Of Faceplants And Fair Values

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by: Investing Doc
Summary

My model for Facebook was insufficiently skeptical.

The market still looks insufficiently skeptical of the technology sector in general.

A bottoms-up view of the S&P 500 suggests opportunities in more defensive names.

I got some well-earned shade earlier this week when a commenter reminded me that my financial model for Facebook (NASDAQ:FB) had proven just a little inaccurate. I had noted that I was having difficulty tweaking my model to get FB’s fair value estimate below $250; the commenter gleefully pointed out that—once the company cratered on poor guidance (related to ongoing security efforts and saturated end markets)—not only had my estimate missed the mark, it had completely failed to account for this rather significant possibility.

This is mostly because the formulae my model uses are based in part upon consensus estimates for forward growth that are scraped from publicly available sources like Zacks, Finviz, and Yahoo!Finance, and if those estimates are sufficiently optimistic, then the model will be as well. It’s a classic “garbage-in/garbage-out” scenario, and while I had made innumerous tweaks to the model to add a dose of skepticism to analysts’ Panglossian opinions, it seems that these weren’t quite enough.

I remain relatively bullish on Facebook as a long-term investment, though my fair value estimate came down considerably following the earnings call, down from about $240 or so to $213 now. (It’s worth pointing out that analyst consensus estimates—as of this writing—have yet to move as much and are still hanging out around $218.) Though growth in daily active users may be limited in Western markets from saturation, the company still has levers to pull to improve monetization and average revenue, and while efforts to improve user privacy and security and reduce exploitation by more unsavory users will be costly, I think it may help in the long term to steady user engagement and time spent on the core platform. Barring that, the company has other products that shouldn’t be affected by any degradation in Facebook’s network effect like WhatsApp and Instagram, and at any rate it’s possible that investors will be repaid for any loss in short-term profitability with a more sustainable cash-rich business long-term.

This, of course, is totally speculative, and there’s no question that any investment in Facebook needs to consider this significantly increased uncertainty. A slight drop in MAU’s may precipitate further declines as network effects go into reverse; such a decline could be further accelerated by the introduction of a new social networking site that didn’t carry any of Facebook’s baggage. Regulatory risks have only been enhanced by recent events, and the company’s performance over the next several months in terms of its policing of content and protecting user data will almost certainly be pivotal. And it could just very well be that Facebook has lost its cachet entirely and that the numbers have yet to catch up with the future.

That said, I didn’t buy Facebook into earnings—I’m glad I didn’t, obviously—and I’m not buying Facebook now. I really meant what I said that I was trying hard to get my model to incorporate a more realistic view of the firm’s prospects; it didn’t seem realistic to assume that one of the most valuable companies in the world could continue growing at an exponential rate indefinitely. Now, it seems, following the earnings call and a raft of downgrades, analysts have curbed their enthusiasm a tad, and the model seems a bit more pessimistic as well. I view FB as a hold at current levels but would be a buyer if the margin of safety improved (if the price dropped, say, below $160).

Historical financial data from Morningstar; Analyst consensus estimates from Zacks, Yahoo!Finance, and Finviz. All calculations and estimates by author.

With Facebook’s example in mind, I think it’s worth looking at the valuations for the broader market, using the S&P 500 as a proxy. That is to say: if analysts were perhaps overly optimistic about Facebook—if Facebook were indeed “priced for perfection” prior to its earnings call—then what does that suggest about the rest of the market? I don’t know the answer for certain, but it suggests to me, at least, that analysts’ collective price targets continue to be highly optimistic, forecasting accelerating earnings growth for firms that both outstrips historical growth rates and continues apace nigh indefinitely.

Based on prices current as of 27 Jul 18 close; all calculations by author.

Overall, the market looks about fairly valued to slightly overvalued. Despite the recent correction in high-flying technology stocks, the sector’s overvaluation has only partially corrected and it continues to trade at the highest premium to my own fair value estimates and the lowest discount to analyst consensus estimates. Keeping in mind the Facebook example, I wonder if the sector as a whole might not still be “priced for perfection” and if the rolling correction in this sector is bound to continue.

That the sector’s growth is already largely priced in might be exemplified by the market’s relatively muted reaction to Amazon’s (NASDAQ:AMZN) earnings report and guidance. With the stock trading pretty much in line with fair value (and analyst consensus target), even the rosiest growth rates seem to have already been accounted for by investors, leaving limited near-term upside.

Historical financial data from Morningstar; Analyst consensus estimates from Zacks, Yahoo!Finance, and Finviz. All calculations and estimates by author.

