On the flip side, just buying a company because the stock is too cheap to pass up (as you have been hearing countlessly on the TV by the analysts, and reading about it on “value investing” websites) is also a recipe for disaster.
On July 21, 2011, the S&P stood at 1345. Around the same time the U.S. government was starting to feel pressure on the debt ceiling debate. New economic data around the same time showed that the existing home sales fell 0.8% in June from an annual rate of 4.81 million in May to 4.77 million in June. Economists were expecting an increase to 4.93 million, according to briefing.com. On July 25, 2011, with time running out on the debt deal debate, the government was still deadlocked and the stock market reacted sharply. On Aug. 5, 2011 the jobs report came in a bit above expectation but the stock market still continued its decline. With the debt ceiling debate over, the S&P downgraded U.S. over the weekend on Aug. 6, 2011. On Aug. 8, 2011 the S&P was sitting at 1119.
The fears from Europe banking contagion were also haunting the market. After a brief rally in the end of August the stock fell again and on Oct. 3, 2011, the S&P was again sitting at 1099.23. The big issue was once again Europe and more specifically Greece which did not meet its economic targets for receiving the new set of bailout funds. This is still in play. With the referendum on the bailout package still to be done in January 2012, which will likely decide the fate of Greece in the euro zone, the market is looking for more volatility and pain.
If you have been priming your portfolio for a significant buying opportunity, this series of articles are targeted at you. In the series, I am going to look at companies with following characteristics:
- Companies built to last. This means wide moat, pricing power and durable competitive advantage. We will not deal with a lot of technical hocus pocus and will not consider most technology stocks because of the ever-changing playing field.
- Companies with strong FCF and good history of FCF growth in the last decade, preferably with market cap which is less that 12 times FCF. Why 12 times FCF? Assuming a 1% growth in FCF forever, with a 10.2% discount rate, gives us the magic number 12 times FCF as the terminal value of the stock. What this means is that the market is pricing the company for less than half of the U.S. economic growth rate (which is around 2%, if seen over a period of larger than 30 years) and a 10% discount rate.
- Companies with good ROE with little or no debt, or companies with good ROIC. We will try to look at companies which have manageable levels of debt. We will err on the side of safety.
- Companies with good management practices and good history of shareholder returns. This will look at the share counts, buybacks and dividends, along with the management compensation, options and stock awards. Good insider holdings/guru holdings will be a plus.
- Companies with very good balance sheets. We don’t want the company to face any major headwinds because of credit crunch in the next year. In particular we would like the company to be well financed with a good current ratio.
The first company I am going to pitch is medical device maker Medtronic (MDT). This company sits on my watch list and sadly I could not buy it in the last pullback. I hope to start a beginning position in the stock if the market continues to fall.
Medtronic: the Company
Medtronic is one of the largest medical device companies. It develops, manufactures and markets therapeutic medical devices for chronic diseases. Its product portfolio includes pacemakers, defibrillators, heart valves, stents, insulin pumps and spinal fixation devices.
Foreign sales account for about 41% of the company’s total sales (Europe $4 billion and Asia Pacific $2 billion).
Mr. Market was paying a P/E of 76.3, P/B of 10.6, P/S of 10.6 and P/CF of 37.7 in 2001 for Medtronic. Since then the valuation has significantly come down. Now MDT sports 12.1 P/E, 2.1 P/B, 2.3 P/S and 9.2 P/CF, a much more reasonable valuation.
If we look at the revenue, free cash flow and the market cap of Medtronic, we see that the revenue has grown at annualized 11% and the FCF has been fairly strong and has grown at 10.3% in the last decade. In the last 10 years the FCF has never been negative and the cap-ex has been fairly stable.
Medtronic has a debt/equity ratio of 0.5 which has been stagnant since 2007. It has a LT debt of $4.7b and LT accrued compensation and retirement benefits of $8.1b. It has shareholder equity of $15.9b and goodwill of $9.5bn. The tangible book value per share is $6.4. The current ratio of Medtronic is 1.93 and the quick ratio is 1.3. Medtronic hence is quite comfortable with its balance sheet at the moment.
Shareholders were paying $51 a stub for Medtronic in 2001. The current price is $33. Medtronic has also returned $4.91 a share in dividends since then (not inflation adjusted). So, per share investors are sitting at a loss of $13 or 25%.
MDT has current market cap of $33.4 billion (at a share price of $33). The FCF has been fairly stable around $3.5 billion since the crisis in 2009. The market is pricing the FCF to grow at a 0% rate with 11% discount (this will give us the FCF multiple of 10, which makes the company worth $35 billion, still more than $33.4 billion).
ICDs are stopwatch-sized devices to monitor the heart and deliver appropriate therapy when an abnormal heart beat is detected. The use of ICDs have grown over the years, mainly due to the trial results which show that ICDs reduce the chances of death by 23% in people with moderate heart failure. MDT owns 50% of the market share and this contributes to nearly 25% of sales of MDT. The growth in the market seems to be hard to come by as it has seen significant penetration. MDT hence risks a stagnant and worse declining market in a substantial part of its sales.
MDT also faces strong competition in all segments it operates in. Primary competitors are Boston Scientific (BSX), St. Jude Medical (STJ), Zimmer Holdings (ZMH), Johnson & Johnson (JNJ), Stryker (SYK), Synthes-Stratec Inc., Kyphon (KYPH), Abbott Laboratories (ABT), Roche Pharmaceuticals (RHHBY), Edwards Lifesciences (EW), Integra LifeSciences Holdings (IART), Cardiac Science (CSCX), Zoll Medical (ZOLL) and Royal Philips Electronics.
With such fierce competition, one needs to trade carefully. Please make your own due diligence before investing. As always, I welcome comments. If you want to argue for or against the stock and also if you want to say something I have missed, you are welcome to do so.