By: Chuck Carnevale, F.A.S.T. Graphs, Inc.
Positioning Statements and Principles
We don’t believe in investing in the stock market. Instead, we believe in investing in great businesses. Therefore, we tend to focus more on how the business is performing on an operating basis than we do on stock price volatility. In other words, we are most interested in whether or not the company is generating growth in earnings and cash flows and thereby increasing their intrinsic value. True Worth™ valuation is what we monitor and measure most closely.
Our rationale is based on the reality that any business, public or private, ultimately derives its value from the amount of cash flows and earnings it can generate for stakeholders. Investors, true investors, buy income streams when they invest. The bigger the income stream they can buy, the bigger the value they will eventually receive. Consequently, the faster a company is capable of growing their business, the more valuable they are to their stakeholders. To us, this is only common sense.
In this same vein, any income stream has a value greater than one. In other words, when purchasing a future stream of income the investor is required to pay a multiple to buy it. Therefore, even a fixed income vehicle like a Bond or CD will command a multiple based on its yield, even with no growth. For example, a 10% bond would be selling at a price to interest ratio of 10 (100/10% = 10). An 8% bond would be selling at a price to interest ratio of 12.5 (100/8% = 12.5). And currently, the 30-year 3.55% Treasury Bond is selling at a price to interest ratio of 28 (100/3.55% = 28.16), again, even though it offers no growth of income.
Therefore, we logically conclude from the above paragraph that a growing income stream should be worth more than a fixed or non-growing income stream. Again, this is based on our principal that a bigger income stream is worth more than a smaller one. Of course, risk would also come into play on the notion that a bird in the hand is worth more than two in the bush. However, our main point is that the actual yield that an income stream provides the investor is where its ultimate value comes from.
We believe that what we have said thus far represents the key to understanding Ben Graham’s famous voting machine vs weighing machine metaphor. In the short run (the voting part), stocks will be priced in an auction market based on the supply and demand of buy and sell orders. These short run periods of time are most often dominated by the emotions of fear or greed. Consequently, the common stocks representing the underlying businesses can rise or fall regardless of their income generating potential. However, we also agree with Mr. Graham that in the long run the weight or the cash flows and earnings of the business, will become manifest. But we also acknowledge that the precise timing of when this would occur is unknown.
The most important takeaway from what has been written so far is the inevitability that True Worth™ valuation will and must come to fruition. The voting machine market, which is often quite irrational, can remain that way for some time. However, eventually the true investor can be assured that the real value of the business based on the weight of its operating success will become a reality. We believe this statement to be true whether the market is over-pricing or under-pricing a business at any given moment in time. Eventually, the company’s stock price will rise or fall and become aligned with its True Worth™ value based on its earnings and cash flows.
8 Strong Growth Stocks Significantly Under-valued by Mr. Market
The following table lists eight companies whose past, present and future business results warrant much higher prices than the market is currently applying to them based on their earnings and cash flows. Each of these companies possesses above-average historical operating records and each are expected to continue to grow at above-average rates in the future. When you understand that a normal price earnings ratio for an average company has been 15 over the last 150 years, the single-digit price earnings ratios applied to these eight above-average companies immediately becomes ludicrous.
Most importantly, our contention that these stocks are undervalued is not based on esoteric statistical inferences. Our valuation model is based on the factual earnings yields and fundamental strengths of each of the companies on this list. From the table below you will discover that most of this group has very low levels of debt and historical normal valuations that are significantly greater than what they are today. The only way these valuations would make any sense, is to assume that each of these companies is perilously close to going out of business.
Yet, as we will develop further later in the article, nothing could be farther from the truth. These companies are healthy and strong companies with bright futures and growing income streams. Consequently, we consider it a conservative assumption and a realistic forecast to state emphatically that each of these companies should command an average PE ratio of 15 as a bare minimum. Therefore, because they are at such low valuations, we believe the rewards from owning these companies over the next 3 to 5 years are potentially extraordinary, and the risks relatively low.
To better understand our position we would ask the reader to focus on the five columns following each company’s name and stock symbol on the table below. For perspective, note that the historical earnings per share growth rate of the S&P 500 over that same 11-year (10 years eight months) time frame has been 5.3% per annum. The historical EPS growth rate of each of these eight companies has been significantly above that average. But perhaps even more importantly, the consensus of leading analysts forecast of earnings growth over the next five years is also above average.
Consequently, the five-year estimated potential annual total return for each is enormous. Finally, the single-digit PE ratio the market is currently applying to these companies in contrast to their historical normal PE ratio simply makes no economic sense. Based on the strength, and therefore, value of their cash flow and earnings generation capabilities, these companies represent a classic case of a market gone mad, at least in our humble opinion. In other words, the fundamental value of these businesses is clearly greater than their current market value.
