4 Keepers

4 Keepers

This is the second posting addressing stocks that were overpriced and/or overweight in a portfolio update posted on Oct. 16, 2017, (“Dividend Growth Portfolio Update“). The first posting in this series addressed three stocks that were contributing more than 5% of the dividend flow from the portfolio and represented more than 5% of the value of the portfolio (Seeking Alpha, “Let Hitters Swing For The Fence” Dec. 15, 2017).

This posting addresses four stocks: Johnson & Johnson (NYSE:JNJ), Microsoft (NASDAQ:MSFT), PPG (NYSE:PPG), and Honeywell (NYSE:HON). Each of those stocks represented more than 5% of the portfolio value, but they did not contribute more than 5% of the dividend flow. Since dividend flow is an important metric for measuring the success of the portfolio, addressing the overweight positions in these stocks might appear less urgent than the discussion in the previous post. However, at the same time, one has to consider the relative outlook for the different stocks being considered.

Addressing these four stocks is in many ways easier than planning what to do with the three discussed in previous posting. Two of the four companies discussed in this posting (Microsoft and Johnson & Johnson) are AAA rated. They represent companies in very strong financial positions. They’re also experiencing company-specific developments that are worth special note. Regarding the other two, PPG seems like a no-brainer given what’s going on in the industry, and how to handle Honeywell was somewhat dictated by the phenomenal performance of Boeing (NYSE:BA) aerospace.

What’s particularly interesting is that a case will be made for how to approach the holdings in each of the four stocks. To me, everything in this posting just represents special cases that illustrate the point made in the previous posting entitled “Let Your Winners Run” (Seeking Alpha, October 26, 2017).

The table below presents a short summary of how the stocks have performed since the posting noting their overweight status. That’s when I began working on this posting. It also notes performance since the posting entitled “Let Your Winners Run” was finished and published on Seeking Alpha. For comparison purposes, or benchmarking, it also includes the performance of the S&P 500 and Dow 30. (For those who are sticklers for detail, the Johnson & Johnson numbers were noted real-time during days when the market was open. Consequently, they do not represent opening or closing values for any given day. By contrast, the figures for Microsoft, PPG, and Honeywell were collected on the weekend of December 16, and they are the closing values.)

PRICE DATA

JNJ

MSFT

PPG

HON

S&P 500

Dow 30

Start writing the posting

$ 136.00

$ 77.65

$ 113.17

$ 143.75

2560

23157

Posting is published

$ 141.00

$ 78.76

$ 118.67

$ 145.84

2560

23400

As of December 16

$ 142.46

$ 86.85

$ 115.09

$ 154.25

2676

24652

Change from start date

$ 6.46

$ 9.20

$ 1.92

$ 10.50

116

1495

Change from publication

$ 1.46

$ 8.09

$ (3.58)

$ 8.41

116

1252

PERCENT CHANGE

Change from start date

4.8%

11.8%

1.7%

7.3%

4.5%

6.5%

Change from publication

1.0%

10.3%

-3.0%

5.8%

4.5%

5.3%

It’s worth noting that the choice of December 16 is totally arbitrary. It just happens to be the date on which this posting was being written. It’s also clearly a very short-run period of time that’s inappropriate for an honest assessment of the strategy of holding the stocks. Next year, at about this time of year, I’ll try to remember to do an update. Nevertheless, it appears that holding the four stocks as a group did not hurt the portfolio’s performance. Further, as will be discussed subsequently, PPG, the stock that was weakest during this time, is in a peculiar position that could result in a significant discontinuity in its performance. So, all in all, I view holding the stocks as successful to date.

This posting will address each of the stocks individually. There will then be some general comments regarding the issue.

