Which Sectors Have Strong Predictable Value Potential?

As the U.S. stock market remains significantly overvalued, several gurus are investing in companies with strong predictable value. Such companies meet two of the most important criteria in Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio)’s investing approach: undervaluation and high business predictability. While the co-managers of Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) valued companies with the price-earnings to growth (PEG) ratio, this article will focus on undervalued companies based on discounted cash flow models.

Overview of DCF models: the theory and practical uses

The DCF model depends on four factors, including the book value of shareholder’s equity, the future business earnings, the discount rate and the terminal value. Each of these factors controls a specific component in the calculation: the initial earnings, the rate of future business growth, the time-value of money factor and the business growth at the terminal stage.

As we usually do in business finance classes, we set the initial earnings value equal to the company’s free cash flow per share since free cash flow represents how much cash a company can generate after accounting for capital expenditures and working capital. Companies can generate shareholder value with this excess cash either through product invention and acquisitions, or by reducing debt and issuing dividends.

As the name suggests, the discounted cash flow model first projects future free cash flows using the future business growth rate for the next n years, i.e., the n­-year FCF growth rate. Since “a dollar today is worth more than a dollar tomorrow,” we must discount the future free cash flows at the appropriate discount rate, usually the company’s weighted average cost of capital (WACC). Finally, since a business usually does not grow indefinitely, we must also input a terminal growth rate for m years after the growth stage ends. In business finance classes, we simply assume that the terminal growth lasts forever, i.e., m is infinity.

How GuruFocus applies the DCF model

GuruFocus departs from the “DCF model as we know it” in several ways, including the use of earnings per share (without nonrecurring items) instead of free cash flow per share and a finite number of terminal-growth years. As discussed in the research article, the correlation between the intrinsic value and margin of safety strengthens when we use earnings per share based on generally accepted accounting principles instead of free cash flow per share.

By default, GuruFocus computes the intrinsic value with 10 years of future growth because 10 years is sufficient to cover a full business cycle for most companies. We also assume 10 years of terminal growth, i.e., we ignore the small contributions beyond 10 years after the terminal stage. To remain consistent, we use the company’s 10-year earnings per share growth as the future business growth rate. However, there is a caveat: This growth rate must be between 5% and 20%.

The terminal growth rate should be less than the future business growth rate to allow the DCF calculation to converge. While we can use any terminal growth rate less than the future business growth rate, we normally set the terminal growth rate to 4%, close to the average U.S. annual long-term inflation rate. Finally, we assume a universal discount rate of 12%, instead of each company’s WACC. The 12% discount rate represents the average long-term stock market index return, which is around 11%. The extra 1% likely represents a small error correction.

Brief overview of the DCF Calculator

The GuruFocus Fair Value Calculator allows users to estimate a company’s intrinsic value by entering values for the parameters discussed above. The inputs, conveniently located on the left, produce the company’s fair value, displayed in bold on the right. (Note the “greater than” symbol between the two gray boxes.) Users can change the white boxes within the calculator based on personal preferences –Â for example using the free cash flow per share instead of earnings per share, a different terminal growth rate or a different discount rate. The fair value immediately reflects the changed inputs.

For more information on how to use the DCF Calculator, please consult the user manual.

Margin of safety analysis identifies the best sectors

For this statistical study, we first collected data on each company’s stock price, predictability rank, trailing 12-month EPS without nonrecurring items and 10-year earnings growth rate from SQL queries. We then computed the company’s growth value and terminal value based on the DCF earnings model and took the sum of the two values to get the fair value.

To compute the company’s fair value, we must first calculate the company’s future business growth factor and the terminal growth factor. For the former, we first adjust the company’s 10-year earnings growth rate: If a company’s earnings growth rate exceeds 20%, we simply use 20% as the 10-year earnings growth rate. However, we set the 10-year earnings growth rate to 5% for companies with no 10-year earnings growth rate or a 10-year earnings growth rate below 5%. The latter depends on the terminal growth rate, which by default is 4% for all companies.

Figure 1 shows the average margin of safety across the 11 sectors. For each sector, we first considered the average margin of safety for all companies trading on the New York Stock Exchange and the Nasdaq. As observed from the blue bars, materials and real estate companies have the highest average margin of safety among the sectors. However, these results are inaccurate since we have included unpredictable and unranked companies. To get more accurate results, we repeated the analysis for predictable companies and then for companies with at least a four-star predictable rank. The red bars in Figure 1 show the average margin of safety for predictable companies while the green bars show the average margin of safety for 4- to 5-star companies.

Figure 1

When we remove unpredictable and unranked companies from our analysis, real estate companies no longer have good margins of safety. Instead, financial and industrial companies have the highest margins of safety. Among companies with at least a 4-star predictability rank, financial companies have a slightly positive average margin of safety.

Value screeners identify best opportunities

The value screeners give an alternate perspective on the best sectors to invest in a significantly overvalued stock market. Figure 2 shows the number of undervalued predictable companies for each sector while Figure 3 shows the distribution of Buffett-Munger companies across sectors.

Figure 2

Figure 3

Six of the 11 sectors have at least seven undervalued predictable companies, but only two sectors, consumer cyclical and financial services, have more than seven Buffett-Munger companies. Table 1 summarizes the NYSE and Nasdaq companies that made both value screeners.

Table 1

As these companies present strong predictable value potential, several gurus invested in these companies during the past quarter. Based on most active picks data, four gurus –Â Ken Fisher (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio), Jeremy Grantham (Trades, Portfolio) and Jim Simons (Trades, Portfolio) –Â increased their positions in Wipro, an information-technology services company based in India.

See also

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Disclosure: The author has no position in the stocks mentioned in this article.

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