Nine new stocks made our Most Attractive list this month, while three new stocks joined the Most Dangerous list. We published January’s Most Attractive and Most Dangerous stocks to members on January 5, 2023.
December Performance Recap
Our Most Attractive Stocks (-2.4%) outperformed the S&P 500 (-2.8%) from December 7, 2022 through January 3, 2023 by 0.4%. The best-performing large cap stock gained 4% and the best-performing small cap stock was up 8%. Overall, 24 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (-1.5%) underperformed the S&P 500 (-2.8%) as a short portfolio from December 7, 2022 through January 3, 2023 by 1.3%. The best-performing large cap short stock fell by 8% and the best-performing small cap short stock fell by 21%. Overall, 13 out of the 40 Most Dangerous stocks outperformed the S&P 500 as shorts.
The Most Attractive/Most Dangerous Model Portfolios underperformed as an equal-weighted long/short portfolio by 0.9%.
This report leverages our cutting-edge Robo-Analyst technology to deliver proven-superior[1] fundamental research and support more cost-effective fulfillment of the fiduciary duty of care.
All of our Most Attractive stocks have high (and rising) return on invested capital (ROIC) and low price to economic book value ratio. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for January: MSC Industrial Direct Co, Inc. (MSM: $80/share)
MSC Industrial is the featured stock from January’s Most Attractive Stocks Model Portfolio.
MSC Industrial has grown revenue by 5% compounded annually and net operating profit after tax (NOPAT) by 9% compounded annually since fiscal 2017 (FYE is 9/2/17). The company’s NOPAT margin has increased from 8% in fiscal 2017 to 10% over the trailing-twelve-months (TTM) while invested capital turns rose from 1.5 to 1.6 over the same time. Rising NOPAT margins and invested capital turns drive MSC Industrial’s return on invested capital (ROIC) from 13% in fiscal 2017 to 16% over the TTM.
Figure 1: MSC Industrial Revenue and NOPAT Since Fiscal 2017
Sources: New Constructs, LLC and company filings
MSC Industrial Is Undervalued
At its current price of $80/share, MSM has a price-to-economic book value (PEBV) ratio of 0.8, which means the market expects MSC Industrial’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic for a company that has grown NOPAT by 9% compounded annually since fiscal 2017 and 14% compounded annually since fiscal 2002.
Even if MSC Industrial maintains its TTM NOPAT margin of 10% and grows revenue just 3% compounded annually for the next decade, the stock would be worth $115+/share today – a 44% upside. In this scenario, MSC Industrial’s NOPAT would grow 3% compounded annually for the next 10 years. See the math behind this reverse DCF scenario. Should MSC Industrial grow profits more in line with historical levels, the stock has even more upside.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Below are specifics on the adjustments we made based on Robo-Analyst findings in MSC Industrial’s 10-Qs and 10-Ks:
Income Statement: we made $56 million in adjustments, with a net effect of removing $20 million in non-operating expenses (1% of revenue). Clients can see all adjustments made to MSC Industrial’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $766 million in adjustments to calculate invested capital with a net increase of $648 million. One of the most notable adjustments was $55 million in mid-year acquisitions. This adjustment represents 3% of reported net assets. Clients can see all adjustments made to MSC Industrial’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $974 million in adjustments, all of which decreased shareholder value. Apart from total debt, the most notable adjustment was $115 million in deferred tax liabilities. This adjustment represents 3% of MSC Industrial’s market cap. Clients can see all adjustments to MSC Industrial’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
Most Dangerous Stocks Feature: Vertiv Holdings Co (VRT: $15/share)
Vertiv Holdings Co (VRT) is the featured stock from January’s Most Dangerous Stocks Model Portfolio.
Vertiv’s economic earnings, the true cash flows of the business, have fallen from $52 million in 2019 to -$236 million over the TTM. Over the same time, Vertiv’s NOPAT margin has fallen from 5% to 1%, while invested capital turns fell from 1.4 to 1.1. Falling NOPAT margins and invested capital turns drive Vertiv’s ROIC from 7% in 2019 to 1% over the TTM.
Figure 2: Vertiv Holdings Economic Earnings Since 2019
Sources: New Constructs, LLC and company filings
Vertiv Offers Poor Risk/Reward
Despite its poor fundamentals, Vertiv’s stock is priced for significant profit growth. Therefore, we believe the stock is overvalued.
To justify its current price of $15/share, Vertiv must improve its NOPAT margin to 5% (compared to 1% in the TTM) and grow revenue by 13% compounded annually for the next 10 years. In this scenario, Vertiv’s NOPAT would grow 13% compounded annually over the next decade. See the math behind this reverse DCF scenario. Given that Vertiv’s NOPAT has fallen 41% compounded annually since 2019, we think these expectations are overly optimistic.
Even if Vertiv improves its NOPAT margin to 4% and grows revenue by 10% compounded annually for the next decade, the stock would be worth no more than $5/share today – a 67% downside to the current stock price. See the math behind this reverse DCF scenario.
Each of these scenarios also assumes Vertiv can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows us to create best-case scenarios that demonstrate the high expectations embedded in the current valuation.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Below are specifics on the adjustments we made based on Robo-Analyst findings in Vertiv’s 10-Qs and 10-Ks:
Income Statement: we made $315 million in adjustments, with a net effect of removing $110 million in non-operating expenses (2% of revenue). Clients can see all adjustments made to Vertiv’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $2.0 billion in adjustments to calculate invested capital with a net decrease of $1.8 billion. One of the most notable adjustments was $1.6 billion in mid-year acquisitions. This adjustment represented 32% of reported net assets. Clients can see all adjustments made to Vertiv’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $3.6 billion in adjustments, all of which decreased shareholder value. Apart from total debt, the most notable adjustment to shareholder value was $109 million in deferred tax liabilities. This adjustment represents 2% of Vertiv’s market cap. Clients can see all adjustments to Vertiv’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
This article was originally published on January 13, 2022.
Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.
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[1] Our research utilizes our Core Earnings, a more reliable measure of profits, as proven in Core Earnings: New Data & Evidence, written by professors at Harvard Business School (HBS) & MIT Sloan and published in The Journal of Financial Economics.