PPG

Since a lack of concern about PPG was mentioned above, it’s probably a good place to start. For those who want more detail on what is going on in the industry than the summary below, the Wall Street Journal on December 11, 2017, published an article entitled “The Big Paint Companies Still Look Primed for an M&A Wave.” The article noted that there have been three failed merger/takeover attempts in the paint industry the last 12 months. Of particular relevance to this discussion is that PPG Industries ended its three-month pursuit of European leader Akzo Nobel (OTCQX:AKZOY) in June.

The article then goes on to speculate as to which companies are likely takeover or merger candidates. The reason for the high potential of M&A is, according to the article, competitive pressures originating from increasing input costs.

However, the reason for the potential may well be that one of the major companies in the industry, PPG to be specific, has been sufficiently successful to position itself so that it is capable of acquiring almost any other firm in the industry. Where one company in an industry is in the position to be looking for mergers, it can set off chain reactions involving all of the other companies in the industry.

For example, the attempt to merge Akzo Nobel and Axalta (NYSE:AXTA) looks suspiciously like an effort on the part of Akzo to gain the scale that would deter PPG from renewing its efforts to acquire Akzo once the six-month waiting period that Dutch law requires before a failed acquisition effort can be renewed. However, the efforts of Akzo Nobel and Axalta have probably placed every company in the industry in play. So, Akzo may end up being an orphan too small to compete in a consolidated industry.

Further, one tends to think of paint as a rather uniform commodity. That is not always the case. Considerable research is put into developing proprietary aspects of the coatings that are often referred to as paint. That may go unnoticed because it’s hardly visible in the paint products that most consumers use directly. However, it is true of many other coating products, especially those used in the auto industry. The greater emphasis on research and development is a key differentiator between PPG and other paint and coatings companies.

In addition, there can be considerable differences in input costs depending upon where particular manufacturing facilities are located. The petrochemical industry supplies a substantial amount of input into the paint industry. Keep in mind that while oil prices tend to be set globally, natural gas prices and the price of some of the derivatives from natural gas and oil can vary regionally. Thus, at any given point in time, relative energy prices create attractive competitive advantages based on location. They can lead to a desire to acquire facilities in those locations. Consequently, scale is not the only reason for interest in a potential merger or acquisition.

It is reasonable to assume that the conditions in the paint industry are conducive to abrupt changes in the pricing of the stocks of companies in the industry. While that would not preclude making a judgment about whether to buy, sell, or hold PPG, it does make it difficult to develop an option strategy around PPG stock. That is particularly the case if one believes that there is a potential for a temporary period of heightened volatility during the continuation of PPG’s stock price increase.

Consequently, a previous discussion in “Buying Stocks For A Dividend Growth Portfolio: Postscript A,” Sept. 21, 2017, summarized the situation as follows:

“Because of the potential for rapid [price] movement, selling a covered call would seem to be very risky unless one wants to intentionally reduce the position. However, because of that upward potential, it would seem advisable to continue to hold the existing position with PPG …. PPG should be watched for any pullback …. selling cash covered put(s)… would not be a bad way to initiate one’s position.” The opportunity to sell cash covered put(s) at a level that seemed reasonable, for example the levels discussed in the posting, was very fleeting. The market very quickly recognized the elimination of the uncertainty associated with what PPG would do.

The September 21, 2017, posting noted a couple of factors that are still in play, but whose influence has changed. For example, PPG’s “decision to withdraw the offer rather than continue to pursue the takeover [of Akzo] demonstrates the discipline in capital allocation that has been characteristic of PPG.” That still seems to be the case. The steps taken by Akzo (discussed in a previous posting) and the subsequent failure of its attempt to merge with Axalta just accentuated a point made in the previous posting. Akzo “could end up being forced to accept a new takeover approach.” In reality, PPG’s position has not changed: “PPG is in the rather advantageous position of being able to wait and perhaps pick up all or part of Akzo Nobel at a better price or look elsewhere for alternative opportunities.”

