Blue Chip Is The New Alpha

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Includes: AAPL, ABT, CL, CVX, DD, GE, IBM, JNJ, JPM, KO, MCD, MDT, MMM, MRK, MSFT, PEP, PFE, PG, T, TGT, VZ, WFC, WMT, XOM
by: Stephen Perry

It's been difficult to find alpha in a market that is so volatile and dependent on global macro events, but I think I've found where it's hiding out. Interest rates are reaching all time lows and much of the world is riddled with debt. Investors are fleeing from the stock market but, as Alexander Graham Bell once said; "When one door closes another door opens; but we so often look so long and so regretfully upon the closed door, that we do not see the ones which open for us."

Low interest rates may have made it very difficult to find income opportunities in the market, but they have also created the necessity to re-price the market. All value is relative, whether it's gold, one currency versus another, or the value of the expected returns from the stock market versus risk free alternatives.

After seeing some big companies like Procter & Gamble (NYSE:PG) and McDonald's (NYSE:MCD) have their share prices beat up recently, I decided to do a quick analysis and found that the companies were both greatly undervalued using a discounted cash flow valuation model. After performing the valuation for many other well-known blue-chips, a trend started to arise. Most of these names were grossly undervalued by 20-70%.

How is this possible? Read on, as this could prove to be one of the cheapest markets for large-cap blue-chips ever. I was extremely skeptical at first as to how unglamorous household names could have so much potential upside. Using very gloomy outlooks, I still found unbelievable value and potential for double digit returns. I have come to the conclusion that blue is the new alpha.

When it comes to valuating a stock, there are three generally accepted ways to do so; P/E multiple, book value or sum-of-the-parts, and discounted cash flow. There are advantages and disadvantages to each method, but in my own opinion there is one that is clearly the most effective, being the discounted cash flow. P/E ratios are often very subject to investor sentiment and can fluctuate substantially without any substantive changes in the business. With impairment testing and large amounts of goodwill being carried by most companies, book value becomes complicated to determine accurately. Discounted cash flow valuations use future predicted cash flows and finds their present value by adjusting for the time-value of money. DCF valuation is dictated by a variety of factors, including financial and economic. The model can also be adjusted to reflect the analyst's view of future conditions.

This is the same method that Warren Buffett uses to evaluate a potential investment. The DCF model takes into account the following factors:

  1. Return Period
  2. Revenue Growth
  3. Operating Margins
  4. Risk Free Rate (10 yr. T-Bill) and Expected Market Return
  5. The company's weighted average cost of capital
  6. Financial data such as: working capital and debt outstanding

The valuations gained from the use of this model have been the basis for my analysis. The model is subject to the analyst's opinion of future conditions regarding the selected return period. My assumptions are taking a very negative view of economic growth prospects and predicting a bleak outlook. These assumptions include:

  1. Zero revenue growth
  2. A decline in net operating profit margins (NOPM is predicted by normalizing underlying trends for the last 4 years then lowering them by an average of 3%)
  3. 2% treasury yield
  4. 3.5% equity risk premium
  5. 7 year return period
  6. Balance sheet statistics are updated according to most recent quarter's earnings reports

With these assumptions, these large-cap, big-name stocks are still undervalued by about 20-70%. That being said, there are factors that could change the model substantially. The three inputs that could have the biggest impact on the model are the risk-free-rate, revenue growth rate, and net operating profit margin. To illustrate this, I have included an example of how each of these factors could change the intrinsic value of McDonald's stock, given the DCF model:

McDonald's with my assumptions

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McDonald's with a 4% risk-free-rate

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With a 5% revenue growth rate

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Raising operating margins 3%

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All other inputs being the same, changing one of these three inputs can obviously have a dramatic impact on the valuation. This is why I have taken such a pessimistic attitude on these companies' futures. Here are some examples of some big blue-chips and their DCF valuations along with their potential upside or downside. I want to emphasize the assumptions I used in my calculations; zero-revenue growth, normalized, margins, 2% risk free rate of return, seven year terminal return period.

Dogs of the Dow

Description

Ticker

Div. Yield

Current Price

DCF Valuation

%Upside/ Downside

1.

AT&T*

T

4.98%

$ 35.48

$ 24.87

-29.90%

2.

Verizon

VZ

4.42%

$ 45.25

$ 56.27

24.35%

3.

Merck

MRK

3.86%

$ 43.30

$ 67.35

55.54%

4.

Pfizer

PFE

3.86%

$ 23.14

$ 38.71

67.29%

5.

DuPont

DD

3.61%

$ 47.59

$ 50.75

6.64%

6.

Johnson & Johnson*

JNJ

3.56%

$ 68.45

$ 107.53

57.09%

7.

Procter & Gamble*

PG

3.46%

$ 64.81

$ 95.62

47.54%

8.

General Electric

GE

3.44%

$ 19.59

$ 4.70

-76.01%

9.

Chevron

CVX

3.40%

$ 106.78

$ 164.80

54.34%

10.

J.P. Morgan Chase

JPM

3.33%

$ 35.09

$ 39.24

11.83%

(as of 7/17)

Average

22%

Click to enlarge

10 Notable Dividend Aristocrats

Description

Ticker

Div. Yield

Current Price

DCF Valuation

% Upside/ Downside

1.

Abbott Labs

ABT

3.12%

$ 66.23

$ 80.97

22.26%

2.

PepsiCo.

