The Present is Tough, But I Am Confident About the Future

Value stocks are off to a rough start in May, with the Russell 3000 Value Index down 1.68% thus far for the month. In comparison, the Russell 3000 Growth Index is 3.02% higher.

This is the continuation of a trend that we have seen all year. Indeed, the value index is currently down 20.47% for the year, while growth stocks have squeezed out a 0.71% gain.

This divergence merely reflects the perception that sectors which generally fall under the value label, like Energy, Industrials and Financials, will see their earnings over the next few years pressured by the recession that was caused by the coronavirus. At the same time, growth sectors, such as technology, will be less impacted. In fact, they could even benefit from companies having to spend more on technology to enable remote operations.

I do believe that this scenario is an oversimplification that is reminiscent of the old economy versus new economy scenario that was used in the year 2000 to explain why the NASDAQ reached bubble levels, while many solid companies were being virtually given away. The fact is that all companies will be impacted by the weaker economy to a certain extent. For example, banks are among the largest purchasers of technology. If their earnings are suffering due to loan losses, the amount of purchases on technology will be reduced. Given the extreme valuation of many growth stocks, any marginal reduction on expected growth will hurt the shares’ future performance.

I have seen these divergences many times in the past, and I know that this tough time for value will end. In the meantime, I have prepared ourselves to face the challenges ahead with a two-pronged approach. First, I have set up a core holding of attractively valued solid companies, many of which have dividends above 3%. These companies should come out of the pandemic and recession in a good condition. They should also rally even before the economy turns higher, as the stock market always anticipates the future. Second, I plan to buy more aggressive companies after the sharp selloff we are likely to occasionally have from time to time in order to nab quick gains. This strategy was recently executed with regards to Valero (VLO) and Envista (NVST).

So, while it continues to be a tough year for value stocks, better times will come at some point. Prices will move higher eventually, and in the meantime, dividends are providing much better yields than even some investment-grade corporate bonds. Please be patient as better times are ahead.

A Grand Old Company

Old Republic (ORI) is an old company, as it was formed in 1923. Many of its acquired subsidiaries in business have been around for even longer. The company has two main divisions. General Insurance underwrites commercial lines, primarily in transportation, including trucking and inland marine services. This division also provides workers’ compensation insurance and home and auto warranties. The other division is title insurance, which insures lenders and homeowners. These policies insure against losses that arise out of defects, liens and encumbrances that affect the insured title and are paid for by one-time premiums.

In 2019, general insurance accounted for 64% of the premiums that were written. Title insurance made up the remaining 36%.

The company is long-term in nature and is primarily concerned about returns that are achieved over a 10-year underwriting cycle. ORI is disciplined in terms of its risk selection and pricing and is able to achieve its desired returns. ORI also looks to manage its risk through appropriate diversification and the use of reinsurance.

Old Republic’s historical financial performance has been strong. Premiums have grown each year since 2012, except for a flat year in 2014. Claims have been very steady over the same period, with no spikes for “prior period adjustments,” which happens when insurance companies underestimate the amount of their future claims on policies. Investment income also grew steadily. As a result, operating earnings per share (EPS) increased from $1.01 in 2013 to $1.84 on 2019. Over the same period, book value per share grew from $14.66 to $19.98 per share, even with the company paying a generous dividend each year.

The company had a good operating first quarter, with EPS growing to $0.47 from $0.40. However, the company had $745 million in unrealized investment losses during the quarter due to the weak stock market and falling corporate bond prices. Old Republic has a significant portion of its investment portfolio, approximately 30%, invested in stocks. This is much higher than most other insurance companies. However, since management feels that stocks offer superior long-term returns, a move which makes sense with bonds yielding so little, those leaders prefer this more aggressive approach. However, the tough short-term period caused the company’s book value to decline to $17.29 from $19.98 a share.

On the conference call, the company also warned that the recession could cause declines in premiums, especially in such areas as trucking and workers’ compensation. This will likely lead to a decline in operating EPS to around $1.50 to $1.60 this year.

Despite the current rough stretch, the stock is very cheap at 10X EPS estimates and 91% of a book value which should increase during this quarter with a much better stock market. Old Republic has an outstanding long-term record, and the company should continue to provide good long-term returns to shareholders in the years ahead. Buy ORI under $18. My target is $22. The 5.35% dividend yield will add to total returns.

Position Reviews

An analysis of all the earnings reports I reference below is available in the Hotlines/Flash Alerts section of my website.

The fact that shares of 3M (MMM) could not hold their post-earnings surge reflects a general weakness in the industrial sector due to macroeconomic concerns. However, 3M still has been a relatively strong performer since my Feb. 26 recommendation, and I believe that its trajectory will continue, given the strength in its health care operations and 4% dividend yield. 3M is a buy below $150. My target is $170.

Cognizant Technology Solutions (CTSH) has struggled since the company reported its first-quarter earnings last week and warned that COVID-19 was weakening demand in the most-impacted industries, like lodging, in the second quarter. However, there were some encouraging signs in the report as well. The company’s win rate for new contracts grew, and first-quarter contract rewards were up 30% from last year. Despite the cyclical weakness, the growth strategies that CEO Brian Humphries put in place a year ago seem to be paying off. I think that the stock will reflect this fact at some point. Buy CTSH under $55. My target is $70.

Genuine Parts (GPC) is higher than its worst post-earnings levels, and the stock appears to have strong support at around $72.50. With economies opening and the number of driving miles rising, I look for the stock to recover as next year’s EPS should approach last year’s $5.69. Buy GPC below $80. My target is $90.

Ingredion (INGR) has traded firmly post-earnings. While the company anticipates some weakness in its institutional business and South America as the number of COVID-19 cases are growing on that continent, EPS should remain flat versus last year’s $6.65 a share. Given fewer COVID-19 headwinds and continued growth in the company’s specialty products, EPS has the potential to improve to over $7.00 next year. This should drive the stock close to my $105 target. INGR is a buy below $90.

MSC Industrial Direct (MSM) shares have been trading relatively firmly when one considers the pressure that the industrial sector has been under. The company’s fiscal quarter does not end until May, so there will likely not be an earnings report until early July. However, the company has indicated that it will be providing monthly sales updates in place of guidance. I will let you know as soon as I hear anything. Buy MSM below $60. My target is $75.

Universal Health Services (UHS) shares have been volatile, with the stock reflecting concerns that we may face a second COVID-19 outbreak and the continual growth in the number of COVID-19 cases in many parts of the country. However, I want to stay with the name. Hospital procedures that have been delayed cannot go untreated indefinitely, and I believe that the country and our health care system are much better prepared to handle a second wave of COVID-19 cases. So, any future business interruptions may not be as significant. UHS is a buy below $106. My $130 target is based on EPS returning to $10 a share next year.

Valvoline (VVV) shares have traded in a volatile range between $16 and $18 post-earnings. However, I would ignore the noise. Instead, I would rely on the fact that the number of miles driven are on their way to a recovery, and the company continues to grow its Quick Lube business as well. EPS may decline by 10% to 15% this year from last year’s $1.39, but with volumes approaching normal levels next year, a recovery in EPS to at least $1.45 should allow the stock to reach my $21 target. It might even move beyond that. VVV is a buy below $17.