Skies May be Clearing

Stocks have been trying to stabilize over the past week. I think there is a sense of relief that earnings season is over.

Even though there have been a few high-profile earnings misses and sharp sell-offs, the bottom line is that, for now, earnings expectations for the S&P 500 in 2019 are $177.90 per share. This is only about $1 below the level where earnings season started.

This number could drift a little lower through year’s end as many companies start to hold year-end analysts’ meetings and give guidance for 2019. However, barring a significant decline in economic data, which I do not see coming, I do not think we will see S&P 500 estimates for 2019 drop much below $175 per share, which would still represent a nice increase from the $162.50 per share expected this year.

Given that estimates have not collapsed, along with my belief the market will have another sense of relief from the end of elections season, I do not believe we will get below last week’s low for the remainder of 2018. November and December are typically seasonally strong months, and with bargain hunters on the prowl after this recent correction, I expect this rebound to continue.

This is not to say the market will not have challenges as we head into next year. Long-term interest rates are firming, and central banks globally are not nearly as accommodative as they once were. The Chinese and European economies remain a concern for next year. I will monitor these issues carefully and make changes as needed. For now, though, I think we are excellently positioned to take advantage of the year-end rally I expect.

Ignore the Stumble of This Powerful Opportunity

3M (MMM), my latest Value Authority pick, is not the sexiest company in the world. It is, however, an industrial and money-making powerhouse.

The company is a favorite among investors seeking conservative exposure to the industrial sector. It has earned this favor through excellent capital efficiency, with a very high return on assets of 19% last year, and strong free cash flow generation, which has averaged around 100% of net income the past three years. In simpler terms, you can rest assured the company’s profits represent actual cash, not just what accounting conventions say they are.

The company has generated this record through five diversified segments that are a little less cyclical then the average industrial business. These segments are:

Industrial: A variety of tapes, sealants, abrasives and advanced ceramics used in a wide range of industries.

Safety and Graphics:  These products increase the productivity and safety of people and facilities, including respiratory, hearing and eye protection equipment, along with safety products used in transportation such as reflective materials for street signs and license plates.  In addition, this segment offers architectural design solutions for floors and industrial cleaning products.

Health Care: This segment consists of tapes used to dress and close patient wounds, orthopedic casting materials, and products used by health care professionals that include surgical masks and drapes, stethoscopes, sterilization assurance systems and drug delivery systems.

Electronics and Energy Business: This segment makes films used in electronic displays in products such as televisions, cell phones and automotive displays. The energy portion of the business includes infrastructure protection equipment for electrical utilities and electronic construction, along with components used in wind and solar energy systems.

Consumer Business: The disposable products of this segment are used in offices and homes, including the company’s iconic Scotch Tapes and Post-It notes, along with a variety of scrubs and sponges.

In 2017, total sales consisted of the industrial segment, 34.4%; safety and graphics, 19.4%; health care, 18.4%; Electronics and Energy, 16.3%; and consumer, 14.5%.

3M has posted solid results in recent years as the economic expansion picked up steam. Earnings per share (EPS) improved from $7.49 a share in 2014 to $9.17 a share in 2017, with organic revenue growth increasing just under 3% per year over the same period.  However, the company hit a little speed bump when it recently reported third-quarter earnings. EPS of $2.58 in Q3 2018 vs. $2.33 in Q3 2017 was $0.12 below expectations, as unfavorable foreign currency movements and softness in health care due to a slowing in drug delivery systems weighed on results. Organic growth in the quarter slowed to 1.3%, but the company was facing a very tough comparison with growth of 7% the prior year. 3M also lowered its earnings guidance for the year to $9.90-$10.00 from $10.20-$10.45 and also lowered its organic growth expectations for the year from 3-4% to just 3%.

The shares sold off on the news, reaching its lowest levels since February 2017. I view the disappointment as primarily due to transitory factors, such as currency and softness in drug delivery systems, which is contract-based and can be lumpy. However, I thought we had an excellent opportunity to get into this high-quality company, which traded close to $260 a share earlier in the year.

