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J. Stephen Castellano steve@ascenderellc.com
This week, 62 stocks make the "high-quality" list, with 18 additions and 18 deletions. 42 stocks make the "low-quality" list, with 6 additions and 7 deletions to
our "low-quality" list. In our opinion, American Express (AXP) is the most important new "high-quality" stock this week.
We define quality as relative to four key factors: 1) Relative Value; 2) Operating Momentum; 3) Analyst Revision Momentum; and 4) Fundamental Quality.
About 1/3 of these stocks make it to our model portfolios that turnover monthly, but we think some of these stock ideas could work well with average 12-month
holding periods as well. Our opinion is based on a backtest we conducted back to 12/31/2004, which showed that 12-month returns from stocks on refined list
averaged about 11%, with the highest 12-month returns averaging +95% and the lowest 12-month returns averaging -42%. Deeper fundamental analysis of
stocks on this list might reveal some of the stronger, longer-term ideas.
Of the 18 new "high-quality" stock ideas this week, five of them stand out to us. These include RenaissanceRe Holdings Ltd. (RNR), American Express Company
(AXP), Gilead Sciences Inc. (GILD), Union Pacific Corporation (UNP) and Telecom Argentina S A (TEO).
RenaissanceRe Holdings Ltd. (RNR) is a "global provider of reinsurance and insurance to cover the risk of natural and man-made catastrophes." This $3.8b
market cap company is trading at 1.05x tangible book value and 7.6x the consensus calendar-year 2011 EPS estimate of $7.95, and is yielding 1.6%. It reports
3Q10 results on Thursday morning, October 28, 2010. The company states in its 2009 annual report that the most important metric by which it measures
shareholder value is tangible book value per share plus the change in accumulated dividends. This company has a history of raising dividends each year by $0.04
per share; its latest annualized dividend is $1.00, up from $0.96 in 2009. The stock has traded between 0.81x to 2.11x tangible book over the last 7 years, and in
2008 and 2009 traded at an average tangible book value of 1.21x and 1.19x. RNR stock got our attention because it is only two of the 18 new adds that scored
the best possible score in 3 out of 4 factors, and the second highest score for a fourth. Based on forward looking estimates, it looks like operating momentum
may have peaked in the June 2010 quarter, but given its rising stock price though still low P/BV multiple and rising analyst revision momentum, we wonder if
analyst revisions will continue. Perhaps earnings estimates are too low because of overly-high estimates for the cost of Gulf of Mexico cleanup? This is one
stock that deserves further study.
American Express Company (AXP) is a "go-to" stock in the Financials sector, the same way that Freeport McMoran (FCX) is a go-to stock in Materials. When
portfolio managers speak of financials, they always want to know about AXP. We have not been able to say anything good about American Express for a long
time, but this may be changing. AXP, a $47b market cap company, is trading at 3.2x book value, 11.0x times the calendar 2011 consensus EPS estimate of $3.55,
with an annualized dividend of $0.72 and yield of 1.8%. The stock sold off 3% this past Friday following its 3Q10 report the night before. Revenue and earnings
beat consensus, helped in part by rising card usage, lower defaults, and a release of bad debt reserves. That sounds like positive developments to us, but a
number of analysts expressed concern about higher expenses and increasing risk of a decline in its merchant discount rate and ongoing pressure related to the
Credit Card Accountability, Responsibility and Disclosure Act. These risks are real, but perhaps embedded enough in current valuations, likely ongoing analyst
revision momentum and relatively low but still likely positive operating momentum. In our opinion, AXP as of today, looks like one of the best relative Financial
Sector stocks out there and deserves a look as both a short-term and long-term holding idea.
