Recap from July Picks
Our Most Attractive Stocks (+4.6) outperformed the S&P 500 (+3.5%) last month. Most Attractive Large Cap stock VMware Inc. (VMW) gained 25% and Most Attractive Small Cap stock American Axle & Manufacturing (AXL) was up 21%. Overall, 25 out of the 40 Most Attractive stocks outperformed the S&P 500 in July.
Our Most Dangerous Stocks (+6.2%) underperformed the S&P 500 (+3.5%) last month. Most Dangerous Large Cap stock Hartford Financial Services (HIG) fell by 6% and Most Dangerous Small Cap Stock Almost Family (AFAM) fell by 10%. Overall, 14 out of the 40 Most Dangerous stocks outperformed the S&P 500 in July.
The successes of the Most Attractive and Most Dangerous stocks highlight the value of our forensic accounting as featured in Barron’s. Being a true value investor is an increasingly difficult, if not impossible, task considering the amount of data contained in the ever-longer annual reports. By analyzing key details in these SEC filings, our research protects investors’ portfolios and allows our clients to execute value-investing strategies with more confidence and integrity.
13 new stocks make our Most Attractive list this month and 14 new stocks fall onto the Most Dangerous list this month. August’s Most Attractive and Most Dangerous stocks were made available to members on August 3, 2016.
Our Most Attractive stocks have high and rising return 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 Stock Feature for August: American Express (AXP: $65/share)
American Express (AXP), global credit card provider, is one of the additions to our Most Attractive stocks for August. We’ve previously detailed a strategy that could boost AXP’s value by $50 billion.
Since 2010, American Express has grown after-tax profit (NOPAT) by 25% compounded annually to $5.5 billion in 2015. Over the past twelve months (TTM), NOPAT has grown to $5.8 billion. AXP’s NOPAT margin has improved from 7% in 2010 to 18% TTM, per Figure 1.
Figure 1: American Express’ Improving Margins & Profit
Sources: New Constructs, LLC and company filings
Further testament to fundamental strength of AXP’s business, the company has improved its return on invested capital (ROIC) from 11% in 2005 to 14% TTM and generated cumulative $16.6 billion in free cash flow over the past five years.
Impacts of Footnotes Adjustments And Forensic Accounting
Income Statement: we made $733 million of adjustments, with a net effect of removing $495 million in non-operating expenses (2% of revenue). We removed $119 million in non-operating income and $614 million in non-operating expenses. You can see all the adjustments made to AXP’s income statement here.
Balance Sheet: we made $7.5 billion of adjustments to calculate invested capital with a net increase of $2.5 billion. One of the largest adjustments was $2.7 billion due to other comprehensive income. This adjustment represented 7% of reported net assets. You can see all the adjustments made to AXP’s balance sheet here.
Valuation: we made $2 billion of adjustments with a net effect of decreasing shareholder value by $2 billion. There were no adjustments that increased shareholder value. The largest adjustment was the removal of $1.1 billion in off-balance-sheet operating leases. This adjustment represents 2% of American Express’ market cap. Despite the decrease in shareholder value, AXP remains undervalued.
Current Valuation Implies Permanent Profit Decline
AXP is down around 6% on the year and its share price is significantly undervalued. At its current price of $65/share, AXP has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects AXP’s NOPAT to permanently decline by 20%. This expectation seems overly pessimistic given American Express’ long history of profit growth.
If American Express can grow NOPAT by just 3% compounded annually for the next decade, the stock is worth $94/share today – a 45% upside.
Most Dangerous Stock Feature: Cirrus Logic (CRUS: $51/share)
Cirrus Logic (CRUS), specialized semiconductor provider, is one of the additions to our Most Dangerous stocks for August.
Cirrus Logic has grown revenue by 13% compounded annually from 2013-2016. Over this same time, Cirrus Logic’s economic earnings, the true cash flows of the business, have declined from $66 million to -$11 million in 2016, or -56% compounded annually. Economic earnings have fallen even further, to -$35 million, over the last twelve months, per Figure 2.
Figure 2: CRUS’s Growing Losses
Sources: New Constructs, LLC and company filings
In addition to increasing losses, since 2013, Cirrus’ ROIC has fallen from 20% to 8% TTM. Furthermore, Cirrus Logic has burned through cumulative $244 million in free cash flow over the past five years.
Forensic Accounting Reveals Overstated EPS
In order to derive the true recurring cash flows, an accurate invested capital, and a real shareholder value, we made the following adjustments to Cirrus Logic’s 2016 10-K:
Income Statement: we made $37 million of adjustments with a net impact of removing $4 million in non-operating income (<1% of revenue). We removed $16 million in non-operating expenses and $21 million in non-operating income. You can see all the adjustments made to CRUS’s income statement here.
Balance Sheet: we made $837 million of adjustments to calculate invested capital with a net increase of $213 million. The largest adjustment was $457 million related to asset write-downs. This adjustment represented 43% of reported net assets. You can see all the adjustments made to CRUS’s balance sheet here.
Valuation: we made $479 million of adjustments with a net effect of decreasing shareholder value by $113 million. The largest adjustment was the removal of $72 million in outstanding employee stock options. This adjustment represents 2% of Cirrus’ market cap.
High Expectations Already Baked Into Valuation
Despite the clear deterioration of CRUS’ fundamentals, the stock is priced for significant profit growth long into the future. To justify its current price of $51/share, CRUS must grow NOPAT by 15% compounded annually for the next 15 years. In this scenario, Cirrus Logic would be generating nearly $10 billion in revenue 15 years from now, nearly equal to that of MasterCard’s (MA) 2015 revenue and $1.5 billion greater than eBay’s (EBAY) 2015 revenue.
On the other hand, even if CRUS can grow NOPAT by 10% compounded annually for the next decade, the stock is worth only $29/share today – a 43% downside.
This article originally published here on August 12, 2016.
Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.
Photo Credit: Alberto Carrasco-Casado (Flickr)