly competition of sorts.

Because of this portfolio format, this piece will be focused on core positions for the year. The three stocks that will make up my 2016 core are Apple (NASDAQ:AAPL), Disney (NYSE:DIS), and Johnson & Johnson (NYSE:JNJ). These three companies are what I consider to be the best of the best in their given areas of the market. All three are selling at or below what I believe their fair valuations to be. They are well diversified (I know some of you may be rolling your eyes when I say this regarding Apple, I'll discuss this in a bit) and have wide competitive moats. And lastly, they each pay a highly respectable dividend, either in terms of yield, growth, or a combination of the two.

Enough general pleasantries though, I think it's time we dive into the individual company specifics and my rationale for them holding dominant positions on my 2016 picks list.

Nick's Picks 2016 Core positions:

Apple

Apple has long been one of my favorite holdings. I see it as a defensive pick due to its gorgeous balance sheet and namely, the massive cash pile it's built up over the years. Albeit, most of this cash is stuck overseas until there are changes made to the corporate tax code here in the U.S. However, I can only assume the great minds employed by Apple can find someone productive to do with those funds in international markets. Apple's tremendous buy back is a bullish signal in my eyes. I think the company's single digit P/E ratio means the billions dedicated toward buying back shares have been and will continue to be well spent. I know some don't agree with buybacks, with phrases like "financial engineering" coming to mind, but the way I see it, if shares are significantly under valued, then retiring them is a great thing for long-term owners in terms of value creation.

And speaking of valuation, I don't buy into the mindset that Apple deserves a 10x P/E ratio in line with other hardware companies. Sure, the vast majority of its revenues come from hardware, and namely the iPhone, but I think the company has built a vibrant ecosystem and brand name which justifies a premium on shares. Apple's hardware is of much higher quality that its competitors and because of this the company has a strong global following of fans, some so serious that they're accused of cult-like passion. This sort of market place reaction isn't something that should be taken lightly. Apple's brand name is high recognizable and well respected. This stock has been in trouble as of late, but the company is doing just fine.

When you buy Apple shares today you're getting a blue chip technology company for 9.6x 2016 earning estimates. You're getting exposure to a company with nearly $234B in revenues....revenues that increased 27.9% last year. You're getting exposure to nearly $70B in free cash flows, or roughly $12/share, which covers the company's $1.98 dividend by a wide margin. Because of this I expect for the dividend to continue to grow annually, probably in the high single to low double digit range for the foreseeable future. Looking over the financials, really the only negative I see for Apple is the fact that the company has added a significant amount of long-term debt to the balance sheet over the last several years (previously the company had none). I don't like companies I own raising debt unnecessarily, but I also imagine that management was happy to lock in the low rates while they were still around, and it wouldn't take long for this debt to be paid down if the focus needed to shift to balance sheet repair rather than shareholder returns.

All in all, I think that by investing money into Apple at today's price and valuation, I'm much more likely than not to see the value of those funds increasing years down the road. Sure, there may be more tough times as the market worries about things like iPhone sales, falling margins, and a general lacking of innovation. But I am willing to put my faith, and dollars, with the great minds that Apple has amassed and their ability to continue to be the predominant big tech company in the world moving forward.

Do I know what the next hot, must have product in the world will be? No. Do I think it will be the Apple Watch? No. But, if I had to guess, I'd say that Apple is more likely to create this product than any other tech company out there and if/when it does, I'm sure it will fit in seamlessly into the iEcosystem that already exists, further driving demand for and general fandom of all things Apple.

I'm intrigued by "Project Titan" and although I'm not a huge fan of the auto industry, I think an Apple car could be interesting, especially as cars become driverless and transition from a tool of travel to a pod of entertainment/productivity. I can imagine an Apple car acting as a mobile office, or play room, which is where the company's vast ecosystem comes into play. Obviously this potential reality is years, if not decades down the road. But as a long-term investor these are the types of things I consider when investing.

I think the Apple TV, which has been discussed for ages it seems, could still be a huge success… especially if the company were to use that massive cash pile to acquire Netflix (NASDAQ:NFLX) or create a competitor in streaming of its own (I don't imagine the barriers to entry here are too incredibly high, licensing content could be costly, though I imagine that the strength of Apple's brand name would help with this), and combine these entities into a hardware/software/service bundle that I'm sure the public would love.

This transition into streaming could coincide with original content (which is what we're seeing with Netflix and Amazon currently). I think Apple, more so than most companies, has nice potential synergies within its ecosystem for co-branding content. I know what I'm essentially doing here is turning Apple and its immense portfolio of offering in terms of both hardware and services into a Disney-like entertainment empire where one success trickles down into other areas of business, eventually creating a snowball effect in terms of revenues. I know there is quite a lot of speculation going on here. I also know that I said I was attempting to minimize speculation when making these picks, making myself a bit of a hypocrite, though I really wanted to highlight the potential that Apple has with its cash pile (which it has amassed due to its profitability).

