To everything there is a season: A time to hide in a bunker with a crash helmet on as stock and bond prices plummet, and a time to wade cautiously into the market in search of newly created bargains.
If you've been reading the Barron's Roundtable for a few years, or even decades, you already know what our panelists are doing. And if you're new to the proceedings, you can probably guess. With stocks down 20% this year—and in many cases, much more—these investment pros are busily buying companies with durable franchises, wide moats, strong balance sheets, abundant cash flows, and share prices far below what they think the businesses are worth.
Will these stocks (and funds) rally in the second half of the year? Maybe yes, maybe no. The Roundtable members, who last met on Jan. 10, on Zoom , are unusually divided in their near-term outlook for the stock market and the economy, now that the Federal Reserve has gotten religion about combatting runaway inflation.
But they agreed, to a one, when we caught up by phone in the past few weeks, that plenty of now-blighted investments will shine again when this interest-rate-hike cycle ends and stronger economic growth prevails. It should give comfort that many of their January picks are outperforming the S&P 500 index this year, although there are some notable exceptions—for now.
Just what is the Roundtable crew buying now, and why? It's all in the edited midyear update below.
Barron's: It has been a dreadful six months in the markets. What does your crystal ball show?
Todd Ahlsten: It is a time of uncertainty, but also opportunity. In the short term, it feels like we're driving downhill with no brakes. The Fed is raising rates aggressively. Inflation is at a 40-year high. The pandemic stimulus is rolling off, and earnings-estimate reductions are coming. GDP [gross domestic product] is going to slow. But when the backdrop is overly bearish, it sets up an opportunity for the next three years. By then, the economic backdrop could look very different.
It could look worse.
There is still remarkable innovation in our economy. We have talked in the past about cloud computing, digital content creation, machine learning, life-sciences innovations, precision agriculture, autonomous driving, clean energy, and innovations in financial services. In addition, the strong deflationary forces we have had for more than a decade, including demographics, technology, and high debt levels, haven't gone away but have merely taken a back seat for now.
The Fed's policy may transition us to a different regime over the next three years, if not the next nine to 12 months. There are signs inflation is peaking. We can't ignore things like slowing industrial production and weakening freight and shipping stats. We're also seeing rising inventories across many sectors, and lower prices for industrial metals. We're starting to see early signs of demand destruction for gasoline. Recession odds are 50/50, but it is possible the economy slows dramatically. The Fed may complete its work later this year in a painful tightening cycle, but that sets the market up for a significant opportunity.
Where are the best opportunities?
We still own all our January picks. Applied Materials [ticker: AMAT], which has fallen the most, is going to face a down cycle for semiconductors that might persist for six months, but it could be a strong performer over three years. I've got three stocks today, all durable franchises that will benefit from a more volatile world.
Verisk Analytics [VRSK] is a data-analytics company for the insurance industry, which is at the beginning of a major wave of modernizing and moving to the cloud. Verisk dominates in this business. Its data sets are mission-critical in helping the industry price and underwrite risk. To give you a feel for the moat, Verisk maintains almost 30 billion statistical records with data spanning 50-plus years.
What makes the stock a bargain?
Verisk is trading for about $170 a share. We see a 12% annualized return in the next 2.5 years, to $225 a share. Earnings per share will grow at a 14% annual clip during this period. The stock could command a multiple of 27 times on 2025 estimated earnings, and yields 0.7%.
Verisk misallocated capital in the past. It bought several non-core businesses, and is trimming them. It is getting rid of more-cyclical and lower-margin businesses, and it has improved governance, which we like to see. It has separated the CEO and chairman roles, declassified the board, and is returning more capital to shareholders via stock buybacks. It has implemented new return-on-capital incentives for leaders, and the board has direct oversight on risks and opportunities from sustainability issues.
Ready for my next company?
Marsh & McLennan [MMC] has been around since 1905. It has a $76 billion market cap. It is the world's leading insurance broker and risk adviser, and has demonstrated consistent growth through cycles. The stock trades for 22 times the next 12 months' earnings. The risk-management and insurance-services business is 61% of sales, and 29% of operating margins. About 51% of revenue comes from Marsh, a leading brokerage, and 10% from Guy Carpenter, a specialist in reinsurance. Consulting accounts for 39% of sales, and that business includes Mercer, a leading wealth advisor, and Oliver Wyman.
Marsh & McLennan has 24% operating margins, and we think they can rise. Earnings could grow by 14% a year through 2025. At a 21 price/earnings multiple, that implies a $195 stock, compared with a recent price in the low $150s. Add a 1.5% dividend yield and that's a low double-digit return. The company's best days are ahead. Cyberrisk has to be insured, as do weather-related issues and carbon impacts.
Managing new and emerging threats is right in Marsh's wheelhouse. We expect Marsh to come out of the pandemic and this inflationary cycle stronger. Our investment theme isn't hiding in a bunker and putting on a crash helmet. It's buying good businesses that can compound over a full cycle.
My next pick, Intercontinental Exchange [ICE], has a $55 billion market cap. The stock is trading in the low-$90s, and we see it climbing to around $125 in three years. It yields 1.6%.
What will drive the gains?
We see ICE growing earnings per share 13% a year through 2025 and earning $7.50 per share. At a 16.5 multiple, the stock would trade for $125. ICE operates many of the premier electronic market exchanges for the energy complex, other commodities, fixed income, and equities. The company benefits from market volatility. ICE has one of the widest network-effect businesses with significant pricing power. Its exchange business contributes 54% of revenue and 74% of operating margins.
ICE is also in the fixed-income and data-services business. It is looking to acquire Black Knight [BKI], a leading mortgage-service provider in the U.S., which Henry [Ellenbogen] recommended last year . Yes, the housing cycle is heading down, but we like Black Knight's fit with ICE, and think the mortgage business could see a cyclical recovery in 18 to 36 months.
Much of ICE's growth has come from buying exchanges around the world. Are there many left to acquire?
Another large exchange transaction is unlikely at this point. ICE's move to combine mortgage originations and servicing assets is timely, as is the planned combination of its Ellie Mae unit and Black Knight. ICE needs to pay down some debt from the Black Knight deal, but long term will be able to raise its dividend and buy back stock.
