Do not worry if you have missed out on prior picks in the tech sector because I have another one for you. Like MSFT and IBM, I expect this pick to outperform the S&P 500 substantially. Since we picked it on 9/28/10, MSFT rose 10% while the S&P 500 rose 7%. Since we picked it on 8/17/10, IBM rose 14% while the S&P 500 rose 12%.
As detailed in our ETF report on the tech sector, tech stocks are far and away the most profitable. That sector’s returns on invested capital (ROIC) stand at 42.3%, which is more than double the S&P500 at 17.4%.
And this week’s stock pick of the week is no exception. Analog Devices Inc (ADI), one of December’s Most Attractive Stocks, boasts a 54% ROIC. And like all of our Most Attractive Stocks the company has (1) high and rising economic profits (as distinct from accounting profits) and (2) a cheap valuation.
As shown in our free report on ADI, the company’s return on invested capital (ROIC) (54%) is in the top quintile of all the companies we cover and its economic earnings are growing faster then reported accounting earnings. During its lat fiscal year, ADI’s economic earnings rose by 283% while accounting earnings rose by only 187%. Digging through the financial footnotes, we found $15mm in non-operating/non-recurring charges that cause reported earnings to be understated.
At the same time, the stock’s valuation implies that ADI’s profits will decline by 10% and never grow again. In other words, the stock market is predicting a permanent decline of more than 10% in ADI’s profits. Given that most investors are not aware that the company’s operating profits are as strong as they are, the market is probably not giving ADI appropriate credit for its profitability.
In summary, the market is setting the profit growth bar quite low for this stock.
- About $15 million in non-operating expenses (after-tax) cause reported earnings to be understated.
- Our discounted cash flow analysis shows that ADI’s current valuation (stock price of $37.18) implies that the company’s profits will decline by 10% and never grow again.
- The company grew its economic earnings by $283mm during its last fiscal year.
- Excess cash of $2,462.5mm or nearly 25% of its market cap
For details on what causes the difference between economic versus accounting profits, see Appendix 3 on page 10 of our report on ADI. See Appendix 4 to learn how ADI increased net operating profit after tax (NOPAT) by cutting costs and increased its NOPAT margin from 13.4% to 26.4%. See Appendix 5 for details on how ADI reduced its invested capital while revenue grew and raised its invested capital turns from 1.38x to 2.04x. Appendix 7 (in the ROIC section) shows how the company’s increase in NOPAT margin and invested capital turns result in an increase in ROIC (from 18.5%% to 53.9%) and economic earnings, which rose by $465.4mm.
In summary, ADI is gets our “very attractive” stock rating because its economic earnings are strong and growing while its valuation implies economic earnings will decline permanently by 10%.
ADI fits the risk/reward profile of a great stock to buy.
Note: Stock pick of the week is updated every Tuesday.