Offering a Two-Tiered Approach

It has been a volatile start to December even though the S&P 500 is still within 1% of the all-time high that it set the day before Thanksgiving.

The uncertainty over whether the scheduled increases in tariffs will be put into effect on Dec. 15 is the near-term cause for the uneven markets, and it is possible that we will have a “Santa Claus” rally if the increases are postponed. However, I do expect the stock market at the start of 2020 to consider if investors should really expect the forecast near-10% increase in S&P 500 earnings next year, given that earnings are expected to decline by 1% in the fourth quarter and also slightly decline for all of 2019. Given this uncertainty, I would not be surprised to see the current volatility continue into the start of  2020.

I will have more regarding my outlook for 2020 and my strategy for the year in next month’s issue. For now, as you probably have noticed, I have already made a lot of recent changes that I believe will position us well for the new year.

Our buy list consists of a lot of high dividend payers, with six of the eight stocks on the list yielding more than 3%. This should give us some downside protection should the market correct to start the year.

However, these stocks are not purely defensive in nature. The two stocks that we added over the past week, Chevron (CVX) and MSC Industrial Direct (MSM), should also benefit if the global industrial economy starts to recover. The same is also true of Genuine Parts (GPC). Meanwhile, higher interest rates from a stronger economy should help Valley National (VLY).

When we mix these companies with a more defensive name like General Mills (GIS), I think that we will have a perfect balance of stocks to start the new year that should do well in most market environments.

Chevron: Making the Most of a Tough Situation

It has been a hard time for the energy industry ever since the price of oil started to collapse from close to $100 a barrel in late 2014 after OPEC could not reach its production limits. The core issue for them was that the supply of oil that was coming from the emerging North American shale oil exploration sector was growing.

Chevron (CVX) suffered with the industry and was unable to match the peak earnings per share (EPS) of $13.44 that it set in 2011. However, CVX has remained solidly profitable thanks to its financial and operational stability. Furthermore, the company should be poised to start growing its earnings from the forecast EPS of $6.40 this year if oil prices remain stable, with potential upside if the supply of oil starts to tighten and oil prices increase.

Chevron has a strong and diversified portfolio of oil-producing properties as the company operates on every continent. Its size also gives the company the advantage of scale. The company is an integrated oil company, with refining, marketing and chemical operations in addition to oil and natural gas development and exploration. However, oil and natural gas production has been the bulk of the company’s business, contributing 75-85% of the company’s operating income in recent years.

Recent operating statistics attest to the strength of the company’s asset base. From 2016 through 2018, the company has increased its oil reserves by 11% and its natural gas reserves by 10%. It has accomplished this while keeping capital expenditures well below its depreciation expenses. This has given the company a strong free cash flow that is being used to pay down its $13 billion in debt and to maintain its healthy dividend. The rise in financial reserves will help allow Chevron to grow its production by 3-4% annually through 2023, largely through growth in the Permian Basin area of Texas and New Mexico. In recent years, the company has doubled the portfolio value of its investments in this area.

With production set to increase and costs under control, earnings are set to rise through 2023 should the price of Brent Crude, currently at $63, stay above $60. EPS should improve from an expected $6.40 this year to $6.90 next year.

At the same time, the fact is that oil prices are hard to predict and there were no agreed production cuts at the OPEC meeting last week. However, provided that global economies stay stable and perhaps improve through the passage of a trade agreement, I believe there is a bias towards prices heading higher, with the rate of production growth in the United States possibly starting to slow.

In summary, CVX is a quality operator with a strong worldwide asset base and should realize good production growth over the next few years. The company has good financial discipline, as evidenced by its decision to walk away from purchasing Anadarko Petroleum for $50 billion when Occidental Petroleum (OXY) made a higher offer. Finally, the company has a very strong balance sheet, with its interest charges covered over 20X last quarter.

The strength of Chevron’s financial position should add stability to the company’s earnings and stock price should the oil market weaken. CVX is a buy under $119. My target is $130.

MSC Industrial Direct: As Solid as They Come

You may have never heard of MSC Industrial Direct (MSM), but it is not the new kid on the block. In fact, it has been in business for 75 years and has a market capitalization of $4 billion.

The company is a leading North American distributor of metalworking and maintenance, repair and operations (MRO) products and services. Metalworking is the process of working with metals to create individual parts, assemblies or large-scale structures and is used in a wide range of industrial end markets. The company also offers approximately 1.7 million active, saleable, stock-keeping units (SKUs) through its eCommerce channels and traditional marketing channels such as catalogs and call centers.

The company seeks to differentiate itself from other companies through the value-added services that MSC offers its customers in order to save money and improve productivity. Depending on the customer’s size and needs, MSC customizes its options to address the complexity of the company’s processes, as well as specific products, technical issues and cost targets. It accomplishes this through using modern processes such as big data and analytics to help its customers gain insight into their practices and take most of the costs out of their supply chain operations.

