Stockwatch tips review: Four big hitters and what to do now
As US stocks rally, our analyst thinks it best to focus on quality without losing sight of valuation.
27th December 2019 09:31
by Edmond Jackson from interactive investor
As US stocks rally, our analyst thinks it best to focus on quality without losing sight of valuation.
There’s quite a parallel between the likes of London-listed JD Sports Fashion (LSE:JD.) I discussed last time, and US stocks I’ve preferred; mainly that a capability to leverage global brands correlates with equity out-performance.
Possibly, once a company achieves this status, shareholders are loath to dump its stock and fresh money is attracted to a sense of security – or more ominously, “fear of missing out”. So, pockets of apparent over-valuation appear versus the underlying numbers.
Mind, a key US sentiment indicator suggests traders are as bullish now as they were in early 2018 and autumn 2018, prior to sell-offs. However, I suspect this relates to progress finally with China on trade, and also the financial community reckoning President Trump’s impeachment by Democrats will be thwarted by Republicans in the US Senate.
I suspect it will boost his 2020 re-election campaign similarly as “Stop Brexit” (versus the 2016 referendum) empowered Boris Johnson.
Trusting in market leaders has paid off
My approach has also derived from the tougher challenge, generating investment ideas in the US market with a “bottom up” approach, investigating companies. The UK’s regulatory news service makes it possible to screen the entire market for fresh clues from 7am, whereas in the US you face a dense forest of detail via 10-K reports and the like.
Ideally, a “top-down” quantitative approach is needed, using databases to generate and refine stock lists. If Labour had won our general election then I would have considered a closer focus on the US, although it is a full-time occupation.
My current thinking is that it is best to focus on quality without losing sight of valuation, so Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Estée Lauder (NYSE:EL) and Walmart (NYSE:WMT) are key stocks I’ve alighted on.
US market remains overvalued in historic context
Researching UK and US stocks, price/earnings (PE) multiples have expanded much further over the pond. Market index data affirms so too: the trailing 12-month PE ratio on the S&P 500 index is currently around 23.7x versus a mean average 15.8x and a median 14.8x.
It has tested 20x ranges many times in its history, reaching 25x in the early 1990’s and the low 40s in the early 2000 market peak, although beware that history suggests mean-reversion remains intact.
Apple Inc: the diversification story evolves
The long-term context is my being bullish on Apple initially as a contrarian play back in August 2013 when (adjusted for stock splits) the price of $71 represented 12.5x historic earnings versus 23x recently. And yet the underlying rationale, of diversifying from a past reliance on iPhones, remains similar.
The stock began a sustained rise from mid-2016, though showed vulnerability to a market reverse – hit by the fourth quarter 2018 slump. As a tribute to Apple’s strength, however, this set up a spectacular 81% rally from $148 to $280 over 2019, maintaining an overall uptrend since 2016.
Last November, I switched my stance to “hold” given Apple has some vulnerability to US/China trade tensions.
More positively, the global smartphone market returned to growth in the third quarter of 2019 after a two-year slump, and a year’s free subscription to Apple TV – linked to purchases of Apple hardware – looks likely to rake in potential subscribers versus Netflix (NASDAQ:NFLX). Progress in US/China talks is likely the key driver, near-term.
Microsoft Corp: goes from strength to strength
In a post “Jobs versus Gates” era, the contest rather continues with Microsoft scoring better for PE expansion. When I originally drew attention back in May 2011 at $20.75 the stock was on a forward PE of under 9x and I mooted: “a good example how yesteryear’s growth shares can become today’s value plays, as the fallout in sentiment spurs management to achieve better.”
A hedge fund manager accused Microsoft’s then CEO of “Charlie Brown management”, lurching from one problem to next, failing to exploit the scope for mobile devices and the internet (like Apple was doing). Yet this fund had kept accumulating Microsoft shares which looked able to bounce back, quite similarly as IBM (NYSE:IBM) did in the early 1990’s under a new CEO, also Apple’s resurgence after Steve Jobs took back the reigns in 1996.
So, when Satya Nadella was appointed CEO in July 2014, declaring a strategic break with the past – to prioritise cloud and mobile – it struck me as a game-changing moment.
Around $155 currently, the historic PE has advanced to 29x versus recent earnings per share (EPS) growth of 21% and annualised revenue growth in the low to mid-teen percentages. That’s a continued advance in the rating from 27x when I last commented in October suggesting “hold”, although Microsoft’s PE is nothing like Amazon (NASDAQ:AMZN) mid-70x as a chief rival.
Microsoft also has better-balanced profits, deriving 27% from cloud computing versus 70% for Amazon.
The big boost for cloud has been a required transition for businesses i.e. significantly independent of the general investment/IT spending cycle, although in future it won’t be immune.
So, quite where a PE rating adjusting for this prospect lies is unclear; probably lower than today, but the market isn’t in a mood to contemplate.
Meanwhile, other Microsoft businesses do well, affirming capability to pace change in technology and re-invent itself.
It’s very hard to challenge this stock’s momentum currently and it would probably benefit from a US/China trade deal in the near term - then Trump’s re-election next November.
Though America is divided similarly as Britain, I suspect the Democrats won’t cut it, similarly as Labour.
Microsoft is therefore a particularly good example of how end-2019 valuations are getting riskier, if hard to contest now a compromise-accord on trade with China appears finally to be emerging.
Estée Lauder: riding high on beautification
I drew attention as a “buy” at around $150 last February along a rationale that cosmetics are enjoying a boom amid a global epidemic of narcissism to beautify personas and prop up egos. Also, a globally expanding middle class - China especially - is amenable to repeat purchases. Estée’s revenues had leapt 20% in Asia Pacific and new product launches were at all-time high of nearly 30% of the business.
The stock breached $207 last September and is currently around $204 on a rich trailing PE multiple in the high 30’s, yielding just 1.9% - fundamentally over-priced relative to earnings growth averaging 20% over the last two years, although a private buyer of the business would likely also respect brand values as providing long-term stable cash flows.
Estée looks exposed should the US market take a dive, but overall a “hold” stance appears fair.
Walmart: A success story now embracing digital
The stock attracted me last February to rate a “buy” just below $100: strong annual results reflected astute marketing, while the business also extended grocery store pick-up options and home delivery services across the US. Product availability on Walmart.com had also widened, following several clothing brands’ acquisitions, to become the third-largest online retailer in the US after eBay (NASDAQ:EBAY) and Amazon.
Once again it has worked in the US to swallow a premium PE: Walmart’s trailing multiple was 20 times versus an 11% underlying earnings growth which, like Estée Lauder (also JD Sports even Pets at Home (LSE:PETS)), is to an extent justified by a durable consumer franchise.
Mind the US concept of “franchise” as advocated by Warren Buffett, implies more brand strength rather than a sense of entrepreneurs running an operation as agent for another company’s products/services.
Walmart’s market price has now twice hit $120 since last October, and, barring a US market slump, I suspect a premium (of varying extent) for Walmart will persist. This stock has enjoyed a long period of defensive growth since the early 1970’s, its latest re-rating phase linked to going digital, so should have further to run.
Even in a recessionary scenario the likes of Walmart would cope well, despite its stock being liable to see some PE contraction. With the US market appearing supported, a “hold” stance seems fair.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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