2018 Q4 Non-Taxable Portfolio Update

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Includes: AAPL, AMGN, BRK.A, BRK.B, CL, CLX, CNI, DIA, DPZ, EGOV, FDS, FII, FUPBY, GILD, JNJ, MCD, MO, MSFT, NKE, PAYX, PM, QQQ, ROL, ROST, SEIC, SPY, TJX, TSCO
by: Steven Chen
Summary

This is my second quarterly update of my non-taxable portfolio, a real-cash portfolio through my US retirement accounts.

While the portfolio again outperformed the benchmark, it was a "terrible" quarter with no doubt.

The portfolio now consists of stocks of 21 companies, all of which are running quality businesses in my view.

Leaders and laggers are listed individually with updates.

Fewer motions for more returns - only one position was sold and one position was added during the period.

Overview

During the 4th quarter of 2018, my non-taxable portfolio generated a loss of 13.86%, while S&P 500 was down 14.28% (see the table below for a full comparison against major indices).

Performance of 2018 Q4
My Non-Taxable Portfolio -13.86%
S&P 500 -14.28%
Dow 300 -12.4%
Nasdaq -17.06%

Index Data Source: Yahoo Finance

The absolute performance was certainly unsatisfactory, although the portfolio outperformed the benchmark again (by a narrow margin this time) since my last update (see My Quarterly Non-Taxable Portfolio Update).

In general, I would expect high chances of outperformance during market downturns and of underperformance during bull markets in terms of this portfolio due to its emphasis on fundamental qualities, such as recession-proofness, durable competitive advantages, capital efficiency, cash generation. For those who are unfamiliar with my stock-picking strategy yet, feel free to check out the following two articles to know more.

13 Stocks That Top My Factor-Based Value Investing Ranking Model

Updated Lists Of Stocks Topping Our Ranking Model

The portfolio we discuss here is the real-cash portfolio through my US retirement accounts. I am hoping to keep doing this update on a quarterly basis moving forward.

Again, the reasons why I primarily cover my US retirement portfolio for performance update are that:

  1. Non-taxable (e.g., no dividend withholding tax): This makes it easy to compare to benchmarks; trading costs, however, are included in the calculation of performance so the more trading activities the more my performance is hurt.
  2. No cash inflow or outflow: again, this makes it easy to calculate relative performances.
  3. US-centric (i.e., the majority of the holdings in US stocks): This way, I can appropriately compare to S&P 500, which Warren Buffett claims is hard to beat.

Meanwhile, below are some cons of using this portfolio for performance evaluation (vs. US equity benchmarks):

  1. The portfolio is biased toward dividend-paying stocks (for tax reasons), leaving choices of fast-growing and less mature companies out of the picture.
  2. Although the portfolio is US-centric, it does include some foreign stocks in order to save on dividend withholding taxes (e.g., Canadian and German stocks).

As we speak, this portfolio is concentrated with 21 equity holdings (19 US, 1 Canada, 1 Germany). Below, I list the leaders and laggers for a short 3-month period while it is strongly recommended for readers and myself not to focus on the short-term events, such as quarterly earnings, analyst upgrade/downgrade, guidance issuance, but on fundamental qualities.

Leaders (11) MSFT, EGOV, CL, CLX, DPZ, NKE, FDS, ROL, JNJ, AMGN, PAYX
Laggers (9) PM, MO, GILD, AAPL, CNI, OTCPK:FUPBY, SEIC, TJX, ROST
Position Sold (1) TSCO
New Position (1) FII

Leaders

Microsoft (MSFT)

Performance (2018 Q4, excluding dividends): -12.53%.

Source: Yahoo Finance

Best known for its Windows and Office lines of products, Microsoft is one of the largest software makers.

The asset turnover and pre-tax profit margin both improved during the past 12 months, while FCF margin deteriorated and CapEx increased. Revenue growth for the recent quarter is decent (up 18.53% YoY).

I anticipate the company would maintain its relatively strong returns on capital within the software industry leveraging its market leadership and highly sticky user base of operating systems and business/productivity software. The only major concern is the cyclical and disruptive natures of the tech sector.

Domino's Pizza (DPZ)

Performance (2018 Q4, excluding dividends): -13.14%.

Source: Yahoo Finance

Domino's Pizza is the seventh-largest fast food restaurant chain by the number of locations in the world.