However, what has changed is that, as predicted, PPG stock did run up as the uncertainty associated with their efforts to acquire Akzo was removed. Consequently, PPG stock is now at a higher level. However, since the six-month waiting period is over and other firms in the paint industry are in play, the uncertainty about whether PPG might overpay for an acquisition has returned. Consequently, until the situation once again resolves itself, the upward price movement in PPG may stall. In fact, the strategy of selling a cash covered put in order to initiate a position in PPG again seems viable. However, the risks of a sudden increase in the price of PPG’s stock as the situation resolves itself weighs against the strategy of selling a covered call unless one wants to reduce one’s exposure.

From the perspective of a long-term investor, PPG’s decision to withdraw from that previous merger effort should be viewed as a confirmation of its continued ability to be disciplined in its allocation of capital. It may well end up acquiring another firm in the industry, but there’s no reason to believe that it will overpay for it. PPG has a long history of spending about a third of its cash flow on acquisitions without overpaying. Often, when it does not see advantageous acquisitions, it will devote some of that cash flow to share repurchases. If that’s an accurate assessment, the uncertainty that is currently depressing the stock is unjustified, and holding the stock or adding to the position seems to be an appropriate strategy. It is likely that acquisitions will be a focus of PPG moving forward, but its history would suggest that that is not a reason for concern.

PPG is, in my opinion, a hold, only to be bought on a pullback with a clear understanding that any gain will be small. As has been pointed out in connection with many industrial firms, the best opportunity to buy an industrial firm like PPG occurs during a recession when the price-earnings ratios is extremely high because of temporarily depressed earnings. Currently, PPG is not overpriced, but clearly it is also not a period of depressed earnings. PPG’s latest earnings announcement met earnings expectations, but the encouraging sign was that it beat on revenue. However, given current prosperity, one would expect substantial revenue growth from PPG.

Readers who prefer a more conventional, less management and strategy focus assessment when considering stock selection may want to consult an October 17, 2017, posting by Sure Dividend. The posting is entitled “Dividend Aristocrats In Focus Part 14: PPG Industries.”

Honeywell

Like PPG, Honeywell represented more than 5% of the portfolio and could be fairly characterized as being one of the stocks with a lower dividend yield. However, a very different strategy for managing the position in Honeywell seemed appropriate for this portfolio. (The entire portfolio is listed in “Buying Stocks For A Dividend Growth Portfolio: Postscript A.”) It shows that Honeywell represents only one source of exposure to the commercial aerospace industry. Boeing, United Technologies (NYSE:UTX), and General Electric (NYSE:GE) also provided exposure to the industry.

The exceptional performance of Boeing’s stock suggested that the portfolio’s total exposure to the aerospace industry be reviewed. That review led to the selling of General Electric which, for reasons unique to General Electric, was a prime candidate to be dropped from the portfolio. However, there was no reason to believe that the stock of Boeing would not continue to rise given the advantageous position of the company. It did rise to a degree that justified looking for ways to reduce exposure to the aerospace industry beyond just selling General Electric.

United Technologies is a small holding, and it did not offer an opportunity to make much of an adjustment. Further, it was not a stock where a sale seemed appropriate. That left Honeywell as the other candidate for managing exposure to the commercial aerospace industry. The sale of General Electric made the issue less urgent. Further, Honeywell did not look like a stock where an outright sale seemed appropriate. The stock of Honeywell has advanced fairly steadily because the company has done quite well. However, there were management developments that are concerning. Consequently, risking the sale of some of the stock by selling a covered call seemed appropriate. It could increase the total yield on holding the position if the call was not assigned. Selecting a high enough strike price made the sale, if assigned, more appropriate. The call did end up getting assigned, thus reducing the exposure to Honeywell.

As mentioned, despite its excellent performance, there are some concerns about Honeywell. First, Honeywell has recently experienced a change in senior management. The performance under the previous senior management was exceptional, and it will be hard for the new management to duplicate. There is a risk that the new managers will take on additional risk in order to try to duplicate previous results. Second, Honeywell has announced its intention to modify its industry composition by selling or spinning off some operations. It already spun off an operation in the chemical field. It also pursued an acquisition unsuccessfully. When an industrial firm undertakes a shift in its industry composition, it creates what might legitimately be referred to as the risk of “over-engineering its financials.” General Electric is a recent example of exactly that phenomenon.

