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Top Picks from Steven Romnick
Posted by: Federico F (IP Logged)
Date: November 23, 2011 08:51AM

Steve Romick is the manager of FPA Crescent Fund. In the latest Value Investing Conference, he explained that compelling investment opportunities are few and far between today. He places the blame at the doorstep of the U.S. government, which is spending so much more than it collects in tax revenues that it’s building a debt burden that virtually guarantees tepid economic growth. And that’s a best-case scenario. “We have a calm between two crises,” Romick says. “Our children are going to pay for our sins.”

This pessimistic view of the country’s economic prospects has colored Romick’s investment choices. He’s building cash in Crescent and adding big, diversified companies that have emerging-markets exposure. He holds a conservative, high-quality stocks portfolio.

His latest big investment is CVS Caremark Corp. (CVS), a Rhode Island-based drugstore chain and pharmacy-benefits management company that boasts $96 billion in annual revenue. The company has a clean balance sheet and top positions in all of the areas in which it does business, and it is likely to benefit from the expiration of patents on a variety of drugs. “We know we’re going to make money on CVS” says Romick. “We just don’t know how much.” CVS, which is Crescent’s second-largest holding, is representative of Romick’s focus on an aging population and growing spending on health care, a theme that accounts for 12% of the fund’s assets. Other big holdings include Walmart (WMT), Microsoft (MSFT) and Covidien (COV).

But stocks make up less than 60% of the portfolio. At 19% of assets, Romick’s biggest holding as of September 30 was cash.

That the cautious Romick was not fully invested in stocks should not come as a surprise. Crescent has a go-anywhere charter, which allows Romick to invest wherever he sees the best opportunities. He can invest in stocks and all sorts of bonds. He can even sell stocks short in anticipation of declining prices.

Despite the drag of cash in a mostly up stock market, Crescent has performed reasonably well this year. Year-to-date through November 21, the fund had a flat return, which is good in comparison to the SP&500 performance. Over the past decade, Crescent has crushed the market, returning an annualized 10.6%, compared with 2.6% for the S&P 500.

Romick doesn’t aim to beat the benchmarks every quarter. In fact, the fund’s goal is to get long-term stock-like returns with significantly less risk than the stock market. In a market where risks are rife and bargains are rare, stepping back from the fray may be the best way to play. As the fund’s literature says: “We believe the best way to accomplish our goals is to accept short-term underperformance in exchange for long-term success.”

I will review the stocks that Steve Romnick has most conviction about.

AON: provides risk management, insurance and reinsurance brokerage, and human resource consulting and outsourcing services in the United States and internationally. Aon reported third-quarter revenue jumped 51% to $2.72 billion. Its net income was $198 million for the three months ended Sept. 30, which was up from $144 million in the same quarter last year. The company is expected to earn $3.32 in 2011 and $3.71 in 2012. The stock recently traded at $47.14. Its forward PE ratio is 14.13. Romnick has increased his position in AON at the end of September. Boykin Curry is extremely bullish on AON. He presented his case at the Value Investing Congress. He likes the fact that the stock has a free cash flow yield of 10%.

CVS: Consensus estimates for EPS are that it will increase by 4.1% to $2.80 in 2011 and then by 14.6% and 11.5% more in the following two years. Of the 20 revisions to estimates, all 20 have gone up for a positive change of 0.83%. Assuming a 15x multiple and a conservative 2012 EPS estimate of $3.10, the rough intrinsic value of the stock is $46.50. This implies a 21.9% margin of safety, which I think is what Steve Romnick saw in this strong-moat company.

Walmart (WMT): With inflation pushing up food and energy prices, Walmart will continue to benefit as the consumer looks for bargains. No matter what you sell, Walmart can sell it cheaper. That's the ultimate competitive advantage, and it should last for decades to come. This will become even better if WMT ever finds the right formula to grow outside the U.S.

Walmart has increased its dividends every year for 33 years, with some annual increases as high as 44%. Walmart pays a 2.55% dividend. That sounds small, but it should grow fast. Walmart's dividend has increased 24.3% on a historical basis. Over the last five years, it's up 14.59% on an annual average. EPS increased from $4.07 to $4.49 over the past five quarters indicating an improving growth rate. WMT is expected to increase EPS by 9.5% in 2012. WMT appears normally valued based on its Price/Book of 3.03, which is between the consumer staples sector’s top and bottom quintile values of 4.41 and 1.43, respectively.

Microsoft (MSFT): A portion of Microsoft's huge $55 billion position in cash should be reinvested in organic growth for their business operations, and some for strategic acquisitions in the space. A large portion of the cash, roughly $20 billion should also be used for a massive share repurchase. The shares are clearly undervalued, so they'd effectively be printing money over time. $20 billion would buy over 700 million shares at current prices, reducing the outstanding float by almost 10%. The share buyback could be instituted over several years.

Lastly, proceeds from this spin-off, along with excess cash reserves should be used to increase the dividend. Currently, MSFT spends about $6.72 billion on annual dividends. Given last year's FCF, their payout ratio is a ridiculous 28%. MSFT isn't a young company anymore, and shareholders deserve a larger piece of the pie. With FCF likely rising to $30 billion in fiscal 2012, Microsoft could afford a 50-60% dividend increase.

Even after all of this, Microsoft would have over $20 billion in cash reserves, assuming no further additions to reserves from cash flows, and not taking into account proceeds from business spin-offs.

Steve surely saw these facts and got attracted enough to increase his position in the last quarter.

Covidien (COV): COV is an Irish developer of medical devices, pharmaceuticals and imaging products, and medical supplies for the clinical and home settings. Mega funds added a net $6.09 billion to their $4.51 billion prior quarter position, and taken together mega funds hold 45.4% of the outstanding shares, significantly higher than their 27.3% weighting in the sector. The top buyers were Fidelity Investments ($1.61 billion) and Franklin Street Advisors ($328 million). The top mega fund holders, incidentally also the top overall holders of COV, were Fidelity Investments ($1.51 billion), Vanguard Group ($878 million), and JP Morgan Chase & Co. ($870 million) and State Street Corp. ($841 million) with 6.6%, 3.8%, 3.8% and 3.7% of the outstanding shares respectively.

COV trades at a discount forward 11 P/E compared to the 29 average for its peers in the medical products group, and it trades at a 10.1 P/CF ratio that is also lower than the average 10.7 for the group.

Stocks Discussed: CVS, AON, WMT, MSFT, COV,
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