Top 10 for 2015

A last minute thank you and gift for friends! On this last trading week of 2014, I’d like to thank all of you for reading and responding to my many weekly missives and surveys. You make what we do worthwhile. Thank you.

Farr, Miller & Washington is a “buy-to-hold” investment manager, which means we make each investment with the intent to hold the position for a period of 3-5 years. Nevertheless, in each of the past ten Decembers I have selected and invested (personally) in ten of the stocks we follow with the intention of holding for just one year. These are companies that I find especially attractive in light of their valuations or their potential to benefit from economic developments. I hold these positions for the following year, and then I reinvest in the new list.

I thought you might like to see my selections for 2015. Feel free to forward this commentary to investor friends and invite them to subscribe to our free weekly commentary. You can give them a gift and help in doubling our subscriber base in 2015! Our email address is invest@farrmiller.com. We wish you a happy, healthy, and profitable New Year!

Again, please keep in mind that results have been good in some years and not as good in others. I will sell my 2014 names on Wednesday morning December 31st and buy the following names that afternoon. These are not recommendations to buy or sell securities. There is risk of losing principal. Past performance is no indication of future results. If you are interested in any of these names, please call us or your financial advisor to discuss.

JP Morgan (JPM)
JP Morgan, as with the banking industry at large, has been operating in a very difficult environment over the past several years. Following the biggest financial crisis since the Great Depression, bank regulators have been tightening the screws on the industry so as to reduce risk to the economy at large. While some of the new rules are more constructive than others, the banks will almost certainly produce inferior returns on equity relative to those enjoyed prior to the crisis. Having said that, we think bank fundamentals should slowly improve over the next few years. The housing market seems to be stabilizing, foreclosure-related expenses should decline, unemployment is falling, regulatory uncertainties should gain more clarity, capital ratios are strong, and higher interest rates should improve interest margins at some point. These positive developments in the years to come do not seem to be incorporated into some bank stock valuations. That said, there are still many potential landmines to navigate. Given the balance of risk and reward, we advocate sticking with the highest quality banks trading at reasonable valuations. At about 1.35x tangible book value and 10x the EPS consensus for 2015, we think these negatives are more than baked in for long-term investors seeking exposure to a recovering industry through a well-managed, high-quality bank.

United Technologies (UTX)
United Technologies is a diversified industrial company that provides products and services to the buildings systems and aerospace industries worldwide. The company is well diversified both geographically (61% of 2013 sales outside the US) and by end market (aerospace comprised 53% of 2013 sales and commercial & industrial 47%). The company’s aerospace sales target both commercial and government (including both defense and space) customers. In 2013, approximately 57% of the company’s sales were original equipment manufacturing (OEM) and 43% were aftermarket parts and services. The company has a fantastic long-term track record of financial performance, with strong double-digit EPS growth, outstanding cash generation, and a stock price that has handily outperformed the market over the past 10 years. Looking forward, there are certainly risks to the outlook, including slowing growth outside the US, an aging aerospace cycle, and the integration of a new leader following CEO Chenevert’s abrupt recent departure announcement. Trading at a discount to the overall market, however, we think patient investors will be rewarded.

Valmont (VMI)
Founded in 1946 with its IPO in 1968, Valmont Industries is a diversified global producer of engineered products and services for infrastructure, and water-conserving irrigation equipment for agriculture. In its Engineered Infrastructure Products segment, the company produces fabricated metal products and steel and aluminum pole, tower and other structures. In its Utilities Support Structures segment, it produces steel and concrete pole structures for the global utility industry. The Irrigation segment is a global producer of mechanized irrigation systems. The company also provides metal coating services, including galvanizing, painting and anodizing in its Coatings segment. The balance of company sales come from a variety of smaller businesses. Although the company’s end markets are considered highly cyclical, they run in distinct cycles that should not be highly correlated. Moreover, the company should, in general, benefit from some very powerful long-term secular drivers, including increased urbanization and global infrastructure expansion, increased investment in the power grid and telecommunications infrastructure (4G build out), continued population growth with increased demand for food and healthier diets, and a limited water supply. The stock has done poorly in recent months as earnings expectations have been reduced several times due to global growth concerns. At the current level of less than 14x consensus EPS for 2015, we think the near-term challenges are well understood.

YUM! Brands (YUM)
Yum! Brands, Inc was spun off from PepsiCo in 1997. The company owns and operates three major fast food concepts: KFC, Pizza Hut and Taco Bell. For the second time in 4 years, Yum! Brands has had to deal with negative publicity surrounding food safety issues in China, which accounts for ~50% of the company’s revenue. Due to the weakness in China management lowered its EPS growth target for full-year 2014 to mid-single digits compared to the most recent guidance of +6-10% growth. For 2015, EPS is expected to grow at the long-term guidance pace of 10% or more. The latter compares unfavorable to the current consensus estimate for growth of +17% in 2015. However, we believe the bar has now been set extremely low, and any upside to sales expectations in China next year could lead to very strong earnings leverage. In addition, the company is not reducing its pace of expansion in China, with the expectation that the division will open 700 new restaurants (+10% YOY) in China in 2015. Outside of China the company’s franchise model produces strong free cash flow to support dividend increases and share buybacks. At 20x the depressed consensus estimate for 2015 EPS, we see long-term value in the shares.