However, when I attempt to peer into the future, while many things are hazy, some aren't so much. I expect, barring some sort of mega-catastrophe, that mankind will continue to invent new technologies and innovate exist ones, making life easier. I expect that many jobs will continue to be mechanized and efficiency in just about all aspects of life will increase. This increased efficiency will likely create free-time. I know some will take full advantage of this to continue to be innovative, pushing society ever forever. However, many won't. I expect that as free time increases, so will demand for entertainment and content. This is why, looking at companies in the long-term, I'm bullish on those whose technology will play a part in this efficient future and those whose products and services will fill voids created by such. When I look at Apple, I see a company in a unique position to play a role in both, which is why I am satisfied holding an overweight, core position (Apple is a core holding in my personal portfolio as well).

Just imagine…an Apple car, driving itself efficiently down the highway as you lean back, doing business on a Macbook mounted on a shelf where the steering wheel used to be as your wife shops in the beside you on her tablet (verbally relaying the family grocery list to Siri which will put in the order, including payment with Apple Pay) with the kids sitting behind you enjoying their favorite new Apple branded content on the Apple TV mounted to the dash. Oh, and I forgot, everyone is constantly checking their iPhones for the latest status updates and notifications. Sure, no one is looking out the window enjoying nature's bounty - that's a bit depressing. But, later Junior and Sally will strap on their Apple virtual reality devices and explore the world's wonders from the comfort of their beds at home.

Now, if that isn't diversification, I don't know what is. But, back to reality…

Most importantly in the near to medium term (this is an article about 2016 picks, after all) I don't believe the world is peak smartphone levels. I think Apple will continue to benefit from people switching to smartphones for the first time. I also think Apple will continue to take market share from competitors in the smartphone market. I worry a bit about pricing wars here and what that might do to margins but I also believe that the cream eventually rises to the top and Apple's quality will prevail. Eventually Apple will need to find growth elsewhere, but I don't think 2016 will be that year.

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Disney

If you've followed me for any time here on Seeking Alpha you know that I'm a huge Disney fan. I know you shouldn't become emotionally attached to your holdings but it's difficult with this one - Disney World is the happiest place on earth, after all. Needless to say, this is one of my favorite companies to own. I firmly believe that in the long run, content is king when it comes to entertainment and I can't think of any other company with a better content offering than Disney. CEO Bob Iger has done a wonderful job during his tenure of picking up and bolting on content brands to the already strong stable of characters that Disney has to offer. The most noteworthy examples of this are the Pixar, Marvel and Lucasfilm acquisitions, all of which have turned out to be massive successes for the company, paying for themselves in short order and solidifying the Mouse atop the mountain of today's pop-culture cinema. It takes a keen eye to spot diamonds in the rough like the quickly fading comic book characters of the last century. I know that Bob Iger won't be at the helm of DIS forever, but while he's there, I feel very comfortable accumulating shares.

But, it's not only the new additions that have been revived. DIS has recently ingeniously began the process of revamping its legacy characters and their timeless stories with live action offerings. These films won't be the mega block buster type hits like Star Wars and the Marvel films, though they do a wonderful job of keeping the older content fresh in our minds, bolstering the draw of the more classic aspect of the theme parks and merchandise offerings. Like Apple above, Disney too has created a thriving ecosystem for itself, allowing success in one of its many areas of business to flow into the others, creating organic demand and profits across the board. With superheroes, princesses and heroes from a galaxy far, far away in the forefront of the public's mind, DIS has once again locked in a generation of life long fans... fans who will likely pass down this love of all things Mouse to their children, refreshing the cycle behind my long-term investment thesis.

DIS has experienced pain in the markets lately because investors fear that cord cutting will do great harm to the company's largest revenue stream - its cable division (lead by the world wide leader in sports ESPN and its family of networks). I see the data with regard to cord cutting and I think the theme is real. However, I see profits rising quarter after quarter in the face of this. Also, I find it hard to believe that if we were do go to a la carte television, DIS will be able to charge a healthy premium for its skinny bundle due primarily to the importance of live sporting events on the ESPN networks. Disney may have over paid, but the content they've locked down from the major sporting leagues will continue to serve them well, regardless of what the future television models looks like. I, for one, would be willing to pay a hefty sum to watch games year round. Granted, I'm an avid sports fan and I know others aren't, though I think those like me wouldn't be willing to miss out on the live content that they love and would be willing to pay the price. I think Iger is smart enough to navigate these waters and I'm certain he and other top management have a plan in place for the shift, should it ever become complete.

For 2016 specifically, I'm not only looking forward to the impact that its content will have on earnings, but the major opening of the Shanghai theme park as well. This park, set to open mid-June, will make it much easier for hundreds of millions of people to experience Disney at its finest. I like the move into the China market and I expect DIS to continue to build mega-resorts like this in other high growth areas of the developing world, especially if Shanghai, in the success so many expect it will be. This resort should not only drive revenue with ticket sales, but drastically expand upon DIS's worldwide fan base, bumping up interest in future content in China as well. With Star Wars boosting earnings in the first half of the year and Disney Shanghai boosting in the second half, I expect another year of out performance by the Mouse.

