As should be well-known, a great company doesn’t necessarily make a great stock, because the price you buy at makes a huge difference.
We’ve had a strong rally since the end of 2018, and now many stocks are looking rather expensive again, meaning their prices have outpaced their fundamentals. There are plenty of great companies out there, but only a small subset of them are attractively-priced in my view.
It’s good to have a game plan for what you will do the next time the market turns down. If we get a dip, will you buy, or will you freeze up?
I track well over 100 stocks and ETFs, constantly scanning for good entry points. I already know many securities I’d be happy to buy at certain prices, with a willingness to buy more should they fall still lower.
Currently I’m finding a lot of value in the financial sector, because it’s one of the most sensitive sectors to an economic slowdown and flat yield curve. They deserve low valuations, but some of them have seen price drops below where they should be based on fundamentals, in my opinion.
Looking forward, there are many great companies in other sectors that are above my target entry prices currently, but that may dip to more attractive levels under certain scenarios. Here are three in particular that I’m looking to own for the sake of diversification into sectors I am underweight in, but only at the right price.
Home Depot (HD)
Home Depot and Lowe's have both benefited from long-term consolidation in the hardware retail industry. Various mom-and-pop hardware shops have been displaced by these two growing hardware superstore chains. They churn out consistent profits and free cash flow, with strong growth year after year.
Additionally, this subsector of retail has been among the most resilient to online competition due to the level of service and product complexity that is natural in this industry. Sales staff can help customers find the right tools for the job and can provide various installation and repair services for contractors and homeowners. Additionally, Home Depot is actually one of the largest online retailers in the United States, as it continues to grow its omnichannel presence.
Home Depot’s balance sheet is reasonably strong. While the debt/equity ratio is high, the more relevant debt/income ratio is only about 2.5x, and so they currently have a decent S&P credit rating of “A”.
But, like many great stocks, the price has been at a premium in recent years relative to fundamentals:
Source: F.A.S.T. Graphs
I’d be happy to buy Home Depot stock, but would need to see a share price of under $160 first.
Based on my StockDelver model that breaks the expected forward return down layer by layer, $155 is ideal, although it depends on what expected rate of return you’re willing to accept:
I’m willing to pay up a bit, but not much.
This company is sensitive to the housing market. In recent years with decent economic growth, the company has generated tremendous ROIC, but this can sharply change during a downturn. And during outright recessions, the stock typically drops below fundamentals, and could potentially visit 25%+ below fair value. But during a normal market dip, scooping up shares roughly at fair value is likely a decent entry point.
Becton Dickinson (BDX)
Becton Dickinson is a big medical device producer, and recently acquired C.R. Bard to further grow and diversify its business. The company is only a few years away from hopefully hitting 50 consecutive annual dividend increases, which will be a remarkable achievement.
The company’s core area has historically been medical consumables. But thanks to growth and acquisitions, the company is now diversified into three segments: Medical, Life Sciences, and Interventional.
The healthcare sector is resistant to recessions, but faces political risk because the United States has by far the highest per-capita healthcare cost in the world with health outcomes that are not necessarily superior to other developed countries. The country has huge unfunded medical liabilities over the coming decades, and healthcare is a major political topic.
Additionally, stock valuations in the medical device industry are rather high across the stocks I cover, including Becton Dickinson:
Source: F.A.S.T. Graphs
I’d like to pick up shares closer to $200.
Becton Dickinson historically generates great double-digit ROIC. In recent years their GAAP bottom line has taken a hit from acquisition-costs and tax changes, so on paper their ROIC has diminished, but this should smooth out into 2019 and 2020.
The biggest downside to the company in my view is the debt. The company has taken on quite a bit of leverage in recent years to make big acquisitions. They now have debt equal to about 10x their past 12 months’ worth of free cash flow, they have a negative tangible book value, and their S&P credit rating is “BBB”, which seems generous.
Corporate debt is a big problem in general, and Becton Dickinson is one of the high ones. Fortunately, they plan to prioritize debt reduction in the coming years:
Source: BD 2019 Shareholder Meeting Presentation
Overall, this is a great business with too much leverage, and the market is paying a frothy valuation for it. I’d be happy to invest, but only under $200/share.
Rockwell Automation (ROK)
Rockwell Automation is one of the best-performing automation companies. About a decade ago I briefly worked at an automation company and personally used some of Rockwell’s programmable logic controllers, but of course they’ve come a long way since then.
Most automation companies focus on either process automation or discrete automation, but not both with the same platform. “Process” refers to a continuous systems, like a oil refineries or chemical producers. “Discrete” refers to the production of individual units, like vehicles.
Rockwell is unique in the sense that their platform integrates both process and discrete automation into a single platform, and they’ve thus enjoyed some of the strongest performance and highest valuations in the industry.
The tailwinds in this industry are obvious. Automation is continuing to replace human labor in many industries with no signs of stopping. Further improvements in the internet of things (IoT) allow for more and more points of connectivity, integrating factory automation with enterprise data management.
Industrial automation products are ruggedized to withstand harsh conditions and to operate continuously for years, because even brief periods of downtime result in huge missed profits due to the operational leverage inherent in capital-intensive facilities.
Although Rockwell Automation stock has come down from its 2017 bubble, it still is a bit on the pricey side:
Source: F.A.S.T. Graphs
Due to the high-quality nature of the business, I’d be wiling to buy around $140. Their balance sheet is very strong, with net debt equaling well under 2x annual net income and annual free cash flow, so the company has a well-deserved S&P credit rating of “A”.
However, this is a cyclical industrial stock, and investors should be aware that its stock price fell a whopping 70% during the financial crisis. The fundamentals and stock price both recovered quickly within 3 years, however. This is a stock that might be great for a half-position until the next major downturn, where it could be more heavily invested in up to a full position.