Barron's: Bill, what lies ahead for the economy and the markets?
William Priest: Trouble. We are starting to see tighter monetary policy, and fiscal policy is rolling off. We see four issues that will create a lot of turbulence. First, globalization is unwinding. At the heart of globalization was the law of comparative advantage, which says nations should specialize in producing goods and services in which they have a relative cost advantage, and trade the excess for other goods and services they want. We've had almost 30 years of globalization. Now we are going back to onshoring. Supply chains may become more secure, but deglobalization is inflationary.
Second, we've had a bubble in money creation around the world, and the consequences are coming home to roost. The response to the pandemic also brought a surge in fiscal spending. In hindsight, as the economy recovered, we didn't need all that stimulus, which led to excessive spending.
What else troubles you?
The rise of state capitalism. China's aggressive form of state capitalism increasingly promotes self-reliance in energy, food, semiconductors, and more, so industrial policies rather than comparative advantage are driving trade and capital flows. China's mercantilist behavior has undermined support for free trade.
Lastly, we don't know how Russia's invasion of Ukraine will turn out.
We have an unstable environment. The four-decade-long bull market in bonds is over. Demographics and de-globalization are going to produce low economic growth. Usually, to curb inflation, the federal-funds rate needs to exceed the reported rate of inflation. We can debate what reported inflation is, but the fed-funds rate isn't above it, so that is a headwind for the markets. A recession seems inevitable. There is an unmooring of the principles that drive markets.
Well said. How do you invest under these circumstances?
Portfolios should be tilted toward technology, science, and communications. We look for companies that generate operating cash flow and free cash flow, and are good at capital allocation.
As I said in January, my favorite stock is T-Mobile US. [TMUS]. Deutsche Telekom [DTE.Germany] owns almost 50% of T-Mobile and yields 3.4%. It's a better way to play T-Mobile, but you can buy both. T-Mobile is the No. 2 wireless carrier in the U.S. with approximately 91 million voice subscribers. With its 5G network, it is in a better position, relative to Verizon Communications [VZ] and AT&T [T] to grow postpaid subscribers, expand margins, and increase free cash flow over the next three years.
T-Mobile's combination of spectrum assets, following its merger with Sprint in April 2020, should allow it to continue to grow its subscriber base at a faster rate than peers. Additionally, its in-home Internet service has the potential to generate an incremental $5 billion in annual revenue over time, with a higher margin structure than the voice business. It scaled to one million subscribers, as of the first quarter, within one year of launch, and covers 40 million homes.
How much cash flow will T-Mobile generate in coming years?
Between 2023 and 2025, T-Mobile should generate over $50 billion in cumulative free cash flow. The company might use its free cash and incremental debt to effectuate the $60 billion share buyback referenced at its 2021 analyst day, which would shrink the float by 65%-70%. The shares, now around $136, could be worth $300 exiting 2024.
Deutsche Telekom is one Europe's largest telecom-services providers and a leading provider worldwide. Its domestic business offers high-quality assets and growth. Its stake in T-Mobile provides exposure to higher growth in the U.S. wireless market. As a result, DT could deliver strong free cash flow in the next several years, which isn't reflected in its current valuation. Its shares sell for about 19 euros [$19]. Excluding T-Mobile, DT's European stub trades at a discount to European telecoms, despite having higher-quality assets and one of the best management teams in the industry. Further excluding its EU tower assets [the company is selling 51% of its towers business], DT's European stub is nearly free at current levels.
Taiwan Semiconductor Manufacturing [TSM] is the world's leading semiconductor foundry company. Customers include Apple [AAPL], Qualcomm [QCOM], Advanced Micro Devices [AMD] and other industry giants, which rely on TSMC for the world's leading process technology, neutrality, and a vault-like reputation for confidentiality.
What is the outlook for TSMC?
Management recently upgraded its 2022 guidance to 30% year-over-year growth and reiterated a long-term top-line compound annual growth rate of 15% to 20%. High-performance computing, which grew 58%, year-over-year in the March quarter, is the company's largest end market, at 41% of revenue. Automotive is about 5%. TSMC's book-to-build ratio for 2023 is so robust that it has already notified customers of coming price increases.
TSMC's stock has fallen about 40% this year, to $80. Why?
The market is overly focused on the near-term weakness in the smartphone and PC markets and missing the long-term growth opportunity that TSMC represents. One can never rule out geopolitical risks, either. That is part of the reason for the stock's low valuation. TSMC is on track to generate a 3.5% free-cash-flow yield in 2023, and pays a 2% dividend. We see fair value of $130 for the U.S.-listed shares, and think the stock offers compelling value at 13 times forward consensus earnings and 7.8 times Ebitda [earnings before interest, taxes, depreciation, and amortization].
Liberty SiriusXM Group [LSXMA], is a tracking stock controlled by John Malone that reflects the economic performance of Liberty's stake in several assets, including its 81% interest in Sirius XM Holdings [SIRI], whose satellite-radio system is installed in 80% of all new cars; a 20% stake in Live Nation Entertainment [LYV], the live events and ticketing company; a 2% interest in Formula One Group [FWONA], which holds the rights to the Formula One auto-racing championships; and a 2% interest in Liberty Braves Group [BATRA], owner of the Atlanta Braves baseball team. Nearly 80% of Sirius' revenue comes from subscription sales to relatively affluent drivers, and the remaining 20% comes from ad sales. Podcast hours heard in the U.S. are growing by 20% a year, and the company has quietly built the largest podcasting ad network.
Liberty SiriusXM has a market value of about $12 billion. How does that compare with its asset value?
It trades at a 40% discount to the value of its assets. In November 2021, it crossed the 80% ownership threshold at Sirius, which means Sirius can now return tax-free cash flow to Liberty. We believe Liberty can narrow the discount over the next year through a combination of share buybacks from the dividends from Sirius and eventually a merger with Sirius, thus eliminating the tracking-stock structure.