After years of steady results, the company’s EPS fell in the August 2019 fiscal year. Sales were up 5% to $3.36 billion, with acquisitions accounting for the bulk of the gains. Sales increased a little over 1% on an organic basis, mostly due to price increases. Margins narrowed due to an increase in the cost of metal as well as higher wage and freight costs. EPS declined to $5.20 from $5.80 a share.

On the fourth-quarter conference call, the company indicated that all end markets, except for aerospace, were weakening. This softening of demand, which is in line with the weakness that we have seen in the Institute of Supply Management’s (ISM) monthly reports, will cause a further decline in EPS during the August 2020 fiscal year. This time, EPS is expected to decline to $5.00.

I still believe that the stock is an outstanding value at 14.5X the $5.00 EPS estimate for the August 2020 fiscal year. Since fixed expenses, such as depreciation and interest payments, are a relatively low percentage of the company’s revenue, this will help the company keep its earnings relatively stable in the current downturn.

Another great defensive characteristic of the company is its strong free cash flow generation, which has equaled almost 100% of its net income in recent years. This allows the company to pay a healthy dividend, with a current yield of 4.15%, and engage in share buybacks, with the company lowering its average share count by 2% last year.

If the consumer economy remains strong, the industrial sector will pick up at some point. With employment growth still chugging along, manufacturing should come back. This will be a major catalyst for the share price. Buy MSM under $76. My target is $85.

Position Review

A rally in Cognizant Technology Services (CTSH) was halted by an analyst report which stated that the company was suffering from high turnover in its consulting staff, which produces a good deal of revenue for the company, as a result of the company’s effort to control its costs. While this may be the case, I do not view this as a threat to the company’s plans to reaccelerate earnings growth over the long term. However, I expect the company to be cautious with its cuts and not cut back on areas that will drive future growth. Trading at just 15.5X next year’s EPS with growth likely to reaccelerate next year, the stock is very attractively valued. Buy CTSH under $65. My target is $79.

General Mills (GIS) will report fiscal second-quarter earnings before the market opens on Dec. 18. Expectations are for EPS of $0.88 vs. $0.85 on flat revenues of $4.4 billion. The key for the stock’s reaction to the results will be whether GIS can return to unit growth after a disappointing first quarter. The management remains positive with regards to 1-2% unit growth for the year, as it believes that GIS is gaining shares in several key categories. Trading at 15.8X this fiscal year’s EPS estimates and offering a dividend yield of 3.6%, I believe that little to no growth is reflected in the company’s stock price. As a result, good results this quarter should send the stock higher. GIS is a buy under $54. My target is $60.

Genuine Parts (GPC) has given back some of the gains that it realized following strong third-quarter earnings in recent weeks. However, I still believe that the stock is poised to move closer to my $110 target. The company should be on a steady growth pace in 2020, with currency issues and divestitures being less of a drag. GPC’s results should also benefit from its management’s recent decision to expedite its cost-cutting efforts. I still believe an increase in EPS from a forecast $5.65 this year to $6.00 next year is realistic. Buy GPC should it fall below $100.

Shares of Ingredion (INGR) have been doing well recently. Perhaps these gains are a reflection of the reported progress on the trade talks. While the company has production and sales in China, the impact of tariffs on the company is currently limited. Beyond the market’s obsession with the trade war, INGR remains cheap at 12.5X next year’s EPS estimates. At the same time, lower corn prices will be a major tailwind that should help the company make these estimates alongside continued growth in the company’s portfolio of healthier products. A dividend yield of nearly 3% will add to total returns. Buy INGR below $90. My target is $105.

Valley National (VLY) shares have come under some pressure as the yield on the 10-year Treasury bond has been unable to stay elevated. This has raised some concerns about the company’s long-term interest margins. While this is certainly an issue that deserves consideration, the company should still be able to grow its EPS from $0.91 this year to $1.00 next year with the help of ongoing cost-cutting measures. Once the stock gets greater visibility on this level of earnings, my $12.50 target can be achieved. VLY is a buy under $10.50.

Shares of Valvoline (VVV) have given up most of their gains following a stronger-than-expected fiscal fourth-quarter EPS. However, I still believe that earnings are set to grow in the September 2020 fiscal year and that they will be driven by continued success at the company’s Quick Lube Franchises. While the continued strength of the dollar is of some concern, I believe that we will see the company’s EPS improve from $1.39 last year to at least $1.47 next year. The stock is a good buy at 15X this forward estimate. Buy VVV below $22.50. My target remains $26.

Join Me for the Orlando MoneyShow, February 6-8, 2020, at the Omni Orlando Resort at ChampionsGate. I will be speaking Friday, Feb. 7, 3:00 p.m. about The Stealth Value Investor: Ten Amazing Dividend Yield Plays Flying Under the Radar. On Saturday, Feb. 8, I will talk at 5:15 a.m. about Identifying the Real Future GameChanger Stocks: Ten Companies Positioned to Double — Even if the Bears Take Over Wall Street. Other investment experts who will be speaking include retirement and estate planning specialist Bob Carlson, income and options expert Bryan Perry and world-traveling, free-market economist Mark Skousen, who leads the Forecasts & Strategies newsletter. Register by clicking here or call 1-800-970-4355 and mention my priority code of 049252.