3 Stocks To Buy In 2020 To Outperform A Bear Market

Jan. 16, 2020 2:40 PM ETGILD, ULTA, INTU, AMZN125 Comments

Summary

  • The market has rallied significantly while the economic fundamentals still look pretty poor. As the economy desperately needs a setback after 10 years, my expected returns are low.
  • Consequently, I am looking for stocks which could outperform a bear market to add in my portfolio. I focus on market correlation (beta), valuation and resilience for a recession.
  • I believe that Gilead Sciences, Ulta Beauty and Intuit are good stocks to buy to outperform a bear market. Moreover, I see a lot of value in Amazon.

2019 has been a phenomenal year for investors, as the S&P 500 (SP500) index gained more than 28%, primarily contributed by 50+% gains for big tech giants such as Apple (AAPL), Facebook (FB) and Microsoft (MSFT). Congratulations to all investors who could benefit from this strong rally. However, as I pointed out in a recent article, I believe this bull market was driven by a decline in risk aversion due to the easing of geopolitical tensions and dovish fiscal policy. In contrast, the underlying economic fundamentals were pretty poor as S&P 500 earnings turned negative YoY and the economy is not expected to return to growth levels which we saw over the last decade. As a possible improvement in economic fundamentals looks to be baked into today's prices (low expected returns), I believe it is smart to re-allocate a part of your portfolio into stocks which should be able to perform well during poor market conditions. My stock picking is undergoing a shift to low-risk contrarian stocks with three important factors: the ability to perform well during poor economic conditions, having a relatively low correlation with indices (relatively stable when market tanks) and being undervalued based on the uttermost important number: free cash flow. After some thorough research, I want to provide readers my top 3 stock picks for 2020 which I believe will outperform a bear market.

1. Gilead Sciences

(Price:$66; Price target:$116)

Performance during poor economic conditions: strong, biotech companies' correlation with the economy is low as patients keep buying life-saving drugs. Correlation with indices: not too high, 1-Y beta is 1.12. More importantly has a low beta during recessions. Undervaluation: big, FCF Yield of 10.25% and potential to increase cash flows.

(Source: Tradingview.com)

Gilead Sciences (GILD), a biotechnology giant, is my first favorite contrarian pick which I believe should outperform a bear market. The stock has been in a neutral trend over the last year after declining by 50% from its 2015 peak. This strong decline was caused by the loss of its dominance in HCV disease to AbbVie (ABBV), which is thoroughly discussed in my last article. However, the revenue increase in its HIV franchise partially offset the HCV decline and caused total revenues to stabilize in 2019.

(Source: author based on company information; sales in $ mln)

Furthermore, the company is still generating very strong cash flows, estimated at $8.7 bln, while its recent deals with Kite Pharmaceuticals and Galapagos (GLPG) could increase its revenues by 20% over the coming five years. Additionally, the big cash position of $20 bln gives possibilities for further M&A events which could expand its revenues even more.

(Source: author estimations)

There are more reasons to be bullish about this company. In 2019, Gilead's management team changed significantly, with the appointment of the very experienced O'Day, the former COO of Roche. I believe this management team is very qualified to return Gilead to growth again. His strategically strong deal with Galapagos shows his vision of long-term value creation, which I like. Second, Gilead pays a nice dividend, yielding at almost 4% and increasing steadily by 10% a year. Lastly, Gilead should be relatively resilient to a recession as they sell vital drugs to patients. Gilead and other biotechs rely much more on drug approvements and competition compared to economic strength. The chart below shows that Gilead and biotechs can indeed outperform during a recession. My conservative discounted cash flow valuation stands at $111/share, 77% higher than the price today. Risks include non-approval of future drugs (Filgotinib et al.) and more competition in HIV (which is lowered recently after GSK couldn't get an approval for its new drug).

ChartData by YCharts

2. Ulta Beauty

(Price:$252; Price target:$454)

Performance during poor economic conditions: Ulta showed that they can withstand a declining cosmetic market in the US. Their strong loyalty program should pay off during a tough market environment. Correlation with indices: not too high, 1-Y beta is 1.13. Undervaluation: FCF yield of 4.54%, low given the strong cash flow growth opportunities.

Ulta Beauty (ULTA) is an American chain of beauty stores, primarily selling cosmetics, skin care and hair care products. In contrast to other beauty companies like Estee Lauder (EL) and L'Oreal (OTCPK:LRLCF), Ulta Beauty is fully exposed to the USA. Unfortunately, the US cosmetic market is declining strongly in the United States, which led revenue growth to decrease from 20%+ to high single digits. As a consequence, the stock price saw a pause in its strong track record.

(Source: Tradingview.com)

However, I see a lot of value at this point as Ulta Beauty is a cash flow machine with an extraordinarily strong management. The company is valued twice as cheap as competitors Estee Lauder and L'Oreal at a P/FCF of 22 due to the recent growth slowdown, which is not at all justifiable as management has no grip on the US market conditions. In fact, in 2019 Ulta has shown that it can present superior results in a declining market compared to its competitors as indicated in the graph below. The primary reason for this outperformance is its innovative business model. Ulta is gaining market share by focusing on omni-channeling and personalization via its popular loyalty program which now has 33.9 mln active members. High customer engagement is very important for sales growth, especially during rough market conditions. In addition to Ulta's outperformance, L'Oreal's CEO recently said that beauty products are resilient even against an economic crisis, which together makes Ulta a defensive pick.

