Swing Only At The Best Pitches

9/18/2017


Warren Buffett likes to say that investors need not swing at every pitch or fear that an umpire will call them out on strikes. Wait for a pitch to enter your sweet spot or "circle of competence," he says.

That philosophy helps explain our concentrated portfolios. Our Focus List contains just 15 stocks and just 33 stocks in all are recommended as Buys or Long-Term Buys.

Some stocks are better than others, but none are perfect. With that in mind, our investing strategy involves identifying stocks with strong growth prospects that also offer attractive valuations. Our investment process starts with a quantitative screen, followed by fundamental analysis. Finally, we review a company's qualitative factors, such as business prospects and strategic advantages over rivals.

We typically require our stocks to have a market value above $5 billion, and most exceed $10 billion. That alone leaves less than half of stocks in the S&P 1500 Index as possible candidates. We also demand strong Quadrix scores, preferably an Overall rank of 90 or higher. In doing so, we eliminate all but a small set of stocks. From that group, fewer than 40 stocks score at least 50 for Value and are also not currently recommended.

That leaves an obvious question: Why don't these stocks make the cut? Usually for some combination of the following:

• We like rivals better and don't want too much exposure in the same space.

• We have concerns about earnings quality, such as net income exceeding operating cash flow.

• We are cautious about the industry's outlook or tend to stay away altogether. For example, we typically avoid reinsurance stocks, which often score well in Quadrix and usually generate steady operating growth — until disaster strikes.

• Weakness in key metrics (falling profit margins, cash flow, or analyst estimates) overrides the stock's other merits.

Stocks in the table below hover in the corners of our strike zone, but we're keeping the bat on our shoulder for now. We review three of them in more detail below. 

Everest Re Group ($233; RE) and its rival reinsurers take on the risk of some policies sold by other insurers. About 70% of Everest's business is reinsurance, about 30% primary insurance. Strong operating momentum has benefited from relatively light catastrophic losses in recent years. For the 12 months ended June, Everest grew per-share profits 63%.

But reinsurers can fool Quadrix by delivering steady profit growth until a disaster strikes. One of the largest reinsurers in Florida, Everest's profits will likely take a hit from damage caused by Hurricane Irma. Still, the stock looks cheap, trading at nine times trailing earnings, below its 10-year average of 11 and industry median of 13 for S&P 1500 reinsurers. Yet it's not cheap enough for us to accept the risks that come with an inherently unpredictable business model. We do not monitor this stock.


As the largest pharmacy-benefits manager, Express Scripts ($63; ESRX) enjoys pricing power from its massive scale. The combination of rising drug prices and aging baby boomers should bode well for Express Scripts' long-term growth.

However, its business model has come under attack as escalating drug prices face scrutiny, and generic drug prices are under pressure. Express Scripts has also warned that its biggest customer, Anthem ($190; ANTM), is unlikely to renew its contract ending in 2019. Even if Express Scripts salvages the relationship, management concedes that any new contract with Anthem would feature far less favorable terms. Anthem accounts for about 19% of Express Scripts' revenue.

Earning a Value rank of 99, Express Scripts trades at just nine times trailing earnings, below its 10-year average of 22 and S&P 1500 health-care sector's median of 23. Uncertainty over the future of Express Scripts' business outweighs the discount valuation. Express Scripts is rated B (average).


With an Overall score of 99, Magna International ($49; MGA) receives above-average ranks in all six Quadrix categories, including Value (98) and Earnings Estimates (96). Magna builds automotive systems for most major car manufacturers. Although Magna is a well-run company, we remain concerned about expsoure to the U.S. automotive industry, which has posted lower sales in each of the first eight months of 2017. U.S. auto sales could get a temporary boost, as Hurricane Harvey damaged an estimated 500,000 to 1 million vehicles in Houston.

For the 12 months ended June, Magna grew per-share profits 17%, revenue 7%, and operating cash flow 29%. Profit estimates are rising, with the consensus anticipating 2% profit growth in the September quarter and 17% growth in the December quarter. We may consider upgrading the stock if it drops down into the range of $40 to $43. For now, we prefer fellow auto-parts supplier Lear ($157; LEA), rated a Focus List Buy and a Long-Term Buy. Magna is rated A (above average).

