APRIL 2020: BEST SHARES TO BUY
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5th April 2020
Whenever there is a major downturn on the stockmarket, such as the one that we are currently experiencing, with the S & P 500 index down 30% from its all time high in a matter of weeks - we get some very good evidence of which stocks are the best ones to own.
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In my opinion, these are the very small number of stocks that have managed to retain their upward trend despite the very negative environment for equities.
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However, the favourite strategy of most investors, in my experience as a broker, is to go in exactly the opposite direction. Private investors are very keen to buy the stocks that have fallen the most, thinking that is were the value lies. Very often these are stocks that are lacking in quality in terms of earnings and assets, but they rose during the previous bull market as investors became less discerning about what they bought. Alternatively, these are stocks that are experiencing the greatest loss of earnings due to the immediate cause of the downturn. However, trying to guess the bottom of the market for such stocks is very difficult, and the old adage is that it is like 'trying to catch a falling knife'.
The reason why the strategy of buying the most beaten up stocks usually does not work, is because we do not know how long the bear market will last. Furthermore, the bear market is often followed by a flat market, as it takes some time for investor confidence to return. So even if your instinct is correct, and there is value in these beaten up stocks, the length of time it takes to make a return on your investment could be much, much longer than you expect.
A stock that outperformed in the preceding bull market, and retains its upward trend in the following bear market, is usually a better home for your money than buying the most beaten up stock you can find. These businesses often has what Warren Buffet calls a 'moat' surrounding them. In other words, it is like an old style castle that has a wide moat surrounding it, so that enemy forces (competitors) cannot attack it easily.
These 'moat' stocks are the ones that survive a bear market. I have used the following methodology to identify these stocks below:-
(i) Select stocks only from the US market, confined to the largest corporations that are S & P 100 constituents. The US stockmarket ususally outperforms all other countries in both bull and bear markets. The reason for this is that US corporations usually have much higher growth levels than those outside the US.
(ii) Identify those stocks in the S & P 500 index that have held their upward trend during the recent downturn, as measured by the 150 day simple moving averge.
(iii) Select only those stocks per (ii) above, where the share price is higher than the 150 day simple moving average. This confirms that these stocks are still in an upward trend.
(iv) Eliminate those stocks that were underperforming before the current downturn (to ensure these are not stocks benefitting soley from the current environment).
Only 6 stocks in the S & P 500 index fulfill all of the above criteria, and in alphabetical order, these are:-
1. ADOBE (ADBE)
2. AMAZON (AMZN)
3. ELI LILLY (LLY)
4. MICROSOFT (MSFT)
5. NETFLIX (NFLX)
6. WALMART (WMT)
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Let's have a look at the fundamentals for each of these stocks, and try to ascertain why they are continuing to outperform even when investors are heading for the hills:-
1. ADOBE (ADBE)
Share price:- $293.61
Adobe is a software company that provides assistance to small and medium sized enterprises for on-line marketing and payment. Diluted Earnings Per Share for the quarter ending 29th February 2020 is up 42% from the same quarter in 2019. Earnings per share (eps) for the year ended 30th November 2019 was up 15% on 2018. However, 2018 eps was over 40% higher than 2017, and similarily 2017 eps was over 40% higher than 2016.
The balance sheet at at 30th November 2019 looks quite healthy. Total cash of $4.2 bn is sufficient to pay off all current debt of nearly $3.2 bn and long term debt of nearly $1 bn. The liabilities also contain an item called 'deferred revenues' of $3.4 bn. This means that Adobe has received this cash from clients for projects undertaken, but are not yet recognising it as turnover until the projects are completed. That explains the high cash balance but also indicates a conservative accounting methodology together with a strong position in their market sector as clients are willing to pay in advance.
The historic price to earnings ratio of 44.5 times earnings (trailing twelve months) is not cheap but would seem to be justified in view of the 40% plus earnings growth rate that it is experiencing. As it is a service business, there is very little capital investment required to run the business. The key component, as with most services businesses, is recruiting the right people. There is a goodwill figure of $10 bn on the balance sheet indicating that much of the growth is coming from acquisitions.
2. AMAZON (AMZN)
Share price:- $1,906.59
Amazon originally sold books on-line but has expanded its on-line presence to selling many different type of products and services. It also sells electronic devices, publishing services and has recently expanded into movies and TV through its Amazon Prime service.
Amazon famously incurred losses for many years but investors were prepared to back it due to its rapid growth in revenues. It is notoriously difficult to value for this reason, but investors rationale is that its market dominance in many sectors will inevitably lead to huge profits. Revenue growth has averaged 25% per year in the past three years and earnings are now beginning to materialise with earnings per share jumping from $6.15 in 2017 to $20.14 in 2018. The historic price to earnings ratio is 83 times earnings, based on expected earnings per share for 2019 of around $23.
