When Will The Sky Fall? Part 2

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Includes: BP, BUD, F, FCAU, T, VLO
by: Cory Cook
Summary

We all want to buy a company that is undervalued, then make money as the rest of the market realizes this.

The companies that I look at must produce enough cash flow from operating activities that I find them advantageous at their current positions.

I didn't want this to turn into a thesis paper that had everyone reaching for a cup of coffee halfway through just to finish the read.

When I last left you I was screaming and shouting that the market was going to drop 50%. Okay not exactly. If you haven't checked out part one of this series go ahead and take the time to check it out here.

While I may not have been claiming that I had seen the signs of end times and we all must repent our investing sins, I did make a strong push about the over-valuation that is going on in the current market. This though, is not a reason that you cannot continue to find value.

When finding value, there are obviously some things that everyone has in common:

  1. A company is not valued at the market cap that you believe it is truly worth.

  2. The same company has growth potential that makes it a long-term worthwhile investment.

  3. The company has a moat that will defend it from being overtaken in the near future (think 10 years) or has a substantial stake in an industry that will be hard to overtake.

Okay now that we have those points out in the open, let's talk about the large elephant in the room: Valuation. How you end up getting to a valuation may be a little bit different for everyone. It is like different sects of the same religion, some beliefs may differ but the underlying beliefs are relatively the same:

We all want to buy a company that is undervalued, then make money as the rest of the market realizes this.

Now I won't go exactly into how I find valuations in the companies that I hold but instead some strategies that have led me to owning the companies that I currently have positions in.

First off, cash flow. The companies that I look at must produce enough cash flow from operating activities that I find them advantageous at their current positions. This is definitely the case of Ford (NYSE:F). The amount of cash flow that is currently produced by the company allows me to rest assured that not only the dividend will be able to be paid out but also that it sits at an undervaluation.

"But wait, what about their earnings growth or lack thereof?"

Great question. When I look at a company like Ford, one that has a large claim to an industry that would be very hard to disrupt, I want to see a viable cash flow that supports future operations of the company. Ford obviously does this. With a net operating cash flow of just North of $15 billion I think that there is a lot to like.

Now I realize that this cash flow is on the downtrend the past two years but in the case of Ford I really like the moves that have been made with the new management and the plan that has been laid out. Not only does my valuation method involving cash flow show that Ford is undervalued, the large (and sustainable in my opinion) dividend presents me with a long-term opportunity that I cannot resist. If management can drive home some of the changes that they are currently speaking of, and I can continue to collect a dividend that lowers my basis along the way, I think that this is an investment that can thrive.

But what about another company in my portfolio, AT&T (NYSE:T)? Well, first off I will clear the air by saying that at the current price I believe that T is pretty fairly valued. The dividend is currently at a rate that is significant and the growth history of the dividend is outstanding. That being said, there are a lot of questions that surround T's long-term health and their strategy to take advantage of some of the media and streaming options that they currently hold. Sometimes the market gives you great options and sometimes there are options like T. I like the potential that could unlock and this is a bet that really is a win or only lose a little situation. Sometimes in an overpriced market, the fairly priced holdings become the new bargains.

In the case of BP (NYSE:BP) and Valero (NYSE:VLO) I realize that the end of market cycles, as I believe this is, the energy sector has shown historically good performance. The chart below, presented by Fidelity, shows some sector rotation strategies that can spark industries to look into.

While this is not an end-all to what sectors will do all of the time, it does give some insight into where you can begin looking for companies that may have a statistical chance to increase value due to the cyclical nature of the market during these times. If we truly are in the late innings of this market cycle then it behooves us to look at the three sectors that have been known to outperform consistently during these times: Materials, Healthcare, Energy.

This, added with a very nice dividend yield, has allowed me to feel comfortable with placing an increasing amount of money into both BP and VLO over the past couple of years. Obviously, energy seems to short lifespan of out-performance while healthcare rides the wave of success a bit better.

As they say on TV ads though, "Wait that's not all folks!"

I must say this now, "I solemnly swear that I will never buy a stock purely on dividend yield and/or sector rotation strategies."

The real reason that I like these companies stem from the continued sustainability of earnings, a market share that is going to be hard to crack, and an oil price that is going to support free cash flow that will be used to continue to build the businesses. Without going way into the background of each one, something that I plan on doing another time, I like these two energy companies a lot better than the others and believe that even at current prices they are undervalued (VLO perhaps fairly valued).

Finally, there are two companies left in my current portfolio, Anheuser-Busch Inbev (NYSE:BUD) and Fiat Chrysler Automobiles (NYSE:FCAU). Now these are very different companies but both offer a terrific upside in my opinion. BUD is my pick in the alcohol business with a huge market share and a brand that cannot be beaten (and adding more brands as we speak). Now my current position was highly mistimed and to be frank, completely rushed. There is no way that I should have purchased the company at the price I did and to be honest should have added on the December drop, but my money was tied up and sometimes you lose. That being said, it's a company that I really like (will post about this in the near future), and will add when the market drops off again.

My final position, one that currently makes up almost 10% of my current portfolio is FCAU. Now I noticed FCAU originally because of two things: first it had a very low P/E ratio, second it was being purchased by Mohnish Pabrai. If you read my last article you will know that I follow Mr. Pabrai very closely and usually analyze all of the companies that he purchases. Am I a copycat? Not without good reason! Again I will go into FCAU soon, but for me a small P/E in a company that I believe is stabilizing and is about to hand out a nice dividend to boot, is a great reason to buy a company. Of course, this also goes hand in hand with the fact that I believe that my margin of safety price is well within range of my purchase price.

Conclusion

I know that I started the article with some pinpoint accuracy on things that I look for, then got very vague as I went on. This was really just the tip of the iceberg into what I look for in companies that I purchase, but trust me that was for good reason. I didn't want this to turn into a thesis paper that had everyone reaching for a cup of coffee halfway through just to finish the read. Instead, I wanted to give you all a quick overview of what I am currently looking for in the market and while I believe that there is a downturn coming soon, I will always be evaluating companies for either current or future purchasing.

Thanks for reading!

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.