There are many traps for an unwary investor that can lead you into deep water. One of my all time favourites is the erratic behaviour to buy cheap stocks just because they are cheap. Truth be told, I’m guilty of falling into that trap multiple times. Don’t get me wrong. Valuation is a key factor that requires an examination. But in the first place, quality has to be right. You want to invest in excellent companies that are trading at an attractive price. This is the most important part of the game.
It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful priceWarren Buffett
I’ve set up a quality rating to gain a first understanding about the excellence of a business. Its function is to identify companies with substantial earnings power, great profitability, healthy balance sheet and strong cash flows. Subsequently the next step is to check whether the price is appropriate. This is when the valuation rating comes into play.
That being said, I’ve run the numbers to come up with the TOP 5 ideas for the watchlist in December. These are the criteria, that I used for the screening:
- Quality: Final score => 70 points (min. 4-star-stocks, good quality)
- Valuation: Price/Fair Value Ratio =< 0,90 (min. 10% undervalued)
Final result – December 2018 watchlist
The quality rating is based upon 20 metrics divided into five categories. Each metric can score max. five points. In the end I sum up all points to come to the final quality score. Please take note that this is my individual rating approach. You might come to a different conclusion – and this is OK. The valuation rating presents the final result in form of the Price/Fair Value ratio. It’s an arithmetic average of the four valuation methods that I use to value a company. The further the Price/FV ratio moves below 1, the more the stock is undervalued. For example a Price/FV ratio of 0.89 indicates that the stock is 11% undervalued. Currently there are 50 companies in the pool. Without further ado let’s have a look on the five stocks that have qualified for the watchlist in December.
Dividend: 3.18% | 5-yr. Div. Growth Rate: 11.20% | Payout Ratio: 46%
BlackRock is the largest asset manager in the world, with $6.444 trillion in AUM at the end of September 2018. The company earns a four-star quality grade and appears to be 16% undervalued. I’ve initiated a position in BLK in mid November (you can read more about this purchase here: Recent Buys – BLK & GD). All in all my opinion about this high-quality business hasn’t changed since then. Therefore I believe the recent dip of BLKs share price below $400 offers a good opportunity to add to my position.
What I like: industry leader, trend towards passive managed products, low D/C (13%), excellent credit rating (AA-), wide moat (Morningstar)
What I don’t like: high-beta stock, dependency from economic cycles, increased competition among ETF providers
(2) Illinois Tool Works
Dividend: 3.09% | 5-yr. Div. Growth Rate: 13.30% | Payout Ratio: 60%
Illinois Tool Works (ITW) is a global diversified manufacturer with 85 business divisions and operations in more than 50 countries. ITW has qualified for the watchlist by earning a four-star grade in the quality rating. Furthermore the valuation approach indicates that its share price is about 11% undervalued. ITW is a member of the SF portfolio since July 2018. Thanks to the recent market volatility, we see an attractive price for this high-quality business. That is why I’m considering increasing my position.
What I like: expanding operating margins, 44 years of consecutive dividend increases, recent 28% dividend hike, 80/20 business approach, good diversification
What I don’t like: cyclical stock, sluggish industrial and automotive demand
(3) Bayer AG
Dividend: 4.34% | 5-yr. Div. Growth Rate: 8.06% | Payout Ratio: 70%
Bayer is a German healthcare and chemical conglomerate. The firm achieved a good four-star quality grade and seems to be significantly undervalued by 43%. The company’s shares had lost more than a third of their value this year on concerns about the legal and financial risks associated with its $63 billion takeover of Monsanto. Experts estimate €2 billion of legal costs in total linked to the remaining 9.000 lawsuits. However Bayers market capitalization slipped by more than €16 billion due to legal threats. In case that market participants have already priced in the worst case scenario, Bayer represents a good buy opportunity at current levels.
What I like: well-positioned drug division, leading brands (Aspirin, Aleve), recent focus on the core business (selling of the animal health division), restructuring and cost saving approach, wide moat (Morningstar)
What I don’t like: uncertainty of lawsuits linked to glyphosat, price pressure in the health industry
Dividend: 4.64% | 5-yr. Div. Growth Rate: 51.10% | Payout Ratio: 40%
Broadcom Inc. is a global technology leader that designs, develops and supplies a broad range of semiconductor and infrastructure software solutions. AVGO earns four stars in the quality rating. Its share price appears to be significantly undervalued in the amount of 37%. I bought Broadcom in August when the market was pessimistic due to the CA acquisition. Since then I haven’t regret this purchase. In fact the only regret is that I didn’t buy more, since AVGO continues to fire on all cylinders. On December the 6th, Broadcom has presented rock solid Q4 figures: +12% increase in net revenue and +27% EPS growth. In addition the company has announced to increase its quarterly dividend for fiscal 2019 by 51%! Well, there is a lot to like and very little to dislike about that business.
What I like: well-positioned in the IoT segment, share repurchases, very high dividend growth, growing revenues and earnings, positive free cash flow trend
What I don’t like: cyclical industry, high exposure to Apple (Apple accounted for more than 20% of revenue in fiscal 2017)
(5) Bank of America
Dividend: 2.36% | 5-yr. Div. Growth Rate: 57.70% | Payout Ratio: 25%
With more than $2 trillion in assets, Bank of America is one of the largest financial institutions in the United States. As the previous candidates, BAC also earns a four-star quality grade. Moreover a Price/FV ratio of 0.66 states that the share price might be significantly undervalued. To be honest, Bank of America has been flying under my radar so far. In generall, the SF portfolio is quite underrepresented in the financial sector – without any position in banks. This is something I really would like to change. So BAC passing the quality and valuation criteria came just in time.
In Q3 2018 Warren Buffett’s Berkshire Hathaway bought more than $13 billion in bank shares – including an additional investment of $6 billion in Bank of America. Five out of Berkshire’s TOP 10 holdings are banks, with BAC being the largest. When the most successful investor of all times is heavily into banks, it might be not the worst idea considering investing either.
What I like: Buffett investment, good EPS growth, rising interest rates might be good for BAC (more interest income), focus on efficiency and risk reduction
What I don’t like: risk of legal and regulatory issues, dividend cut in the financial crises
In volatile market environments it is especially crucial to be calm and stick to the plan. Personally, I practice to see market fluctuations as something natural. Share prices go up and fall. It’s their nature. There is nothing to panic about it. As long as the company’s quality is not affected, price fluctuations are nice gifts for long-term investors. The only problem we have to deal with, is to choose what gift we like the most.
Which companies made it to your buy list in December? Let me know about your potential candidates for this month.