8 Under-valued Companies Through the Lens of F.A.S.T. Graphs™
The following F.A.S.T. Graphs™ provide graphic evidence of the fundamental strengths of each of these companies. The historical earnings and price correlated graphs vividly illustrate how the fundamentals have remained strong (the orange earnings line) while the stock price (black line) has fallen.
The performance table associated with each graph illustrates each company’s superior shareholder returns even considering their current undervaluation. Finally, the estimated earnings and return calculator (forecasting graph) illustrates the value these above-average companies should be trading at if the market was pricing them at a normal (average) PE ratio. NOTE: The red circle shows current market price, and the red arrow points to fair value.
Chevron Inc. (CVX)
Chevron (CVX) is the world’s fourth-largest oil company based on reserves. They are financially very strong with little debt and strong cash flow generation. The opportunity to invest in such a high-quality company at such a low valuation is rare.
Chevron (CVX) has a superior track record as compared to the S&P 500 since calendar year 2001. Also, they’ve increased their dividend every year which caused the return to shareholders to exceed double-digits at a time when the average company would have lost shareholder money.
The consensus of 15 leading analysts reporting to Zacks expects Chevron Corp. to continue to grow earnings over the next five years at 18% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PEG PE ratio of 18.
Aflac Inc. (AFL)
Aflac (AFL) is the world’s largest underwriter of supplemental cancer insurance. Since Aflac generates approximately 75% of their revenues and profits in Japan, the recent catastrophe caused their stock price to fall to today’s historically low valuation. Nevertheless, Aflac (AFL) continues to generate solid operating performance and earlier this year dramatically reduced the risk of its portfolio. We believe the only thing truly wrong with this strong insurer is their unreasonably low stock price.
Aflac’s track record has been better than the S&P 500 even though their valuation is so low today. Note their strong dividend record where they raised their dividends in both the recessions of 2001 and 2008.
The consensus of 17 leading analysts reporting to Capital IQ expects Aflac to continue to grow earnings over the next five years at 10% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
Research In Motion LTD (RIMM)
We believe that Research In Motion represents one of the most bizarre and ludicrous valuations of a publicly-traded company that we have ever seen. This maker of the Blackberry smartphone has one of the most outstanding records of earnings growth ever created. However, competition from the Apple iPhone’s, Google’s android and others has created a selloff in their shares that we believe is ridiculous. What is being missed is the fact that the company continues to generate solid growth irrespective of what their competitors are doing.
In other words, if you took Research In Motion’s numbers and applied them to any other company in any other industry their stock would more than likely be trading at nearly 3 times its current value. The company has no debt and generates extremely strong cash flows. Their returns on equity and capital are both over 25% per annum and expected to continue to grow in the future.
Even with a valuation of less than six times earnings, Research In Motion’s shareholders have been rewarded far in excess of the S&P 500. The company pays no dividend, and it carries an A+ financial rating from Value Line. Therefore, we believe their current low valuation is more about hysteria than fundamental value.
The consensus of 47 leading analysts reporting to Capital IQ expects Research In Motion Ltd. to continue to grow earnings over the next five years at 12.6% per annum. In this example, earnings are expected to be down for the current fiscal year before rising again. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
Best Buy Inc. (BBY)
Best Buy is a leading seller of consumer electronics, personal computers, software and appliances. They experienced a modest drop in earnings during the recession of 2008. Since that time earnings have rebounded while the stock price remains at a significantly low valuation. The company has very little debt and generates strong cash flows.
Although Best Buy has outperformed the S&P 500 since calendar year 2001, a high starting valuation and a low current valuation have caused shareholder returns to be lower than fundamentals justify. Conversely, the current low valuation and the abnormally high current dividend yield hold the promise for better results going forward. Note that Best Buy has increased their dividend every year since they instituted one in 2003.
The consensus of 26 leading analysts reporting to Capital IQ expects Best Buy Co. Inc. to continue to grow earnings over the next five years at 10% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
Teva Pharmaceutical Industries (TEVA)
Based in Israel, Teva is a leading global pharmaceutical company that markets generic and branded drugs. Fears over competition to their core drug Copaxone for treating multiple sclerosis has instigated a sharp selloff in their stock. Their recent acquisition of Cephalon and the purchase of a majority stake in Taiyo, a Japanese generic drug maker, should offset the potential slowdown in Copaxone. Nevertheless, this company continues to grow their earnings only to see their stock price trading at a single-digit PE ratio.
Even with their current valuation so low, Teva has rewarded their shareholders far in excess of the S&P 500. Strong earnings growth has also resulted in strong double-digit dividend growth. With very little debt on the balance sheet and strong cash flow generation, coupled with Teva’s well-defined growth strategy should enable this record of dividend growth to continue.
