Thursday, May 04, 2006

Living on the Edge: PFE, WFC, WMT

We live in a world where people take dramatically opposing sides. Watch the politicians or analysts on TV and they tend to come out forcefully against or in support of a topic; there has actually been a remarkable scientific study showing that politicians and other public figures are more successful if they present a less complex personality than average to the public (see the 2003 winner in Psychology here). Voter psychology apparently favors the simplicity and certainty of simple statements. This preference extends into the world of investing as well, which raises difficult issues because it isn’t always obvious how to interpret an analysis.

The simple solution adopted by the finance community is the range of ratings: BUY, HOLD, and SELL.

But using those three ratings has always seemed like a shell game to me. I don’t want to HOLD a stock if my analysis indicates I wouldn’t be willing to BUY it today. Inaction is a decision just as much as action is. Most people don’t think about that too much and HOLD is simply an admonition not to do anything – clear, concise, and easily followed even if ultimately meaningless. Now that trading expenses are vanishingly small why should one client be holding a stock and another not just because of what they were doing before the rating was issued? If a stock isn’t good enough for your advisor to recommend to his other clients, why would you want to hold it?

That’s why I only issue BUY and SELL calls. I won’t HOLD something unless I would buy it right now.

Unfortunately this leaves us with a whole range of companies that aren’t bad enough to cry SELL over, but no so remarkably underpriced that they are a BUY for The Finance Wonk. Each of the three stocks reviewed in this post is a good quality stock representing a good company doing good business. Unfortunately the stock market has already figured this out so the stocks aren’t selling cheaply enough to make them a sure bet for capital gains, but they do each have a nice dividend and offer some sector exposure. I don’t own any of these three and don’t intend to buy them, but I wanted to show an example of the analysis that goes into a near miss – a stock that almost but not quite reaches the status of a Finance Wonk BUY.

Pfizer Inc [PFE] is a great company. They pay a cash dividend with a yield of 3.8% which has been increased in 11 of the last 12 years and with the current dividend taking only 50% of net income there is room for continued payment. Pfizer has increased earnings in 7 of the last 12 years, has very little debt, and most people are expecting them to get FDA approval of their new sleep drug Indiplon as early as May 15. Unfortunately all of this is priced in by my standards. If we apply the industry standard 11% implied discount rate we would get a target price of $27.82, just $2.60 above its current price of $25.22. I like to apply a discount rate of 15% so that I pick stocks where things can go a little less than perfect and we still make money; at a 15% discount rate the stock is only worth $20.95. So this stock already has a shiny outlook priced into it. And though the yield is good, why would I buy this stock over Nokia (profiled yesterday) which gives a slightly higher dividend coupled with a better discount rate and a solidly predictable growth path?

Wells Fargo & Co [WFC] is another company that has been on my radar for a while. From a consumer standpoint they have an excellent set of offerings, they do an excellent job of selling multiple products per customer, and their brokerage services are very attractive for those with high net worth. I keep meaning to go down to my local branch (they’re everywhere now!) and have them show me around their brokerage service since I would qualify for all sorts of free services based on account value. Reading through the annual report is like going to a movie about how a bank SHOULD be run, it reminds me of the glory days of Washington Mutual. They have a 3.1% dividend which has been steadily increasing but is still well covered by their net income so it can keep growing. Earnings have grown in 9 of the last 12 years. Unfortunately we’re not the first people to notice that this is a good stock, the price has been on a slow climb for the last several years. Now the price to free cash flow ratio is nearly 15 (which would require serious capital growth potential to justify), and the implied discount rate is only 12%, just a smidge above the usually applied 11% rate and low enough that a little bit of increase in bond rates would push a reasonable target rate for Wells Fargo to the current price or lower. Keep in mind that this target price also assumes analyst average growth (11.34%) sustained over a long period of time. To reach a 15% discount rate at the current price WFC would need13.8% growth annually for 10 years, this would require WFC to be 3.64 times its current size, employing over half a million people at 22,568 stores (as opposed to the current 6,200). I have a hard time believing that kind of growth would be possible since it seems like WFC has already done a pretty good job of finding the good places for storefronts.

