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 thirteen 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 an equal dollar amount in each of the positions for the following year, and then I reinvest in the new list.
The following is my Top 10 for 2019, listed in no particular order. Prices are as of the December 27 close. This year’s Top Ten represent a nice combination of growth and defensiveness. Eight of the 11 S&P 500 industry sectors are represented, and their average long-term estimated growth rate (in EPS) is well in excess of the overall market. Also on average, these companies are much larger than the average S&P 500 company while carrying an average dividend yield of about 2.1%.
Results have been good in some years and not as good in others. I will sell my 2018 names on Monday, December 31st and buy the following names that afternoon. The reader should not assume that an investment in the securities identified was or will be profitable. 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.
Top Ten for 2019
Prices as of Close on December 27, 2018
Walt Disney is one of the most prestigious brands in the world, having evolved from a small animation studio in its early days to a major media and entertainment conglomerate in its current state. CEO Bob Iger has played a large part in the company’s transformation as he has spearheaded several acquisitions since taking the helm in 2005, including Pixar Animation Studios, Lucasfilm, and Marvel Entertainment. Disney is currently in the process of finalizing the acquisition of most of 21st Century Fox’s (FOXA) assets, which will deepen the company’s library of content and expand its international reach. Further, DIS has decided to pivot its strategy from licensing content to third parties to going directly to the consumer as it prepares to launch a Disney branded “Over the Top” (OTT) service in late 2019. The company already launched an ESPN-branded OTT service in April that is off to a strong start. While this shift will require increased investments and may cause short-term disruption, we believe it is the right strategy as Disney is one of the few companies that can threaten Netflix with its deep library of content and loyal following. Despite paying a large premium for FOXA’s assets, Disney is one of the least indebted media companies and generates strong free cash flow. The stocks trades at 14.9x the consensus for CY2019, which is a small premium to the S&P 500. The dividend yield is 1.7%.
CVS Caremark (CVS)
CVS is comprised of over 9,900 retail pharmacies, more than 1,100 walk-in medical clinics, a pharmacy benefits manager (PBM) with approximately 93 million plan members, a senior pharmacy care business serving more than one million patients per year, an expanding specialty pharmacy business, and a leading stand-alone Medicare Part D prescription drug plan. Further, the company recently closed its transformative acquisition of Aetna as management seeks to become a vertically-integrated, one-stop shop for healthcare services. We believe this acquisition makes strategic sense and has the potential to unlock significant synergies while lowering overall costs for consumers. This will likely be accomplished through the use of integrated data and analytics to increase the effectiveness of patient management. Additionally, the company will look to reduce unnecessary hospital visits by expanding the services available at its Minute Clinics. We believe that CVS is in a favorable position to benefit from the changing market dynamics including the shift towards value-based care delivery and the “retailization” of healthcare. CVS and Aetna both have stable businesses that generate strong cash flow, which should allow them to de-lever the balance sheet to its long-term target of 3x debt-to-EBTIDA within 2-3 years. The stock currently trades at just 8.7x estimated CY19 EPS and offers investors a 3.1% dividend. The depressed valuation seems to have little to no good news priced in and appears attractive for long-term investors.
FedEx stock has suffered recently, falling by 41% from its 52-week high in January. We think the drop reflects a combination of weaker economic growth (in the US and abroad), the trade war with China, and the perception of a competitive threat from Amazon.com. While the first two concerns may be somewhat justified, the Amazon threat is likely overblown. It has taken FedEx several decades to build a world-class distribution network, the likes of which cannot be replicated over a short period of time. Furthermore, we believe the rapid growth in e-commerce will create the opportunity for many different transportation companies to flourish in the years to come. With regard to slower economic growth, it is true that the company’s earnings power can be heavily affected by a deteriorating economic backdrop, to include reduced trade. The reason is that FedEx, along with other transportation companies, have high fixed costs that cannot be quickly and efficiently eliminated in the event of a widespread decrease in demand for its services. Somewhat offsetting the economic and trade risks are the ongoing restructuring of the company’s Express segment and its recent acquisition of TNT Express, both of which serve as sources of profit growth that are not as heavily dependent on the economy. Also providing some downside protection is the company’s current valuation at just around 9.4x our expectation for CY19 EPS, which is a sizable discount to both UPS and the S&P 500. We believe patient investors will be rewarded by establishing positions at current levels. The yield is 1.6%.
