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23-Jun-09
Bullish on PG
When everyone rushes toward the same idea, prices race higher. As a value investor, I gravitate toward what is out of favor. Therefore, sustained rallies neutralize my investment discipline and prevent me from buying solid companies at a discount to fair value. However, when everyone rushes away from an idea, I can apply my analysis to acquire shares of outstanding businesses at low levels.
When following such an approach, we need to understand whether stocks are cheap because of problems in the operating business or because investors have focused elsewhere.
The rally from the March lows has presented some interesting opportunities. Like most bear market rallies, the weakest, most speculative companies have increased the most. In the current market, so many professional investors have trailed their respective indices that momentum chasing has become more pronounced. The outcome is that as speculative niche producers increase, diversified strong businesses lag.
Such events have presented excellent long-term investment options. When I first built my investment universe, I examined large companies with dominant brands such as Microsoft (MSFT), Coca Cola (KO), and others. Over the years I watched these companies receive premium valuations as investors paid for brand names and predictability. Over the past three months, the market has favored beta over stability and I have been able to add some of these names to the portfolio in my weekly newsletter EPIC Insights as their prices dropped. This week, I will add another.
Procter and Gamble (PG) is among the dominant consumer franchises. With 20 different brands that each generates over $1 billion in annual sales, PG is a cash-generating machine. Examining its financial statements, profit margins are wide and stable, liquidity is strong, and operating ratios continue to improve. With a global presence and dominant brands, PG consistently innovates and grows its business.
For such stability, the market has yawned. PG trails its peer group over the one-month, three-month, and year-to-date periods. Further, the shares are off 11% this year while the S&P 500 is 2% higher.
With such uninspired performance, the shares have become attractively valued. Using a conservative earnings yield approach, I find the shares to be worth $65. Apply a Price/Earnings (PE) or Price/Sales (PS) model and the fair value increases to $70. Using the lower number, the shares are more than 20% undervalued. Combine this with PG's 3.44% dividend and the stock becomes an ideal investment. A dominant franchise selling at a large discount to fair value while also paying a high dividend gives us exposure to an improving economy while receiving income as we await the recovery. I recommend a position in PG as this week's fundamental trade.
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