Being only 1/10 of McDonald's (MCD) in terms of market value and taking advantage of the trend that millennials favor pizzas over burgers, Domino's should still have great growth ahead in my view.

During the TTM, the company improved its asset turnover but delivered weaker margins in terms of pre-tax profit and free cash flow. The balance sheet should be the major weak point for the case of DPZ, while the management did accomplish higher liquidity for the business (i.e., higher current ratio and higher quick ratio) in recent years.

In addition to the high growth (DPZ revenue for the recent quarter was up 22.11% YoY), I keep liking the pizza franchise business due to its recession-proof and capital-light characteristics.

Nike (NKE)

Performance (2018 Q4, excluding dividends): -12.31%.

Source: Yahoo Finance

Nike is the world's largest supplier of athletic shoes and apparel and a major manufacturer of sports equipment.

The business achieved a high-single-digit YoY growth in revenue for the latest quarter while improving its already superior FCF, gross, and operating margins over the TTM. I think that Nike possesses a strong brand worldwide but would face headwinds during economic downturns.

Rollins (ROL)

Performance (2018 Q4, excluding dividends): -9.09%.

Source: Yahoo Finance

Rollins is the global leader in providing pest control services and protection against termite damage, rodents, and insects. The stock is also the top American name in my stock quality ranking.

It is also an extremely rare case that has been growing revenue and earnings every year for nearly two decades. There was no exception for the past quarter, where Rollins grew its top line and bottom line by 8.28% and 29.17%, respectively.

It is worth mentioning that ROL managed to consistently improve its FCF and EBT margins over the past 10 years and has a clean balance sheet with no long-term debt. One slight and short-term concern is the drop in asset turnover for the TTM, but the current return on capital is high enough and far from the threshold that would trigger the "alert" for us to re-think about the quality of the business.

I think that the pest control business is recession-proof in the developed world and should benefit from the high growths in the emerging market.

FactSet Research Systems (FDS)

Performance (2018 Q4, excluding dividends): -11.53%.

Source: Yahoo Finance

FactSet provides financial information and analytic software for analysts, portfolio managers, and investment bankers at global financial institutions.

The business maintained its modest growth (revenue up 5.88% YoY) for the past quarter. Gross and operating margins went down while FCF margin trended up in recent years. Asset turnover now hit the lowest level for the past decade. Additionally, the company loaded up plenty of long-term debts on its balance sheet and deteriorated its financial liquidity.

Due to high switch cost, B2B FinTech is an attractive field to place long-term investments in my view, while I need to have FDS on my close watch list in terms of its operating and financial metrics.

Clorox (CLX)

Performance (2018 Q4, excluding dividends): 0.47%.

Source: Yahoo Finance

CLX is the only stock delivering a positive return during Q4, demonstrating a strong defensive characteristic as a consumer staples stock facing market turmoils.

As a leading multinational manufacturer and marketer of consumer and professional products, Clorox markets some of the most trusted and recognized consumer brand names, including its namesake bleach and cleaning products. According to the company, more than 80 percent of the company’s sales are generated from brands that hold the No. 1 or No. 2 market share positions in their categories.

The business experienced modest growth in revenue (up 4.2% YoY) but negative growth in operating income (down 2.64% YoY) due to margin compression for the recent quarter. The company improved the asset turnover a bit in the meantime. With regards to margins, we have actually seen a mixed picture in recent years: gross margin trending down while FCF margin holding up. Overall, I anticipate Clorox, with its strong branding in household goods, continues to generate superior returns on capital regardless of economic conditions going forward.

Johnson & Johnson (JNJ)

Performance (2018 Q4, excluding dividends): -12.6%.

Source: Yahoo Finance

Johnson & Johnson is the global leading medical devices, pharmaceutical and consumer packaged goods manufacturing company.

The best thing I like about JNJ is its track record of dividend growths and recession-proof-ness. For the latest quarter, the company generated modest YoY growth in the top line, but a negative one in operating income, with the margins being pressured down as the long-term and short-term trends. The FCF margin, however, has been firmly kept above 20% for recent years. Lastly, it is worth noting that the asset turnover started to improve a bit during the TTM after having declined for years.

In the long run, I am comfortable with JNJ's businesses in the various defensive domains with continuing high cash returns on capital.