It is extremely telling how a conglomerate chooses to exit an industry. Spinning it off to shareholders is clearly the safest approach from a shareholder’s perspective. It puts the shareholder in the position of deciding how to use the capital. The shareholder can hold the stock in the spinoff, or sell it and redeploy the capital. The risk arises when a conglomerate chooses to sell the operation and redeploy the capital internally. We will have to wait and see how Honeywell proceeds in the future. Regardless of how it structures spinoffs, in the case of Honeywell, indications are that the capital will be redeployed to the aerospace industry. Given the exposures discussed above, that justifies considering reducing exposure to Honeywell.

The danger with the restructuring is that Honeywell may be pursuing justification for a higher price earnings ratio rather than pursuing higher earnings. Indications are that, at current prices, Honeywell is fully priced. For those who would prefer or require a more conventional value analysis, one can be found at “Honeywell: Overvalued,” by Accelerating Dividends, or “Oh Honey, Are You Doing Too Well?” by Stefan Redlich. As a result, Honeywell is currently on hold in this portfolio, and it is being watched for indications of how the restructuring proceeds.

Johnson & Johnson

Johnson & Johnson is generally an extremely well-managed company. Consequently, the stock commands a premium almost all the time. That makes it very hard to trade the stock for short-run gains. Like 3M (NYSE:MMM), it tends to become a perpetual hold. I’ve owned the stock for forty years, and there was only one time that I was able to identify a compelling opportunity for a conviction buy. All other purchases were essentially dividend reinvestment.

Currently, Johnson & Johnson appears fully priced or slightly overpriced. However, in fact, it’s definitely a hold, and perhaps it is presenting a buying opportunity. With a company like Johnson & Johnson, one has to look for any reason that there may be a discontinuity in its level of performance. The one opportunity that I was able to identify related to such a discontinuity that arose from a change in senior management. That opportunity was fairly obvious. For totally different reasons, Johnson & Johnson may currently be experiencing another similar, although less pronounced, discontinuity.

Johnson & Johnson operates in multiple industries, although it tends to be most widely known for its consumer products. Nevertheless, it is a pharmaceutical company, and the performance of the pharmaceutical operations of Johnson & Johnson is the more dynamic portion of its operations. Currently, Johnson & Johnson has one of the strongest drug pipelines it has had in many years. Third-quarter earnings were quite positive with revenue up 10% and non-GAAP earnings per share up 13%. Earnings from its oncology franchise were up more than 25%. Johnson & Johnson raised its guidance for next year, which reflects its confidence in their pipeline. Yet, the important takeaway is that the pipeline has a long run much more than just next year. Its pipeline includes promising drugs in a variety of different stages of development.

One final point of importance to long-run investors is Johnson & Johnson’s financial strength. The company is well-positioned to supplement its pipeline through acquisitions if it desires, or it could acquire additional non-prescription healthcare products if they become available at reasonable prices. In fact, it could probably do both and not become overly leveraged. Alternatively, the company could enhance its dividend and buyback programs.

For those who prefer a more conventional analysis of financial metrics, “Johnson & Johnson: Reliable Dividend Clipper” by ChartMasterPro provides very succinct coverage of key metrics relevant to Johnson & Johnson.

Microsoft

It has now become fairly widely recognized that Microsoft has gone through a major transition in the focus of its business. A company that was once being written off as wed to a dying PC industry is now recognized as a major player in cloud computing. Consequently, valuations based upon performance previous to Nadella’s shift in the company’s focus are totally irrelevant.

