Preparing for a New Environment

It has been a very productive time for Value Authority since last month’s issue.

All our companies reported better-than-expected earnings and responded well to the results. At the same time, we have taken a lot of the risk out of the Buy List since the start of October. Overall, I believe our names are less sensitive to the economy than they have been in the recent past when compared to the average risk in the market.

In addition, and this will be an emerging issue next year, I believe our portfolio has below average exposure to potential policy changes that may occur as a result of the 2020 election. The most important of these changes is the possible repeal of the Tax Cut and Jobs Acts of 2017.

As the law lowered corporate tax rates and gave earnings a boost, it added approximately 15% to 20% to S&P 500 earnings last year. Since these higher earnings have played a big role in supporting prices, taking these incremental earnings away would be bearish for stocks.

While our companies would also be impacted by the change, our companies are international corporations and pay income taxes in several countries. Thus, they are less sensitive to changes in the U.S. corporate tax rate.

I believe that managing risk will become more important because I do not believe that 2020 will be similar to 2019, where stocks pretty much ignored falling earnings estimates and growing political risk as they were more than offset by Fed’s easing and lower long-term interest rates. While the Fed will not be raising rates anytime soon, further easing is unlikely.

In addition, longer-term rates have moved dramatically higher recently. The interest rate on the 10-year U.S. Treasury note was just 1.46% in early September. It is now not far from 2%. The election will also be closer to reality, so the potential consequences of it can no longer be ignored. Therefore, I feel that 2020 will be a year where hope will not be enough. Companies will need to put up solid results to do well.

Fortunately, we are well prepared for what may be the new realities of 2020. The rest of 2019 could be potentially quiet for stocks, and I will use that time to continue to make adjustments.

A Five-Star General

When you think of General Mills (GIS), the first thought that may come to mind is iconic cereal brands like Cheerios, Wheaties and Chex, or baking brands such as Gold Medal Flour or Betty Crocker. However, these brands make up less than 25% of General Mills’ sales.

In reality, General Mills is a broadly diversified food company that controls other brands like Old El Paso Mexican Foods, Yoplait, Colombo Yogurt and Häagen-Dazs ice cream. Through recent acquisitions, GIS also owns growth brands such the Annie’s line of organic products and Blue Buffalo pet food, which marked the company’s entry into pet foods.

I like GIS right now because, like most food stocks, it has a very depressed valuation due to the ongoing challenges facing the food industry such as changing consumer tastes towards healthier eating options and emerging new brands. However, aided by its broad portfolio and marketing strength, the company’s unit volumes have been flat on an organic basis for the past two fiscal years. Earnings per share (EPS) have improved from $2.77 to $3.22 due to well-controlled expenses and a lower tax rate due to the 2017 tax law.

The first quarter of the May 2020 fiscal year was mixed for General Mills. EPS of $0.79 vs. $0.70 was $0.02 better than expectations, but the top-line was disappointing. Sales were down 2% or 1% if we exclude currency factors.

However, the company retained its forecast of 1% to 2% growth for the year and there are encouraging factors underneath the surface. The company held or gained shares in five out of its 10 largest brands and its critical North American retail segment showed signs of improving.

Furthermore, the company continued to enjoy strong growth in Blue Buffalo. If the company can regain some top-line momentum, when combined with a favorable revenue mix and price increases helping margins, management’s guidance of 3% to 5% EPS gains for the year could be conservative.

The company sells for 15.6X EPS estimates for the fiscal estimates for the current fiscal year and offers a dividend yield of 3.7%. While food companies like General Mills sell at a discount to other consumer non-durable stocks such as personal care companies, I believe that the difference is just too great.

For example, Procter & Gamble (PG) sells for over 24X its current fiscal year’s earnings and has a dividend yield of 2.5%. I think that this valuation gap should narrow over time if GIS can continue to produce stable results.

General Mills offers a solid value proposition here, with an attractive valuation and strong free cash flow generation that the company can use to reduce debt or make further acquisitions. As I believe the stock can do well in practically any economic environment, I recommend the shares under $54. My target is $60.

Position Review

Cognizant Technology Solutions (CTSH) has traded steadily since the company reported third-quarter earnings. While it may take a while to reinvigorate growth, CEO Brian Humphries’ plan seems solid. He has initiated heavy investments in digital services and aims to trim the fat at the company. This should allow EPS to rise from $4.00 this year to $4.20 next year, with a hopeful acceleration of growth in 2021. Trading at just 15X next year’s estimates, there is good value in the stock, as CTSH should move closer to a market multiple should the growth plans work out. Buy CTSH under $65. My target is $79.

Shares of F5 Networks have rallied strongly since their October lows. Fiscal fourth-quarter earnings have demonstrated that the company continues to transition well from a hardware to a software-based organization. While growth may be limited while the transition continues and systems revenue continues to decline, the overall trajectory of growth will eventually turn positive. Trading at 14.3X with over $20 a share of net cash on the company’s balance sheet, the stock price does reflect the company’s growth potential. Given the attractive valuation and the company’s experience in launching applications across multi-cloud environments, an acquisition by a larger networking or web services company cannot be ruled out. F5 is a buy below $150. My target is $170.

Although more defensive names have lagged the rallies, Genuine Parts (GPC) has been an exception and has performed very well since my Oct. 7 recommendation. Strong third-quarter earnings and organic growth from both auto and industrial parts helped end a two-quarter-long streak of mediocre results which had sent the shares well below its April high of over $115. The stock is inching closer to my $110 target, which is supported by the potential EPS of $6.00 next year, as well as a dividend yield which remains close to 3%. With the shares well above my $100 buy under price, hold the stock for now.

Ingredion (INGR) lowered earnings guidance for the year even as the company reported better-than-expected results for the third quarter last week. However, the stock continues to move higher, and I believe this is the case because investors remain confident that the worst of the negative impact of commodity prices and the stronger dollar is behind the company. In addition, the shares remain cheap at 13X and 12.2X 2019 and 2020 EPS estimates respectively, and the company still offers a solid dividend yield of 3%. I believe there is room for significant multiple expansion for the shares, as the company sells products that have stable demand in all economic environments. Its specialty products and cost controls should aid earnings growth. Keeping in mind that the stock traded as high as $145 in early 2018, buy INGR under $90. My target is $105.

Morgan Stanley (MS) has benefitted from good third-quarter earnings as well as the big rally in financial shares as trade concerns faded and interest rates rose. The shares are close to my $50 target, and I will assess whether to raise my target price or recommend their sale shortly. While continued solid earnings should lead to book value growth and an even higher stock price, the election next year presents more issues for Morgan Stanley than most stocks. As the election has the potential to lead to more regulations and a higher tax rate, I will weigh the issues and decide. Hold the shares for now.

Valley National (VLY) is another financial stock that has gotten a lift from the strong performance of financial shares. Approaching 12X next year’s EPS, the stock is at the high end of its recent valuation. However, with loan growth strong, credit costs low and the company’s cost initiatives taking hold, I view the stock as a worthwhile hold to my $12.50 target. The dividend yield remains very attractive at 3.8%.

After last week’s strong earnings report, I raised my target price on Valvoline (VVV) to $26, which is roughly a market multiple of 17.6X next year’s EPS estimates. Continued growth in the number of locations and higher same store sales at Quick Lube franchises should continue to drive growth. The company is also taking certain initiatives to improve the volume of lubricants in both the United States and internationally. If these are successful, estimates for next year could be too low. VVV is a buy below $22.50.