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All Contents © 2018The Kiplinger Washington Editors
By Michael Brush, Contributing Writer
| January 12, 2018
The stock market was unkind to Warren Buffett disciples in 2017. Value investors missed out as their “cheap” stocks lagged growth miserably – by as many as 16 percentage points depending on the yardstick.
But that’s going to change in 2018. It’s shaping up to be the year Buffett’s minions may finally rejoice. “Value will have its day in the sun,” predicts John Buckingham, a veteran value investor and chief investment officer at AFAM Capital Asset Management.
Here are five reasons why – followed by 10 value stocks to buy for 2018 and beyond.
Here are 10 value stocks to buy for “the year of value”:
Data is as of Jan. 11, 2017. Dividend yields are calculated by annualizing the most recent quarterly payout and dividing by the share price.
Dividend yield: 2.6%
Gilead Sciences (GILD, $79.06) is a good example of how too much success can be bad for a biotech company. Unlike many drugs, Gilead’s blockbuster Sovaldi and Harvoni effectively cure patients with hepatitis C so they don’t have to keep dosing. The problem: Once Gilead has treated enough hep C patients, there are fewer left to take the drugs. This dynamic, plus competition from AbbVie (ABBV) and Merck (MRK), means Gilead’s hep C therapy revenue growth has vanished.
The hep C “problem” combined with investor concerns about crackdowns on drug pricing helps explain why this once hot growth name has turned into a favorite value stock of Albert Meyer, who runs Bastiat Capital. Meyer is worth listening to because he trounces the S&P 500. His accounts are up 176.5% since April 2006 inception compared to 104% for the S&P 500.
What might turn things around for Gilead, which trades for a forward price-to-earnings ratio of just 11.6? The company recently purchased a pioneering cancer treatment company called Kite Pharma. Its CAR T-cell genetic engineering therapy is poised for takeoff. Gilead has a strong portfolio of HIV therapies, and it is launching more. It also has a pipeline of immunology and liver disease drugs.
Meanwhile, despite its growth slowdown, Gilead still is incredibly profitable, Meyer says. And it pays investors a dividend yield of 2.6% while they wait for the biotech company to turn around.
Dividend yield: 3.7%
International Business Machines (IBM, $164.20) has the blues. The stock has gone virtually nowhere in the past year, in a strong market. “It is probably the most hated stock in the Dow Jones Industrial Average other than General Electric,” says Steven Check, a value investor at Check Capital Management, which has $1.5 billion under management. IBM has a forward price earnings ratio of less than 12, compared to 23 for Microsoft (MSFT).
Of course, hated names often are the ones most loved by value investors. IBM is a great example. Check counts it among his holdings in managed accounts and at his Blue Chip Investor Fund (BCIFX), which has outperformed its category by 2 percentage points a year, annualized, over the past three years. AFAM’s Buckingham also likes Big Blue.
IBM may be in old-school mainframe computers. But that’s not so bad. They still play a big role inside many companies because they’re reliable and secure. IBM recently rolled out a new version, the z14, and sales are picking up. IBM’s core mainframe business serves as a source of stability and funding for its “strategic Imperatives,” like analytics and cloud computing.
“It isn’t going to take too much in the way of good news for this stock to finally react,” Check says. A shift in investor sentiment could work wonders. Check points out that Microsoft shares have more than doubled in the past three years, even though earnings have barely budged from 2013-14 levels – thanks to a sentiment shift alone. Meanwhile, because of IBM’s core strengths, the downside is limited.
“IBM is not going away,” Check says. “Limit the downside, and the upside will take care of itself, eventually.”
Dividend yield: 1.2%
Coming out of the financial crisis when everyone hated Wall Street, Goldman Sachs (GS, $255.13) was described as a “great vampire squid ... relentlessly jamming its blood funnel into anything that smells like money” by Rolling Stone writer Matt Taibbi.
The moniker stuck. But it turns out Goldman was more of a vampire plankton. While colorfully described, the bank’s supposedly domineering presence hasn’t helped much. Goldman’s stock is up only 62% since Rolling Stone introduced the squid metaphor in early April 2010, compared to 169% gains for the SPDR S&P 500 ETF (SPY) exchange-traded fund (both include dividends).