Chevron (CVX)
Chevron is a U.S. based integrated oil and gas company with global operations. We’ve seen the price of oil come down 40% over the past four months. There are multiple factors affecting oil prices – lower global growth (demand increased only half of what was expected in 2014), increased supply from US shale producers, increased supply from Lybia, Iran, and Iraq where political unrest has subsided, and an unwillingness of OPEC to decrease production and balance the market. Prices may indeed head lower before finding equilibrium. Demand has been weak this year, but should recover barring a global recession as global GDP generally drives demand growth. Supply will adjust as low prices will reduce capital expenditures for new supplies and there is a natural decline in production of existing wells of between three and five percent per year. US Shale wells have natural decline rates of 70% or more in just the first year of production. Long-term, until we see a secular change in demand or deflation in the cost of supply, a normal range for prices should be between $85 and $100 per barrel. Chevron has a AA-rated balance sheet and the ability to invest through periods of lower prices. Its mega projects are on schedule to deliver mid-single digit production growth over the next four to five years – much better than its integrated peers. The stock is trading at a cyclically adjusted 14x CY 2015 EPS and pays a 4% dividend. We believe the stock provides a somewhat defensive way to wait for a normalization of oil prices.

Google (GOOG)
After a stellar 2013, Google faced some challenges in 2014 and those issues remain an overhang on the stock. The European Union investigation of vertical search is unlikely to have a material financial impact, but that combined with a separate Android investigation and general tax risks have created uncertainty around the stock. We believe Google has the best exposure to the broad secular growth stories of the internet – mobile, online video, travel, digital content, local, payments, autos, and home automation. The shift of advertising dollars from traditional media to the internet and mobile is still in the early innings. The stock trades at 16.5x the 2015 calendar year earnings per share estimate. We think the company should be able to post mid-teens earnings growth over the next three to five years. This puts the price/earnings-to-growth ratio around one, making it one of the best values in the internet space and technology industry.

Qualcomm (QCOM)
Qualcomm is a leading developer, designer, and manufacturer of digital wireless telecommunication products. The two main divisions of the company are the Technologies group and the Licensing group. The Technologies group offers comprehensive chipset solutions for all types of connected devices such as smartphones and tablets. The Licensing group holds an extensive portfolio of patents related to wireless networks and collects royalty payments from manufacturers of mobile devices. The company hit a rough patch in 2014 as an investigation by China’s National Development and Reform Commission for monopolistic practices has hurt its ability to collect licensing fees on some handsets manufactured in China. These licensing issues hurt earnings per share by roughly 5% over the last two quarters. Ultimately, China and Qualcomm need each other. China would like to grow its nascent foundry business (semiconductor production), and Qualcomm shifting some production to China would be a good start. On the flip side, China is approving licenses for 4G service and the growth in 4G handsets in China is a significant and growing driver of global handset growth. Average handset prices are declining, though the rate of decline is likely to moderate as emerging market middle classes grow and buy more expensive phones. At 13.2x CY15 earnings per share, the stock is trading at a discount to the broader market and a rare discount to the overall semiconductor industry. We believe the company can grow earnings in the high single digits over the next few years and the dividend yield is 2.4%.

Cognizant Technology Solutions (CTSH)
Cognizant Technology Solutions is a global provider of information technology, consulting, and business process outsourcing. The company provides services to its clients through technical and account management teams located on-site at the client location and offshore at its development centers located in India. The company has done a superb job of reinvesting to strengthen client relationships and broaden the scope of services provided. Revenues have grown at more than twice the rate of the IT service industry over the past ten years and, while the growth rate will likely converge towards the industry average, we believe the company is positioned to maintain a growth rate in excess of the overall industry. The stock offers a combination of growth and defensiveness. The growth should come from exposure to the secular trends of globalization, corporate cost-cutting, regulatory changes, and technology shifts (mobility and cloud), and the defensive attributes include outsourcing maintenance revenue that is generally long-term recurring revenue and a balance sheet that has no debt and nearly $3 per share of cash, net of debt. At 17x the calendar 2015 consensus EPS estimate and mid-teens earnings growth, we find solid longer-term value in Cognizant shares.

Patterson Companies (PDCO)
Patterson is a value-added distributor serving the dental, companion-pet veterinarian and rehabilitation supply markets. The company is a top 3 player in each of these end markets. Patterson’s end markets are starting to recover as the U.S. economy gains steam. Dental traffic has picked up which should ultimately lead dentists to increase capital expenditures. This recent improvement in the macro environment has led to a 20% increase in PDCO shares over the past 3 months. Despite this move, we continue to believe that Patterson offers long-term investors an attractive risk/reward proposition from current levels. Patterson should benefit from an aging U.S. population, positive pet ownership trends, and the move towards the use of greater technology in the dental business. The company sports a solid balance sheet, and generates above-average returns on invested capital and free cash flow. The stock trades at 20x CY15E EPS and should generate relatively stable, low double-digit EPS growth over the next 3-5 years.

Perrigo (PRGO)
Perrigo is a diversified drug company headquartered in Dublin, Ireland that stands to benefit from the growing need for low-cost healthcare products. The company should be considered a hybrid between a drug company and a consumer products company. The company produces store brand OTC products & drugs, specialized generic Rx drugs, and holds claims to escalating royalties from Biogen’s blockbuster multiple sclerosis drug Tysabri. The company is unique in the drug industry because it does not face the patent cliffs faced by branded pharmaceutical companies or the intense competition faced by generic drug manufacturers. Perrigo’s 3-year financial guidance calls for 5%-10% organic revenue growth to be leveraged into 10%-20% EPS growth. In addition, growth may be supplemented by additional bolt-on acquisitions, especially now that it has an advantaged tax structure. The current valuation (20x the consensus for calendar 2015 EPS) appears reasonable given the expected growth rate, the less cyclical nature of PRGO’s earnings stream, a strong balance sheet and solid free cash flow generation.

Peace,

Michael