If you liked CSX Corp. (CSX) last week, you will love Union Pacific Corp. (UNP) this week, according to our relative ranking models. Last week, CSX Corp. made
our "high-quality" list, but this week it was knocked off as a result of relatively better financial reports from Industrial sector companies, including Union Pacific
Corp. At $42.6b, UNP's market cap is nearly twice as large as CSX and now sports a better cumulative factor score than CSX. UPN trades at 13.7x the calendar
year 2011 EPS estimate of $6.29 and pays a $1.32 annualized dividend for a yield of 1.4%. UNP is trading at a slight premium to CSX, but this is justified by its
strong analyst revision momentum, which scores a 5 out of 5. UNP reported a strong quarter following the market close on October 21, with 3Q10 EPS of $1.56
beating Street consensus of $1.50, driven by better than expected prices and cost control. This prompted a number of positive analyst revisions to estimates
and price targets. UNP's debt stands at $9.8b, cash is $1.4b, and its debt-to-capital ratio is decent at 31%. Debt-to-capital would only move up to 39% if it
acquired CSX, though we note we have no inkling of the possible synergies between the two or any of the antitrust issues that might be raised. But what better
time to make an acquisition, just prior to a possible upturn in the economy and during growing evidence that freight traffic is recovering? If the PE spread ever
widens significantly more between the two companies, a M&A analysis might be worth some time. Until then, UNP looks like a solid industrial stock, replacing
CSX relative to last week.
This week the ADRs of Telecom Argentina SA (TEO) also catch our attention, showing highest scores for Relative Value, Operating Momentum and Fundamental
Quality. The company is trading at only 7.8x the consensus 2011 EPS estimate of $2.97 per ADR and has net cash on its balance sheet. It is a mystery to us how
any capital intensive company like a telecom can have net cash, but those are the numbers. TEO is growing revenues and earnings at an impressive clip despite
reports of a saturated mobile and fixed line telecom market due to value added services. Perhaps Verizon and AT&T ought to pay a visit to TEO; maybe they will
learn something. This company deserves further study.
Of Note
It is tough to find any solid short ideas among our "low-quality" stocks. For the MTD, low-quality has outperformed high-quality, though that return spread has
narrowed over the past few days (see the latest "Ascendere Daily Update" report). When investors anticipate better economic conditions or increase their risk
appetite for whatever the reason, "low-quality" tends to outperform in the short-term as these beaten-down stocks begin discounting better fundamentals
down the road. Over the long-run, "high-quality" will outperform, but it's very tough to find a compelling short idea among the current "low-quality" list.
Daily Return Data of our Model Portfolio Backtests are Available on Request to Paying Subscribers
In our opinion, cash flow growth and return on invested capital are the key drivers of any stock's valuation. By focusing on various proxies for these data points
and other factors such as relative value, we have been able to generate some terrific investment ideas and avoid some significant value traps over our career in
sell side and buy side equity research.
For those interested in learning more about determining a company's value as it relates to ROIC, we recommend reading McKinsey & Company's "Valuation:
Measuring and Managing the Value of Companies" or "The Value Sphere: The Corporate Executives' Handbook for Creating and Retaining Shareholder Wealth."
We also find the newsletters produced by Michael Mauboussin, the Chief Investment Strategist at Legg Mason Capital Management, an excellent source of
information as it relates to determining the value of companies.
Ascendere does not rate stocks on any scale, but does offer individual stock commentary and valuation opinions. With regard to Ascendere's portfolio
strategies, "long" or "high-quality" baskets should generally be considered buys, unless otherwise noted. Stocks in our "short" or "low-quality" baskets should
generally be considered sells, unless otherwise noted. While exceptions may occasionally occur, typically stocks in the high-quality basket are expected to
outperform the S&P 500 over a month's time and stocks in the low-quality basket are expected to underperform. A more relevant benchmark would comprise
of all stocks and ADRs that trade on major U.S. stock exchanges with a market cap above $2 billion.
Ascendere adheres to professional standards and abides by codes of ethics that put the interests of clients ahead of its own. The following are specific
disclosures made by Ascendere:
1) Ascendere may have a financial interest in the companies referred to in this report ("the Companies"). The research analyst covering the Companies
and members of the analyst's immediate family have a financial interest in one or more of the Companies.
2) Ascendere generates revenue from research subscription revenue and portfolio management fees. At any given time it may be long or short any of
the Companies.
3) Ascendere does not make a market in the securities of any of the Companies.
5) Ascendere has not managed or co-managed a public offering for any of the Companies.
6) Neither Ascendere nor any of its officers or any family member of the covering analyst serve as an officer, director or advisory board member of any
of the Companies.
7) Neither Ascendere nor any of its officers or any family member of the covering analyst beneficially own 1% or more of any class of securities of any of
the Companies.
8) The covering analyst certifies that this report accurately reflects such analyst's personal views.