Friday, July 5, 2019

3 Blue Chip Stocks I'm Buying

Companies with high ROIC have a solid track record of outperformance.
Many stocks are expensive now, but there are still attractively priced companies out there, especially compared with low-yielding or negative-yielding bonds.
This article examines three companies that look appealing, at three different levels of risk.
The core of my investing approach has been focusing on ETFs and blue chip stocks for fifteen years now, which I then augment with some trading in other asset classes around the edges.
More specifically, I complement my blue chip stocks with international ETFs, cash/bonds, precious metals, a few small stocks, and occasional option trades. For example, I like to take advantage of various crashes that happen around the world from time to time, whether it’s Brazil’s major 2014 recession or the sudden oil price crashes of both 2015 and 2018.
But generally, core blue chip stocks don’t require much time or energy to maintain. I like to think of it as pruning the garden now and then.
This article describes the characteristics I look for in a blue chip stock, and then lists three I like right now. These are some of the more interesting stocks for 2019 in my opinion, for those that plan to hold for a long time.

How to Find the Best Blue Chip Stocks

Blue chip stocks are large recognizable businesses that are market leaders in their industries, and they are often (but not always) rather diversified as well.
They get their nickname from blue poker chips, which tend to be high-value chips in the game.
Many people think of blue chip stocks as safer but lower-returning companies, and while there can be truth to that stereotype, it’s not how I approach it.
According to data from Wilshire Associates, mid-caps have been the best performing market segment over the past four decades. Equally weighted large cap stocks are also near the top of the performance list.
Smaller companies are highly variable. Some members of the group have absolutely explosive gains as they break out and become mid-cap or large-cap companies. However, there is a high failure rate, and many of them go bust. The good ones also tend to trade for high valuations.
Larger companies are less variable. They’re already so big that they are less likely to have explosive gains, but they also tend to have lower failure rates.
The sweet spot for risk-adjusted returns, in my experience, is mid-cap stocks or the smaller range of large-cap stocks that have three key quality criteria:

Criteria #1) High Return on Invested Capital

A company’s return on invested capital (ROIC) is its annual operating income with taxes removed, divided by its invested capital. This is a more accurate measure than return on equity (ROE), because it cannot be gamed with high leverage.
It’s a general rule of free markets that if a company begins to achieve excessive returns (high ROIC), other companies will try to compete and get some of that action, which then drives down the return on invested capital in that industry closer to the weighted average cost of capital (WACC).
However, some companies are able to develop economic moats around their business that keep competitors at bay and allow the company to generate superior ROIC for decades, with a wide gap between their ROIC and WACC. These economic moats include prime real estate locations, network effects, high switching costs, patents, cost advantages, trusted brands, and oligopolies.
A blue chip stock, in my opinion, is better-judged by how wide its moat is, rather than based on size of the company. This is more of an art than a science, but the key quantitative indicator of a moat is a consistently high ROIC for long periods of time.
One of the famed applications of ROIC for finding good companies is by Joel Greenblatt. His “magic formula” involves ranking all companies by ROIC (quality), ranking all companies by P/E (valuation), and then cross-ranking those lists to find the companies that have the best blend of high ROIC and low P/E (quality and value), and his funds that have been based on this approach have enjoyed long-term outperformance.
For more reading on this subject, there’s a great article on Forbes by David Trainer that goes into ROIC in detail, describing how it’s an under-followed metric but that companies that focus on it tend to outperform.
What constitutes a “good” ROIC varies by industry. Successful software companies tend to have sky-high ROIC because their cost of capital is so low. Commodity producers tend to struggle with low ROIC because they have little or no control over the price of their product and yet have huge fixed capital expenditures.
For a blue chip stock, I look for an ROIC over 12%, and higher than its competitors.

Criteria #2) A Healthy Balance Sheet

High leverage can undo in a day what took a century to build.
Large debt levels can sink an otherwise high-quality company, and worsening debt metrics can be a sign of a problem, indicating that a company is losing some of its luster. For this reason, I turn down many popular “value” stocks for inclusion in my portfolio due to ugly balance sheets more than any other reason.
During periods of turmoil, well-capitalized companies with strong balance sheets can take advantage of fallen competitors that took on too much debt and make low-cost acquisitions or take market share.
However, it’s important to keep context in mind. Low interest rates through much of the developed world give companies an incentive to shift their capital structure more towards debt than equity, for better or worse. Different industries require very different levels of leverage to operate, so we can’t compare software to infrastructure as though they were the same business, for example.
For me, the most important debt metric is the debt/income ratio. I favor this metric more-so than debt/equity (which varies quite a bit based on how capital-intensive a business is), and more-so than the interest coverage ratio (because this ratio can lull us into a sense of complacency during periods of unusually low interest rates, which are not guaranteed to stay that way forever).

