(Image Credit, fortune.com)
This is Part 2 of How to Find Undervalued Stocks Using the 80/20 Rule – Bill Nygren. To read Part 1, click here.
The following is a continuation of the speech given by Bill Nygren at the Thirteenth Annual Louis Rukeyser Investment Conference, in 2005.
Let’s take a look…
Another new holding for us is Citigroup. Citi has often been referred to as the strongest global financial services franchise. That’s why we believe that five years ago, Citi sold at twenty-two times earnings when most financial service companies sold at single-digit P/E ratios.
Earnings this year are expected to be almost two-thirds higher than they were in 2000. Despite that, the stock has declined about 20%, making its current P/E ratio only about eleven times, half what it was in 2000. Most other financial service stocks have increased in price over the past five years, so they now also trade at double-digit P/Es.
Citi no longer commands any premium. It sells at eleven times earnings, yields nearly 4% (exceeding money market fund yields) and has an asset base that is broadly diversified across both geography and product lines. We believe Citigroup is a competitively advantaged financial services company that is being priced like it is only mediocre. If we are right, it is likely that five years from now, Citi will have grown EPS faster than other financial stocks and will also sell at a higher P/E than they do.
We’ve added Limited Brands to our portfolio. We think Victoria’s Secret and Bath & Body Works are two of the strongest franchises in all of specialty retailing. They sell products to which consumers have shown below-average price sensitivity, and they are brand and image conscious.
We think that means they are unusually well protected from Wal-Mart competition — which is the first concern about any potential retail investment. Victoria’s Secret and Bath & Body Works account for over two-thirds of Limited’s sales and for nearly all of their operating profit.
If that were the end of the story, I don’t think Limited, with no net-debt on their balance sheet, would be selling below the S&P multiple at about sixteen times earnings. The problem is that Limited also owns two apparel retailers that are struggling — Express and, their namesake, the Limited chain. Despite management efforts to turnaround these businesses, results are still disappointing with declining same-store sales and non-existent profitability.
Should management succeed at making Express as successful as The Gap has made Banana Republic, it would add tremendously to Limited’s value. If not, management has a good track record of closing down failed concepts, pulling out cash from those businesses, and redeploying that cash effectively. One of their favorite ways to redeploy cash is through share repurchase; in just over a year, Limited has repurchased about 20% of their outstanding shares.
So, at a slight discount to the market P/E, Limited offers participation in two great specialty retailers, offers an option on a successful turnaround of Express and if that fails, some cash from shutting it down that would likely be used to further reduce the share base. I’d gladly own Victoria’s Secret and Bath & Body Works at the price of an average company. The market today not only allows us to pay less than an average price, but it throws in apparel for free.
Coca-Cola is a high quality name that has come close to falling enough for us to buy, but we think there is a cheaper way to piggyback on their growth — Coca-Cola Enterprises. It is the world’s largest soft drink bottler. Coca-Cola Enterprises accounts for about 80% of Coca-Cola’s U.S. sales and about 25% of their sales outside the U.S.
The stock has been publicly held for almost twenty years, following Coca-Cola’s decision to separate the two businesses. In 1998, Coca-Cola Enterprises sold at $42 per share. Despite sales growing by a third and income growing more, the stock price has been cut in half, now selling for $21.
At sixteen times earnings, Coca-Cola Enterprises sports a below average price. As the primary vehicle for Coke to sell its concentrate, we think Coca-Cola Enterprises enjoys a competitive advantage deserving of a premium valuation.
We’ve also bought Raytheon, the fourth largest defense contractor. The stock peaked six years ago at $75. It now trades at half that price. In hindsight, Raytheon was a poorly managed company that significantly destroyed value through a misguided acquisitions program. Especially bad was the construction business they purchased, which turned out to be worth much less than zero.
New management was put in place just under two years ago. We like the way they think about increasing the value of their business and the discipline they bring to capital allocation. The stock sells at just over twenty times trailing earnings but only twelve times expected 2006 earnings.
The rapid fall off in the P/E is not because Raytheon is a super-normal grower; rather, its business jet division was at a cyclic trough last year and seems to be headed toward normal profitability next year. We think the lingering perception of sub-par management and the fact that a simple P/E analysis on trailing earnings values the third largest business jet company at zero creates an opportunity for long-term investors.
JPMorgan Chase. In the Oakmark quarterly report following our purchase of JPMorgan, I joked that if all the acquisitions were still in the company name, it would be called JPMorgan, Chase Manhattan, Chemical, Manufacturers Hanover, Bank One, First Chicago, NBD Bank!
