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Where to invest now? – November 2009

19 November 2009

Dear Fellow Investor

I am always on the lookout to find out if there are any parts of the investment universe that are undervalued.

I do not have the resources or time to be able to do such analysis and thus rely on a few fund managers and market commentators I have come to respect.

I read their commentary and try to combine what they have said or written to form my own picture.

Usually one or two of them have ideas that I investigate further but its usually not all that clear as to what is undervalued.

The recent third quarter commentaries was however so clear as to what is undervalued that it was hard to miss.

Below are extracts of the Q3 reports (emphasis mine):

Jeremy Grantahm – GMO – Just Deserts and Markets Being Silly Again (pdf)

October 2009

Yet Another Plug for U.S. Quality Stocks

Our main argument is quantitative. Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper as the Fed beats investors into buying junk and other risky assets, a hair-of-the-dog strategy if ever there was one.

In our seven-year forecast the quality segment has a full seven-percentage-point lead per year over the whole S&P 500, or 9% over the balance ex-quality. This is now at genuine outlier levels.

In addition, there are qualitative arguments. We like owning high-quality blue chips if we are indeed going into a more difficult seven years than any we have faced since the 1970s.

The problems of reducing debt and the potential share dilution that can go with it as it did in Japan for a decade, particularly play to the strength of the largely debt-free high-quality companies.
And for nervous investors there is yet another reason for favoring quality stocks: their more than 50% foreign earnings component, which is higher than the balance of the S&P 500 with its heavy financial component.

In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest.

Richard Pzena – Pzena Investment Management – Third Quarter 2009 Commentary

October 2009

Quality continues to be a significant theme in our portfolios, as many companies with strong balance sheets that are leaders in their industries areavailable to us in the cheapest quintile of valuation.

This is particularly prevalent in (but not limited to) the technology sector, where companies have low or no debt, and cash balances that would see them through the most extreme business downturn.

These businesses typically attract premium valuations, but are now some of the cheapest in our investment universe. We have taken advantage of this unusual opportunity

Conclusion

While market pundits are counseling “de-risking” as their advice du jour, equities in general and value spreads in particular remain attractive despite the sharp run up of the last seven months.

History suggests that we are still in the early innings of this value cycle, with the next leg up likely to be driven by earnings increases in the context of a modest economic recovery.

We continue to find high quality companies in sectors experiencing near term stress where we believe research and patience are the ingredients for long term outperformance.

Joel Greenblatt – In a Yahoo Tech Ticker interview – Seeking Value in a momentum market

28 October 2009

Generally speaking, Greenblatt says the value today is predominantly in “higher quality business that didn’t get hurt as badly in the recession” vs. the low-quality names like AIG and Fannie Mae which led the rally off the March lows.

Among the “beaten up stocks” currently ranked highly by Greenblatt’s are construction companies, select retailers and McGraw-Hill.

If large quality companies are cheap I looked at a few possible candidates in the USA as identified by Joel Greenblatt’s “Magic Formula” and sorted by price to earnings (“PE”) ratio.

