Recap from March Picks
Our Most Attractive Stocks (+0.6%) outperformed the S&P 500 (-1.0%) last month. Most Attractive Large Cap stock Lam Research Corp (LRCX) gained 8%. Most Attractive Small Cap stock Maui Land & Pineapple (MLP) was up 30%. Overall, 17 out of the 40 Most Attractive stocks outperformed the S&P 500 in March.
Our Most Dangerous Stocks (-2.2%) outperformed the S&P 500 (-1.0%) last month. Most Dangerous Large Cap stock Vornado Realty Trust (VNO) fell by 7% and Most Dangerous Small Cap Stock IDT Corporation (IDT) fell by 38%. Overall, 13 out of the 40 Most Dangerous stocks outperformed the S&P 500 in March and 15 had negative returns.
The successes of the Most Attractive and Most Dangerous stocks highlight the value of our robo-analyst technology, which helps clients fulfill the fiduciary duty of care when making investment recommendations.
15 new stocks make our Most Attractive list this month and 27 new stocks fall onto the Most Dangerous list this month. April’s Most Attractive and Most Dangerous stocks were made available to members on 4/5/17.
Our Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for April: The Cheesecake Factory (CAKE: $63/share)
The Cheesecake Factory (CAKE) is one of the additions to our Most Attractive stocks for April.
Since 2008, Cheesecake Factory has grown after-tax profit (NOPAT) by 9% compounded annually. Per Figure 1, Cheesecake Factory has also improved its NOPAT margin from 6% in 2008 to 8% in 2016.
Figure 1: Cheesecake Factory’s Improving NOPAT Since 2008
Sources: New Constructs, LLC and company filings
Cheesecake Factory currently earns an 11% return on invested capital (ROIC), which is up from 6% in 2008. Furthermore, Cheesecake Factory has generated a cumulative $564 million (19% of market cap) in free cash flow over the past five years.
CAKE Valuation Holds Significant Upside Potential
The market has rewarded CAKE for its consistent profit growth and the stock is up 21% over the past year while the S&P is up just 14%. However, CAKE remains undervalued. At its current price of $63/share, Cheesecake Factory has a price-to-economic book value (PEBV) ratio of 1.1. This ratio means the market expects Cheesecake Factory’s profits to grow by no more than 10% over the remainder of its corporate life. This expectation seems rather pessimistic for a company that has grown NOPAT by 9% compounded annually since 2008.
If Cheesecake Factory can maintain 2016 NOPAT margins (8%) and grow NOPAT by just 6% compounded annually for the next decade, the stock is worth $88/share today – a 40% upside.
Impacts of Footnotes Adjustments and Forensic Accounting
Our robo-analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill the fiduciary duty of care. In order to derive the true recurring cash flows, an accurate invested capital, and an accurate shareholder value, we made the following adjustments to The Cheesecake Factory’s 2016 10-K:
Income Statement: we made $59 million of adjustments, with a net effect of removing $35 million in non-operating expense (2% of revenue). We removed $12 million in non-operating income and $47 million in non-operating expenses. You can see all the adjustments made to CAKE’s income statement here.
Balance Sheet: we made $831 million of adjustments to calculate invested capital with a net increase of $733 million. One of the largest adjustments was $745 million due to operating leases. This adjustment represented 81% of reported net assets. You can see all the adjustments made to CAKE’s balance sheet here.
Valuation: we made $962 million of adjustments with a net effect of decreasing shareholder value by $962 million. There were no adjustments that increased shareholder value. Apart from total debt, which includes the $745 million in operating leases noted above, the largest adjustment to shareholder value was $82 million in net deferred tax liabilities. This adjustment represents 3% of CAKE’s market cap. Despite decreasing shareholder value, CAKE remains undervalued.
Most Dangerous Stocks Feature: The Andersons, Inc. (ANDE: $38/share)
The Anderson’s (ANDE) is one of the additions to our Most Dangerous stocks for April.
The Andersons’ economic earnings, the true cash flows of the business, have declined from $39 million in 2011 to -$69 million in 2016, per Figure 1. The firm’s NOPAT margins fell from 2% to below 1% over the same time.
Figure 2: The Andersons’ Deteriorating Economic Earnings
Sources: New Constructs, LLC and company filings
The Andersons’ ROIC has fallen from 9% in 2011 to a bottom-quintile 2% in 2016. Worse yet, The Anderson’s burned through $69 million (7% of market cap) in FCF in 2016 and a cumulative $11 million (1% of market cap) in FCF over the past five years.
ANDE Is Priced to Perfection
ANDE is up 22% over the past year while the S&P is up just 14%. This price appreciation amidst deteriorating fundamentals makes ANDE significantly overvalued. To justify its current price of $38/share, ANDE must grow NOPAT by 13% compounded annually for the next 11 years. This scenario seems overly optimistic given The Andersons’ NOPAT has declined by 22% compounded annually since 2011.
Even if ANDE can grow NOPAT at a more reasonable, yet still optimistic, 8% compounded annually for the next decade, the stock is worth $13/share today – a 66% downside.
Each of these scenarios assumes The Anderson’s is able to grow revenue and NOPAT/free cash flow without spending on working capital or fixed assets. This assumption is unlikely but allows us to create very optimistic scenarios that demonstrate how high expectations in the current valuation are. For reference ANDE’s invested capital has grown on average $101 million (3% of 2016 revenue) per year over the last five years.
Impacts of Footnotes Adjustments and Forensic Accounting
Our robo-analyst technology enables us to perform forensic accounting with scale and provide the research needed to fulfill the fiduciary duty of care. In order to derive the true recurring cash flows, an accurate invested capital, and an accurate shareholder value, we made the following adjustments to The Andersons’ 2016 10-K:
Income Statement: we made $74 million of adjustments, with a net effect of removing $20 million in non-operating expense (1% of revenue). We removed $27 million in non-operating income and $47 million in non-operating expenses. You can see all the adjustments made to ANDE’s income statement here.
Balance Sheet: we made $251 million of adjustments to calculate invested capital with a net increase of $241 million. One of the largest adjustments was $104 million due to asset write-downs. This adjustment represented 7% of reported net assets. You can see all the adjustments made to ANDE’s balance sheet here.
Valuation: we made $768 million of adjustments with a net effect of decreasing shareholder value by $768 million. There were no adjustments that increased shareholder value. One of the largest adjustments to shareholder value was $182 million in deferred tax liabilities. This adjustment represents 17% of ANDE’s market cap.
This article originally published on April 11, 2017.
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.
Article by Kyle Guske II, New Constructs
