Monday, December 23, 2013

Ignore and Embrace the Noise

Ignore the Noise

This is a phrase I have heard many times with regards to investing. This can be looked at from both a macro level and at a security level. For instance, at the macro level there is constant noise coming from Washington DC. With all the doomsday stories that will accompany a budget standoff or debt ceiling deadline, it can be easy for an investor to get uneasy. However, while there may be a short term effect from any given deadlock “crisis” the long-term picture and valuation of most companies is unlikely to be effected.

What I am more focused on with this post is noise that affects a specific company. A couple of years ago, someone reading the headlines could easily have concluded Johnson & Johnson (JNJ) was heading in the wrong direction as there was story after story with regards to various recalls and safety concerns at some of their factories. These headlines can be downright scary for any investor. Hindsight now shows that this was a great buying opportunity.

Whether it is McDonalds and concerns of the consumer shift to healthier foods or defense companies (LMT, GD, RTN, etc) ahead of the sequestration, there is a long list of companies that have been great investments despite headlines that may lead a person to a different conclusion.

Embrace the Noise

Noise can be very profitable for an opportunistic investor. When JNJ was struggling with Tylenol recalls and factory safety concerns an investor who ignored the noise could have spotted the buying opportunity by focusing on the fundamentals of the business. During this time, JNJ continued increasing revenue, increasing profits and increasing dividends. JNJ’s P/E, however, was compressing as a result of the negative sentiment surrounding the stock as the headlines continued to hit. As such, JNJ became a great bargain for a very high quality company. The key here is to focus on fundamentals of the underlying business and not just the headlines. If the fundamentals are also showing negative trends, then that is likely a company to avoid. However, if the fundamentals remain strong, noise can create compelling opportunities.

Current Noise

Right now there are a couple of companies I am watching that I believe are at potentially compelling valuations as a result of noise. One is Ford (F). Ford is down over 9% over the past week as a result of forward guidance that indicated 2014 would likely not be as profitable as 2013. The key here is to determine why. Is this a sign of deeper problems for Ford or is this a potential buying opportunity? 2013 is expected to be among the best years in Ford’s history with full-year automotive revenue increasing 10% and profit of approx. $8.5 billion. The company has cut the underfunded status of its global pension plans in half this year. Automotive operating profit margin increased year over year and profit came in higher than previously expected. 2014 will be the most aggressive product launch schedule in Ford’s history with 23 all-new or significantly refreshed vehicles being launched globally. Profit is expected to be in the range of $7 billion - $8 billion, down from $8.5 billion in 2013. This does not concern me as the aggressive launch will carry increased costs but will set Ford up for a stronger 2015 & 2016. So rather than seeing deteriorating fundamentals, I see a business that is investing in its future. I also see an improving balance sheet and overall strong financial performance. In addition, I would not be surprised if 2014 ends up stronger than expected (conservative guidance) and equals or even betters 2013 as the economy continues to improve here in the U.S. and in Europe. Now a pullback on headlines does not necessarily mean a company is undervalued but I like the valuation of Ford very much at these levels. Ford currently has a dividend yield of 2.6% and a trailing P/E of 10.7. I will look to do more in depth valuation analysis post in the future.

The second company I am watching is Target (TGT). Target stock has struggled over the past four or five months and is currently under pressure as a result of the security breach announced late last week which has resulted in up to 40 million credit and debit cards potentially being compromised. Timing on this breach was about as bad as possible for Target and, according to Reuters, transactions fell 3-4% this past weekend (last before Christmas) as compared to last year. In addition, Chase and other banks have imposed limits on debit card transactions for cards that were potentially compromised. This has the potential to affect millions of customers during the final holiday shopping rush which may cause greater inconvenience to Target customers, affecting their view of the retailer. It is too early to see how much of a lasting effect this will have on Target but this is a very well retailer. If they are able to regain the confidence of their customers, this may prove to be an excellent opportunity to pick up shares. Given the size of the breach, the easiest comparison is to the breach TJX experienced in 2007. TJX has rebounded strongly and I believe that this will be but a blip for Target as well. Obviously, Target’s experience may be significantly different than TJX but I will continue watching and look for a potential entry point as funds are available. I liked TGT’s relative valuation compared to many other dividend growth stocks prior to the breach and I continue to like it here under $62.

The Lesson

The lesson here is that noisy negative headlines can potentially lead to great investment opportunities if you are looking at a strong company and the underlying fundamentals of the business remain strong. Keep a list of companies you would like to own at the right valuation and monitor the “noise”. Happy Investing.

Divi Me Up

Dislcosure: I am currently long Jan 2015 $15 & $17 call options for Ford and have a limit order in to pick up shares at $15.00 (subject to change). I currently have no position in TGT.

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