A similarly rosy outlook appears to have been baked into shares of Microsoft (NASDAQ:MSFT). While I’m not nearly as bearish on the name as the esteemed Chuck Carnevale (whose recent opinion on Microsoft generated no small amount of controversy), I too wonder if investors aren’t sufficiently discounting risks faced by the firm as it builds up its cloud business—a business in which multiple large firms (such as Amazon and Oracle) are already entrenched. I’m not suggesting that Microsoft hasn’t proven spectacularly successful in its efforts so far—it has—but current valuations don’t seem to reflect growing competitive risks and Microsoft’s other legacy business lines.

Historical financial data from Morningstar; Analyst consensus estimates from Zacks, Yahoo!Finance, and Finviz. All calculations and estimates by author. For some reason the Financial Health data from Morningstar wouldn’t load correctly.

Other more cyclical sectors strike me as overvalued as well at this point, and really the only sectors I’m able to find reasonable values have been in more defensive areas such as Utilities, Communication Services, and Consumer Defensive stocks. I recently opined that investors ought to take advantage of the recent weakness in the Dividend Aristocrats (BATS:NOBL) to open a position. Short-term movements don’t mean very much, but if the recent weakness in Technology stocks leads to a broader decline, then I think investors who decide to add some dividend-paying ballast to their portfolios now might be happier in both short and long runs.

So which stocks in the S&P 500 do I personally think look intriguing? I’m looking for companies with solid economic moats, relatively low valuation uncertainty, less demanding valuations, and strong forecasted growth rates. As I anticipate the end of this bull market at some point in the next couple years—though of course this has proven ill-timed in the past—I’d prefer names with lower earnings volatility and lower market correlation. Running these screens through the S&P 500 yields the following names, some of which look more interesting than others. I intend to sift through these names to see if there are any that look promising as destinations for new money.

Company Name

Ticker

Price

FVE

Analyst Target

5-Year EPS CAGR (Projected)

Beta

Cerner Corp

CERN

$61.13

$83.18

$68.06

13.87%

0.917

ResMed Inc

RMD

$106.48

$126.19

$90.29

20.62%

0.874

Hormel Foods Corp

HRL

$36.65

$41.72

$37.43

10.50%

0.596

General Mills Inc

GIS

$43.55

$57.60

$49.31

8.42%

0.654

Sysco Corp

SYY

$70.93

$79.58

$67.25

12.36%

0.632

Omnicom Group Inc

OMC

$67.80

$82.69

$76.44

5.61%

0.799

Dollar General Corp

DG

$98.75

$116.43

$107.27

15.92%

0.664

Starbucks Corp

SBUX

$51.45

$68.76

$58.50

14.00%

0.904

Procter & Gamble Co

PG

$79.47

$91.02

$80.55

6.46%

0.589

Raytheon Co

RTN

$197.56

$184.62

$233.54

11.50%

0.697

McCormick & Co Inc Non-Voting

MKC

$117.68

$118.78

$115.00

9.81%

0.632

Kellogg Co

K

$70.85

$77.95

$73.77

7.29%

0.536

Costco Wholesale Corp

COST

$220.70

$193.58

$218.88

11.58%

0.703

Paychex Inc

PAYX

$72.00

$71.40

$68.38

8.00%

0.918

Anthem Inc

ANTM

$247.93

$241.57

$286.09

13.53%

0.892

Expeditors International of Washington Inc

EXPD

$76.05

$71.59

$68.63

9.25%

0.834

W.W. Grainger Inc

GWW

$343.19

$284.78

$324.56

12.45%

0.851

Nike Inc B

NKE

$77.16

$75.07

$78.71

11.43%

0.903

Darden Restaurants Inc

DRI

$107.05

$108.35

$111.50

9.35%

0.659

Edwards Lifesciences Corp

EW

$155.12

$150.57

$151.41

14.75%

1.017

A.O. Smith Corp

AOS

$60.11

$61.78

$71.60

12.12%

1.283

Emerson Electric Co

EMR

$70.20

$63.46

$77.50

10.69%

1.134

Microsoft Corp

MSFT

$107.68

$95.36

$115.95

11.21%

1.281

Tiffany & Co

TIF

$139.50

$122.41

$132.00

10.17%

0.974

Rockwell Automation Inc

ROK

$183.46

$149.87

$190.90

11.39%

1.224

All calculations by author; analyst estimates from Zacks, Finviz, and Yahoo!Finance. Estimates reflect author’s own opinions and are not guarantees.

Disclosure: I am/we are long FB, MSFT, AMZN, CERN, GIS, OMC, SBUX, PG, ANTM, NKE. 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.

Additional disclosure: Not formal investment advice. I am not an investment adviser.