The stock has had a nice little bump since my recommendation, but it still offers good value at 18X a reasonable EPS estimate of $2.70 next year, with an attractive 2.9% dividend yield. 3M at this time offers a nice combination to participate in a potential recovery of industrial names, while at the same time offering more earnings stability than most industrial companies if the economy disappoints. Buy 3M under $190. My target is $210.

Review of Recommendations

I believe it was a good earnings season for our companies, and I believe they are poised to do well through year-end.

Big Lots (BIG) likely will report earnings in late December. Expectations in a very weak seasonal quarter  for the company are breakeven versus EPS of $0.06 last year on a 2.4% revenue gain to $1.14 billion. Higher freight costs and investments will continue to restrict profitability. Since the quarter is not an important contributor to annual earnings, the focus mainly could be on fourth-quarter guidance.

The stock held up decently in the market selling, although it was weak at times in sympathy with some of the selling at Home Depot (HD), which was driven by concerns over slowing housing. I will keep an eye on the macro trends, but I expect the sales momentum to continue to build at BIG as more remodeled stores come in line. I continue to look for a nice gain in profits next year as expense growth slows. The stock is very attractive at less than 10X EPS, and I continue to recommend purchase of BIG below $42.

Shares of Chubb (CB) have been stable following the company’s third-quarter earnings release, which I discussed in a special report two weeks ago. While there are concerns about more competitive pricing, this is more than priced into the shares at their current valuation of 1.1X book value, and CB should be a solid performer in the current nervous market environment. Buy CB under $130. My new target is $145.

Cognizant Technology Solutions (CTSH) reported a good third quarter last week, with EPS of $1.19 vs. $0.98 on an 8.3% revenue gain to $4.08 billion. The results were $0.06 EPS above expectations. However, fourth-quarter guidance of at least $1.05 EPS was lower than estimates of $1.14 EPS, and revenue guidance of $4.09 to $4.13 billion was short of expectations of $4.14 billion. However, the stock quickly recovered following initial weakness, as the expected EPS underperformance in the fourth quarter largely was due to timing differences in the tax rate that drove third-quarter outperformance. The company is on pace to have operating margins of 21% this year, and I am comfortable it can improve margins to 22% in 2019.

The company will further discuss its growth prospects at an analysts’ meeting in New York on Nov. 16. I will have any important updates from this meeting. However, just looking at the big picture for CTSH, this is a company that should grow EPS in the upper single digits as it helps its clients digitalize and automate their operations. Yet it sells for only 14X next year’s EPS estimates, a more than 10% discount from a market multiple. The stock continues to represent good value, and I am recommending CTSH below $77.50. My target is $90.

DowDuPont (DWDP) reacted very well last Thursday to third-quarter earnings, as EPS of $0.74 vs. $0.55 was $0.03 a share better than expectations. Sales were up 10%, consisting of 5% unit growth and 5% pricing gains in the healthy global economy.  The results were $0.03 a share below what was expected in September, before estimates began coming down due to rising cost pressure. However, the stock price was quite depressed, and I feel some investors were perhaps even bracing for worse from DWDP, so the reported results were more than enough to lift the stock sharply higher. Also helping the shares was the company’s announcement of a $3 billion stock buyback.

DWDP currently is doing well, but the market is more concerned about what is happening next, with global economies uncertain. I will keep an eye on the market and economic outlook. But with the stock selling at 12X next year’s estimates and with the buyback likely to support the shares, I am going to stick with DowDuPont for now in hopes it participates in a year-end rally. Continue to buy DWDP. My new buy under price is $62, while my target price is now $70.

EMCOR Group (EME) has traded firmly since releasing its third-quarter results two weeks ago. With its backlog continuing to expand, the near-term outlook is good. The stock could be vulnerable from recession fears, which caused the shares to sell off in October. However, I think we will avoid this anxiety through year’s end. I continue to recommend EME below $72. My target is $82.