We think JPMorgan is a case of superior management coming in to a previously under-managed business. Last July, JPMorgan and Bank One merged. Bank One, which, like us, is headquartered in Chicago, has been managed by Jamie Dimon. Being a local company, we heard numerous anecdotes about the low-cost culture that Jamie brought to the bank.
Jamie’s challenge now is to infuse that same cost-cutting mentality into the JPMorgan side. Earnings in 2004 and 2005 are messy because the costs of combining the two businesses are depressing earnings, but the synergy benefits aren’t yet kicking in. By next year, we think the foundation will have been built for a significant earnings increase.
We think the stock is trading at about ten times next year’s earnings and that beyond 2006 there is a good possibility that revenue synergies will lead to above-average earnings growth. For us, JPMorgan is an example that shows the hunt for value doesn’t end with analysis of the assets. It’s also important to consider who’s in charge of those assets.
One of our founders consistently reminded us that the worst bet you can make is the bet that people will change. That’s why we always prefer investing with a management that has a proven track record of delivering value to its shareholders, and Jamie Dimon fits that bill.
Finally, for anyone disappointed that these stocks don’t sound like “real” value stocks, last quarter we did buy a stock with a single digit P/E ratio — Pulte Homes.
Pulte is the largest homebuilder in the United States. The stock sells at $73 (March 2005 month end). Pulte management says they expect to earn over $9 per share this year, and they see that number growing to between $13 and $14 by 2007. Clearly, investors don’t believe them, or the stock would be higher.
But betting against this management so far has been a losing bet. Earnings over the past decade have grown at nearly 30% per year, and book value has increased almost five-fold. I think there are two major issues that prevent Pulte from selling at a higher P/E.
First is a fear of a collapse in housing prices. I’m sure we’ve all heard stories about specific markets in which home prices have gone crazy — horror stories if someone needed to buy a home, bragging if they were selling! But in spite of imbalances in specific markets, we believe that two major factors have driven most of the increase in housing prices.
First, demographics: increased demand for both first-time homeowners and for second homes.
Second, lower interest rates. Despite higher home prices, we still hear stories of renters saving money by buying a home and making a mortgage payment instead of paying rent. We think that instead of a housing bubble, we are more likely at a several year plateau in prices.
The second reason investors are reluctant to give Pulte a higher P/E is the lingering perception that homebuilders make their money primarily on land sales, and that the only reason they build houses is to assist in selling off appreciated real estate. I think that view of the industry was reasonably accurate a decade ago, but this is no longer the case.
We believe the large homebuilders have achieved very significant scale advantages that allow them to buy building products at lower prices than their smaller competitors, and they can be much more efficient with labor. Today, we think the homebuilding leaders primarily make their money by building houses, not by buying and selling land.
If we are right, then managements’ earnings projections aren’t as crazy as the market believes, and a P/E ratio of less than half the market P/E is inadequate. If we are wrong, well, every year that passes until housing demand crashes sees Pulte’s book value grow by about 20%. We think book value is conservatively stated, and it should be in the mid-50s per share by the end of next year.
This stock is clearly not without risk and, I should caution anyone who hasn’t looked at homebuilders before, that these are some of the market’s most volatile stocks. But remember, in the hunt for value, we believe the volatility created by short-term traders is what creates our opportunities.
In closing, over the past five years, the market return was unsatisfactory. Most investors lost money despite outperforming the market. But a price sensitive stock-picker was able to add enough value through stock selection to achieve a decent return.
I think the next five years are likely to see a very different pattern. Since the large stocks that are weighted most heavily in the S&P are the stocks we think are most attractive, if we are right, it is going to be much more difficult for active managers to beat the market. But the market as a whole, to us, looks much more appropriately valued than it did five years ago — selling at about two-thirds the P/E, despite slightly lower interest rates.
I don’t normally plug competitors, but I thought Bill Miller made some great observations in his very bullish year-end report to shareholders. My favorite comment from that report was, “Being bearish or cautious always sounds smarter than being bullish.” How true.
At Oakmark, we spend most of our time finding undervalued stocks and put very little effort into developing a view of the overall market. It never sounds especially intelligent to say we don’t worry much about macro issues because they just usually work out! In fact, sometimes it can sound naive, but that approach has produced very good long-term results.
In contrast, the bears spend almost all of their time and energy refining their negative market arguments, so they usually sound not only smart but also almost prophetic. Next time someone sounds smart explaining that they don’t own stocks now because of the debilitating effects of the twin deficits, or the inevitability of higher interest rates, or the lack of global political stability, remember that they need to be really smart — they are the ones facing the difficult decision of when to get back into the market.
Because, over a generation, just owning stocks and piggybacking on the success of corporate America has proven to be extremely profitable.
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