Amazon has a very strong balance sheet as at 31st December 2019. Total cash of $50 bn is more than twice the long term debt of $23 bn. Liabilities include a figue for $8 bn for 'deferred revenues' indicating a reasonably conservative approach to revenue recognition.
3. ELI LILLY (LLY)
Share price:- $139.66
Pharmaceutical stock Eli Lilly has risen approximately 25% in the past six months as it has a strong pipeline of new drugs which is expected to offset the pressure from generics exploiting the expiry of patent protection, and pricing pressure from the US government. The historic price to earnings ratio is a fairly modest 15.7 time earnings, which provides comfort that investors have not over hyped Lilly's new prospects.
Lilly reported a small loss in 2017, partly due to a large tax liability arising from an underprovision in previous years, and this adversely affected investor sentiment. However, it bounced back in 2018 reporting earnings per share of $3.13, which rose to $8.90 for 2019.
The recent recovery in the shares following a disappointing update on their Alzheimers drug, indicates that some positive developments may be forthcoming. The long term debt level is relatively high at $13.8 bn as at 31st Decembr 2019. However, the strong cash flow from operations has enabled Lilly to do stock buy backs in excess of $4 bn each year for the past three years.
4. MICROSOFT (MSFT)
Share price:- $153.83
Microsoft is enjoying good growth in its cloud computing operation and this is compensating for the more mature windows operating system business which once dominated the software sector. Earnings per share gyrated between $2.10 to $2.71 in the 2016 to 2018 but jumped to $5.06 in 2019. The historic price to earnings ratio of 27 times (trailing twelve months) is not cheap but looks justifiable in light of the increase in earnings in 2019. In addition, it has absorbed higher year on year research and development costs, and the 'deferrred revenue' of $32 bn on the balance sheet indicates a conservative revenue recognition policy.
The balance sheet is legendary with a cash balance at at 29th June 2019 of $134 bn versus total debt of $72 bn. The net cash of $62 bn represents about 5% of the current market capitalisation of $1.17 trillion.
5. NETFLIX (NFLX)
Share price:- $361.76
Netflix provides on-line streaming of movies and TV shows. It is seen by many investors as having benefitted from the coronavirus pandemic, with people staying indoors and watching various content on it. Hoever, the share were trading in a range from early 2018, and have continued to trade within this range since the current downturn began about a month ago.
Similar to Amazon, Netflix incurred losses for many years but investors were prepared to back it due to the hugh annual growth in revenues. Netflix made a small profit of 43 cents per share in 2016, and this was followed by earnings per share of $1.25 in 2017, $2.68 in 2018 and around $4 in 2019. The historic price to earnings ratio is 87 times earnings (trailing twelve months). That might look high, but Netflix looks like it has turned the corner in terms of achieving profits and earnings rose 50% between 2018 & 2019. Revenue grew by 33% in the same period.
Netflix was once a heavily shorted stock. However the short interest has declined significantly in recent months per nasdaq.com. At the 31st of October 2019, over 25 million shares were sold short, mostly by hedge funds betting on a fall in price. This short interest had declined to 18.5 million by the 13th of March 2020 (representing 4.34% of the shares outstanding). A short interest of over 10% of the shares outstanding is considered high.
However, the current level of 4.34% is significant and further closing out of short positions in the coming months should underpin the share price.
6. WALMART (WMT)
Share price:- $119.48
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Walmart, in common with all supermarket chains, has certainly benefitted from the Covid 19 lockdown. However, the shares were on a strong upward trend for many years prior to the recent break downwards in the market.
Walmart's earnings per share declined from 2017 to 2018 - from $4.38 in the year ended 31st January 2019 to $2.26 in year ended 31st January 2019. This was due to the increased focus and investment in building an on-line presence. The earnings have rebounded to $5.19 per share for the year ended 31st of January 2020, putting the stock on a price to earnings ratio of 23 times.
The huge cash flow generated annually of between $25 to $30 bn has enabled Walmart to engage in stock buybacks of between $5.7 to $8 bn each year in the past four years.
Stock buy backs often attract unfavourable comment in the media, as it highlights the wealth of huge corporations compared to low paid employees in the 'gig' economy. However, it should be noted that the reason why some employees are on very low pay is because the job they do is unskilled, and there is a large supply of unskilled labour. This is good for an economy because it forces those on low pay to upskill and find better paid work where labour is in short supply.
The management of a corporation that has surplus cash would be plain daft to pay all of that out to shareholders in the form of a special dividend. The shareholder will be subject to income tax on receiving the dividend, usually at a rate of about 40% depending on the jurisdiction. So for every $1 that is paid out, the shareholder will end up receiving only 60 cents. If the corporation buys back shares instead with this surplus cash, and cancels these shares, the shareholder receiv, es no cash but his shares are now more valuable as there are fewer of them is issue. This will lead to an increase in the earnings per share for that accounting period even if the net profit remains unchanged.