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My Watch List – September 21, 2010

|Includes: BRK.B, CI, COL, CPSI, LH, LMT, LNCR, MKL, Orbital ATK, Inc. (OA), TECH, UNH, USB

I have reviewed issue 4 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

The valuations are very simplistic, although the basic conceptual framework is sound. Over time, an asset should deliver a total return equal to the sum of its current free cash flow yield and its growth rate (assuming that growth rate continue over the long-term).

The valuations attempt to calculate the annualized return that is discounted in a stock’s current price. The first component of the valuation is the company’s earnings yield based on the consensus estimate for this year’s earnings. This may overstate or understate the true free cash flow yield depending on a number of factors, primarily the company’s level of depreciation and amortization and its level of capital expenditures. Ideally, it makes more sense to look at the ratio of EBIT (EBITDA – maintenance capex) to enterprise value in order to compare businesses, so as to normalize earnings and the capital structure. See Greenblatt’s book The Little Book that Beats the Market for more details.

Nevertheless, the earnings yield is easy to calculate and, since we’re looking for stocks that are compellingly (obviously) undervalued, it should serve as a useful screen so we can focus our time on stocks with the greatest potential.

The second component of the valuation is the growth rate. Here I take 60% of the growth rate over the past ten years. The use of 60% is an attempt to be conservative. Caution: even taking 60% of the past growth rate can grossly overstate the future growth prospects of a business. The primary idea here is that you want to determine if the factors that led to the past growth are still in place, and, if so, how much growth potential is left. If you can’t figure it out, you can’t value the stock, at least not its future growth prospects. It still may be worth considering if the stock is so undervalued that it is cheap even if you factor in zero growth going forward.

I’ve added the following stock this week:

Alliant Techsystems Inc. (ATK)

Rockwell Collins, Inc. (NYSE:COL)

Lockheed Martin Corporation (NYSE:LMT)

Markel Corporation (NYSE:MKL)

Berkshire Hathaway Inc. (NYSE:BRK.B)

Fairfax Financial Holdings Limited (OTCPK:FRFHF)

U.S. Bancorp (NYSE:USB)

CIGNA Corporation (NYSE:CI)

Laboratory Corp. of America Holdings (NYSE:LH)

Lincare Holdings Inc. (NASDAQ:LNCR)

UnitedHealth Group Inc. (NYSE:UNH)

Computer Programs & Systems, Inc. (NASDAQ:CPSI)

Techne Corporation (NASDAQ:TECH)

Here’s the updated Watch List for September 21, 2010.

Tip: Don’t forget to utilize the link to GuruFocus in column U. It’s a quick way to see who is buying a stock.


Disclosure: Long MKL, BRK.B, FRFHF, USB