From their recent annual letter Trapeze Asset Management hit on a theme that we see as fairly common among well known managers. And that is that large capital quality stocks are more attractive than they have been for a long time.
Jeremy Grantham is perhaps the most vocal among the investing gurus suggesting this.
Trapeze provides a couple of ideas for us:
Bottoms Up—Bigger Is Better
Not a toast, but a recommendation that investors today, while not entirely ignoring the confusing macro, should foremost focus on and emphasize the micro opportunities in cheap stocks relative to all else.
We have now been able to increase our weighting in large-cap companies, because they are unusually cheap. Large-cap stocks currently trade at their lowest valuation compared to small caps since 1982. And, bigger is usually better—more liquid, experienced managements, strong market shares with presences in growing emerging markets, good balance sheets, low borrowing costs and so on.
Bigger is also better, inasmuch as we can more easily exit larger cap positions if we get a TRAC™ sell signal or our opinion has changed or we are fearful of an overall market decline. But, we are otherwise indifferent to whether our holdings are small or large cap, though our return expectations need to be higher for small-cap holdings and our anticipated hold period longer, thereby potentially offsetting the liquidity risk (i.e. being stuck) inherent in smaller company positions.
We now own several large-cap familiar names. Hewlett-Packard for one. We believe resurgence in the entire global IT space lies ahead. Corporations restrained spending since the recession and are now flush with cash and refresh cycles are reasonably short. HP has also reinvented itself somewhat into a service provider and that business, along with its staple printers and associated cartridges, is thriving. The company trades at 8x free cash flow offering upside to a revaluation back to its growing FMV. If the 35% discount to FMV is alleviated in the next 2 years and the FMV grows by 8% per year then HP could deliver a 35% annualized rate of return in 2 years.
Dell is our latest addition. Somewhat misunderstood, as the consumer PC business for which Dell is widely known now only represents less than 3% of profits. Like IBM, HP and others, Dell has morphed its business toward the enterprise market and IT services. What attracted us to Dell now was the recent lift in its FMV—it is adding value again—to the mid $20s while its share price sank to a floor in our work just below $14. And the company has $9 billion of net cash and generating more from record earnings. Excluding the cash from the overall enterprise value the company is trading at a mere 5x free cash flow, remarkable, for one of the top brands on the planet. Michael Dell has the reins again and insiders are buying. There is a clear strategy for growth, even for the PC business, headwinds seem to have evaporated and Windows 7 (a successful product whereas its predecessor Vista was a bust) which only has 20% penetration should alone provide growth as consumers seek to upgrade. A simple jump back up to 12x free cash flow, plus the cash and the reasonable growth we expect has the potential to lift the shares by over 40% per year over the next couple of years.
Aetna’s recent results exceeded the market’s expectations and lifted the stock. Its medical loss ratio fell smartly, guidance was raised by about 15%, the company bought back about 5% of its outstanding shares and it lifted its insignificant dividend to a respectable 1.6% yield. Generally results improved as the company has been pricing its risks better. Aetna has now shown meaningful recovery in the profit margins that we had been anticipating. Our thesis is proving correct and the stock remains undervalued at 10x earnings with a 30% annualized return potential over the next 2 years.
We added MasterCard late in 2010 after its share price declined to a floor on the news of regulatory reform which could hamper debit card transaction fees. It's not often one can find a rapidly growing, world-class franchise opportunity at 13x earnings. When Mastercard sold off on news that our analysis suggested would only knock 5% off earnings, if any at all, we took a position. The share price has lifted in the last month and now offers a 21% potential annual rate of return to our FMV in the next 2 years.
We also added VISA in our “big cap” mandated accounts. Visa, the preeminent player, suffered from the same news as MasterCard. We established the position at a floor in our work at a reasonable discount to our appraised value.