Like AAPL, I feel very comfortable investing in DIS shares. Its upside (content) far outweighs and cord cutting downside in my opinion. I continue to buy shares on weakness and with monthly flexible re-investments. I can't imagine a world without Disney and therefore, I have a hard time imagining a situation where it doesn't hold an overweight, core position in my portfolio.

I will say that as of late, it seems like analysts are coming out of the wood work expressing fear with regard to DIS's revenues, some even downgrading the stock. This has attributed toward recent downward pressure. Now, it's up to investors to decide whether or not DIS's sell-off has created a buying opportunity or not. It's obvious that I'm not really all that worried about the issues highlighted by these professionals. Granted, I'm sure that these men and women have reason for their negative publications. Although I'm not worried doesn't mean that I don't think it's prudent to take these risks into consideration and put a hedge in place to mitigate them.

Cord cutting seems to be the biggest issue facing DIS due to the cable networks segment of the company making up a large share of its revenues (although Barclays released a note adding studio segment growth to its list of DIS concerns). Because of this - the cord cutting, not the studio growth, I have no qualms with Disney's studio performance. I think that Netflix is the obvious hedge for a long Disney position. In the introduction to this piece I made it clear that due to macro fears related to the market, I'm focusing on value for 2016. I don't think there is any question that NFLX is overvalued trading at nearly 430x consensus earnings for 2016. However, a hedge would be a relatively small position in this case, so even if NFLX tanks due to valuation issues, it won't be the end of the world for Nick's Picks performance in 2016. Also, I will mention that picking up shares of NFLX at $103 today sounds much better than it did a month ago at $130. So, not only am I picking up a small hedge for my core position in DIS, I'm exposing myself to a small turnaround play should my gut be wrong about markets in 2016 and the bull overtakes the bear moving forward in the short term.

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Johnson & Johnson

Johnson & Johnson has been one of the greatest wealth creators for investors in America's history. This is an absolutely wonderful company and serves as one of the most defensive picks in the market. No matter how bad things get with regard to the world's economy, medicine will remain important and JNJ plays a huge role here. This company has a diverse offering of products and services across the spectrum in the medical industry, from surgery rooms in hospitals to the nurse's office at your local pre-school.

What I like even more than JNJ's established business(es) is its ability as of late to target potential blockbuster drugs and to create lucrative partnerships with smaller, research based bio-tech companies, using its cash as a bank roll for progress and its weight in the industry to usher along these drugs through the trial phases quickly. I view JNJ as the Berkshire Hathaway (NYSE:BRK.B)(NYSE:BRK.A) of medicine, meaning that JNJ has turned itself into an attractive destination for companies looking for partnerships in the developmental phases of their products. Like BRK, JNJ has proven in recent years to be a highly productive partner for these smaller firms. And although it doesn't buy them outright like BRK might (JNJ isn't a conglomerate, after all), I expect that moving forward, JNJ will continue to profit from these sort of deals and potentially give itself a competitive benefit as far as pricing power goes due to the confidence that potential partners can have in the outcome of its co-branded research.

Here's a wonderful article written on this subject, showing how JNJ intends to profit from these partnerships moving forward.

After its recent weakness, JNJ is offering investors exposure to this low beta, blue chip name at less than 14.8x expected 2015 earnings and 13.5x 2016 estimates. These low valuations come with a 3.09% yield that has been increasing annually for 53 consecutive years. JNJ's five-year DGR is 7.42%. This isn't outstanding for a 3% yield, but it is highly respectable and works well as a defensive anchor for a portfolio in a wearisome macro environment. JNJ has a low debt load, steady free cash flow, a very long and illustrious history of rising earnings, and a diverse series of revenue streams. This is the type of company that I think most would consider to be a conservative defensive core holding and like AAPL and DIS mentioned before, I sleep well knowing that I own shares of JNJ.

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Recap

Alright, 4,300 words later, there we have it. The three core positions for the 2016 edition of the Nick's Picks portfolio are Apple, Disney and Johnson and Johnson. The arbitrary figure that I've decided to use for the value of this portfolio is $100,000.00. I will weight each of these core positions at 10% of the portfolio, meaning that using the closing price for each company on Friday, January 15th, I'll "own"103 shares of Apple at $97.13, 106 shares of Disney at $93.90, and 103 shares of JNJ at $97.00. I also will be putting the Netflix hedge into play at a 3% weighting, or 29 shares at $104.04.

As we move forward I will put all information regarding this portfolio into spreadsheets and update readers on a quarterly basis. Moving forward, I will use market closing prices to "buy" shares on the day that I've finished each article. I will begin my S&P 500 comparison for the year on January 15th. I plan on getting the rest of these Nick's Picks pieces published by the end of January, giving my selections as much time in the market as possible - this series isn't about holding cash, it's about making picks for the year.

Up next: Trains and Planes, Finding Value In The Transports.

*All images used in this piece were taken from F.A.S.T Graphs

Disclosure: I am/we are long AAPL, DIS, JNJ.

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.