My final call of “not quite good enough” is nearly an act of sacrilege to criticize in some stock-picking circles, Wal-Mart stores [WMT]. Wal-Mart is a great and well managed company, the problem from my point of view is just that it’s still being priced as a growth stock when they will have to transition to a mature stock at some point within the next decade (and some would say that change has already begun). WMT has a price to free cash flow ratio of 12, where I would expect about half that from a mature company, and in order to get my preferred implied discount of 15% Wal-Mart would have to grow 10.5% annually for 10 years. The analyst consensus for 5 year growth is 13% per year but let’s do some reality checking here. To grow just 10.5% annually for ten years the company would grow by 2.7 times. This is a mind-blowing concept for an employer who currently has 1.8 million full-time employees, far more hands than the entire US military has in all branches and at all levels. Growing by a factor of 2.7 would imply nearly 5 million full time employees just for this one company. If we apply current demographic trends (which predict about 49% of the population would be of working age then) a staggering 3% of all Americans with jobs would work for Wal-Mart (yes some growth would be overseas, consider this number as illustrative). Even without this giggle-inducing number the concept of continuing to grow at this high rate for another 10 years would require them to continue to hold down costs and find good places for stores: Wal-Mart has already seen an uptick in employee costs due to demands for benefits and has been opening stores so close together in some cities that it is stealing its own sales. I just can’t believe the growth will be as high as some analysts predict. I think the stock market has just been slow to lose its love affair with one of the nations most amazing success stories and I wouldn’t want to hold the stock when they come to their senses.

If you own some of these stocks should you sell? Well, I would probably sell WMT but WFC and PFE are much harder to predict. This comes down to psychology. If you would be unhappy if you sold and it then went up, don’t sell. But if you can come up with some better ideas (such as the BUYS we come up with here), these stocks might be good sources of cash. Keep your money in your best ideas.

Finally, do remember that in the stock market you can have you cake and eat it too. If you have a position in one of these and we work out a promising lead here like Lincoln Electric Company or Dow Chemical, you can always split the position by selling half your shares and moving it into the other stock. If only one goes up you will feel better that you participated.

I always practice what I preach here and own every stock I have a BUY rating on, but these aren’t on that list. If PFE or WFC drop a bit in price they may qualify and I’ll let you know, WMT seems unlikely to get cheap enough anytime soon.

Have a good weekend and take good care of your investor psychology,

The Finance Wonk

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Anonymous Michael Brothers said...

Good post. I completely agree with you on the issue of holding stocks. I know plenty of investors who come up with a stock. It ends up not working out because the fundamentals deteriorate or something goes wrong, and they just hold because they have a loss in the position, and hope that it goes back up so they can have a small gain. If they would wakeup, sell the stock, and get into a new position worth owning they would be much richer.
I own a little PFE that I got into at 22 for valuation reasons. It'll be time to sell at 26 though, which I'm thinking will come at the middle of the month if the FDA is nice.

12:10 PM  
Anonymous Anonymous said...

What about taxes on realized gains? If you are 100% invested (no idle cash), wouldn't you sometimes HOLD so as not to take the tax loss if there isn't another investment to make up for it?
Of course, no analyst can understand your individual tax impact and therefore could not viably recommend a HOLD position.


4:23 PM  
Blogger FinanceWonk said...


You are correct.

There are certainly reasons for individuals to HOLD a stock, I just object to the assertion by the analyst industry that this constitutes "making a call." I may have been overly emphatic in the way I phrased it, but I think that to often a HOLD call provides little or no information to the investor. I would prefer if they would just admit that sometimes its too close to call.

Your description of a tax situation is a perfect example where it might make sense to hold if you were uncertain, especially if you were coming up on the long term cutoff date.


4:40 PM  

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