Amgen (AMGN)

Performance (2018 Q4, excluding dividends): -7.25%.

Source: Yahoo Finance

As a leading biotech company, Amgen discovers, develops, manufactures and delivers various human therapeutics. This is a defensive stock with a wide moat, proven growth capability, high profitability, and demonstrated the willingness of delivering returns to its shareholders (AMGN increased its dividend per share 8x for the past six years).

Amgen experienced a low-single-digit YoY growth for the latest quarter in terms of sales (2.27%) but a negative one in terms of operating income (-4.76%). The FCF margin, however, has improved over the years, standing at 44.8% for the TTM. While the total asset turnover has declined for the past 10 years, the fixed asset turnover has been going up, helping the company achieve a superior cash return on fixed asset for its owners.

The only concern to me here is the instability nature of the biotech space.

Paychex (PAYX)

Performance (2018 Q4, excluding dividends): -11.73%.

Source: Finance Yahoo

Paychex is the "ADP" (i.e., provider of payroll, human resource, and benefits outsourcing services) for small-to-medium-sized businesses in the US. It operates with even higher capital efficiencies compared to ADP in terms of returns on capital.

Like many of the business mentioned above, Paychex continued its YoY growth in revenue for the latest quarter but at the expense of negative growth in operating income due to margin pressure. However, its TTM asset turnover and FCF margin are both at their multi-year highs. The company has a clean balance sheet with no long-term debt.

Paychex is not a defensive play when facing economic headwinds - smaller businesses are more prone to downside volatilities. But considering the consistently high ROICs achieved by the management, I anticipate that the company should do well in the long run with an expanding customer base and high retention rate.

NIC Inc. (EGOV)

Performance (2018 Q4, excluding dividends): -13.06%.

Source: Yahoo Finance

This was a new position which I established in Q3. The stock is regarded as a high-quality hidden gems stock, being undercovered here in the Seeking Alpha community.

NIC Inc. is the leading provider of digital government services that help governments use technology to provide a higher level of service to businesses and citizens and increase efficiencies.

The company operates through a transaction-based funding model (so-called B2B2C) to fund most enterprise partnerships. Hence, it generates predictable, repeatable, small-ticket, non-bargainable revenue streams through almost monopolized channels of public services, whenever users want to renew vehicle registration online or purchase a national park ticket over the mobile app.

Of course, I need to admit one risk facing the business is losing government contracts as the client base appears a bit concentrated. For the past decade, the company has consistently generated double-digit returns on assets, equity and invested capital.

During the TTM, operating and FCF margins deteriorated while the gross margin improved. The business achieved a low-single-digit YoY growth (2.95%) in revenue and negative growth (-3.18%) in operating income for the recent quarter. The company has a decent financial position with no debt and high liquidity.

Colgate-Palmolive (CL)

Performance (2018 Q4, excluding dividends): -11.66%.

Source: Yahoo Finance

CL was also a newly-initiated position from Q3.

The company is the leading provider of oral, personal and home care products and pet nutrition products.

You may find the story boring here but be aware that 1/3 of the world population are still brushing teeth without toothpaste and that people are more likely to cut spending on their own food or even their children's than they are to save money on pet food.

Colgate-Palmolive delivered negative YoY growth in both sales and operating earnings for the latest quarter. The margins and asset turnover have been stable or experienced minimal compression in recent years. Like some other names here, the defensive nature of the business can be a treasure in today's market full of recession fears.

Looking forward, I see that one of the biggest challenges facing the company (like many other consumer staples businesses) is the trend of digitization/e-commerce along with the associated changing consumer behavior.

Laggers

Gilead Sciences (GILD)

Performance (2018 Q4, excluding dividends): -18.62%.

Source: Yahoo Finance

Gilead Sciences is a research-based biopharmaceutical company that discovers, develops and commercializes medicines in areas of unmet medical need. The company focuses primarily on antiviral drugs used in the treatment of HIV, hepatitis B, hepatitis C, and influenza.

The stock is a turnaround play in my view, which I do not recommend investors do a lot of. However, Gilead Sciences does possess great cash generation/reserves with prudence in M&A spending. For the past 12 months, the business produced 36 cents FCF on every dollar of sales, with 44% of assets in cash (or cash equivalents) on the balance sheet. The company is increasing its presence in China, which is a potential growth story.