Deere [DE] is another stock we like. It's a favorite of our friend on the West Coast [Todd Ahlsten], who has recommended it several times. The stock is down about 12%, to $300, this year, but Deere is an extraordinary company. It is the global leader in agricultural equipment, with the largest installed base and broadest suite of products. Its equipment portfolio, proprietary precision technologies, and large dealer network provide its customers with solutions that are difficult to replicate. Deere enjoys strong pricing power in a highly cyclical industry and has competitive advantages. Its evolving business model is well positioned to capture secular growth opportunities, while delivering more stable revenue to dampen the amplitude of cyclical peaks and troughs.
Deere is evolving from selling products at the point-of-sale to monetizing an integrated system that combines its products with value-added technology solutions delivered via a SaaS [software as a service] model. Management believes that recurring revenue could reach about 40%, longer term. In the next three years, Deere should be able to generate high-single digit revenue growth and free-cash-flow growth.
Thank you, Bill.
Rupal J. Bhansali
Barron's: Markets are down across the world. Do you see a reprieve in the second half?
Rupal J. Bhansali: No. It is too early to view a 20% correction as a buying opportunity because we are at the beginning of a regime change from quantitative easing to quantitative tightening. My January recommendation to avoid junk bonds and junk equities continues to play out. Junk equities comprise the four Ls: stocks of loss-making or levered companies, or those with ludicrous expectations or lofty valuations. The earliest and worst price corrections have occurred in stocks with one or more of these Ls.
From a macro perspective, the worry is no longer about inflation. It is about recession. Corporate earnings estimates need to come down, and valuation multiples will deflate alongside them. Cyclical sectors will prove more vulnerable, but defensive sectors don't offer a safe haven, as they are too expensive. The sweet spot, in my view, is owning high-dividend-yielding stocks of companies with strong balance sheets. All of my stock picks from the January Roundtable continue to meet these criteria, and I continue to recommend them, even though they have outperformed, year-to-date.
Are non-U.S. markets more attractive than the U.S. now?
International markets are a far better opportunity. In order of priority, I would call out Latin America, the U.K., and Europe as offering the most fertile ground for bargains. In January, I recommended BB Seguridade Participacoes [BBSEY], in Brazil, which yields 7%, and Credicorp [BAP], in Peru, where we forecast a 5% dividend when earnings normalize post-Covid. In the U.K. Direct Line Insurance Group [DLG.UK] offers a mouthwatering 9% dividend yield. I am sticking with all three. Stocks I've mentioned in earlier roundtables, such as Endesa [ELE.Spain], Snam [SRG.Italy], and Philip Morris International [PM], my Tesla of tobacco, all have more than 5% dividend yields, as well. These stocks have performed well, relative to the market, this year and will continue to offer outperformance.
What makes Latin America attractive today?
Emerging markets, and Latin America in particular, sold off for thematic reasons. Typically, whenever the Fed is raising rates, that tends to hurt emerging markets most. LatAm didn't deal well with Covid; the economy was badly hurt. In Brazil, interest rates rose from 2% to 13.25% as the central bank acted aggressively to curb inflation, which has been running around 10%-12% since the second half of 2021.
What is the bullish case for Europe?
I'm not making a blanket case for Europe, but for certain parts of the market. Europe tends to be a high dividend-yielding part of the world.
Are you still bullish on Baidu [BIDU]?
Baidu isn't part of my dividend-yield thesis, but as a Chinese stock it is a beneficiary of Chinese stimulus. Unlike the rest of the world, where inflation is a problem and central banks are trying to raise rates to lower demand, China is stimulating its economy to stoke demand to achieve a 5.5% GDP growth rate. This explains why many Chinese stocks are likely to decouple from other markets. Baidu can perform well even as markets around the world decline.
To be clear, I am calling for a lost decade for the U.S. stock market, similar to how it declined by 4.74% between 2001 and 2010 and 7.46% between 1969 and 1978. There is a way to make money at times like this. It means investing in established, mature companies that generate a lot of cash and return that cash to shareholders.
Thank you, Rupal.
Barron: Growth-stock investors are getting hammered this year. Is it time to wade back into the market?
Henry Ellenbogen: It's the worst market, in some respects, since 1970. It's the worst first half ever for the Russell 2000. I expect a recession to happen sooner than many people think. Information travels quickly. The consumer is either feeling the effects of the economy's transition or reading about it. The lower-income consumer is feeling the impact of inflation on discretionary spending. CEOs have switched from a growth to a recession mind-set.
And, the selloff in the markets is creating a negative wealth effect, not only among holders of traditional assets, but in the crypto economy, where some $2 trillion has been lost. The repair on the other side will also happen sooner than many people think. It is an attractive time to be buying equities. The opportunity now is in quality growth assets, rather than commodities or more economically sensitive assets. The market is demanding both growth and profitability.
My first two recommendations, Intuit [INTU] and Atlassian [TEAM], are both driving increased market share in their profitable core business, and using those profits to extend their market share and launch additional growth legs. Both—Intuit, based on 2022 and '23 estimates, and Atlassian, based on 2023 and '24 numbers—trade at attractive multiples of earnings and free cash flow.
Intuit was a good stock in 2021, and we like it for much the same reasons now. The company has built two dominant franchises that represent about 80% of Ebitda. Its TurboTax franchise is a market leader for people looking to do their own taxes, with a 60% market share, and growing. Intuit recently launched an assisted tax service, which addresses a market five times larger. If you need help from a bookkeeper or an accountant, you pay more and get help remotely. This business is driving the growth of the franchise and making it more durable.
Intuit's QuickBooks franchise is the dominant small- and medium-business accounting software solution, and, like TurboTax, it has about a 60% share. Intuit is in the early days of adding breadth of functionality to QuickBooks, including payments and customer-relationship management. As with the consumer tax business, the company has transitioned QuickBooks to the cloud.
The stock took a tumble this year. What spooked investors?
The market is concerned about the business' cyclicality. During the financial crisis, Intuit proved not to be that cyclical. Second, with Treasury yields rising, high-multiple stocks have been falling. That is appropriate, but with Intuit, you're paying mid-20-times earnings for a business that will compound at a high-teens rate once we get past the downturn.
