Eleven new stocks made our Most Attractive list this month, while five new stocks joined the Most Dangerous list. We published July’s Most Attractive and Most Dangerous stocks to members on July 7, 2023.
June Performance Recap
Our Most Attractive Stocks (+4.5%) outperformed the S&P 500 (+3.8%) last month by 0.7%. The best performing large cap stock gained 17% and the best performing small cap stock was up 19%. Overall, 19 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (+1.3%) outperformed the S&P 500 (+3.8%) as a short portfolio last month by 2.5%. The best performing large cap short stock fell by 17% and the best performing small cap short stock fell by 9%. Overall, 21 out of the 32 Most Dangerous stocks outperformed the S&P 500 as shorts.
The Most Attractive/Most Dangerous Model Portfolios outperformed as an equal-weighted long/short portfolio by 3.2%.
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 July: Comerica Inc. (CMA: $45/share)
Comerica Inc. is the featured stock from July’s Most Attractive Stocks Model Portfolio.
Comerica has grown revenue by 5% compounded annually and net operating profit after tax (NOPAT) by 9% compounded annually since 2012. Comerica’s NOPAT margin increased from 20% in 2012 to 31% in the trailing twelve months (TTM), and invested capital turns rose from 0.3 to 0.5 over the same time. Rising NOPAT margins and invested capital turns drive Comerica’s return on invested capital (ROIC) from 6% in 2012 to 14% in the TTM.
Figure 1: Comerica’s Revenue and NOPAT Since 2012
Sources: New Constructs, LLC and company filings
Comerica Is Undervalued
At its current price of $45/share, CMA has a price-to-economic book value (PEBV) ratio of 0.4. This ratio means the market expects Comerica’s NOPAT to permanently decline by 60%. This expectation seems overly pessimistic for a company that has grown NOPAT by 6% compounded annually since 2017 and 9% compounded annually since 2012. We think the depressed stock price is impounding more bad news or potential dilution than will occur.
Even if Comerica’s NOPAT margin falls to 20% (ten-year low compared to 31% in the TTM) and the company’s revenue grows just 1% compounded annually through 2032, the stock would be worth $66/share today – a 47% upside. In this scenario, CMA’s NOPAT would decline 3% compounded annually through 2032. Should Comerica 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 Comerica’s 10-Qs and 10-Ks:
Income Statement: we made $429 million in adjustments, with a net effect of removing $27 million in non-operating income (1% of revenue). Clients can see all adjustments made to Comerica’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $7.5 billion in adjustments to calculate invested capital with a net increase of $3.4 billion. One of the most notable adjustments was $3.7 billion in adjustments for other comprehensive income. This adjustment represents 72% of reported net assets. Clients can see all adjustments made to Comerica’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $1.6 billion in adjustments, with a net decrease in shareholder value of $121 million. The most notable adjustment was $759 million in overfunded pensions. This adjustment represents 13% of Comerica’s market value. Clients can see all adjustments to Comerica’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
Most Dangerous Stocks Feature: Chegg Inc. (CHGG: $9/share)
Chegg Inc. (CHGG) is the featured stock from July’s Most Dangerous Stocks Model Portfolio.
Chegg’s NOPAT has fallen from $21 million (first positive NOPAT in company history) in 2019 to just $3 million over the TTM. NOPAT margin has fallen from 5% in 2019 to <1% in the TTM while invested capital turns fell from at 1.3 to 0.8 over the same time. Falling NOPAT margins and invested capital turns drive Chegg’s ROIC from 7% in 2019 to 0% over the TTM.
Chegg’s economic earnings, the true cash flows of the business, have fallen from <$1 million in 2019 to -$71 million in the TTM. See Figure 2.
Figure 2: CHGG Economic Earnings Since 2018
Sources: New Constructs, LLC and company filings
CHGG Provides Poor Risk/Reward
Despite its poor fundamentals, CHGG’s stock is priced for significant profit growth, and we believe the stock is overvalued.
To justify its current price of $9/share, CHGG must improve its NOPAT margin to 5% (10x its TTM margin) and grow revenue by 10% compounded annually for the next decade. In this scenario, Chegg’s NOPAT grows 24% compounded annually through 2032 and would equal $95 million in that year, or 1.3x its highest-ever NOPAT achieved in 2020. We think these expectations are overly optimistic.
Even if Chegg improves its NOPAT margin to 4.7% (5-year average) and grows NOPAT 16% compounded annually for the next decade, the stock would be worth no more than $5.50/share today – a 29% downside to the current stock price.
Each of these scenarios also assumes CHGG 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 Chegg’s 10-Qs and 10-K:
Income Statement: we made $274 million in adjustments, with a net effect of removing $259 million in non-operating income (34% of revenue). Clients can see all adjustments made to Chegg’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $1.5 billion in adjustments to calculate invested capital with a net decrease of $1.3 billion. One of the most notable adjustments was $168 million in deferred tax assets. This adjustment represented 7% of reported net assets. Clients can see all adjustments made to Chegg’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $2.2 billion in adjustments, with a net increase to shareholder value of $36 million. The most notable adjustment to shareholder value was $1.1 billion in excess cash. This adjustment represents 97% of Chegg’s market value. Clients can see all adjustments to Chegg’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
This article was originally published on July 11, 2023.
Disclosure: David Trainer, Kyle Guske II, Hakan Salt, 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.