Includes:
Summary
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.
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.
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:
Source: 2018 Investor Day Slides
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.
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.
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.
Chart Source: U.S. Global Investors via Forbes
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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