The risk is, however, that the margins (gross, operating, FCF, and EBT) and asset turnover (fixed and total) are still trending down. The company generated negative growth in both sales and operating income in the last quarter.

TJX Companies (TJX)

Performance (2018 Q4, excluding dividends): -20.41%.

Source: Yahoo Finance

The TJX Companies is the leading off-price retailer of apparel and home fashions in the U.S. and worldwide.

The company delivered a low-double-digit YoY growth in sales (12.14%) and modest growth in operating income (5.63%) for the latest quarter. The TTM asset turnover (total and fixed) improved. It is also worth mentioning that the margins (gross, operating, FCF, and EBT) have improved over the past 10 years, indicating widening moat through economies of scale as the store number grows.

Like Tractor Supply and Ross Stores (both discussed below), TJX is the niche retailer that is Amazon-proof (NASDAQ:AMZN). The discount retailer business should also be recession-proof to some extent.

Ross Stores (ROST)

Performance (2018 Q4, excluding dividends): -15.6%.

Source: Yahoo Finance

Officially operating under the brand name "Ross Dress for Less," Ross Stores is the largest American chain of off-price department stores. Being a direct competitor with TJX in the States (TJX also operates overseas), ROST did have performances correlated with TJX. Both stocks were down over 15% (excluding dividends) for the period.

As of the recent quarter, both companies offer similar gross margins. While Ross Stores did better in operating and pre-tax profit margins, TJX was more efficient in terms of fixed and total asset turnover. Although holding both stocks, I like ROST a bit better as the business is focused on the States only (not a huge fan of diversification).

As of the recent quarter, Ross Stores generated a modest YoY growth in revenue (6.63%) and a negative growth in operating income (-0.4%) due to margin compression.

Apple (AAPL)

Performance (2018 Q4, excluding dividends): -30.51%.

Source: Yahoo Finance

Being Warren Buffett's largest stock holding in his Berkshire Hathaway (BRK.A) (BRK.B), Apple is the leading global brand in consumer electronics, software, and related online services.

In contrast to the huge stock price decline, the business of Apple has delivered double-digit YoY growth in both revenue (19.63%) and operating earnings (22.85%) during the last quarter. Moreover, the FCF margin and asset turnover improved as of TTM while gross/operating/EBT margins held steadily.

Apple has been consistently able to convert more than 100% of its earnings to free cash flow for the owners, which should be rare and remarkable (MSFT being another example of this kind).

Philip Morris (PM)

Performance (2018 Q4, excluding dividends): -17.73%.

Source: Yahoo Finance

Without any doubt, 2018 Q4 was a terrible quarter for tobacco stocks, with all negative news (mainly related to regulations) coming in at almost the same time.

Philip Morris International is a US cigarette and tobacco manufacturing company, with products (including the most recognized and best-selling product, Marlboro) sold only outside the US (in over 180 countries actually).

I like PM's international market share and think it would benefit from the growth story in the emerging markets. The business should also be immune to the tighter regulation in the States.

Over the TTM, the management has been able to improve total/fixed asset turnover and gross/FCF margins while the operating/EBT margins have been facing pressure. For the recent quarter, the business delivered near-zero YoY growth in terms of revenue (0.41%) and low-single-digit growth in operating income (2.64%).

Altria (MO)

Performance (2018 Q4, excluding dividends): -18.27%.

Source: Yahoo Finance

Altria can be regarded as the "US-only" Philip Morris and is one of the world's largest producers and marketers of tobacco, cigarettes and related products.

The stock (excluding dividends) underperformed the benchmark during the period mainly due to regulatory concerns, but as Fundsmith's Terry Smith once pointed out, more regulation would actually benefit big tobacco players already in the market in the long run.

Altria is one of the many cases in my portfolio to have experienced a low-single-digit growth in sales but a negative growth in operating income over the past quarter. For the past 12 months, the management was able to improve most key metrics, such as gross/operating/FCF/EBT margins as total/fixed asset turnover.

I anticipate more improvements in both MO's and PM's operations and financials, relying on the management's proven capital allocation skills, the near-monopoly positions, and the counter-cyclical nature of the business.

SEI Investments (SEIC)

Performance (2018 Q4, excluding dividends): -23.47%.