Atlassian is earlier in its free-cash-flow trajectory. Its product, Jira, is the global standard in agile software-development workflow. Most companies need software for customer relationship management and internal efficiency. Atlassian provides the workflow tool. Over 200,000 businesses use Jira globally, and that number keeps growing. The company has successfully transitioned its core business to a cloud architecture. That makes the product more sticky, and allows customers to attach other services to this workflow suite. A second product, a workflow-management tool for IT departments, started to shine in the past year.
This stock has round-tripped, too. What was the issue?
The market is concerned about cyclicality. The company said at its analyst day in April that margins will be lower in the fiscal year that begins in July. The decline in margins has positive long-term returns: Atlassian earns significantly more from customers that move to the cloud, so it must ensure a flawless migration. It has invested in the product and the migration process, and offered discounts to customers for the first three years.
Looking out to 2025, Atlassian should earn between $8 and $11 a share. Revenue will be growing by more than 25% annually. The shares could trade for a mid-30s multiple of earnings.
Do you have another pick?
There were about 400 IPOs [initial public offerings] in 2021. In a weak market, people sell what they don't know. In addition, the market has taken the view that because many of these companies grew up in an environment where capital was essentially free, there wasn't as much accountability in terms of profitability. The selloff in these stocks creates an opportunity.
Duolingo [DUOL], which came public in July 2021, develops language apps. For many people in the U.S., learning a foreign language is a way of self-improvement. But for many outside the U.S., it is a way to access opportunity. Duolingo has more than a 90% market share among language learning apps.
Duolingo users can begin their learning journey for free and only pay a subscription for paywalled features, such as no advertisements. The company has 55 million monthly active users and a little over three million paying users. Both numbers are growing. The company recently introduced a family plan, which should increase monetization and reduce churn. We're also excited about Duolingo's second business, which administers language tests remotely for students seeking qualifications to enter foreign schools.
Duolingo's CEO is an entrepreneur who sold his first two companies to Google. He has assembled an excellent team. The business model could show software-like economics. Free cash flow will ramp from $30 million this year to $90 million next year, to $165 million in 2024.
What could go wrong?
The percentage of users converting from free to paying might not increase the way we expect. Also, if user growth and conversion to subscriptions slow, incremental margins would disappoint. On a small revenue base, that would lead to a significant change in free cash flow.
Abby Joseph Cohen
Recession, or no recession? Abby, where do you stand?
Abby Joseph Cohen: I am not in the recession camp. I don't see the preconditions. I'm focused on the health of the labor market. We have 11 million unfilled jobs in the U.S., up from seven million pre-pandemic. Wages are rising. There is demand for workers. Household balance sheets are robust. We may well have a recession out there, but I don't see it this year or in 2023.
If there is no recession, corporate profits will probably be OK. Year-on-year, the comparisons are difficult; record profit margins are coming under pressure. But taking a broader perspective, profit margins are still high in most industries. Corporate balance sheets are good, with some $4 trillion in cash. Within six to 12 months, we could see some recovery in the S&P 500, with leadership coming from different sectors.
At the start of the year, markets were priced for perfection. Valuation metrics were in the 95th percentile historically. With no margin for error, it wasn't a surprise that equities faltered when problems arose. I didn't think it would be a great year, but I didn't think it was going to be as horrendous as it has turned out to be. We have had a lot of issues: the invasion of Ukraine, the ongoing shutdown in China, and a return to the old inventory cycle.
Don't forget inflation and rate hikes.
The bond market figured it out before the Fed, as intermediate and long rates rose. Now, some of those rates have moderated. We may have seen at least a temporary peak in commodity prices. A slowing housing market might also take some of the pressure off the Fed. Cryptocurrencies have also been an issue, as has the strong dollar. I tip my hat to Meryl Witmer, who said at the January Roundtable that if crypto tanks, there could be contagion in the stock market.
Let's get your midyear picks.
First, I want to note that there has been a change in the availability of cash that has impacted fundraising in the start-up community, private equity, SPACs, and so on. Professional investors who had levered up to improve results have had to de-lever. Many endowments and pension funds invested with private-equity managers who reported incredibly good results in recent years. I am concerned about what may happen to some of them when private-equity holdings are marked to market later this year.
My first pick is LG Chem [051910.Korea]. It has performed poorly in the past several months. Now, it looks appealing. When I first spoke about LG Chem, in 2017, it was a way to participate in electric vehicles without placing a bet on which manufacturers would succeed. LG Chem has plants in Asia, Europe, and the U.S. making batteries for EVs. It also produces chemicals.
Batteries account for about 30% of earnings before taxes, and that is likely to rise to maybe 50% in the next couple of years as capacity expands. Their specialty chemicals are used for plastic recycling and solar panels. They are involved in a number of businesses that a lot of ESG [environmental, social, and corporate governance]-sensitive investors care about. LG trades roughly at book value. The P/E is about 16 times this year's earnings and about 10 times next year's.
What is your next pick?
Fanuc [6954.Japan] is the leading manufacturer of industrial robots. Robot demand is at an unprecedented level in a world of labor shortages. Fanuc is a leader in autos and electronics. For a lot of newer technologies, commercialization can take a long time. Barriers to entry are high. That Fanuc is a leader when there is a lot of demand and inadequate supply of robots makes it appealing to me. The company, based in Japan, is a significant exporter, so one worry would be the impact of the yen's appreciation on demand for its exports.
How is the stock trading?
At about 22 times earnings for the March 2023 fiscal year, it isn't cheap. But it yields about 2.7%, and has sustainable cash flow for this dividend.
Booking Holdings [BKNG] is the umbrella company for Booking.com, OpenTable, Kayak, Priceline, and Rocketmiles. It is a great play on travel, and a leader in providing hotels, flights, car rentals, and such. To give you an idea of Booking's breadth, its website uses 44 languages. It has 28 million listings for accommodations, and 100 million monthly users.
It is a record summer for travel. What happens next summer?
We need to look at the macro environment. I expect consumption to be focused on services and experiences. Some travel-related decision-making will be related to gas prices, and prices in general, but we may have seen much of the rise in energy prices. Booking is trading for $1,673, or about 15-16 times 2023 estimated earnings of more than $100 a share.
My fourth recommendation is Nordstrom (JWN), the fashion retailer. People are refreshing their wardrobes as they go back to work—full-time or in hybrid fashion. People are going to social events again. There is also a bit of change in style: People are buying bright colors and prints again. There is an overall wardrobe refresh.
