The rise in correlations amongst all asset classes makes us wonder what to buy. The correlations amongst S&P 500 stocks are near all time highs; however, it has started to come off recently. I believe once the economies and the markets normalize, long-term investors will start focusing on companies with a clear competitive advantage. These high quality companies with an edge will also be safer plays in case of a market turmoil.
In order to identify such quality stocks, I have focused on:
- Power of the business model and market positioning
- A sustainable competitive advantage
- Either cost leadership or pricing power
- Growth opportunities combined with profitability and returns.
For this analysis, I also looked at a similar analysis done by Morgan Stanley in their report "50 for 2015", published on December 15, 2011.
Below is my analysis on the top 5 stocks that have met the criterion. I did the filtration and analysis for investors with a long-term investing horizon.
Oracle (ORCL) has built a structural competitive advantage in the enterprise software space through organic growth and strategic acquisitions. Revenues of $15bn are recurring in nature and bring together 80% of contribution margins. Oracle has the ability to combine its software infrastructure and hardware technologies into engineering systems that will have a disruptive force strong enough to wipe out the competition. Its effective execution strategy, strong management, unique technologies and a cash rich balance sheet ($30bn of total cash) will help it redefine the enterprise wide solutions industry; the same way Apple (AAPL) redefined the consumer electronics market. Oracle spends more than $4bn, annually, on R&D. Its customer base is in north of 380k and margins will improve significantly once it starts selling additional integrated hardware and software technologies to its existing customers. The product portfolio of Oracle consists of more than 9,000 products; however, only 10% of its customers have more than five products. This presents a great cross-selling opportunity for the company.
The stock is trading at a 40% discount to its software industry peers. The price to earnings ratio of 11 times is also at a big discount to the stock's 15-year average P/E ratio of 24x. Oracle has the ability to grow its bottom line by 10-15% each year.
Schlumberger (SLB) is a "go-to guy" for oil and gas industry. It is the premier oilfield services company providing technology, project management and information solutions. It has the asset of a best in class field personnel team along with a very effective management. The company is renowned for its execution ability. Its business is highly exposed to the exploration cycle and the boom in upstream spending is more likely to benefit SLB than any other player in the market. In their most recent earnings release management was very confident on its international performance shown by the margin expansion in Middle East and Asia, along with more executions in North Africa. The operational expertise of SLB helps it secure contracts globally.
Schlumberger has been successful in moving towards the eastern Hemisphere and more importantly, over last many years, it has expanded and strengthened its relations with the national oil companies.
SLB has an hefty EBITDA margin of 27%. It has more than $4bn in cash and generates $6bn of operating cash flows each year. Return on equity is around 16%. Though the forecasted dividend yield is 1.5%; a payout ratio of only 26% gives management the room to boost dividends in the future. The stock is trading at a forward P/E of 13x vs. its historical average of 25x. The stock is also cheap when analyzed from a growth perspective, as the PEG ratio is only 0.7.
Qualcomm (QCOM) has the best quality business model in the communications equipment industry. The key catalyst for the company is going to be the growth in smart phone sales. Smart phone sales are expected to double by 2015. Most of the 3G smart phones (60% of Android devices) as well as the tablets contain QCOM's manufactured chips. Late last year, Apple announced it would start using Qualcomm's chips, followed by RIM's switchover to Qualcomm's Snapdragon chips too. Another catalyst will be Qualcomm likelihood of providing processors for the Windows 8 based laptops and tablets. This represents a huge market as Qualcomm will replace the Intel and AMD based processors. Recently, there have been supply related issues in the industry; however, QCOM is immune to such supply disruptions. It has a very strong management team and is one of the best plays on consumer shift towards smart phones, tablets and i-pads.
QCOM's stock is trading a P/E of around 16x, its historical range has been between 10x-20x. However, the growth prospects are too huge to consider it as an expensive stock. The revenue and earnings CAGR is projected to be 25% and 20%, respectively. It has a very strong balance sheet and has approximately net cash per share of $10.
Visa (V) is the owner of the world's largest network of credit and debit cards. The company has massive growth opportunity because of a secular shift from paper/check based transactions to electronic based payments. The penetration rate of electronic payments is still very low; 85% of transactions, globally, are still paper/check based. Visa's superior technologies in the area of retail payments, e-commerce, electronic remittances, prepaid payments and transfers will make it the prime beneficiary of the boom in electronic transactions and payments. The US "credit payment volume" growth has been around 12% for 1Q2012 and for the rest of the world it stands near 17%.
The company has plans to generate more than half of its revenues from outside US by 2015. Its business model is highly scalable and as revenues grow the cost is not going to follow the revenues in a "lock-step" fashion. This operating leverage presents a significant opportunity to grow the bottom line and hence Visa deserves premium valuation. The growth in earnings is expected to be in north of 15% for the next few years. It's EBIT margin of 60% is way above the peer average of 25%.
Target (TGT) has a history of successful executions. Target is a US retailer that can drive traffic and growth in a weakening economy as well. The company's recent initiatives of P-Fresh and REDcard can help the comps to accelerate more than the sell side estimates. Its entry into the Canadian market (a positive NPV project) will be accretive for the bottom line in 2013/14 and onwards. The Canadian venture will boost the EPS growth to 15-20%. More importantly, the stock can double its free cash flow yield to 14%, once the Canadian operations become cash flow positive.
Due to the stock's weak performance over the last year, the management decided to accelerate the share buyback program which can add 4-5%, annually, to the EPS. Historically, the stock has traded at a forward price to earnings ratio of 15-16x. The current valuation of 12x is near its historical lows. Its competitors are trading at an average P/E of 16x. The stock also offers a dividend yield of 2% and a ROIC of 12%.