Financials, Healthcare More Undervalued Than Utilities
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Often times, beginning value investors become too focused on past multiples and lose sight, ironically, on the real driver of value: the future. Companies that are valuable - because of the fundamentals, not what the fluctuating market dictates - may trade at very high past multiples, for example, when a breakthrough product is about to released. Other times, companies teetering into bankruptcy, like Research In Motion, can trade at rather low multiples, because they have a poor future ahead. Any consideration of multiples thus ought to be considered in context to earnings power and growth.
The Russell 1000 Value Index Fund currently has 26.48% of its holdings in financials, which is almost more than the next two sector holdings - energy (16.4%) and healthcare (11.9%) - combined. I have been touting the virtues of all of these sectors for some time now. My stance on financials has been that simply too much risk is being factored into stock prices despite evidence that the American banking system remains fundamentally strong. My stance on energy has been that natural gas will soar from its lows and fuel the economy for many years ahead. And my view on healthcare is that investors remain overly focused on patent cliffs and product recalls while failing to consider accretive takeover activity and pipeline catalysts.
Then there is the popular utility holding for the Russell 1000 Value Index Fund, which represents 11.1% of the fund. My stance on this sector is that it will underperform due to low growth as the rest of the American economy hits an inflection point towards acceleration. Since growth trends are poor and regulatory costs are high for utilities, much of the sector's luster (ie. the generous capital allocation policies) will be lost if the Obama administration is successful in redefining dividend income as ordinary income for tax purposes. To illustrate why I am more bullish on the Russell 1000 Value Index Fund's healthcare and financial holdings than I am about its utility holdings, consider Duke Energy (NYSE: DUK), Bristol Myers (NYSE: BMY), JPMorgan (NYSE: JPM).
Duke Energy isn't even very cheap on a multiples basis. It trades at a respective 20x and 12.3x past and forward earnings while the S&P 500 trades at a PE multiple of around 15.4x. The company offers a generous dividend yield of 4.6%, but is rated closer to a "sell" than a "buy" according to data from FINVIZ.com. The consensus price target of $68 also leaves little margin for error. Here's why.
Duke is expected to grow EPS by just 4.7% annually over the next 5 years. It grow 7.1% over the preceding 5 years. Based on consensus figures, 2016 EPS should be around $6.23. A 16x multiple puts the future stock value at $99.68. Discounting backwards by 8% yields a price target of $67.84 - virtually in-line with the consensus figure. Moreover, the utility firm has ROA, ROE, and ROI in the low single-digits.
Since companies are valued based on their after-tax dividend yields, the Obama administration's dividend tax hike from 15% to nearly 40% will necessarily have to lower shareholder value. In economic theory, the magnitude of a disincentive's impact is disputed, not its existence. Thus, demand will lower for income-yielding equities as a result of the tax policy, ceteris paribus, but it is unclear just how low demand will fall. Duke currently offers an after-tax dividend yield of 3.9% and if dividend taxes rise to 40%, the after-tax yield will fall to 2.7%. In order for the after-tax dividend yield to return to normal, the stock will need to decline to $51 - an approximate 33% loss in value.
By contrast, BioPharma offers both high reward and meaningful safety. The dividend tax hikes will likely have less of a negative impact on the sector, since most of the shareholders do not own a position excessively for guaranteed income streams. Healthcare is significantly undervalued by my estimates. Bristol trades fairly high at a respective 15.9x and 18.7x past and forward earnings but has meaningful growth ahead. It offers a dividend yield of 3.9%.
Over the past 5 years, Bristol yielded annual EPS growth of 28.4%. If it yields just half of this amount over the next 5, 2016 EPS will be around $3.30. At a 16x multiple, the company's future stock value is $52.80. Discounting backwards by 8% yields a price target roughly in-line with the market's figure. Even still, the company has performed well over the recent 5 quarters and is likely to appreciate off of analyst revisions.
Moving onto financials, there is JPMorgan, which showcases just how far the market will lose sight of the fundamentals. The legendary investment bank's trading loss reportedly ballooned from $2 billion to nearly $6 billion, and the political dialogue has been so intense that CEO Jamie Dimon had to give a testimony. Dimon is a terrific CEO who was recognized by Institutional Investor as one of the best CEOs from 2008 to 2011. In 2011, he was even named CEO of the year. He has done a particularly noteworthy job of de-risking his business since the financial crisis and taking the necessary steps to curtail sector-wide losses from the second worst economic downswing in American history.
It is unfortunate then that the stock is down 16.5% over the last 3 months. This is in direct contrast to JPMorgan's stellar financial results. The investment bank has actually beaten consensus over 4 of the last 5 quarters by an average of 15.9%. Shareholder value thus has plenty of room to recover. The company trades at only a respective 8x and 6.8x past and forward earnings with a generous 3.3% dividend yield. I thus strongly recommend investors accumulating shares in JPMorgan and Bristol and holding out on Duke.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