Source: Yahoo Finance

SEIC is one of the top American names on my quality ranking list, but was a bit of a disappointment for both this and last quarters, due to significant underperformance to S&P 500 (excluding dividends). SEI Investments Company is a global provider of investment processing, investment management, and investment operations solutions.

The growth for the latest quarter is again healthy with a modest increase in revenue (up 5.87% YoY) but a double-digit increase in both operating earnings (13.28%). The business is also able to convert more than 30% of its sales into free cash flow for its shareholders. For the past 12 months, the management improved the company's gross/operating/EBT margins as well as total/fixed asset turnover.

Despite the market price drop, I would definitely continue to be patient here.

Canadian Railway (CNI)

Performance (2018 Q4, excluding dividends): -19.09%.

Source: Yahoo Finance

Canadian National Railway is Canada's largest railway, in terms of both revenue and the physical size of its rail network and is Canada's only transcontinental railway company, spanning Canada from the Atlantic coast in Nova Scotia to the Pacific coast in British Columbia.

This is one of the few cyclical stocks in my portfolio, simply because of its consistently high returns on capital on top of its legal monopoly kind of market position. For the recent quarter, the management delivered a 14.5% growth in revenue and a 4.23% increase in operating earnings (both Y/Y). One minor alert here is that margins at all levels (gross, operating, FCF, and EBT) deteriorate over the past 12 months. However, in the long run, I anticipate that CNI will do just fine, given its performance facing ups and downs over the past full economic cycle.

Last but not least, Canadian stocks are exempted from dividend withholding taxes in US retirement accounts - a saving of more than 20%. This is why CNI appears here in my US-centric portfolio.

Fuchs Petrolub (OTCPK:FUPBY)

Performance (2018 Q4, excluding dividends): -26.58%.

Source: Yahoo Finance

Fuchs Petrolub is the world's largest independent manufacturer of lubricants, and related specialty products.

I like the management's focus on Fuchs Value Added (i.e., EBIT - Cost of Capital), which is the central KPI. For the past quarter, the company generated low-single-digit YoY growth in both sales (4.39%) and operating income (1.16%). The total and fixed asset turnover has been trending down over the past couple of years, which is worth further tracking. The FCF and EBT margins improved slightly during the TTM.

If you are wondering why a German name appears here, then please be aware that German ADRs are also exempted from dividend withholding taxes in US retirement accounts - another saving of more than 20%.

Sold Position

Tractor Supply (TSCO)

Tractor Supply Company is an American retail chain that offers products for home improvement, agriculture, lawn, and garden maintenance, and livestock, equine and pet care.

Even though the top-line growth is still in place, I have been getting uncomfortable with the low margins and cash generation of TSCO as well as this niche retail business overall.

New Position

Federated Investors (FII)

Since 1955, Federated Investors has been a leading provider of investment management products and related financial services.

The majority (more than 60%) of the AUM is held through money market strategies and/or products at Federated. The heavy emphasis on money market assets lends to a stable AUM revenue stream regardless of market volatility. Actually, the money market portion of the business is a hedge on stock market volatility as any sell-off in the stock market may contribute to money market investments as the safe haven. Moreover, the rising interest rate would benefit Federated's money market funds due to less likelihood of the fee waiver program, which cost losses to the company for many years during the low-rate period.

Federated Investors employs a super capital-light business model, consistently generating high returns on capital over the past decade (see below). The business produces strong free cash flow (around 13% FCF margin) for its owners and spends little CapEx on sales (around 1%).

Source: Morningstar; data as of 1/6/2019.

Summary

-13.86% is never a satisfying record, even though beating the benchmark. However, market volatilities (mainly downside ones) create opportunities for long-term investors. No one should be able to predict the market, but if the current bear market continues or (even better) gets worse, I would anticipate a continuing outperformance of this portfolio consisting of high-quality businesses (with high returns on capitals, healthy balance sheet, strong cash flow, and durable competitive advantages) at more reasonable prices than in previous quarters of the year.

In case of a panic Mr. Market, chances of buying wonderful businesses at wonderful prices may often arise, and therefore, the portfolio would need some adjustment to a larger degree. Until then, I intend to limit the trading activities to a minimal level, as the saying goes "returns decrease as motion increases".

Lastly and once again, because of the taxation benefits, this portfolio is more concentrated in dividend-paying US stocks.

Disclosure: I am/we are long MOST OF THE STOCKS MENTIONED. 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.