Our Most Attractive and Most Dangerous stocks for April were made available to the public at midnight on Wednesday. March saw some strong performances from our picks. Our Most Attractive Stocks portfolio rose by 2.3%, outperforming the S&P 500 (-0.1%). Small Cap Minerals Technologies (MTX) led the way with an 18% gain, followed by Large/Mid Cap Pilgrim’s Pride Corp (PPC) with a 15% gain.
Our Most Dangerous stocks also outperformed as a short portfolio last month as they fell by 1%. Small Cap Kelly Services (KELYA) fell by 7% while Large/Mid Cap Realty Income Corp (O) fell by 6%.
This success underscores the benefit of sticking to our value-investing strategy. Being a true value investor is an increasingly difficult, if not impossible, task (see “Secrets to Annual Reports”). By scrupulously analyzing every word in annual reports, our research protects investors’ portfolios and allows our clients to execute value investing with more confidence and integrity.
27 new stocks make our Most Attractive list and 28 new stocks fall onto the Most Dangerous list this month.
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 in their market valuations.
Most Attractive Stock Feature For April: The Chubb Corporation (CB: ~$88/share)
The Chubb Corporation (CB) is one of the new additions to the Most Attractive list this month. CB makes the list due to the decrease in rank of some of the stocks ahead of it.
We are bullish on the insurance sector right now. PowerShares KBW Property & Casualty Insurance Portfolio (KBWP) is the only ETF or mutual fund to earn our Very Attractive rating and a full 10 out of the 40 stocks on our Most Attractive list for April are insurance companies. While popular sectors like social media and cloud stocks have no profits and sky-high valuations, we see these insurance stocks as having solid profitability to go along with cheap valuations.
CB might just be the very best stock in this attractive sector. CB grew after-tax profit (NOPAT) by over 57% in 2013 and increased its ROIC from 11% to 16%. This 16% is higher than the industry average of 11% and higher than all but five of the 50 property and casualty insurance companies we cover.
Even though CB’s profits took a bit of a hit during the financial crisis, it has still grown NOPAT by 13% compounded annually over the past decade. Not many companies can match that track record of long-term growth.
If we dig deeper into CB’s numbers, we see strength in every element of its business. In 2013, net premiums increased in each of CB’s three segments, Personal Insurance, Commercial Insurance, and Specialty Insurance. The biggest impact on NOPAT came from the 13% decline in losses and loss expenses, from $7.5 billion to $6.5 billion. Superstorm Sandy was primarily responsible for the high level of losses in 2012, and the $6.5 billion in 2013 is closer to CB’s long-term average.
Even if costs start to come back up to counteract CB’s growth in revenues, this stock still has significant upside. At its current valuation of ~$88/share, CB has a price to economic book value ratio of just 0.7, which implies that NOPAT will permanently decline by 30%. Given CB’s strong long-term prospects it deserves a much higher valuation.
Figure 1 shows just how rare it is to get this good company at such a cheap price. The gap between the stock price and economic book value is the largest it’s been since the market bottomed in 2009.
Figure 1: Trading at a Discount to Economic Book Value
If we assume CB is capable of just 2% NOPAT growth compounded annually for 15 years, a fairly low bar given its historical profit growth, the stock has a fair value of ~$135/share. That’s a 50% premium to the current stock price if the company can just grow profits in the low single digits. If it can surpass those low expectations the upside is even greater. I like that risk/reward profile for CB.
Most Dangerous Stock Feature For April: Inland Real Estate (IRC: $10.50/share)
Inland Real Estate (IRC) is one of the new additions to the Most Dangerous list this month.
On the opposite end of the spectrum from insurance stocks, REITs are one of my least favorite sectors. 11 out of our 40 Most Dangerous Stocks this month are REITs, and we put REITs in the Danger Zone last year.
IRC is one of the worst stocks in this dangerous sector. In the ten years that our model covers, IRC has never earned positive economic earnings. It currently earns a bottom-quintile ROIC of just 3%. Since the financial crisis, IRC has only managed to grow NOPAT by 5% compounded annually.
What’s worse, IRC is burning through cash. In three of the past four years IRC has earned a negative free cash flow, including 2013, where it burned through $240 million (23% of market cap). This negative cash flow has left IRC with an unhealthy balance sheet, as it has nearly $900 million in adjusted total debt with almost no excess cash.
Someone who just looked at IRC’s P/E of 10 might be tempted to think this was a cheap stock, but they would be sorely mistaken. IRC recorded a $95 million unusual gain due to the change in control of investment properties that massively distorted earnings. IRC’s true NOPAT was just $43 million, not the $103 million in GAAP net income IRC reported.
Plus, IRC is dangerously expensive. In order to justify its current valuation of ~$10.50/share, the company would need to grow NOPAT by 10% compounded annually for 28 years. For a company with low returns on capital and meager profit growth in recent years, such a high expectation is unwarranted. We’ve seen what happens to stocks with high valuations and low profitability in recent weeks (see “Hope you didn’t own these 5 ‘most dangerous’ stocks”). Look for IRC to follow suit.
The Most Dangerous Stocks report for April can be purchased here, while the Most Attractive Stocks can be purchased here. To gain access to these reports one week earlier each month, click here to view our subscription options.
Sam McBride contributed to this report.
Disclosure: David Trainer owns CB. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.