A.O. Smith: Time To Jump Back In

About: A. O. Smith Corporation (AOS)
by: ChartMasterPro

The Momentum Growth Quotient for the company is 15.14, which is 64.46% higher than the average for the S&P 100.

Shares present a forward rate of return of 22.52% at the current price.

ChartMasterPro upward target price of $52.00.

Shares of AO Smith Corp (AOS) are down 26.76% since peaking on June 12, 2018, and in my opinion, the shares of this manufacturer of gas and electric water heaters are a compelling buy at current price levels. The company has a solid history of generating impressive earnings growth, and the future growth ratios point to continued growth over the next twelve months. I lay out my bullish argument for the company below by reviewing some pertinent fundamental and technical aspects of the stock.

Momentum Growth Quotient

My Momentum Growth Quotient (MGQ) plays a critical part when it comes to determining if I am going to go long or short a stock. Generally, I only want to go long a stock with an MGQ higher than that of the S&P 100, and I want to go short a stock with an MGQ lower than that of the index (for a more detailed explanation of how I calculate the MGQ, please see my blog post).

As of the end of October 2018, the MGQ for the S&P 100 was 9.21.

The current MGQ for AOS stands at 15.14, which implies a 64.46% higher growth rate compared to the S&P 100. This tells us that AOS has strong future growth potential and is a good candidate for a long position.

Financial Snapshot

Let's dig a little deeper into the financial data to get a better feel for how the company has performed on certain fundamental metrics and what these numbers imply for future growth.

Caveat Lector: I am Quant Trader - that is, I seek to understand market behaviour by using mathematical and statistical modelling, measurement, and research. So, you won't find much qualitative analysis in my work or in my trading process. The goal is to identify optimum entry points for trades based on my quantitative model and execute those trades as effectively as possible.

The Past

During the past 12 months, the average EBITDA per Share Growth Rate of A.O. Smith Corp was 10.30% per year. During the past 3 years, the average EBITDA per Share Growth Rate was 21.20% per year. During the past 5 years, the average EBITDA per Share Growth Rate was 18.70% per year. During the past 10 years, the average EBITDA per Share Growth Rate was 15.10% per year (GuruFocus). The earnings growth for the company has been strong and consistent over the last ten years.

The operating margin % for AOS stands at 17.03%. Each dollar of revenue the company generated brought in 17.03 cents of earnings. The company's 5-year average operating margin growth rate was 12.10% per year.

The Future

Knowing how a company has performed in the past is important in order to evaluate management's past record in running the business. But more important to us is how profitable the company will be in the future because we are investing going forward, not backward. And it's the forward-looking metrics that should really get you excited about AOS.

I like to use two measuring sticks to gauge the future growth potential for companies: forward P/E and forward rate of return.

I prefer to use the forward P/E ratio (current stock's price over its "expected" earnings per share) rather than historical P/E to gauge a company's expected future earnings power. A high forward P/E ratio means that investors are anticipating higher growth in the future and are willing to pay more for future earnings - momentum investing is all about following the trend (perceived or real).

AOS has a forward P/E of 16.92 compared to a 17.10 forward P/E for the S&P 100. The Forward P/E for AOS is more or less equal to that of the index, indicating that investor growth prospects for the stock are the same as for the broader index.

The forward rate of return for a stock (created by Donald Yacktman) is one of my favorite quotients for gauging the market's expectation for future growth for a company. Yacktman defines forward rate of return as the normalized free cash flow yield plus real growth plus inflation. In simple terms, the forward rate of return can be thought of as the return that investors buying the stock today can expect from it in the future.

The forward rate of return for AOS stands at 22.44%. This implies that an investor buying the stock today should expect a 22.44% return over the next 12 months. The average forward rate of return for the S&P 100 as of the end of October was at 8.03%, so AOS has an implied potential rate of return that is 2.80x greater than that of the index.

The risk inherent in the forward rate of return is that the calculation is reliable only if the company can grow at the same rate in the future as it did in the past. If the growth rate falters, the projected returns will not materialize. But we are willing to accept this risk as part of the difficult process of forecasting earnings and growth momentum.

Technical Snapshot

As per my ChartMasterPro Daily Trade Model, there is a high probability of a rally to the $52.00 level from here, which would represent a 10% gain in the shares price.

  1. The RSI 14 is rising and just broke above 50.00 today
  2. The MACD is positive and rising
  3. The shares found support at the $46.00 support level and look poised to break back above the 200ma.

I will buy call options for AOS to participate in the anticipated run to $52.00. To view the option details (strike price, expiry date, and leverage), you can sign up for a Free Trial for The Options Trader. Only members receive detailed trade alerts.

For investors in the shares, I recommend that you hold for 3 months or $52.00, whichever comes first. For longer-term investors, I believe AOS is a solid addition to any growth portfolio over the next 12 months.

Relative Strength

When looking for companies to invest in, I like to find ones with a management team that has outperformed its peers in the same industry in regards to effectively turning revenue into profits and generating returns for shareholders.

Management Effectiveness

AOS Industry
Sales - 5-Yr Growth Rate 9.09% 8.49%
Return on Assets TTM 13.78% 8.90%
Return on Investments TTM 18.13% 11.17%

Return on Equity - 5-Yr Average

19.26% 9.63%

Source: Reuters

This is a company that with a management team that is very good at generating higher-than-average returns on equity and assets for its shareholder both on a twelve month rolling basis and over the last five years.

Shares Oversold

The chart below shows the company's Operating Margin TTM over the last five years compared to its share price. Though it is true that the Operating Margins have flattened for most of 2018, you can see that the shares have fallen off a cliff. In my opinion, this is a gross overreaction by the markets to the pause in profit growth for the company. There is a high probability from here that the shares will climb higher to correct the overreaction to the downside that has occurred since June.

Chart AOS data by YCharts

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When I go long a stock, I want to invest in a company that provides superior future growth potential, but I also want to time the entry into any position to try to maximize my return.

So, I use fundamental analysis to identify shares with a strong future growth rate, and then I apply technical analysis to identify ideal entry points.

In my opinion, AOS is a compelling buy at these levels from both a fundamental and technical perspective.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AOS over the next 72 hours. 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.