Nordstrom trades for about 11 times earnings and yields 3.7%. It's had a bad year, along with most other retailers. Nordstrom has its own stores, boutiques in other stores, and an e-tailing business, which has been improving.
Thanks Abby, for the stock picks, and the fashion update.
Barron's: Where do we go from here?
Scott Black: The U.S. equity market is heading lower. The S&P 500 closed yesterday [July 5] at 3831.39. Analysts are estimating 2022 earnings of $224.06, which represents a 7.6% increase, year-over-year. Yet, first-quarter earnings rose only 4.1%. Second-quarter estimates show a 5.7% increase. That suggests earnings growth will have to accelerate in the third and fourth quarters. The bottom-up estimate for third-quarter operating earnings reflects a gain of 13.9%, which is unrealistic. Operating margins have been falling off a cliff for S&P 500 companies since the second quarter of last year, due to rising labor, materials, and transportation costs. They peaked at 13.54% in the second quarter of 2021, and fell to 11.93% in this year's first quarter. I estimate that S&P 500 earnings will be $219 this year, up about 5%. That implies a price/earnings multiple of 17.5. Also ludicrous is next year's consensus earnings estimate of $249.01. We are already in a recession. I don't see how corporate profits can jump 11%.
The small-cap Russell 2000 is selling for 19.8 times this year's estimated earnings. The Nasdaq 100 is at 21 times. As bond yields move up, equity multiples move down. The Federal Reserve is going to raise the federal-funds rate by another 75 basis points [0.75 of a percentage point] this month, and possibly another 100 basis points before year end. It needs to break the back of inflation, like Paul Volcker did in 1981. A drop in the inflation rate, to 4% to 5% from more than 8%, would be a catalyst for the market to move up. The other catalyst would be the Republicans regaining control of the House of Representatives in the midterm elections.
What is your economic forecast?
We'll see a shallow recession, and we could see 2% growth next year. But with gasoline at around $5 a gallon and grocery prices up 11%, year-over-year, the U.S. consumer is hampered by inflation. Revolving-credit debt, at $1.14 trillion, is at an all-time record. Total household debt is $15.84 trillion, up substantially since the end of the year. My advice is to own good companies with a high return on equity, but avoid story stocks with little or no earnings, even though they might be down 70% or 80% from their highs. I wouldn't be bottom-fishing in Snowflake [SNOW] or Wayfair [W] or Spotify Technology [SPOT], which I call Stupefy.
So, where are you shopping?
CACI International [CACI], based in Reston, Va., provides consulting services and technology to U.S. government agencies. The company's goal is to grow revenue by 5% to 8% a year, and earnings at a faster rate, maybe 9% to 11%. The stock closed yesterday at $279.18. There are 23 million fully diluted shares, and the market cap is $6.4 billion. The stock is down about 11% from an all-time high of $313.52.
CACI's fiscal year ends June 30. I have revenue rising 6.2%, to $6.61 billion, in fiscal 2023. Costs, mostly labor, are 65.2% of that. Selling, general, and administrative expenses are 24.4%. Accounting for amortization and depreciation of about $142 million, I get operating income of $545 million. Subtracting interest expense of $36 million, I get pretax profits of $509 million. After adjustments for intangibles and other factors, CACI could earn $453 million, or $19.70 per share, versus an estimated $17.85 for the year just ended. The stock is trading for 14.2 times estimated earnings, with a prospective return on equity of 14%, after taxes. The net debt-to-equity ratio is 0.58 times.
What drives the business?
We'll get to that. CACI's backlog is $23.5 billion, up 5.4% year over year, and equal to 3½ years of revenue. The company generated $519 million in free cash in fiscal 2021, and $554 million in the first nine month of fiscal '22. It was projecting $720 million for the full year. The business mix is Department of Defense, 69%; federal civilian agencies, 26%; and commercial, 5%. Consulting accounts for 46% of revenue, and implementation of technology, 54%. Because so much of the business is funded by government agencies, revenue will be steady.
Moving on, people still need property and casualty insurance. Chubb [CB], the world's largest publicly traded P&C insurer, trades for $193.14. It has 423.7 million fully diluted shares, for an $81.8 billion market cap. It pays an annual dividend of $3.32 a share, and yields 1.7%.
You rarely recommend large-caps. Why the exception?
Chubb's fixed-income portfolio will benefit as interest rates go up. For every 100-basis-point increase, it will get an extra $1.2 billion in pretax income. The company earned $3.82 in the first quarter, against $2.52 the prior year. The combined ratio [an industry measure of profitability] was sensational, at 84.3%. First-quarter return on equity was 13.6%.
For the full year, I have Chubb earning about $15.28 a share, versus the Street estimate of $15.04. That puts the P/E at 12.6 times. My 2023 earnings estimate is $16.91; the Street is at $16.88. The price-to-book ratio is 1.44. Chubb has a double-A credit rating from S&P, almost unheard of today. The company has been buying back stock, spending $523 million in 2020, $4.86 billion last year, and $1 billion in this year's first quarter. A $5 billion authorization remains.
The large-corporation commercial property and casualty market is 22% of premiums. Middle-market and small commercial is 30%. Personal lines, such as homeowner's and auto insurance, is 19%. Wholesale specialty P&C is 12%, and global accident and health is 14%. A few other businesses are 3%. If the stock trades up to 14.5 times earnings, it could go as high as $245.
Thank you, Scott.
Barron's: In January, you predicted a "rocky" adjustment for the market, due to rich valuations and the unwinding of easy-money policies. How much more rocky will it get?
Sonal Desai: The amount of volatility we're seeing in the most liquid market in the world—U.S. Treasuries—is remarkable. The Treasury market is reflecting the debate about which is the greater concern: growth or inflation. My biggest worry is that if extremely poor growth occurs too soon, the Federal Reserve won't be in a position to react the way the market wants. I'm not calling for a recession in the second half of this year or the first half of next year. But suppose we get really poor growth while inflation is still running at 7.7%? The Fed won't be able to step in and stimulate the economy while it is trying to curb inflation.
What are you calling for?
