The ups and downs of the post credit crisis markets are enough to drive the average market participant crazy, and certainly enough to push the average American largely out of stocks. Billions of dollars has continued to flow into bonds, and material inflows to equities haven’t been seen in years. I have written fairly extensively on bonds the past year, and this post will be a break from that topic. I can’t tell you whether or not today is a good time to buy equities versus tomorrow, next week, next month or next year.
The purpose of this post is to assume that someone wants to own equities “long term”, and can withstand a moderate/high amount of volatility along the way. I would preface volatility to mean systematic risk (risk inherent to the whole market), and not unsystematic risk – risk particular to an individual company etc. Now I’ll undoubtedly get people who say, “buy and hold is dead”, and “how long is long term?”. Those are valid comments and questions, but again the purpose is to identify a handful of equities that look cheap due to unlocked value (legal®ulatory overhang, management risk, macro-environment etc) but which value I believe will be realised in the medium/long term.
JP Morgan ($JPM)
I am very comfortable holding JP Morgan, but first here are two assumptions I have regarding their future. 1. Future “Big Whale” type events while still possible are unlikely. 2. The US yield curve, which has materially flattened over the past few years, will not stay as flat as it is long term. The current and obvious overhand on the stock is the trading loss, which while not material to capital or P&L levels, has impaired JPM’s reputation as a rock solid “conservative” bank. Here is what I believe are where the Street is getting it wrong:
1. Value of core deposit base: Longer term, JPM has substantial advantages that people often forget living in this ZIRP environment. JPM has a very sizable and stable deposit base. This is overlooked as ZIRP has caused the cost of funds on most banks to come down substantially. In other words, banks (including JPM) are already paying people near nothing on their deposits – and they can’t lower this expense any further. Conversely, as assets reprice in today’s environment, may are repricing lower. Liquidity is so plentiful right now, that the value of a stable deposit base is not what it once was.
If/when short rates move up, JPM will have a substantial advantage as they will maintain a deposit base that won’t reprice up as fast as competitors. The implications to this are obvious, assets will likely reprice faster than liabilities and NIM will expand. Nobody knows how long we will stay in this interest rate environment, but my bet is that it won’t be forever. Liquidity will, at some point, leave the banking system, and banks with a stable deposit franchise will trade at a premium once again.
2. Valuation: The combination of the ZIRP environment, the recent multi-billion dollar trading loss, and general disdain for large banks has caused JPM’s valuation to fall close to 1x P/TBV. Valuing JPM which is still generating a very respectable ROE (and nice dividend yield), like it will perpetually be unable to monetise on its valuable deposit base is unreasonable and a bad bet in my opinion. A more likely scenario is JPM growing its equity and seeing a multiple which reverts close to 1.5x P/TBV. On a 2-3yr horizon, I see a very skewed return distribution ($5 of downside versus $15-20 of upside) to the upside as the aforementioned headwinds are pricing JPM like ZIRP is forever & it will have a perpetual risk management problem.
Some of the reasons for choosing this stock are very generic and common. For one, big pharma is “cheap” and very defensive to various economic cycles. Next, the stock (and sector) throws off a ton of income with the dividend yield in the 4.5% range. Now after this, I think there are some compelling reasons for owning NVS versus other large pharma stocks that provide a better risk/reward profile. The stock has admittedly had a lot of headwinds with manufacturing problems and patent expirations. As a comparison, has underperformed virtually the whole the peer group as well as Swiss competitor Roche by over 11% during the TTM.
The major catalyst that Novartis can eventually realise is the embedded value of the Alcon business, an eye care products company gradually acquired over the past five years. This unit, which should be a long-term beneficiary of an ageing population, is projected by management to grow top line in the double digit range over the coming years- an estimate significantly higher than the Street saw. As far as the patent expirations go, scepticism is ripe whether NVS can replace the looming lost revenue of Diovan – but this may be overblown. Though I’m not a huge fan of sell-side research, I believe the analysts at Morgan Stanley have a realistic view of NVS: “Novartis shares are pricing in a near worst case scenario post recent headwinds. 2012 represents the trough year and we see potential for pipeline surprises, cost saving opportunities and improved shareholder returns. Risk-reward is attractive and valuation is underpinned by a ~5% dividend yield and 10% FCF yield.”
Now admittedly, part of the reason I like $NVS is wanting a piece of a mega-cap pharma in general. These companies in general are very defensive, and I believe lowers the overall risk to a portfolio. That being said, it is debatable whether NVS is the best way to gain exposure within this sector.
Like JPM above, BP is largely viewed as a very cheap stock that lacks visible catalysts that would unlock the value. The TNK-BP situation has been a disaster and it’s uncertain what the outcome will be. Despite the political drama of the venture, the operational performance of TNK-BP has been strong. In 2011, according to JPM analysts, the BP share of TNK-BP dividends accounted for 13% of BP’s cash flow,19% of BP’s earnings, and 29% of their production. After investing over $8.3bil in the entity in 2003, BP’s has recovered over $9.7bil in cumulative cash flows – a 12% IRR since 2003. The current equity market value of ~$19bil would imply a yield based on 2011 dividends of over 20%. Analysts speculate the 50% stake could sell for a 25%-75% premium, with a 50% premium around $30bil.
The other obvious overhang with BP is the lack of a settlement with the Gulf oil spill. A resolution would obviously remove the uncertainty associated with this large liability. BP has a laundry list of famous value investors as holders of their stock including Seth Klarman’s Baupost fund. On almost any metric you look at (P/E, Dividend Yield, P/B, EV/EBITDA), BP screens very cheaply on an absolute and relative basis. Various analysts have sum of the parts valuations for BP to have anywhere from 30% to 100% upside. Its my view that too many positive potential catalysts are present for BP to continue to trade at these levels. As a bonus, the stock theoretically has decent positive carry with a dividend yield of ~5%. Any combination of strong global growth, a positive TNK resolution, and/or the gulf settlement could lead BP to trade closer to its estimated intrinsic/SOTP valuation.