This reminds us that the media regularly serve as a source of great contrarian signals. Beyond that lesson, Goldman confirms that quality companies lagging the markets by huge amounts often are targets of value investors. Goldman’s weakness is one reason Meyer, at Bastiat Capital, owns the bank for clients. The stock trades well below the market multiple. It has a forward price earnings ratio of 12, Meyer says.
What could go right? Goldman should benefit from ongoing deregulation in the U.S. and strong, synchronized global growth. Goldman gets about 40% of its revenue from abroad. It has been cutting costs and buying back stock. Meanwhile, it can repatriate more than $25 billion, which it could use to support more share buybacks or a dividend hike, Meyer says.
Dividend yield: 2.5%
Fabled General Electric (GE, $19.02) has a reputation as a top management training ground that spawns great leaders. They go on to guide other companies to greatness once it’s clear they aren’t getting the CEO slot at GE.
But something went wrong with Jeffrey Immelt, a General Electric alum who won the CEO job in 2000. Either he got dealt a bad hand by being on the job during the financial crisis. Or he simply tried to do too much. Whatever the reason, his tenure – which ended in October 2017 – was a disaster. The stock is lower than it was when he took the helm. And it is down 40% in the past year.
But there’s a silver lining to the story: These kinds of declines are a value investor’s dream. Many have stepped in to buy the stock amid the current weakness. “Long term, it is going to be a decent investment,” says Bob Bacarella, co-manager of Monetta Young Investor Fund (MYIFX).
New CEO John Flannery, who took over last summer, is managing a restructuring, including selling off non-core assets and cutting costs. He has been buying GE stock, a bullish sign. A big positive for investors is that about 70% of General Electric’s sales come from business where the company dominates the market, meaning aviation, power and healthcare, points out George Putnam, who recently suggested the stock in his Turnaround Letter.
“I think GE has good long-term fundamentals, and the new CEO is taking the right steps to clean house and set the stage for the stock to do well,” he says.
Dividend yield: 1.7%
Unlike competitors Delta Air Lines (DAL) and American Airlines (AAL) which are soaring near 52-week highs, shares of Alaska Air Group (ALK, $74.81) are flying low – at least relative to where they were last winter. The stock is down 20% over the past 52 weeks.
What’s the problem? “It’s in the penalty box because of the Virgin America acquisition,” says AFAM’s Buckingham, who also manages the Al Frank Fund (VALUX). Alaska Air picked up the competitor in late 2016. Some analysts question whether it makes sense to kill off the Virgin brand, which Alaska Air plans to do in late 2019 to avoid licensing fees.
But the merger gives Alaska Air greater access to the California market and valuable East Coast airport gates. “We think the merger will be a positive,” Buckingham says. “It’s one of the best-run airlines, and it has great routes. The combination of low fares and a top-level customer experience will continue to be the recipe for Alaska Air’s long-term success.”
An added bonus: Alaska Air pays a tax rate in the mid-30% range. So it will get a big boost from tax reform, which lowers the corporate rate to 21%. Alaska Airlines trades for a little more than 11 times forward earnings, a discount to its five-year average forward P/E of 12.6, Buckingham says.
Dividend yield: 1.0%
Despite the big gains in the shares of Twenty-First Century Fox (FOXA, $36.20) since Walt Disney (DIS) announced plans to purchase its entertainment assets in December, the media giant still looks undervalued, maintains HighMark’s Lowenstein.
In the deal, Disney will get 20th Century Fox film studio, Fox’s television studios, Fox Sports, regional U.S. sports networks, international cable networks and Fox’s 30% stake in Hulu, the online TV platform. FOXA shareholders will get about 25% of the new Disney. And they will be left with a collection of Fox broadcast assets, like its news channels. “The remaining company is an interesting collection of unique assets that look mispriced,” Lowenstein says.
The broadcast assets are probably worth $9 to $12 per share. But the implied valuation of these assets in the deal – basically Twenty-First Century Fox’s market cap minus the value of Disney shares they will get – is $4.50 a share. “It looks like a mispriced asset,” Lowenstein says. “It looks like it is trading at 50 cents on the dollar.”
The risk here is that the Disney-Fox deal fails to go through. But Lowenstein thinks it will.
Dividend yield: 2.8%
People are funny about their underwear. They don’t like to change them – the brand, that is. Once they find a brand that fits and feels right, they tend to stick with it. That loyalty works in favor of Hanesbrands (HBI, $22.34).