Goldman Sachs (GS)
Goldman Sachs stock has plummeted about 40% from its 52-week high early in the year. While some of the drop reflects the poor performance of the financial sector at large (the S&P 500 Financials sector is down 22% from its high), the weakness also reflects an ongoing scandal that has implicated both GS and some of its employees. The controversy, which involves an obscure investment fund in Malaysia known as 1MDB, seems likely to result in financial penalties that could reach into the billions of dollars. The bigger threat, however, could be the damage that GS may sustain to its reputation, putting future business opportunities at risk. Still, similar improprieties by competitors, most notably the London Whale incident at JP Morgan, have been resolved without major long-term damage – either financial or reputational. We suspect that the attention surrounding these allegations will subside after a period of time, following which investors may once again focus on the company’s efforts to grow revenue by $5 billion or more annually over the next 2-3 years. The company remains the premier global investment bank, with consistently high revenue share in equity offerings and mergers & acquisitions, as well as a growing presence in fixed income. Moreover, the current valuation should serve as downside protection while affording plenty of room for financial penalties related to the 1MDB scandal. At 0.89x current tangible book value, the stock is trading as if the company will not be able to earn its cost of capital over time. We think this assumption is far too conservative. The current dividend yield is 1.9%.
Johnson & Johnson (JNJ)
Johnson & Johnson is one of the world’s largest and most diversified healthcare companies with revenue divided among the Pharmaceutical, Medical Device, and Consumer segments. The company should continue to benefit from an aging global population and rising standards of living in the world’s emerging economies. Johnson & Johnson has a long history of growing its businesses organically while simultaneously adding value by adeptly managing its portfolio of over 250 operating companies. JNJ enjoys a AAA-rated balance sheet, produces ample free cash flow, and generates above-average returns on equity. The company has been pressured over the past couple of weeks following a damaging Reuters article which alleges that JNJ’s management knew for decades that asbestosis, a cancer-causing agent, lurked in its signature baby powder product. These concerns have left JNJ trading at 17.0x the estimated CY2019 EPS. This reasonable multiple, the 2.8% dividend yield, and our expectation that JNJ should continue to grow faster, and in a more stable fashion, than the overall market over the next five years, underpins our positive view of the stock at current levels.
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 around the globe. The company is moving from one focused on growth at any cost to a more mature company that will grow closer to the industry average in the future. That transformation includes focusing on faster growing and more profitable digital services. The company has also reduced its dependence on off-shore labor and is hiring more domestically. We think the stock offers a combination of growth and defensiveness. Growth should come from exposure to the secular trends of increasing digitalization, corporate cost-cutting, regulatory change, and technology shifts (mobility and cloud), and the defensive attributes include the company’s outsourcing maintenance revenue (generally long-term recurring revenue) and a balance sheet that has nearly $7 per share of cash, net of debt. At 13.0x the calendar 2019 consensus EPS estimate and high-single digit to low double digit growth, we find solid longer-term value in Cognizant shares. The dividend yield is 1.3%.
Ross Stores (ROST)
Ross Stores operates in the growing off-price retail channel and has increased its market share in recent years. The company has benefitted from slowing mall traffic as it offers a better value proposition than department stores and other full-price retailers. ROST continues to expand its 1,720-store base at 5-6% per year, and management sees the potential for 3,000 stores over the long term. Unlike most specialty retailers and department stores, ROST does not require fashion or product innovation to drive profits. Instead, access to cheap inventory and the quick turnover of that inventory drive traffic and allow the company to leverage operating costs. The company promotes a “treasure hunt” experience as they offer name-brand items at 20-60% below department stores, which drives repeat visits and is difficult to replicate in an online setting. ROST has only failed to grow EPS in three years since 1988, and their ability to grow earnings during the last two recessions shows that the company has been more defensive than the average retailer during economic downturns. ROST trades at 18.3x on a CY2019 basis, which represents a premium to both peers and the S&P 500. Having said this, we think this stock deserves the higher valuation given its strong cash flow generation, resilient balance sheet, and ability to generate double-digit EPS growth. The dividend is 1.1%.
