Seven new stocks made our Most Attractive list this month, while three new stocks joined the Most Dangerous list. We published October’s Most Attractive and Most Dangerous stocks to members on October 5, 2022.
September Performance Recap
Our Most Attractive Stocks (-7.1%) underperformed the S&P 500 (-6.3%) from September 2, 2022 through October 3, 2022 by 0.8%. The best performing large cap stock gained 5% and the best performing small cap stock was up 9%. Overall, 20 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (-5.3%) underperformed the S&P 500 (-6.3%) as a short portfolio from September 2, 2022 through October 3, 2022 by 1.0%. The best performing large cap short stock fell by 18% and the best performing small cap short stock fell by 20%. Overall, 16 out of the 39 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 1.8%.
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.
Our Most Attractive stocks all 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 October: Discover Financial Services (DFS: $94/share)
Discover is the featured stock from October’s Most Attractive Stocks Model Portfolio.
Discover has grown revenue and net operating profit after-tax (NOPAT) by 5% and 16% compounded annually, respectively, over the past 10 years. Discover’s NOPAT margin has increased from 12% in 2011 to 36% over the trailing-twelve-months (TTM), while return on invested capital (ROIC) rose from 11% to 26% over the same time.
Figure 1: Revenue & NOPAT Since 2011
Sources: New Constructs, LLC and company filings
Discover Is Undervalued
At its current price of $94/share, DFS has a price-to-economic book value (PEBV) ratio of 0.5. This ratio means the market expects Discover’s NOPAT to permanently decline by 50%. This expectation seems overly pessimistic for a company that has grown NOPAT by 12% compounded annually over the past five years and 16% compounded annually over the past decade.
Even if Discover’s NOPAT margin falls to its 10-year average of 26% (vs. 36% TTM) and NOPAT falls 1% compounded annually for the next decade, the stock would be worth $125+/share today – a 33% upside. See the math behind this reverse DCF scenario. Should Discover 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 Discover’s 10-Qs and 10-Ks:
Income Statement: we made $1.6 billion in adjustments, with a net effect of removing $1.2 billion in non-operating income (9% of revenue). Clients can see all adjustments made to Discover’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $9.8 billion in adjustments to calculate invested capital with a net increase of $5.2 billion. One of the most notable adjustments was $6.8 billion in total reserves. This adjustment represents 51% of reported net assets. Clients can see all adjustments made to Discover’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $1.2 billion of adjustments all of which decreased shareholder value. The most notable adjustment to shareholder value was $1.1 billion in preferred stock. This adjustment represents 4% of Discover’s market cap. Clients can see all adjustments to Discover’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
Most Dangerous Stocks Feature: AeroVironment (AVAV: $80/share)
AeroVironment Inc. (AVAV) is the featured stock from October’s Most Dangerous Stocks Model Portfolio.
Since its acquisition of Arcturus, AeroVironment’s economic earnings, the true cash flows of the business, have fallen from $24 million in FYE 2020 (fiscal year end was 4/30/20) to -$39 million over the TTM. AeroVironment’s NOPAT margin has fallen from 10% to 2%, while invested capital turns fell from 1.6 to 0.6 over the same time. Falling NOPAT margins and invested capital turns drive AeroVironment’s ROIC from 17% in FYE 2020 to 1% over the TTM.
Figure 2: Economic Earnings Since FYE 2020
Sources: New Constructs, LLC and company filings
AeroVironment Provides Poor Risk/Reward
Despite its poor fundamentals, AeroVironment’s stock is priced for significant profit growth, and we believe the stock is overvalued.
To justify its current price of $80/share, AeroVironment must improve its NOPAT margin to 11% (all-time high in 2019 compared to 2% TTM) and grow NOPAT by 39% compounded annually for the next ten years. See the math behind this reverse DCF scenario. Given that AeroVironment’s NOPAT fell 34% compounded annually over the past three years, we think these expectations are overly optimistic.
Even if AeroVironment can improve its NOPAT margin to 9% and grow NOPAT by 30% compounded annually for the next decade, the stock would be worth no more than $40/share today – a 50% downside to the current stock price. See the math behind this reverse DCF scenario.
Each of these scenarios also assumes AeroVironment can grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely but allows us to create truly 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
Below are specifics on the adjustments we made based on Robo-Analyst findings in AeroVironment’s 10-Qs and 10-Ks:
Income Statement: we made $39 million in adjustments, with a net effect of removing $1 million in non-operating expense (<1% of revenue). Clients can see all adjustments made to AeroVironment’s income statement on the GAAP Reconciliation tab on the Ratings page on our website.
Balance Sheet: we made $150 million in adjustments to calculate invested capital with a net decrease of $48 million. One of the most notable adjustments was $22 million in asset write-downs. This adjustment represented 3% of reported net assets. Clients can see all adjustments made to AeroVironment’s balance sheet on the GAAP Reconciliation tab on the Ratings page on our website.
Valuation: we made $319 million in adjustments, with a net decrease to shareholder value of $117 million. Apart from total debt, the most notable adjustment to shareholder value was $101 million in excess cash. This adjustment represents 5% of AeroVironment’s market cap. Clients can see all adjustments to AeroVironment’s valuation on the GAAP Reconciliation tab on the Ratings page on our website.
This article originally published on October 14, 2022.
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] 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.