It’s been a while since I’ve bought individual stocks, but the March sell off has me scrambling to scoop up some good deals. My aim for these discretionary stock picks is to find quality companies trading at attractive free cash flow yields. Each position I bought in March make up approximately 5% of my portfolio. So far, I’ve bought Capital One, Simon Property Group, and Emerson Electric. I believe all of these are quality businesses, however they are not without their short term troubles.
Capital One Financial
Capital One Financial Corp (COF) was the first purchase during the recent market selloff. Capital One is a diversified financial company providing consumer lending, commercial lending, and commercial banking. COF is one of the 10 largest banks based on deposits, and third largest credit card issuer. The business model is to lend money to consumers and businesses from capital received by bank deposits.
The founder of Capital One, Richard Fairbank, is still the CEO of the company. Managers that are founders is a trait I like in businesses because I believe their interests are better aligned with all the stakeholders, and are more likely to be above average capital allocators. Capital One used its strong balance sheet to make acquisitions during the 2008 financial crisis, so I have confidence they can navigate this current market turmoil.
The main risks to COF are low interest rates, which compresses the spread between the interest they receive from lending and the interest they must pay on deposits. The falling interest rate trend has impacted most bank stock valuations. During a recession, default rates and charge off rates could increase. While COF has reserves for increased defaults, it could temporarily affect earnings. Another reason for Capital One’s lower valuation is the recent data breach that occured in 2019.
The table below shows my purchase price, and some of the key metrics I use to evaluate a business. Typically I don’t use Price to Book value, but it can be useful to valuing financial companies. A stock trading below its book value, a P/B less than 1, is a sign of undervaluation.
| Purchase Price | $63.25 |
| FCF Yield | 52% |
| P/B | 0.5 |
| D/E | 0.95 |
| RoE | 9.5% |
Simon Property Group
The second stock I bought in March was Simon Property Group (SPG), a mall REIT. Owning a bunch of shopping malls sounds like a terrible idea since the narrative is that brick and mortar retail is dead. While I think many malls will close, I believe this will be concentrated on the lower class malls in unattractive markets. SPG owns 204 properties, including 106 malls and 69 premium outlet malls. These properties are located in major metro areas such as Miami, Boston, San Jose, and Las Vegas. The quality properties in great markets should allow SPG to continue to provide steady cash flow to shareholders. Simon has the highest credit rating for a REIT, pays an average interest rate of 3.3% on its debt, and has a 5.3x interest coverage ratio.
SPG share price has been heavily beaten up from the Retail Apocalypse narrative, and now COVID19 fears. I believe these fears are overblown. Yes online shopping will continue to grow, but I believe brands will still want some physical locations as a showroom for their products. Since 2017, SPGs occupancy rate has only fallen 0.5%, to an occupancy rate of 95.3%. During this same period, base rents have increased. SPG is focusing on providing not only shopping, but dining and entertainment options to diversify the experience. As for the COVID19 concerns, it is possible some corporate tenants will not be able to pay their rent. However, I do not think it is likely that more than 50% of tenants are going to break their lease, or go bankrupt. It is my belief that Simon will be producing healthy cash flows two years from now despite a near term rough patch. If I’m wrong, then we are probably in the Great Depression 2.0 and have bigger things to worry about.
The table below shows my purchase price and key metrics used to judge the quality of the business. The debt to equity is high for this company because it owns real estate with mortgages. The return on equity is very high because the debt allows SPG to own a large amount of income producing assets. This debt means there is relatively low amount of equity, thereby creating a large RoE.
| Purchase Price | $74.50 |
| FCF Yield | 13% |
| D/E | 9.4 |
| RoE | 73% |
Emerson Electric
Emerson Electric (EMR) is a diversified industrial company consisting of climate technologies, automation solutions, and tools & home product segments. Climate technologies include residential heating and cooling, commercial air conditioning, commercial and industrial refrigeration. The tools & home products segment makes professional tools, food disposal systems (such as its InSinkErator brand), electric water heaters, among others. Both the climate technologies, and tools & home products segments are low growth, almost commodity type products. What makes me interested in EMR is the automation segment, that provides measurement instruments, fluid control, process control, and Industrial Internet of Things solutions. This segment should provide Emerson with a runway of modest growth in the future. One application of EMRs automation products is in the oil industry, with computer controlled valves, pumps, flow rate sensors that accurately measure the transfer of oil in custodial transactions.
The main risks to EMR are a general economic slowdown, and slowdown in the oil industry specifically. While EMR is quite diversified, the shale oil recession in 2016 impacted Emersons automation segment. Going forward EMR could face near term headwinds with the economic slowdown from COVID19, as well as the collapse in oil prices. Despite this, I believe Emerson is a high quality company that is rarely undervalued.
It can be seen from the table that EMR appears to be a quality company that can produce healthy returns on equity, while having a strong balance sheet.
| Purchase Price | $31 |
| FCF Yield | 13% |
| D/E | 0.48 |
| RoE | 26% |