PEP

3.06%

$ 70.07

$ 98.72

40.89%

3.

McDonald's

MCD

3.06%

$ 91.92

$ 121.53

32.21%

4.

Medtronic

MDT

2.75%

$ 38.56

$ 55.81

44.74%

5.

Exxon Mobil

XOM

2.68%

$ 85.34

$ 120.60

41.32%

6.

3M Co.

MMM

2.68%

$ 88.82

$ 99.19

11.68%

7.

Coca-Cola

KO

2.67%

$ 77.89

$ 71.41

-8.32%

8.

Colgate Palmolive

CL

2.38%

$ 105.34

$ 126.47

20.06%

9.

Target

TGT

2.34%

$ 61.18

$ 72.36

18.27%

10.

Wal-Mart

WMT

2.18%

$ 72.98

$ 91.42

25.27%

(as of 7/18)

Average

24.84%

Click to enlarge

Top 10 Market Caps: S&P 500

Description

Ticker

Div. Yield

Current Price

DCF Valuation

% Upside/ Downside

1.

Apple (w/ 5% growth)

AAPL

0.44%

$ 606.94

$ 679.52

11.96%

2.

Exxon Mobil*

XOM

2.68%

$ 85.34

$ 120.60

41.32%

3.

Microsoft

MSFT

2.70%

$ 29.66

$ 49.67

67.46%

4.

Intl Bus. Machines

IBM

1.85%

$ 183.65

$ 254.02

38.32%

5.

General Electric

GE

3.44%

$ 19.59

$ 4.70

-76.01%

6.

AT&T*

T

4.98%

$ 35.48

$ 24.87

-29.90%

7.

Chevron

CVX

3.40%

$ 106.78

$ 164.80

54.34%

8.

Johnson & Johnson*

JNJ

3.56%

$ 68.45

$ 107.53

57.09%

9.

Wells Fargo

WFC

2.58%

$ 34.12

$ 15.98

-53.17%

10.

Coca-Cola*

KO

2.67%

$ 77.89

$ 71.41

-8.32%

(as of 7/18)

Average

10.31%

Click to enlarge

*Also an S&P Dividend Aristocrat (has raised dividends for at least 25 consecutive years)

Note: Software used is available for free at www.valuepro.net. The authors of the software are Gary Gray and Patrick Cusatis. Comprehensive information about how the software works as well as the basis for the DCF model is available on the site.

My Thesis

With hyper-low interest rates and no indication that they will be rising anytime soon, we are seeing perhaps the cheapest big cap market ever. My analysis has shown that many well-known names are grossly undervalued in this near zero interest rate new reality. Investors are now barely catching up to this re-marking. Most pension funds have average annual return assumptions of 8% and the only place where they can find this type of return is in high dividend blue-chips.

Many say that this strategy is already played out and that everyone is already in these names. Although the reason for buying these names is predicated on low interest rates, my theory is not based on seeking the income opportunity, but rather in the value that can be found in these names as a side-effect of interest rates based on the DCF valuation model. The income gained on the dividends is merely a perk of the strategy. A good dividend yield (especially if a dividend aristocrat) can often be a good indicator of positive future cash flows and can be used to affirm confidence in the valuation. If these stocks can reach their fair valuation or even become overvalued then the returns could be immense.

The biggest threat to this model is obviously rising interest rates. The most likely way I foresee interest rates rising is with positive economic data (jobs, GDP). If these numbers start to pick up steam then the interest rates will go up. If this happens then eventually there could be some serious downward moves seen among these stocks. Initially, the stocks will probably rise due to the economic data's positive impact on the market and this trend could continue for quite some time.

There is also the possibility of a selloff, especially if rates continue to escalate because people will be able to find yield in other assets. The downward movement will most likely start slow and continue to accelerate as rates rise. By the time this happens the positions should already be liquidated. If the country does fall into a double dip recession, then business conditions could worsen. Revenues could decline substantially and margins could collapse. Stock prices would fall and dividend yields would rise.

Procter & Gamble's dividend yield at a price of 64.15 is 3.49%. If the company keeps the dividend of $2.24/share, the stock price will have to fall about $20 to $45 for the yield to get to 5%. In order to recoup that loss in principal with dividends, you would need to collect the dividend for almost 9 years. P&G has historically raised its dividend every year, so that period should be shorter, but if revenues and margins fall then they may not be able to raise the dividend as much as they have in the past. When it comes down to it, the market can stay irrational far longer than you can stay solvent. In any case, this strategy does offer excellent liquidity and these bridges can be crossed when they appear.

The best part about this strategy is perhaps the limited downside. These selections are A-rated companies, average dividend yields over 3%, and histories of raising their dividend year after year. From this standpoint, the strategy has very low risk tied to it. I am also not recommending buying stocks that are already near the top of their range. I am looking for names like the ones I mentioned before (PG, MCD) that are beaten down. They are much less exposed to dramatic price changes in short time periods because they are not overbought.

Companies like Verizon or Altria could see an exodus with rising rates. Their current levels do not seem sustainable without the run towards dividends, but if rates do stay low then they could continue to make new 52 week highs. With the downbeat attitude I have taken in performing valuations, there is much more potential upside if business is better than I projected.

Bottom line: There is unprecedented value in desirable names, an opportunity that does not come around very often. If rates stay low, blue could be the new alpha and present a generational buying opportunity.

Disclosure: I am long MCD, JPM, PG, INTC, AAPL, GE, VZ.