Facebook has had a rough 2018, much of it brought upon itself. The company did not manage user data with proper care and caused self-inflicted wounds with its slow response. Additionally, the company is deemphasizing the news feed and encouraging the use of “stories.” The short-term downside to all of this is increased costs to secure data and better police its user-generated content, plus slower revenue growth as stories monetize at a much lower rate than the newsfeed. We think a long-term benefit to the “stories” format is that it will monetize across all of its properties – Facebook, Instagram, and WhatsApp. The same network effects that brought 2.3 billion monthly users to Facebook is now working for Instagram, which passed the billion user mark in the second quarter of this year. The two biggest risks are users leaving Facebook en masse and government regulation. We see little evidence of the former and unless the latter is specifically targeted at Facebook, the company will still have the best data set, targeting, and return on investment for advertisers. The negative sentiment is extreme, but looking out a few years, we think it has ample earnings power. Shares trade at 17.9x the CY19 EPS estimate, and while earnings will show little to no growth over 2018, revenue growth and expense growth should be better aligned exiting 2019. We believe this should allow for double-digit EPS growth in 2020-2022. The company does not currently pay a dividend.
Chevron is a US-based integrated oil and gas company with global operations. Chevron’s production profile is 67% liquids (primarily oil), and oil prices have fallen over 40% from the 2018 high. Oil is suffering from oversupply fears as demand estimates fall on global economic and trade-war concerns. Globally, oil fields have natural decline rates of roughly 5-7%. Decline rates for US shale wells are far more rapid with initial production rates falling 70% over the first 12-18 months of operation. Production from the fracking of shale rock is rising domestically, but few are able to achieve sufficient returns on capital. Moreover, higher interest rates make it more difficult for these companies to finance cash-flow deficits. Chevron has been devoting more focus to its cost structure. The mega projects are complete and are lifting production volumes, putting the company in a position to generate cash sufficient to cover capital spending and dividends at $50 oil. This discipline should serve the company well in this new era of shorter oil cycles. The stock is trading at 13.5x CY19 estimated EPS with a 4.1% dividend yield. It helps to normalize earnings of companies that operate in cyclical markets, and doing this with Chevron leads to a valuation at 18x normalized earnings or 16x its average annual EPS for the last 17 years.
United Technologies (UTX)
United Technologies is a diversified industrial company that provides products and services to the building systems and aerospace industries worldwide. The company’s aerospace segments, Pratt & Whitney and UTC Aerospace, target both commercial and government (including both defense and space) customers, while its industrial businesses include its Otis elevator business and its Carrier HVAC business. The company has an enviable long-term track record of financial performance, with strong double-digit EPS growth, outstanding cash generation, and a rock-solid balance sheet. However, recent performance has been held back by development costs for the company’s ground-breaking new geared turbofan (GTF) jet engine as well as increasing competition and pricing pressure in Europe and China for Otis elevators (both new equipment and service revenue). We think the company is taking the appropriate action to improve performance in these two areas, including the decision to split the company into three parts within the next 18-24 months. Once the separation is complete, each company will be able to increase focus, transparency, and earnings visibility, with the goal of ultimately creating more shareholder value than under one umbrella. At 13.6x estimated CY19 EPS – a discount to the overall market – we don’t think the company is getting credit for its world-class franchises or the deferred earnings created by its investments in the new GTF engine. In addition, the current dividend yield is an attractive 2.8%.
Data obtained from Thomson Reuters, Bloomberg, and Yahoo Finance. Long-term growth rates are an average of FirstCall and Bloomberg.