Criteria #3) Long-term Growth Potential

A healthy company is a growing company, but again, the metric is somewhat relative compared to industry and valuation.
A good benchmark is the nominal GDP growth rate of the company’s primary markets.
If a company is growing more slowly than the rate of GDP growth, it’s a sign that the company’s industry is becoming a smaller piece of the economy, or that competitors within that industry are taking market share, or both. In contrast, if a company is growing more quickly than the rate of GDP growth, it’s a sign that the company’s industry is becoming more relevant, or that the company is taking market share from its competitors.
Occasionally, there are exceptions, where growth is not very relevant. Some of my best investments over the past decade have been insurance companies with little or no growth, because their low valuations justified the stock, most of the cash went towards dividends and buybacks (thus growing earnings and dividends per share at high rates), and their lack of growth was mainly attributable to a low interest rate environment, which put pressure on their float returns.

3 Blue Chip Stocks I’m Buying Now

Rockwell Automation (ROK)

Rockwell Automation is one of the leading providers of industrial automation hardware and software.
Compared to some of the big components of the S&P 500, it’s a relatively small company at only $20 billion in market capitalization. For example, it is less than a tenth of the value of Cisco (NASDAQ:CSCO) and less than one-fiftieth the value of Microsoft (NASDAQ:MSFT). In a world that is becoming increasingly more automated, I think Rockwell has a long runway of profitable growth ahead of them.
Chart Source: F.A.S.T. Graphs

Their ROIC is usually over 20% in any given year, and dropped to a “low” of just 11% during the 2009 crisis. Virtually, all of their free cash flow from this excessive profitability goes towards dividends and share repurchases, which make up a substantial portion of total shareholder returns.
Total debt is slightly more than 2x annual net income, and net debt (debt minus cash) is a bit above 1 year’s worth of annual net income. Their balance sheet is rock solid.
As recently as 2018, Rockwell was trading at over $200/share. I’ve had a $145 fair value on the company for a while, which looked small compared to that high level. It’s a great company, but the market realizes this to be the case, so it’s often priced at a premium.
However, during the big sell-off in Q4 2018, Rockwell’s stock dipped to $141. Then, it dipped again to $148 again last month, which led me to write a detailed analysis of it.
This company rarely gets quite as cheap as I’d like, but I began a small position in June in the low $150s. If we have a recession within the next two years, we could very well see lower lows on this one, since it is cyclical. If that becomes the case, I will likely increase my position with another purchase.
Chart Data by YCharts
In the meantime, it is a small part of my nearly equal-weight dividend portfolio that I dollar-cost average into, so whenever it underperforms the rest of the stocks in that group, I’ll be accumulating more shares.
As an engineer, I’ve used some of their automation products in the past, and it’s a company I’ve followed for a long time.

Nordstrom (JWN)

For investors with some risk tolerance, Nordstrom is starting to look interesting. I expect this one might be the most controversial on the list, and for good reason.
Nordstrom is a luxury and semi-luxury department store chain that was founded in 1901. They have 121 full-price Nordstrom locations in the United States and Canada, and 245 Nordstrom Rack off-price locations. Importantly, they have high-selling websites for both sides of the brand. They also own Trunk Club, which is a service that sends a personalize box of clothes to your house, and you can buy what you like and send the rest back.
With a market capitalization of less than $5 billion, it’s a large mid-cap or a small large-cap company. They pay a dividend yield of about 4.6%.
Nordstrom maintains relatively high ROIC for the retail sector (typically around 14%, although it’s quite variable), remained profitable during the 2008 global financial crisis, and has been growing revenue over the past decade, while Macy’s (NYSE:M) and other big stores have been slowly or in some cases quickly withering away from the onslaught of Amazon (NASDAQ:AMZN) and other online retailers.
Nonetheless, Nordstrom’s stock has taken a dive lately:

Chart Source: F.A.S.T. Graphs
The key problem here is that although Nordstrom has had reasonably strong sales, their margins have been deteriorating, which has hurt their profitability. Gross margins have declined from a peak of over 39% in 2012 to under 36% today, and operating margins have declined from over 11% to under 5%.
However, while the company is indeed under external pressure, a portion of this margin reduction was due to intentional investments that management expects to pay off in the 2020s.
These investment outlays are expected to end in the early 2020s, resulting in what management hopes is improved ROIC:

Nordstrom Plan
Nordstrom Plans

The disappointing results of Q1 2019 have cast a shadow on Nordstrom’s operations, but the stock price decline was a bit of an overreaction in my view.
Nordstrom’s balance sheet is solid, with a net debt that is equal to about four years’ worth of annual income and a BBB+ credit rating. I’d like to see a little bit less debt for a company with this level of pressure, but it’s not concerning at this point.
Nordstrom doesn’t have quite the blue chip stock status that it once had before the retail apocalypse started happening, but I conclude that the current valuation more than justifies the metrics at this time. The stock price is less than 10x expected 2019 earnings, which only makes sense under a negative growth scenario going forward.
That negative outcome could occur, and there is risk here. However, I have a cautiously optimistic long-term outlook on the company for two reasons.
The first reason is that online retail is likely to stop eating physical retail’s market share at some point, and the two categories are merging. Amazon, for example, is opening its own physical stores and partnering with some physical store chains. Nordstrom has been strongly growing their online sales as a percentage of total sales, and now 31% of their sales are online compared to only 18% five years ago. Having a combined physical/online footprint makes the overall experience better, makes the return process smoother, and gives more direct access points to the customer.
It’s best to stop thinking in terms of online vs physical at this point, and instead think about which companies will survive and thrive in their categories as omnichannel retailers. Will Nordstrom continue to be a relevant brand in the higher-end space, both online and offline? I would wager yes. The company is taking important steps to close under-performing stores and focus on its healthiest locations and its online platforms.
The second reason that I have a reasonably favorable outlook is that Nordstrom targets a higher-end demographic in terms of income and wealth. The top 10% richest Americans have 70% of the wealth.
When it comes to understanding the U.S. consumer, there is a broad misconception that the typical American is rich relative to the rest of the developed world. This comes from not differentiating between the mean net worth (the total net worth simply divided by the number of adults, which is skewed heavily by the top end), and the median net worth (the net worth that someone in the 50th percentile has; the actual typical/middle person).
Imagine an extreme example where you have 10 people in a room. One of them is Jeff Bezos, and the other nine each have a net worth of $100,000. The mean net worth in that room is about $15 billion while the median is $100,000. The median is a better representation of most people in that room.
According to the most recent Credit Suisse global wealth report, the United States is the fourth richest country in the world based on mean net worth, but only 19th in the world based on median net worth, which puts us behind the majority of other advanced countries.

Wealth Chart
Data Source: Credit Suisse Global Wealth Report

The U.S. is a bit of an outlier because we have more wealth concentration than most other developed countries. Typical folks in South Korea, Japan, Taiwan, Canada, and much of western Europe are wealthier than their middle class peers in the United States.
I’m not a fan of retail stocks in general and have avoided losing money in the industry. My only retail stocks are Nordstrom, which I’m just buying for the first time recently, and Dollar General (DG). One targets the higher-end where most of the money is, and one targets the lower end where most of the people are. I stay out of the middle.
Nordstrom would also be a good candidate to add to my top 3 value stocks list, replacing the most expensive one in that group.

Unilever (UL)

Unilever is a well-known British-Dutch consumer goods company, and perhaps deserves “blue chip stock” status the most on this list. With a market capitalization of about $180 billion, it’s by far the largest business on this list as well.

Chart Source: F.A.S.T. Graphs
The company maintains ROIC consistently in the high teens, and sometimes over 20%. This compares favorably to Procter & Gamble (PG), which usually has low-teens ROIC, even though Unilever’s stock is also cheaper and with a slightly higher dividend yield.
Unilever’s net debt is equal to about two years’ worth of annual net income. Although they do make generous use of cheap leverage, the company maintains a very solid balance sheet, especially considering how stable and diversified their cash flows are.
While I’m not a fan of the consumer staples sector in general, what draws me to Unilever is their very large emerging markets exposure. They earn a full 60% of their revenue from emerging markets, which is where the majority of population and world GDP growth is coming from.

Emerging Markets Growth Projections
Chart Source: PwC Global

This global focus unshackles Unilever from Europe’s slow growth, and yet their valuation remains somewhat muted due to bearishness on European stocks in general.
Moreover, the company has increased their operating margin over time. As they described in their Deutsche Bank Paris 2019 Global Consumer Conference, over the past 10 years, they have deemphasized packaged foods from 54% to 38% of sales while boosting beauty and health products from 28% to 42% of sales. Home care has remained relatively flat at 18% of sales 10 years ago compared with 20% of sales today.
Unilever pays a dividend yield of nearly 3% and has doubled their dividend in local currency over the past decade.
There is now $13 trillion worth of negative-yielding debt in the world, mostly from Europe and Japan.

Investors normally think of bonds as being safer than stocks, but when a stable company like Unilever pays you to own its stock, and sovereign bond issuers want you to pay them for the privilege of owning their debt, then I would be more worried about negative-yielding long-term bond performance at this level than the performance of solid dividend stocks like Unilever.
Disclosure: I am/we are long ROK, JWN, UL, DG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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