First Hawaiian (FHB) stock is trading off of its recent lows, but it still remains well below its best levels of the year. It is important to understand that this does not reflect any issues at First Hawaiian, but rather the heavy selling that has hit regional banks in general, with the S&P Regional Bank Sector SPDR (KBE) off 16% from its highs of the year. I feel as though FHB’s third-quarter earnings showed the underlying business remains sound. Renewed loan growth along with slower expense growth should drive EPS higher from an expected $2.02 per share this year to $2.20 next year. The stock is a good value here at less than 12X next year’s EPS with a 3.9% dividend yield. Buy FHB under $26. My price target is $30.

J.M. Smucker (SJM) will report fiscal third-quarter results on Wednesday, Nov. 28. Expectations are for EPS of $2.33 vs. $2.02 on a 6.7% revenue increase to $2.05 billion. Most of the revenue growth will come from the Ainsworth premium pet food acquisition, but hopefully new products will drive some organic growth as well. The earnings gains will come primarily from the lower tax rate, as higher marketing expenses in a more competitive environment will restrict margins.

The stock was doing well as a “safe haven” in an uncertain market but took a hit last Friday when Kraft Heinz (KHC) announced disappointing earnings, as the food industry environment remains difficult. Still, at just over 12X forward EPS estimates and with a 3.1% dividend yield, I think there is enough margin of safety and upside reward in the shares to give the company an opportunity to return to growth. Buy SJM under $108. My target is $120.

Morgan Stanley (MS) drifts with the market but has built up a good base of support at around $43 a share. I expected MS to be a strong performer in the year-end rally I foresee. The company’s businesses are doing well, market volatility in October could lift fourth-quarter results and the stock remains very attractively valued at 1.15X book value and 9X 2019 EPS estimates. Buy MS under $49. My price target is $56.

Omnicom (OMC) has been trading firmly since it reported first-quarter results.  EPS of $1.24, excluding extraordinary gains of $0.07 a share, improved from $1.13 last year and were $0.03 better than expectations. Revenues were flat and in-line with expectations at $3.7 billion, although organic growth in the quarter of 2.9%, driven by a 6.5% gain in Customer Relations Management (CRM) Consumer Experience, impressed investors. EPS comparisons also benefitted by a 3% decline in average share count as the company continues to repurchase its shares at favorable prices.

I had mentioned previously that Omnicom could see some cost cutting, and today the company announced it was laying off 7,000 workers and consolidating locations. I do not view these moves as bad news, but rather the company trying to get the size of its workforce in line with more realistic growth expectations.

Even with this recent rally, OMC remains attractive at 13X next year’s EPS and a dividend yield of 3.2%. OMC remains a buy below $71. My target is $80.

United Health Services (UHS) posted a solid third quarter, with EPS of $2.23 vs. $1.39, which was $0.22 a share better than expectations, although the beat included $0.09 a share of benefits from the increase in value of marketable securities.  Revenues increased 4.7%, with a 6.7% rise in acute care hospitals aided by an easy comparison from hurricane-impacted results last year and a 2.5% increase in behavioral health facilities. EPS comparisons were helped by the higher revenues, a lower tax rate from last year’s tax law, and a 3% decline in the average share count. The company aggressively bought back shares in the third quarter to show its management continues to view its stock as a good investment at its current price.

The company continues to have success with facility expansion. Its management seems to expect facility expansion to drive growth. I believe current EPS estimates of $10.00 next year, up from an expected $9.50 this year, are very realistic and supportive of my $130 target. The stock is well above my $115 buy under price, so continue to hold UHS shares for now.

Valley National Bank (VLY), like First Hawaiian, has seen considerable weakness in its shares the past two months due to the poor performance in regional bank stocks in general.  As we discussed in our special earnings report a few weeks back, VLY’s EPS was $0.02 short of estimates, largely due to duplicate expenditures as the company invests to become more efficient. I believe these investments will start to pay off in time and we should see improved profitability for VLY next year as the benefits from the investments kick in. I believe fears about the economy and a flattening yield curve that have hurt all bank stocks are overdone. As these fears fade, the stock should have a strong 2019. Buy VLY under $10.50. My target is $13.