Consumers remain strong. Unemployment is low, and wage growth is strong. These factors argue against a recession. When we get one, and we will, perhaps toward the second half of next year, I expect a standard recession, not a collapse in GDP growth that fires up the Fed's QE engine.
The unpredictability of China's stop-and-start zero-Covid policy, and its impact on supply chains, also makes me uncertain about where we are headed. We are forecasting that inflation will be close to 8% at the end of this year, as measured by the consumer price index. For the next three or four months, things could look ugly. The silver lining is that 12 months from now, a lot of excesses will have been flushed out of the system.
Fixed-income investments are finally delivering income. What looks most enticing to you?
I am not recommending new picks; I am closing out some January picks, including Global X US Infrastructure Development [PAVE]. My recommendation that exchange-traded fund was based on its exposure to infrastructure spending in the U.S., primarily through companies that provide materials, equipment, or expertise. While the longer-term themes remain attractive, the strategy tends to focus on sectors likely to be out of favor until there is clear visibility as to the length and severity of an economic slowdown.
I am also closing out my recommendation of Franklin Equity Income [FEIFX]. Equity markets are vulnerable to further drawdowns and are likely to experience elevated volatility, near term.
Are you sticking with Parametric Commodity Strategy [EAPCX]?
Yes. The fund returned almost 13% through June 30. Commodities have historically provided investors with a hedge against inflation, and returns uncorrelated to stocks and bonds. The fund offers broad-based commodity exposure utilizing a top-down process that seeks to take advantage of quantitative and behavioral characteristics of commodity markets.
I am also sticking with Franklin High Yield Tax-Free Income [FHYVX]. The municipal-bond asset class suffered one of the worst absolute returns in the first half since the early 1980s. We are moderately bullish. Muni issuance has declined by 8% from the year prior, and net supply is on track to be negative for the full year, creating favorable supply/demand dynamics once yields stabilize. Our outlook for credit across the muni market remains stable to positive. The passage of the Infrastructure Investment and Jobs Act, or IIJA, should provide significant federal funding of infrastructure projects, reducing the burden on state and local agencies.
What is the outlook for Lazard Global Listed Infrastructure Portfolio [GLFOX]? It had a decent first half.
The strategy continues to perform relatively well. The fund focuses on companies that own regulated utilities or assets that may have long-term, inflation-linked contracts. That provides high revenue certainty and strong profitability. The long-tenured managers conduct meticulous research to uncover companies trading at a discount to the team's estimate of intrinsic value. As of June 30, the strategy was yielding 5.89% on a 12-month trailing basis, according to Morningstar.
I will also stick with Clarion Partners Real Estate Income [CPREX]. Real assets have historically provided a hedge against inflation and a negative correlation to U.S. equity and debt markets. The asset class demonstrated these benefits again in the first half. This fund provides access to Clarion's institutional-quality commercial real estate investment portfolio in an innovative retail product. It targets high-quality, well-leased buildings that generate 5% net target annual distributions. It is taxed as a real estate investment trust, providing tax advantages, and it focuses on themes that can capitalize on demographic, technology, and lifestyle trends.
How about an update on SPDR Blackstone Senior Loan [SRLN] and Franklin Income [FRIAX]?
The Blackstone fund's floating-rate instruments provide an income, based on credit spread alone. The bank-loan market has grown substantially in recent years, providing an underresearched opportunity set. The strategy has underperformed this year, due to higher exposure to lower-quality credits, but has historically tended to outperform during periods of market distress.
Franklin Income has a consistent record of income generation, even in rising-rate environments. Steady income distributions may be a stronger driver of total returns over the remaining half of 2022 than capital appreciation. A dividend focus for the equity allocation, and more defensive positioning in fixed income, have helped performance this year. I'm sticking with it.
Thank you, Sonal.
Barron's: It has been a confusing year. Where to from here?
Mario Gabelli: The U.S. consumer is in good shape, with a net worth, in my estimate, of about $138 trillion as of June 30. Sure, that's down from $149 trillion as of March 31, as financial assets have fallen, but it is more than twice as high as $65 trillion in 2012.
As for an economic slowdown in the U.S., a recession should be mild. A year ago at this time, we were talking about Robinhood Markets [HOOD], payment for order flow, SPACs [special-purpose acquisition companies], NFTs [nonfungible tokens], blockchain, Bitcoin—all those things. Today we are talking about the I's— inflation, interest rates, infection, invasion, infrastructure, incomplete energy policy. Inflation for goods should ebb, but wage pressure will continue. We're going back to business fundamentals: gross margins, pretax profits, taxes, inventory, pension costs, and so forth.
Will deal-making activity pick up?
On the M&A [mergers and acquisitions] front, SPACs aren't much of a factor today. But we are going to see more private equity and strategic deals as companies take advantage of the increased willingness of other companies to sell.
The big negative for the stock market is rising interest rates. Higher yields have a negative impact on valuations. I expect the stock market to start to improve toward the end of the year, as the U.S. election results are in. China and Europe (40% of global GDP) and the U.S. will have a brighter outlook for the first half of 2023. In the short term, you just keep your seatbelt fastened.
Which stocks do you favor now?
The American farmer's cash flow is estimated at $461 billion in 2022, from crops and livestock. Farmers will be buying more equipment. Deere is the leader in precision agriculture, with an estimated $22 per share in earnings for fiscal 2022 and a market cap of $93 billion. CNH Industrial, [CNHI], which I am recommending, is catching up. It has 1.3 billion shares outstanding. The stock is trading around $11 and has a market cap of around $15 billion. The company could earn about $1.50 in 2023.
Aerospace will benefit from more spending by the U.S., NATO, Japan, and others. The world is full of hot spots, not only Ukraine. My pick is Aerojet Rocketdyne Holdings [AJRD]. Current management just won control in a proxy contest that pitted the now-former chairman against the CEO, Eileen Drake. The company has embedded technology for use with hypersonic missiles. There are 86 million fully diluted shares outstanding. The company has about $4 a share of cash, and land that is worth $5 or $6 a share. Aerojet could earn $2 a share this year and $2.20 in 2023. The stock trades for $40 and could be worth something in the mid-$50s or mid-$60s in the next two years as earnings return and its participation in critical propulsion systems become more visible.
