Thu, 12 Jun 2014
StockInvestor editor Matt Coffina recently added to several well-known names that have the potential to provide healthy earnings growth over a long time horizon.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Matt Coffina. He's editor of Morningstar StockInvestor newsletter. He recently made some portfolio moves in his real-money Tortoise and Hare portfolios. He's here to discuss them with me.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: This market certainly doesn't provide a ton of opportunities right now. What did you find to add some money to?
Coffina: You're absolutely right about that. There's very few opportunities that I'm finding in the current market environment, especially new opportunities. The three purchases that I most recently made in our Hare portfolio were all add-on purchases of existing holdings. I added to our stake in Express Scripts, BlackRock, and MasterCard. Maybe we could take these one at a time.
Express Scripts I'd say is probably the best bargain of the three. The company is trading for a low-double-digit multiple of forward-year earnings. The concern with Express Scripts is that they lost a meaningful percentage of their client base during the Medco integration: They acquired major competitor Medco last year, and during that integration it seems like they lost maybe 5% to 6% of their client book, which I think is normal for such a large-scale integration like this.
Some of the Medco clients that were acquired were even former Express Scripts clients that had left Express Scripts for whatever reason in the past, and I think it's reasonable to expect that some of them for whatever reason might not be happy with Express Scripts' service. Maybe there was some disruption during integration and that caused client losses.
That said, all the other aspects of our thesis on Express Scripts are working out very well. And in particular, the company has unmatched bargaining power and operating leverage in the wake of the Medco purchase. Their profitability per prescription has never been higher, at certainly industry-leading levels. And this is a company that I think can generate--even with low- to mid-single-digit top-line growth, thanks to operating leverage, and thanks to share repurchases. Right now they are repurchasing 7% to 8% of the float every year given where the stock price is--this is a company that can generate pretty easily double-digit probably more like midteens annual earnings per share growth. So trading at 11 to 13 times forward earnings. I think that's a pretty good bargain.
Glaser: How about your addition to MasterCard?
Coffina: MasterCard is one of my all-time favorite companies, a company that I've owned for years, and it's been very good to us, both to me personally and to our Hare portfolio, really our best-performing position of all time in the Hare. MasterCard is a company that is benefiting from the shift to electronic forms of payment away from cash and checks, and this is a shift you might not believe, but the shift it's still in its very early stages. Only about 15% of total transaction volumes currently occur on electronic forms of payment versus cash and checks. It's a significantly higher percentage in the U.S. obviously and also somewhat higher in developed markets and significantly lower in developing markets.
I think it's inevitable that more and more transactions are going to occur on credit cards, debit cards, and prepaid cards over time, and there's really only two global brands out there that have very, very strong competitive positions, very, very wide economic moats: MasterCard and Visa. Between the two I tend to prefer MasterCard because it has greater exposure to those international markets with faster growth potential. The company also has somewhat lower customer concentration risk. That said, the valuation is a little bit higher on MasterCard. At the time of purchase at least MasterCard was around $73, $74 last time I added to it, and that's still a pretty rich price, some 24 times current-year earnings, maybe 20 times forward-year earnings.
But MasterCard I think can grow earnings per share in the mid- to high teens for the foreseeable future, between growth and personal consumption expenditures, add on that the secular shift to electronic forms of payment, it can get to maybe high-single-digit to low-double-digit top-line growth. And then there is natural operating leverage within the business model and again a lot of free cash flow similar to Express Scripts, which they are using to repurchase shares over time, a lot of potential to raise the dividend over time. You add all that together, and I think you are looking at 15% to 20% earnings per share growth for the foreseeable future.
In which case, I think the mid-20s multiple is justified. Not exactly cheap, but I think it's a fair price to pay for a wonderful business.
Glaser: And why did you add to BlackRock?
Coffina: This is a situation where the company, and the stock in particular, is going to be very vulnerable to short-term shifts in financial market performance. The company is an asset manager, very broadly diversified. Basically, its assets under management are similar to a very broadly diversified global balanced mutual fund. So over the long run, you expect stock prices are going to go up, bonds are going to deliver positive total returns, and BlackRock's revenue should benefit directly from that. But on top of that you can add asset inflows over time.
BlackRock tends to gain market share especially in its market-leading iShares exchange-traded fund product portfolio. The company also enjoys natural operating leverage similar to MasterCard: As revenue grows you'd expect operating income to grow more quickly. That's offset to a certain extent by some fee pressure within mutual funds. People are increasingly gravitating toward index funds and BlackRock's position is very strong within index funds, but also as those index funds tend to carry much lower fee rates than actively managed equity funds, for example. But also you have asset inflows, operating leverage, and you have return of capital on top of the market returns that you are already getting automatically through assets under management.
In this case, BlackRock's dividend is about 2.5%. They are probably capable repurchasing about 2% to 3% of the float every year, and that gets you another 5% on top of what you'd expect from a global balanced diversified mutual fund. So all things considered, I think in the short run if you think the stock market's overvalued and headed for a crash, BlackRock is certainly not a company you want to own right now. But if you have a longer-term investment horizon, and we do, I usually think in 5-, 10-, 15-year increments, I think it is very, very likely that BlackRock stock will outperform the S&P 500 over that longer time horizon. And if we do get some kind of short-term correction, we can always add to our position.
Glaser: Even after these additions, though, you still have a pretty sizable cash position. Why are you holding this cash right now? Do you think this is a time for investors to be holding some dry powder?
Coffina: We have right now about 12.5% cash in the Hare portfolio. We have very little cash in the Tortoise, about 50 basis points of cash. This isn't necessarily an active decision on my part. I'm not trying to hold cash, but I really take cash on a case-by-case basis, so I think in the long run it's a mistake for investors to hold lot of cash, at least common stock investors, and obviously beyond the cash that you need to meet your daily living needs and to have a margin of safety there.
But in terms of actively holding a cash position, stocks tend to go up over time, they tend to compound their intrinsic values over time, earnings tend to grow, they tend to raise their dividends, and they are also paying dividends in the meantime. So I think it's a mistake to hold a significant portion of cash over a longer time horizon. But that said, I'm not interested in investing in a stock just for the sake of it. Just for the sake of staying fully invested. If I don't think that any of the opportunities that are being presented to us, at least beyond the current existing holdings that we have, and for the most part those are already a positioned weight that I am comfortable with. As we just mentioned I added to a few of them.
But that said, in terms of new opportunities. If I can't identify a situation where I think the risk reward trade-off is in our favor, I would rather just hold cash than take on a mediocre investment idea that could turn south in the future. Where we are right now, I don't think the market is significantly overvalued, but I do think it's fully valued, and I'm not seeing a whole lot of opportunities jump off the page at me. In which case, I am willing to take my time and hope for better opportunities down the road. There is no guarantee that we'll get them. But I think that if you wait long enough from time to time, we don't necessarily need the whole the market to correct to get a better opportunity than we are being offered right now, from time to time some opportunities are going to pop up.
And I think we've seen just in the last few months a lot of growth stocks in particular come down a lot from their former highs and there are some opportunities that are maybe not jumping off the page, but at least interesting enough that there are definitely some things that I am researching and hoping to get that cash to work sooner rather than later. That said, again, I'm not interested in taking on an unfavorable risk/reward prospect just for the sake of staying fully invested. Zero percent return beats the negative-25% return any day of the week.
Glaser: Matt, thanks for the update on your portfolio today.
Coffina: Thanks for having me, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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