It also should help investors who take advantage of the current weakness in Hanesbrands stock to establish positions. HBI shares have been weak for reasons that won’t last forever. Walmart (WMT) and Target (TGT) have been reducing inventory, which slowed sales growth at Hanesbrands, says Check, whose Check Capital Management owns the stock. “That has probably played itself out by now,” he says.
Then there’s the shift in retails sales to online venues like Amazon.com (AMZN). That’s not really a problem for Hanesbrands, though. Thanks to the loyalty consumers have to the Hanes, Champion and Maidenform brands, the company can just sell skivvies, bras and socks on Amazon. “There is nothing wrong with the brand or market share, and the stock trades at a P/E of around 10,” Check says. “The slight sales growth decline spooked everyone.”
Behind the scenes, the company has a huge advantage. Hanesbrands owns a big global supply chain with plants in Asia, Central America and the Caribbean Basin. This means its costs are 15%-20% below those of competitors.
Dividend yield: N/A
Liberty Interactive (QVCA, $26.65) is media mogul John Malone’s tracking stock for the QVC and HSN home shopping networks. (Tracking stocks represent the value of an underlying business without giving investors a claim on any of the assets.)
In a pricey stock market, Liberty Interactive looks cheap because it has a very high free cash flow yield, HighMark’s Lowenstein says. Free cash flow yield is free cash flow, or operating cash flow, divided by market cap. So the lower market cap is relative to operating cash flow, the cheaper the stock. QVCA trades for about a 10% free cash flow yield, compared to 4.5% for the S&P 500.
Why is the company trading so cheap? “It is considered a dinosaur business in terminal decline,” Lowenstein says. “But we think it’s a quality business with a loyal customer base.” He sees three catalysts. First, QVC recently merged with its biggest competitor, HSN, so there should be cost savings. Next, the company is converting the tracking shares into normal shares, which should reduce the natural discount that tracking stocks carry.
Finally, Liberty has been holding off on stock buybacks because of the HSN transaction. But the deal closed in December, so buybacks should resume. “In a stock market that is very expensive, this is a cheap stock with catalysts,” Lowenstein says.
Dividend yield: 2%
No roundup of value stocks for 2018 would be complete without a few small-cap names. Not only do they suffer from the 2017 value curse, they’ve been held back by a market cap headwind. Small-cap stocks have been lagging, too.
These challenges could fade for several reasons. Small-cap companies pay higher taxes – in part because they can’t afford the army of tax lawyers funded by big companies, and in part because they generate more of their revenues domestically. So they will benefit more from the corporate tax cuts. Also, since many large caps appear fully valued, investors may start hunting among smaller names for cheaper stocks. Finally, small-cap companies tend to be leaner and meaner. This means they benefit more from inflation, since more of any price increases fall to the bottom line.
All these trends may help Schnitzer Steel Industries (SCHN, $38.70), a leader in scrap metal dealing. Schnitzer collects, processes and sells huge amounts of metal, primarily steel. The company cut costs and paid down debt during a 2014-16 steel sector slump, so now that the sector is recovering, Schnitzer stands to benefit.
“The end markets have entered into fairly robust recovery,” says Evans, at the Heartland Value Plus Fund, which owns this stock. He thinks annual earnings before interest, taxes, depreciation and amortization could return to $200 million to $250 million, from recent levels of $150 million. If so, that could send Schnitzer Steel’s stock up to $50 from the high $30s, based on historical valuation metrics.
Dividend yield: 3.6%
Powell Industries (POWL, $29.88) – which makes switchgear and other products regulating power used by huge oil and gas refining plants, petrochemical producers, railroads and utilities – is another small-cap name that may outperform, Evans says.
Its stock sure looks cheap. Shares trade at just above tangible book value, compared to a multiple of 1.7 times over the past 10 years, Evans says. That’s the kind of discount that grabs a value investor’s attention.
Why so cheap? Evans says it’s because of the scant sell-side analyst coverage. Plus, many of the company’s customers are in the energy sector, which has been weak. But things are looking up there, as oil prices continue to rise, and that should help Powell. “The end markets are beginning to recover,” he says.
Meanwhile, the company has another quality value investors love to see – solid financial strength. The company has solid free cash flow and $11 a share in cash, Evans says, or about a third of its stock price. This suggests Powell’s 3.6% dividend yield is secure.
Michael Brush has suggested FB, AMZN, NFLX, GOOGL, GILD, IBM, GS and GE in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.
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