Turning to infrastructure, there is an influx of spending and potential reshoring ahead. Companies are going to need equipment. One of my favorite suppliers, which I have recommended before, is Herc Holdings [HRI]. The stock went from $30 (following its spinoff from Hertz) to $180, and is back to $90. There are 30 million shares, and a $2.7 billion market cap. Herc has about $2.1 billion of debt. The stock is selling for a fraction of what it could command a year and a half from now. Management has done an outstanding job of increasing profit margins and diversifying Herc's customer base and end-market exposure, making the business more resilient throughout economic cycles.
Now, let's talk about the Liberty Braves Group.
What has changed?
This is a tracking stock for Liberty Media's ownership of the Atlanta Braves and the real estate around their ballpark. To go from a tracking stock to a C Corp. requires them to meet certain tax requirements, which they have done. John Malone and Greg Maffei control the voting stock, and are likely to spin Liberty Braves from the Liberty tacking structure. That would tee it up for a sale. The Braves could be valued in the low-$40s a share, versus a recent $26. A deal could happen within the next two years. The team is well positioned in terms of its stadium and attendance. Investor up!
Next, Minions: The Rise of Gru did well at the box office. So did Top Gun: Maverick. The theatrical film industry and investors are learning to live with Netflix [NFLX]. I am recommending Paramount Global [PARA] because it has the lowest enterprise value among the majors relative to its strengths in content and distribution. There are approximately 660 million shares outstanding, inclusive of the mandatory convertible preferred stock. The company has about $11 billion of debt before it sells Simon & Schuster and some real estate. Cash into content has gone up from about $10 billion in 2020 to probably $17 billion to $18 billion in 2022-23. Amortization of that cash is rising, impacting Ebitda [earnings before interest, taxes, depreciation, and amortization]. Paramount will earn about two bucks a share this year. What does Disney [DIS] do? What does Paramount do? What does Comcast [CMCSA] do?
Do about what?
Do they spin off their linear television businesses? The possibilities are interesting. Short term, local broadcasters face a lack of spending by auto companies. This year, political spending is robust, and 2024 will be a tsunami.
Paramount's voting stock [PARAA] sells for $27. The nonvoting stock is $24; that's what I'm recommending.
You recommended Sinclair Broadcast Group [SBGI] last July. It has come down. Do you still like it?
It is trading around $20, down from $28 and change. I still like it. Sinclair has 70 million shares outstanding, and is buying back stock. The $3.8 billion in debt is being reduced at an accelerating rate. Capex [capital expenditure] is de minimis. Broadcasting cash flow could approach $900 million this year. The company benefits from political advertising.
I recommended Dril-Quip [DRQ] in January. The U.S. has done an uninspiring job of encouraging capex in the oil patch. In 2022, the majors, independents, and national oil companies will spend about $360 billion on capex. In 2012, they spent $700 billion. In North America, the peak was $217 billion in 2014. It dropped to $82 billion, and it's back to $107 billion this year.
I'm re-recommending Dril-Quip, a maker of offshore drilling equipment, and Halliburton [HAL], my favorite stock in this space. Dril-Quip sells for around $24 a share, with 35 million shares outstanding and $10 a share in cash. Halliburton has 900 million shares. It can earn as much as $2.55 in 2023, up from $1.90 this year. Debt is coming down at an accelerating rate.
Barron's: The world has changed since January. How do things look to you?
Meryl Witmer: The markets have suffered under the current administration, which is pro excessive regulation. Stimulus payments have ended, which had to happen. We're still dealing with supply-chain problems. Plus, there's the war in Ukraine. In the markets, the speculative bubble in tech stocks has been popped, which has had an effect on all stocks. The popping of the crypto bubble has caused panic among people who don't have a feel for value and viewed the market as a casino.
Although stocks aren't as washed up as in March 2020, there are some great values, especially in small- and mid-cap value. There is also a lot of buying power because institutions and individuals have been taking money off the table. My first pick is a repeat from January: Sylvamo [SLVM], which is trading below $30 again, after having traded as high as $53 earlier this year. This is a pound-the-table cheap stock.
Sylvamo makes uncoated free-sheet paper, basically copy paper, and related products. There is a great industry structure, which is important in the commodity business. The company has 44 million shares outstanding, for a market cap of $1.3 billion. It has about $200 million in cash, and $1.4 billion of debt.
Sylvamo has guided to full-year Ebitda of $725 million to $775 million. The midpoint equates to earnings of more than $7.50 a share. The stock sells for four times earnings. Four times! There is more demand for the products, and a dearth of supply in Europe. Sylvamo is one of the few games in town in Europe. Ebitda, by the way, isn't burdened by capital spending above depreciation levels.
How is the company using its cash?
Starting in 2023, Sylvamo should begin paying down debt every year. Within a couple of years, it should be able to pay a dividend of $5 a share annually, with an incremental special dividend to investors when results warrant it. Our target price is $50-$60 a share.
Donnelley Financial Solutions [DFIN] has 34.4 million shares outstanding and an equity capitalization of just under $1 billion. It has $194 million of debt. The company reported earnings last year of $4.14 a share according to GAAP [generally accepted accounting principles], and adjusted earnings of $4.89. We think the adjustments are warranted, although we don't add back share-based compensation. The stock trades for $30, down from a 52-week high of $52.
What does Donnelley do?
Donnelley provides solutions to help companies, mutual funds, and other investment firms with regulatory filings. Clients use its technology and expertise to navigate the Securities and Exchange Commission's many requirements. It also offers tech and services used for merger and acquisition transactions, IPOs, and the creation and dissolution of SPACs. With M&A and SPAC volume slowing, the stock has traded down. The remaining businesses should produce a growing annuity-like stream of cash that is deserving of a higher multiple.
Donnelley's Software Solutions businesses include ActiveDisclosure, an SaaS-based product used by more than 1,000 corporate clients to manage their SEC filings, and Arc Suite, which offers software solutions for investment companies to create and manage regulatory compliance needs. The company also has a compliance and communications division to assist clients with ongoing regulatory needs, and services related to secondary offerings and other transactions.
What will Donnelley earn in 2022?