NEAR MISSES
The 20 large-cap stocks below narrowly miss making the cut for joining the ranks of our recommended stocks.
Stock-
Market
Value
($Bil.)
Div.
Yield
(%)
--- 12-Month Change ---
Est. EPS
Change,
Curr. Yr.
(%)
--- P/E Ratio ---
Quadrix Scores
Company (Price; Ticker)
EPS
(%)
Sales
(%)
Operating
Cash Flow
(%)
Trailing
Curr.
Year
Value
Overall
Industry
Allstate ($91; ALL)
33.6
1.6
73
4
8
29
14
15
86
97
Ppty. & casualty
insurance
Postives: Strong growth prospects, cheap versus peers. Negatives: Business can fool Quadrix by offering steady profit growth until disaster hits.
Bank of America
($24; BAC)
263.3
2.0
24
4
NA
21
14
13
84
89
Diversified banks
Positives: Cheap versus history and peers. Negatives: Prefer other, faster-growing banks.
Best Buy ($59; BBY)
18.2
2.3
35
1
(15)
14
15
14
83
96
Computer retail
Positives: Rising profit estimates, expanding profit margins. Negatives: Retail outlook cloudy, recent results disappointing, weak cash flow.
Biogen Idec
($324; BIIB)
68.8
0.0
0
4
2
6
16
15
69
94
Biotechnology
Positives: Rising profit estimates, cheap versus peers and history. Negatives: Pipeline concerns, sluggish operating momentum, falling profit margins, cash provided by operations (CPO) less than net income.
Boeing ($242; BA)
147.2
2.4
17
(6)
25
38
23
24
43
90
Aerospace
& defense
Positives: Strong cash-flow trends, rising profit estimates. Negatives: No longer cheap after rally.
CBRE Group ($37; CBG)
12.8
0.0
21
7
(3)
12
15
15
82
94
Real estate
services
Positives: Cheap, solid sales growth. Negatives: Declining cash flow, CPO less than net Income.
Dollar Tree
($84; DLTR)
20.0
0.0
28
4
11
25
21
18
83
98
General
merchandise
Positives: Rising profit estimates, strong cash flow. Negatives: Expensive versus peers, falling profit margins.
Energy Transfer
Equity ($18; ETE)
20.3
6.4
39
20
1
(31)
9
10
88
92
Oil & gas storage
Positives: Surging profit estimates, quite cheap, high dividend yield. Negatives: Falling profit margins, negative free cash flow.
Everest Re Group
($233; RE)
9.5
2.1
63
11
3
(17)
9
12
88
95
Reinsurance
Positives: Strong sales growth, cheap versus peers. Negatives: Business can fool Quadrix by offering steady profit growth until disaster hits.
Express Scripts
($63; ESRX)
37.0
0.0
17
(1)
20
9
9
9
99
98
Health-care
services
Positives: Exceptionally cheap. Negatives: Lack confidence in business model.
Intel ($36; INTC)
176.0
3.0
15
9
18
10
12
12
88
97
Semiconductors
Positives: Strong operating growth, rising profit estimates, cheap. Negatives: Sluggish share-price action, cloudy long-term outlook.
KLA-Tencor
($97; KLAC)
15.3
2.4
28
17
42
13
16
14
78
93
Semiconductor
equipment
Positives: Cheap, strong sales and cash-flow growth. Negatives: Prefer semiconductor-equipment rivals AMAT & LRCX.
LyondellBasel
($94; LYB)
37.9
3.8
2
8
(4)
8
10
9
90
93
Commodity
chemicals
Positives: Cheap, attractive yield. Negatives: Declining cash flow, contracting margins.
Magna International
($49; MGA)
18.7
2.2 e
17
7
29
13
9
8
98
99
Auto parts &
equipment
Positives: Great company, could add if stock falls to $40 to $43. Negatives: Concerned about auto market.
Micron Technology
($35; MU)
40.7
0.0
655
36
77
7,731
12
7
87
100
Semiconductors
Positives: Outstanding operating growth, rising profit estimates, cheap. Negatives: Very cyclical business, prefer rivals.
NetApp ($40; NTAP)
11.2
2.0
51
1
(6)
13
14
13
86
92
Tech hardware
Positives: Rising profit estimates, strong growth prospects. Negatives: Soft operating momentum, not cheap versus peers.
Raymond James Fin'l
($78; RJF)
11.5
1.1
47
16
183
31
16
16
85
97
Investment
banking
Positives: Strong sales and growth prospects, rising profit margins. Negatives: Not cheap versus peers or history.
Skyworks Solutions
($107; SWKS)
19.9
1.2
13
5
72
15
17
17
62
97
Semiconductors
Positives: Surging cash flow, cheap versus history and peers. Negatives: Prefer other Apple suppliers.
United Rentals
($129; URI)
11.0
0.0
15
3
3
15
14
13
87
97
Trading
companies
Positives: Robust growth prospects, cheap versus peers and history. Negatives: Weak profit margins, volatile stock due to energy exposure.
UnitedHealth Group
($198; UNH)
195.3
1.5
30
9
40
22
22
20
50
88
Managed
health care
Positives: Great company, close to upgrading. Negatives: Very expensive versus history.
Note: Quadrix scores are percentile ranks, with 100 the best.   NA because banks do not report cash flow.     e Dividend yield estimated.

 


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