My Watch List – September 21, 2010

I have reviewed issue 4 of Value Line and added companies that have exceptional returns on equity or growth in book value. The list is not perfect and some judgment is required in deciding whether to include a particular stock. As always, I welcome your feedback and comments.

The idea here is to have a dashboard of substantially all the high quality businesses in the U.S. in one place that you can review at least weekly to see what Mr. Market is making available to you.

The valuations are very simplistic, although the basic conceptual framework is sound. Over time, an asset should deliver a total return equal to the sum of its current free cash flow yield and its growth rate (assuming that growth rate continues over the long-term).

The valuations attempt to calculate the annualized return that is discounted in a stock’s current price. The first component of the valuation is the company’s earnings yield based on the consensus estimate for this year’s earnings. This may overstate or understate the true free cash flow yield depending on a number of factors, primarily the company’s level of depreciation and amortization and its level of capital expenditures. Ideally, it makes more sense to look at the ratio of EBIT (EBITDA – maintenance capex) to enterprise value in order to compare businesses, so as to normalize earnings and the capital structure. See Greenblatt’s book The Little Book that Beats the Market for more details.

Nevertheless, the earnings yield is easy to calculate and, since we’re looking for stocks that are compellingly (obviously) undervalued, it should serve as a useful screen so we can focus our time on stocks with the greatest potential.

The second component of the valuation is the growth rate. Here I take 60% of the growth rate over the past ten years. The use of 60% is an attempt to be conservative. Caution: even taking 60% of the past growth rate can grossly overstate the future growth prospects of a business. The primary idea here is that you want to determine if the factors that led to the past growth are still in place, and, if so, how much growth potential is left. If you can’t figure it out, you can’t value the stock, at least not its future growth prospects. It still may be worth considering if the stock is so undervalued that it is cheap even if you factor in zero growth going forward.

I’ve added the following stocks this week:

Alliant Techsystems Inc. (ATK)

Rockwell Collins, Inc. (COL)

Lockheed Martin Corporation (LMT)

Markel Corporation (MKL)

Berkshire Hathaway Inc. (BRK.B)

Fairfax Financial Holdings Limited (FRFHF)

U.S. Bancorp (USB)

CIGNA Corporation (CI)

Laboratory Corp. of America Holdings (LH)

Lincare Holdings Inc. (LNCR)

UnitedHealth Group Inc. (UNH)

Computer Programs & Systems, Inc. (CPSI)

Techne Corporation (TECH)

Here’s the updated Watch List for September 21, 2010.

Tip: Don’t forget to utilize the link to GuruFocus in column U. It’s a quick way to see who is buying a stock.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

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5 thoughts on “My Watch List – September 21, 2010

  1. Andrew Schneck

    * Amgen, Inc.
    * Cigna Corp
    * General Dynamics
    * Laboratory Corp of America
    * Mednax Inc.
    * Precision Castparts
    * Quest Diagnostics
    * Rockwell Collins
    * Techne Corp
    * UnitedHealth Group

    That was my list of “great businesses” from Issue 4. I don’t think ANY of them are at value prices… just something to consider. I do not know how to value banks, so U.S. Bancorp didn’t make it. Lockheed Martin is not QUITE good enough for the list, although close. I didn’t like Alliant b/c of the run up in receivables & their large pension obligation. I didnt like Lincare due to the high receivables & the decreasing margins over the decade. I like your mindset- you seem to have a good head on your shoulders in identifying good businesses. Just make sure to heed Buffett’s advice in paying a reasonable price for these- you could get into trouble with the current prices of most of these.

    Take a second look at Amgen, Quest Diagnostics, Precision Castparts, Mednax, and General Dynamics.

    Andrew

    Reply
  2. Greg Speicher Post author

    Andrew, thanks for the list. I will take a second look and I do expect the list will evolve as I cycle through Value Line over time. Lookheed Martin is interesting because, according to Glenn Greenberg, its earnings are materially understated because they have made large pension contributions in recent years. Under law, a large portion of this expense will be picked up by the government and paid back in future years. The accounting is tricky and I have not been able to get my arms around it. Perhaps it will be destined for the “too hard” pile.

    Also, inclusion on the list does not indicate that something is necessarily cheap.

    Reply
  3. Aron

    Hi Greg,

    Great site, thanks very much for all of your ideas.

    I’ve looked at your watch list every time you’ve posted it, but I’m finding it very unintuitive.

    I think I understand your concept of Expected Return expressed as a %, but why not have an implied valuation and Margin of Safety columns as well so you can quickly see the variance from current price and best opportunity to research?

    If I understand correctly, you could just rank opportunities from greatest yield to least, but the metric feels very unfamiliar.

    I’m interested in your thoughts,

    thanks,

    aron

    Reply
  4. Andrew Schneck

    That’s interesting about Lockheed, I still haven’t looked in-depth at pension obligations, but that makes sense. They were right on the fence for me in terms of what I consider “Great Businesses”, I’ll take a second look. Still, they’re not at a good price so I’m not too worried about my analysis of them. You may be right on the pension liabilities offsetting the earnings, but unless it was an extremely large difference, it still looks overpriced from what I’d be willing to pay.

    Yeah, I realized that you didn’t mean they were cheap after reading your post again- sorry about that. Thanks for running the blog- I like some of your articles quite a bit.

    Reply
  5. Greg Speicher Post author

    Aron, thanks for the comment and question. Please see my blog post on September 22, 2010 for my answer. It was such a good question, I decided to answer it in a blog post.

    Reply

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