Recap From April’s Picks
Our Most Attractive Stocks (+3.9%) outperformed the S&P 500 (+2.8%) from April 7, 2021 through May 3, 2021 by 1.1%. The best performing large cap stock gained 18% and the best performing small cap stock was up 23%. Overall, 21 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (+1.4%) outperformed the S&P 500 (+2.8%) as a short portfolio from April 7, 2021 through May 3, 2021 by 1.4%. The best performing large cap stock fell by 13% and the best performing small cap stock fell by 14%. Overall, 11 out of the 21 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 1.3%.
More reliable & proprietary fundamental data, proven in The Journal of Financial Economics, drives our research. Our proprietary Robo-Analyst Technology[1] scales our forensic accounting expertise (featured in Barron's ) across thousands of stocks[2] to produce an unrivaled database of fundamental data.
13 new stocks make our Most Attractive list this month, and 13 new stocks fall onto the Most Dangerous list this month. May’s Most Attractive and Most Dangerous stocks were made available to members on May 5, 2021.
Our Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for May: Quest Diagnostics Inc. (DGX: $136/share)
Quest Diagnostics Inc. is the featured stock from May’s Most Attractive Stocks Model Portfolio.
Quest Diagnostics grew revenue by 5% compounded annually and net operating profit after-tax (NOPAT) by 15% compounded annually over the past five years.
The firm’s NOPAT margin increased from 11% in 2015 to 20% over the tailing twelve months (TTM), while its invested capital turns increased from 0.8 to 0.9 over the same period. Rising margins and invested capital turns drive the increase in Quest Diagnostics ROIC from 8% in 2015 to 17% TTM.
Over the past five years, Quest Diagnostics generated $2.9 billion (16% of market cap) in cumulative free cash flow (FCF). Over the TTM, Quest Diagnostics has generated $1.6 billion in FCF.
Figure 1: Revenue & NOPAT Since 2015
Sources: New Constructs, LLC and company filings
DGX Is Undervalued
At its current price of $136/share, DGX has a price-to-economic book value (PEBV) ratio of 0.3. This ratio means the market expects Quest Diagnostics’ NOPAT to permanently decline by 70%. This expectation seems overly pessimistic for a firm that grew NOPAT by 5% compounded annually over the past two decades.
Even if Quest Diagnostics’ NOPAT margin falls to 13% (equal to its five-year average, compared to 20% TTM) and the firm grows revenue by just 1% compounded annually for the next decade, the stock is worth $268/share today – a 97% upside. See the math behind this reverse DCF scenario. This scenario assumes lower profit growth after the COVID-19 driven increase in 2020, but should Quest Diagnostics grow profits in line with historical levels, the stock has even more upside.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Fact: we provide more reliable fundamental data and earnings models – unrivaled in the world.
Proof: Core Earnings: New Data & Evidence, forthcoming in The Journal of Financial Economics.
Below are specifics on the adjustments we make based on Robo-Analyst findings in Quest Diagnostics’ 10-K and 10-Q:
Income Statement: we made $584 million of adjustments, with a net effect of removing $218 million in non-operating expenses (2% of revenue). You can see all the adjustments made to Quest Diagnostics’ income statement here.
Balance Sheet: we made $1.7 billion of adjustments to calculate invested capital with a net decrease of $518 million. One of the most notable adjustments was $215 million in asset write-downs. This adjustment represented 2% of reported net assets. You can see all the adjustments made to Quest Diagnostics’ balance sheet here.
Valuation: we made $6.7 billion of adjustments with a net impact of decreasing shareholder value by $5.3 billion. Apart from total debt, one of the most notable adjustments to shareholder value was $713 million in excess cash. This adjustment represents 4% of Quest Diagnostics’ market cap. See all adjustments Quest Diagnostics’ valuation here.
Most Dangerous Stocks Feature: Global Payments, Inc. (GPN: $195/share)
Global Payments, Inc. (GPN) is the featured stock from May’s Most Dangerous Stocks Model Portfolio.
Global Payments’ GAAP net income improved from $278 million in 2015 to $638 million TTM. However, the firm’s economic earnings, the true cash flows of the business, fell from $127 million to -$1.3 billion over the same time. The firm’s invested capital turns fell from 0.9 in 2015 to 0.2 TTM while ROIC fell from 11% to 3% over the same time.
Figure 2: Misleading GAAP Net Income vs. Economic Earnings
Sources: New Constructs, LLC and company filings
GPN Provides Poor Risk/Reward
Despite its poor fundamentals, GPN is still priced for significant profit growth and is overvalued.
To justify its current price of $195/share, Global Payments must maintain its TTM NOPAT margin of 16% (vs. 10-year average of 14%) and grow NOPAT by 16% compounded annually for the next decade. See the math behind this reverse DCF scenario. This scenario assumes Global Payments’ ROIC improves from 3% in 2020 to 12% in 2030. Given Global Payments’ ROIC has fallen year-over-year in seven of the past eight years, and the destruction of shareholder value since 2015 (See Figure 1), we think these expectations are overly optimistic.
Even if Global Payments maintains its TTM NOPAT margin of 16% and grows NOPAT by 11% compounded annually for the next decade, the stock is worth just $113/share today, a 42% downside to the current stock price. See the math behind this reverse DCF scenario. This scenario assumes Global Payments grows revenue by 10% (equal to consensus revenue estimate CAGR of 10% from 2021 to 2023) over the next 10 years. Should Global Payments’ revenue grow at a slower rate, the stock has even more downside.
Each of these scenarios also assumes Global Payments is able to 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 how high expectations embedded in the current valuation are.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
Fact: we provide more reliable fundamental data and earnings models – unrivaled in the world.
Proof: Core Earnings: New Data & Evidence, forthcoming in The Journal of Financial Economics.
Below are specifics on the adjustments we make based on Robo-Analyst findings in Global Payments’ 10-K and 10-Q:
Income Statement: we made $869 million of adjustments, with a net effect of removing $547 million in in non-operating expenses (7% of revenue). You can see all the adjustments made to Global Payments’ income statement here.
Balance Sheet: we made $3.8 billion in adjustments to calculate invested capital with a net increase of $154 million. One of the largest adjustments was $202 million in other comprehensive income. This adjustment represented 1% of reported net assets. You can see all the adjustments made to Global Payments’ balance sheet here.
Valuation: we made $15.8 billion in adjustments with a net effect of decreasing shareholder value by $11.9 billion. Apart from total debt, the most notable adjustment to shareholder value was $2.9 billion in net deferred tax liabilities. This adjustment represents 5% of Global Payments’ market cap. See all adjustments to Global Payments’ valuation here.
This article originally published on May 13, 2021.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
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[1] Harvard Business School features our research automation technology in the case Disrupting Fundamental Analysis with Robo-Analysts.
[2] See how our models overcome flaws in Bloomberg and Capital IQ’s (SPGI) analytics in the detailed appendix of this paper.