Donnelley could earn about $2.80 a share, rising to about $3.15 in 2024. It trades for less than 10 times 2024 earnings. It should have no debt by the end of 2023,. We could see the company earning as much as $3.50 a share in 2024, with normalized transaction revenue. Given the quality of the earnings streams after normalization of the transaction/merger earnings, we think the company deserves a 15 P/E, at a minimum. Our target price is above $45 a share in early 2024.
Euronet Worldwide [EEFT], my last pick, has 54.5 million shares outstanding, for an equity capitalization of $5.45 billion. Debt is $1.76 billion, and cash was almost $1 billion at the end of the first quarter. It has three business segments: electronic funds transfer, or its ATM business; epay, a digital and mobile payments business; and Money Transfer. Euronet was hurt during Covid when travel essentially stopped. Transactions at its international ATMs slowed dramatically, and customers seeking currency conversions disappeared. That's where the money is made in its ATMs. That segment went from earning almost $300 million to losing $45 million in operating income.
And the rest of the business?
Its growth was masked by the downturn in the ATM business. Travel is now picking up. We think Euronet could earn more than $7 a share this year, growing to $9.60 in 2024, and trade at a 15-to-20 P/E. Our target price is $150 to $190 by the end of 2023, versus the current $100 a share.
Barron's: David, how does the back half of the year look to you?
David Giroux: Market and macro uncertainty is creating a unique opportunity to buy great companies with attractive long-term fundamentals at meaningful discounts to fair value.
The market is already pricing in a mild recession, but we don't expect a financial crisis like the crisis in 2008-09, as bank balance sheets and reserves are in good shape. We came into the year underweight equities, versus our normal weighting, due to elevated valuations. Given the market's 20% decline, we are now overweight. Today, we're underweight staples and utilities, and overweight information technology. Our largest overweight is industrials.
Fortive [FTV] is one of my favorite industrials. It was spun out of Danaher [DHR] in 2016. It is trading for about 17 times the next 12 months' earnings, and about 16 times free cash flow. Fortive has divested about $3.7 billion of sales since 2016, exiting its most cyclical businesses and lowest-growth assets. In the short term, this has been materially dilutive to earnings. The company has also struggled as two large deals failed to live up to expectations, only one of which was really its fault. The majority of acquisitions have been successful, and the quality of the business mix has improved immensely. Recurring revenue used to be 20% of the business; now it is 40%. Fortive has a good balance sheet, and should have about $5 billion or $6 billion in cash to spend in the next three years. We think the stock could double in three to four years.
What else are you buying?
NXP Semiconductors [NXPI] trades for $148 a share, down from $240 earlier in the year. Consensus earnings estimates are $13.80 this year and $14.36 next year. The stock trades for a little more than 10 times expected earnings, a valuation that suggests investors see a 40% decline in earnings. Our estimate is $11 or $12 next year. Even so, you can paint a picture of a $225 stock at the end of 2023, trading for 17 to 18 times 2024 estimates of $13 a share.
We like NXP for two reasons. The auto business accounts for 51% of sales. Global auto sales are still depressed. Thus, the business has less room to fall, relative to other semi end markets. In the long term, NXP will benefit from rising EV adoption. EVs were 8% or 9% of auto sales last year, rising to an estimated 11% this year. They could account for 90% to 100% by 2040.
What are NXP's other markets?
Its other end markets are industrial and communications. We estimate that annual revenue will grow organically in the mid-single to high-single digits. NXP will aggressively buy back stock. It pays a dividend yield of greater than 2%. People have been focused on the supply/demand imbalance in semiconductors. The pricing environment may be more favorable than in the past.
My other two picks are January recommendations that didn't deliver as well as expected. General Electric [GE] has two great businesses, healthcare and aviation. Combined, they are worth materially more than what the company is trading for today. We estimate the market is putting a negative $20 billion valuation on the renewables business, which is still a mess operationally and financially. Oversight of that business was given to Scott Strazik early this year; he successfully turned around GE's power business. We believe there will be material progress in returning renewables to mid-single-digit-plus profitability by 2025-26.
GE is planning to split into three companies in early 2024. How do you value the parts now?
GE will spin off at least 80% of its healthcare business early next year. The 80% will be worth $28 a share in early 2023, based on a multiple of 17-18 times earnings and free cash flow. This business has mid-single digit organic growth, low cyclicality, significant margin expansion, and double-digit earnings-per-share growth.
That leaves power, renewables, aviation, and the 20% stub of healthcare trading in the low- to mid-$30s, which doesn't make sense. The power and renewables businesses will be separated from GE Aviation (and the healthcare stub) in early 2024. Aviation could earn about $3.80 a share in 2024. A conservative multiple of 20 times earnings would get you to $76. Reduce that by $14 for pension and long-term care liabilities, add back $7-$8 of value for the healthcare stub, and you get to $70 for GE standalone, versus a current share price of $61.
The power and renewables spin is worth $10 a share, and more if the renewables business can be turned around. In 18 months, you would own 80% of a great healthcare business, worth $31 per share; the aviation business, worth probably $70; and the power business, worth $10. That's $111 stock, offering more than 80% upside.
What else are you reprising?
TE Connectivity [TEL] gets 45% of its revenue from the auto market. It is also a play on the long-term growth of EVs, which have materially more connector dollar content than ICE [internal combustion engine] vehicles. TE exited its lower-margin personal electronics, communications, and undersea-cable businesses. It has built or acquired fast-growing franchises in data centers, renewables, and medical connectors. The shares are trading around $115. This could be a $200 stock in three or four years, with a 20 times multiple on $10 earnings and free cash flow. The management team is excellent, and it is a great ESG story.
You were bullish on leveraged loans in January. Are you still?
Leveraged loans is one of the best-performing asset classes this year. The S&P/LSTA Leveraged Loan index is down 4%, year-to-date. I still like the asset class, but we aren't buying additional loans now, as other asset classes have become more attractive. But you still have the potential to earn a 6%, 7%, 8% return from leveraged loans.
Thank you, David.
Write to Lauren R. RUblin at email@example.com
What to Buy Right Now: 42 Picks From Barron's Roundtable Pros
Credit: By Lauren R. Rublin