(Source: author based on company disclosures)

I believe Ulta's multiples will expand again when market conditions improve and earnings growth revives. The first signs of improvement were given in its Q4 guidance, as YoY Q4 comparable sales are expected to jump to 4.4% from 3.2% in Q3. Moreover, Ulta is expected to start expanding internationally. They planned to open new stores in Canada in 2020 and are expected to operate in Europe later as well. This could put some pressure on free cash flows (as capex grows) but should benefit revenues and cash flows strongly over the long term.

(Source: author estimates)

Furthermore, director Charles Heilbronn and CEO Mary Dillon put their money where their mouth is by acquiring shares worth $55 mln and $308,000 respectively in September which indicates that they believe the company is undervalued. I followed their purchases after estimating its fair value at $454, possibly returning 80% to investors purchasing shares right now. My estimates include revenue growth revival during late 2020 as the US cosmetic market should improve soon. Risks involved in this investment is a longer downturn of the US cosmetic market. However, this looks to be baked into its share price already.

3. Intuit

(Price:$276; Price target:$371)

Performance during poor economic conditions: Very strong. Intuit is a steady revenue/earnings compounder which kept growing earnings during the big financial crisis. Market dominance and subscriptions fees make its growth very reliable. Correlation with indices: not too high, 1-Y beta is 1.05. More importantly low beta during crises. Undervaluation: FCF yield of 3.10% looks quite high. But compared with other market dominators and SaaS companies it isn't.

Intuit (INTU) is a software-as-a-service ("SaaS") company which sells financial and tax preparation software such as QuickBooks for small and medium sized companies' finances and TurboTax for taxes.

(Source: Tradingview.com)

Its subscription model and market dominance are the main drivers for very high shareholder value creation in the past. As you can see below, Intuit managed to grow very steadily over the past years, both in revenues (low double digit CAGR) and free cash flow margins (+900 bps over the last 13 years). Astonishingly, they managed to grow revenues and margins during the financial crisis (in red)!

(Source: author based on company information)

This steady performance is the first reason why I believe that this company deserves a place in your risk-averse portfolio. As you can see below, Intuit outperformed the S&P 500 significantly in stock price as well during the crisis.

ChartData by YCharts

However, there is no free lunch available in the stock market, as the company is highly priced at 32 times free cash flow, compared to an average of 20 for the S&P 500. However, if you compare the stock with SaaS peers such as Adobe (ADBE), SAP (SAP) and Salesforce (CRM), Intuit does not look expensive at all. Furthermore, I like to compare the company with other dominating (you can call it oligopolies if you want) companies like Baxter (BAX), Visa (V) and Facebook, which makes Intuit look pretty cheap. In fact, my DCF valuation shows that Intuit is still undervalued by 34.52%. Assumptions of this valuation are: WACC of 7.23% (CAPM model), revenue growth slowdown by 0.75% per year, long-term growth rate of 2.5% and a margin improvement of 20 bps per year. Intuit could potentially be my first buy in 2020 if it could dip around 10%.

ChartData by YCharts

The past decade was an 'era of mobile and cloud' for Intuit. Going into software as a subscription included many benefits such as easy cross-selling, higher customer monetization and easy software improvements. In the 2020s, Intuit will focus on artificial intelligence which should improve customer satisfaction significantly and will broaden Intuit's market potential.

(Source: Intuit investor presentation)

Bonus pick: Amazon

As a bonus pick, I want to include Amazon (AMZN), the worst performing FAANG stock in 2019, which is still being misinterpreted by the market. The company has been growing its gross margins by 13.97% over the last 6 years. However, much of this growth has been reinvested in future growth opportunities such as Amazon Prime and one-day deliveries to maintain and/or build Amazon as a leader. The 3 biggest operating costs (fulfillment, marketing and technology) have grown from 24.50% of revenues to 33.20% of revenues.

(Source: author based on company disclosures. 2019 are estimates.)

As a consequence of strong sales and gross margin growth, free cash flows have grown significantly over the past years. However, it is important to understand that without the increasing spending for future growth opportunities, this amount would be much bigger. If these operating costs would've grown at the same rate as revenues (which is still pretty high), operating margins would've been 14.2% and free cash flows around $60 bln for 2019.

(Source: author based on company disclosures. 2019 are estimates. Leasing is excluded in FCF calculations)

It's these current thin margins which make Amazon very interesting in my opinion. Amazon could easily triple its margins while increasing revenues by a CAGR of 20% over the coming years. If that happens, Amazon will increase in value significantly. Furthermore, Amazon Web Services will keep growing significantly as the public cloud market is expected to grow at a CAGR of 20%+ over the coming five years. The stock did not make the list of 3 stocks to buy to outperform a bear market as it has a very high beta (1.51) which makes the stock vulnerable to a market downturn. Anyway, I believe the company can be quite resilient to a recession and is undervalued compared to other FAANG stocks. Amazon should be able to maintain its long-term growth path.

This article was written by

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Disclosure: I am/we are long GILD, ULTA, GLPG. 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.

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