The consensus of 22 leading analysts reporting to Capital IQ expects Teva Pharmaceuticals Inc. to continue to grow earnings over the next five years at 10.3% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
L3 Communications Holdings Inc. (LLL)
L3 Communications is a leading supplier of communications systems and defense electronics with a strong focus in homeland security. Fears of cuts in defense spending had driven this quality company’s valuation to an absurdly low level in our opinion. We believe this is a quality company with a very bright long-term future that the market is ruefully mispricing.
L3 Communications has generated shareholder returns far in excess of the S&P 500 since calendar year 2001. Since they instituted a dividend in calendar year 2004, it has grown at a very rapid rate every year. Their low payout ratio and superior cash flow generation leaves plenty of room for dividend increases to continue in the future.
The consensus of 15 leading analysts reporting to Zacks expects L-3 Communications Holdings Inc. to continue to grow earnings over the next five years at 8.3% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
ITT Educational Services Inc. (ESI)
ITT Educational Services Inc. has one of the strongest records of consistent earnings growth of any company you could examine. Although they are a for-profit educational company, we believe they distinguish themselves by offering educations in areas that provide their students employable skills. For example they offer curriculums in information technology, electronic technology, CAD (computer aided design), nursing and many others.
When the Department of Education announced that there were reviewing their “gainful employment” rule, the entire for-profit educational industry experienced sharp drops in their stock prices. However, the Department of Education’s recent softening on that position augers well for the future.
Due to the superior earnings record of ITT Educational Services Inc., their shareholders have enjoyed returns significantly above the average company as measured by the S&P 500. It’s important to note that this success was achieved even considering that the stock now trades at a ridiculously low valuation of less than seven times earnings
The consensus of 22 leading analysts reporting to Capital IQ expects ITT Educational Services Inc. to continue to grow earnings over the next five years at 15% per annum. The red circle shows what their current stock price is, and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15. In this example, the arrow points to earnings by year-end 2012, because expectations are for earnings to fall in 2011 and 2012 before advancing again. Nevertheless, it is anticipated that the company will remain very profitable in both of these years.
Gamestop Corp (GME)
Gamestop is a leading specialty retailer of new and used video games, hardware, software and accessories throughout the world. Their recent emphasis on the digital gaming platform has been bearing fruit and is generating compound annual growth of over 50% per annum. Recent acquisitions have strengthened their digital platform. Also, their traditional business continues to grow. Nevertheless, this company, with solid earnings growth, powerful cash flow generation and low debt, finds its stock trading at a single-digit PE ratio.
Even with valuation sitting at an all-time low, Gamestop’s shareholders have been rewarded with a rate of return significantly greater than the average company as measured by the S&P 500. The company pays no dividends but does offer an attractive risk reward ratio at today’s levels. Long-term capital appreciation potential is high and risk is mitigated by its low valuation.
The consensus of 10 leading analysts reporting to Capital IQ expects Gamestop Corp. to continue to grow earnings over the next five years at 10% per annum. The red circle shows what their current stock price is and the red arrow points to what it should be if the market was pricing it at a normal PE ratio of 15.
Summary and Conclusions
To get the most out of this article, you have to be willing to accept the undeniable fact that the market price and the intrinsic value of a publicly-traded company can be materially out of alignment. In other words, the stock market can often grossly miss-appraise the true value of a stock. In the late 1990s, the market grossly overpriced most companies with a special emphasis on technology stocks. We believe that today’s market represents, in essence a mirror image, or extreme undervaluation of many stocks in different sectors.
But most importantly, nothing that we have written is based on statistical inferences or measurements. Instead, our thesis is based on mathematical calculations supported by undeniable principles of business economics and accounting. The valuations that the market is currently applying on the eight companies in this article are extreme and illogical based on the strength and size of the cash flows, earnings and other fundamentals supporting higher valuations.
In a recent interview on CNBC, renowned portfolio manager Ron Baron forecast that future stock market returns should be extraordinary. This is in stark contrast to what has occurred over the past decade or so. His primary reasoning was based on valuation. Over the last 10 to 12 years, the stock market in general and many stocks individually were being grossly overpriced by the marketplace. Because of this overvaluation, the outcome was inevitable and shareholders experienced poor returns as a result.
Today, the situation is exactly the opposite. The eight stocks covered in this article represent glaring examples of extremely high quality companies with ridiculously low valuations. There is not one company on this list that should not be trading at the very least at a market multiple of 15 times earnings. We believe this based on our contention that True Worth valuation ™ must and therefore will eventually manifest. It requires patience and the understanding of where a business truly derives its value from.
Disclosure: Long CVX, AFL, RIMM, BBY, TEVA, LLL, ESI, GME at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.