Company Price (17.11.09) Debt/Equity (%) Market cap (USD m) PE Ratio Dividend Yield (%) Price to book
NOBLE CORP 44.76 17.5 11,724 7.1 0.4 1.8
ELI LILLY & CO 35.94 155.3 41,296 7.8 5.5 4.2
PFIZER INC 17.94 30.1 144,768 8.2 3.6 2.2
FOREST LABS INC 28.98 0.0 8,745 8.3 0.0 1.9
HARRIS CORP 45.12 68.7 5,943 9.3 2.0 3.1
CARDINAL HEALTH 31.49 41.8 11,421 9.5 2.2 2.3
DIAMOND OFFSHORE 103.58 15.0 14,399 10.2 0.5 4.0
LOCKHEED MARTIN 76.31 132.8 29,058 10.2 3.3 9.3
L-3 COMM HLDGS 79.34 77.8 9,221 10.3 1.8 1.4
PITNEY BOWES INC 25.07 N/A 5,193 10.4 5.7 67.8
NATL OILWELL VAR 46.13 6.9 19,295 10.4 0.9 1.4
NORTHROP GRUMMAN 56.03 33.1 17,580 10.5 3.1 1.4
RAYTHEON CO 50.21 25.4 19,241 10.6 2.5 2.0
GENERAL DYNAMICS 67.94 40.0 26,211 10.9 2.2 2.2
DISH NETWORK-A 22.15 N/A 9,898 11.2 0.0 N/A
GARMIN LTD 32.33 0.0 6,488 11.3 2.3 2.5
FLUOR CORP 45.37 5.7 8,121 11.4 1.1 2.6
AMGEN INC 56.28 49.9 56,963 12.0 0.0 2.5
AUTOZONE INC 142.62 N/A 7,112 12.1 0.0 N/A
JACOBS ENGIN GRP 38.88 2.5 4,818 12.1 0.0 1.8
BIOGEN IDEC INC 46.05 19.7 13,317 12.2 0.0 2.0
BRISTOL-MYER SQB 24.23 55.1 47,999 12.4 5.1 3.7
JOY GLOBAL INC 56.85 106.6 5,817 12.8 1.2 6.6
IBM 128.63 251.9 168,969 13.3 1.7 9.2
APOLLO GROUP-A 56.39 50.9 8,731 13.4 0.0 7.5
JOHNSON&JOHNSON 62.17 27.9 171,533 13.7 3.2 3.4
FISERV INC 48.73 158.2 7,499 13.7 0.0 2.6
LORILLARD INC 79.38 0.0 12,752 13.8 5.0 33.5
OMNICOM GROUP 37.26 87.2 11,597 13.9 1.6 2.9
ITT CORP 53.06 70.2 9,694 14.0 1.6 2.7
VIACOM INC-B 31.27 113.8 19,130 14.0 0.0 2.4
MCGRAW-HILL COS 31.85 98.9 10,030 14.0 2.8 6.0
AMERISOURCEBERGE 24.28 43.4 7,217 14.0 1.3 2.6
CA INC 22.36 44.6 11,666 14.1 0.7 2.4
AMDOCS LTD 27.01 0.0 5,509 14.1 0.0 1.7
DELL INC 15.95 47.1 31,192 14.4 0.0 6.7
CLOROX CO 60.21 N/A 8,418 14.4 3.3 N/A
DR PEPPER SNAPPL 27.78 135.1 7,058 14.5 0.0 2.3
MCKESSON CORP 63.74 40.5 17,081 14.8 0.8 2.5
TIME WARNER INC 32.55 94.5 38,005 14.8 2.3 1.1
UNITED TECH CORP 69.93 72.1 65,562 15.3 2.2 3.5
LABORATORY CP 74.19 102.0 7,879 15.3 0.0 3.9
QUEST DIAGNOSTIC 59.07 85.5 10,922 15.7 0.7 2.8
ROSS STORES INC 45.59 15.1 5,703 16.6 1.0 5.3
GAP INC/THE 22.31 1.1 15,569 16.8 1.5 3.3
COACH INC 34.48 2.0 10,997 17.9 0.9 6.0
AUTOMATIC DATA 44.01 14.5 22,209 18.3 3.1 3.9
EXPEDIA INC 24.96 66.3 7,207 20.5 0.0 2.8
MASTERCARD INC-A 231.00 8.8 29,973 21.2 0.3 9.3
DISCOVERY COMM-A 31.88 68.3 8,510 34.3 0.0 1.5

Source: List of companies – Magic Formula Investing (www.magicformulainvesting.com)

Financial information – Bloomberg (www.bloomberg.com)
 

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A list of cheap large European companies can be found on my article Dogs of the STOXX 2009 – Update

Kindly note that the output of the two screens above is just to identify possibly undervalued companies. It should just be a starting point for your analysis.

Next week Tuesday Nikki and I am off on holiday to South Africa. I am really looking forward to more sunny days and spending relaxing time with my family.

I have lined up some interesting guest posts for the first two weeks when I have limited internet access.

Your packing his bags analyst.

Tim du Toit

Disclosure: I have a position in Johnson & Johnson