There is little doubt that the phenomenal growth in cloud-related computing will carry Microsoft for a number of years. It is likely that the growth impact will actually accelerate. Further, Microsoft has an advantage in approaching the cloud-computing marketplace. It is a trusted vendor well entrenched in many major corporations.

Further, Microsoft can use its existing software exposure, basically cannibalizing itself, to grow its cloud computing. It is easy to underestimate how much of a competitive advantage it is to be the disruptor of one’s own business as opposed to trying to enter a market. Nevertheless, investors seem currently to be overly fascinated with firms that are identified as disruptors. That fascination does not guarantee that new entrants into an industry will succeed.

In addition, Microsoft is cash-rich, and it will become much richer when is able to repatriate profits currently held overseas. That’s a marked contrast from some of its competitors that are highly dependent upon external sources for capital. Microsoft will be able to continue to pick up valuable technical expertise through recruitment and acquisitions of promising new companies. Its competitors’ ability to do the same is dependent upon the continued availability of external capital sources and the appreciation of their stock. As the Fed shifts to more normalize monetary policy, it is conceivable that capital from external sources will become less plentiful, accentuating Microsoft’s advantage.

Finally, Microsoft has businesses that it can leverage to generate cash or to position itself against competitors. It has a computer business, a gaming business, the LinkedIn (LNKD) franchise, successful database analytics software, and a major head-start in experience with operating system software. It is also easy to overlook Microsoft’s global reach. The company has ample experience in dealing with foreign governments whose interest may conflict with the operating models of some of its competitors.

Those interested in more conventional analysis of the stock’s metrics should consult “This Epic Dividend Growth Stock Is Firing On All Cylinders” by Dividend Sensei or “Should You Buy Microsoft At Current Prices?” by Ploutos Investing. Ploutos Investing uses five years of history to calculate some of the metrics, and Dividend Sensei focuses on metrics relevant to assessing the growth potential. Thus, they avoid the trap of using irrelevant data to calculate metrics.

Perspective

There are numerous analyses on Seeking Alpha and other sources that attempt to value the stock of various companies. Those analyses are valuable, but their approach is quite different from this posting. The underlying philosophy behind the analysis in this posting is not to focus on the valuation of the stock. Rather, it focuses on evaluating the company. The focus is much more on management and strategy, and less on financial ratios. That shouldn’t be taken to imply the financial ratios are irrelevant or that they’ve been ignored when deciding how to handle the positions discussed in this posting. Rather, financial metrics should be viewed as complementing the analysis of management, markets, and strategies.

One also has to decide which is more enduring, financial ratios or the quality of management. My focus reflects my bet that the quality of management is more important. It is worth noting that Microsoft, Johnson & Johnson, and McDonald’s (NYSE:MCD), three of the seven companies discussed in these two postings, were identified as instances where a change of management was used to make a conviction buy that, given subsequent performance, has resulted in the positions becoming overweight. Further, it’s legitimate to say that the conviction buy in Boeing was a result of continued competence in management. That’s slightly different from the other three where it was a change in management, but it’s equally indicative of the success of focusing on the quality of management. It would also be legitimate to argue that PPG and 3M became overweight because of ongoing competence in the management of those companies. Every effort is made to purchase at advantageous prices, but the price is only advantageous if the valuation it reflects is consistent with an analysis of the quality of the management and the positioning of the company.

Another major difference in perspective of this analysis and many other analyses of the same companies, concerns the importance attached to portfolio considerations. Analyzing a particular stock individually is interesting, but it can never provide criteria to buy, sell, or hold the stock unless one is a short-term trader. If one’s objective is to build a portfolio, existing holdings have to be considered and differences in performance characteristics of different companies have to be analyzed. That’s led to a curious observation. On October 26, 2017, a posting entitled “Let Your Winners Run” discussed some general principles related to how to maximize one’s return from stock investments.

It noted that one can’t go broke taking a profit, but one can under-perform the market. The reason is quite simple: every stock won’t be a winner, so it makes sense to maximize the size of the winners. The posting noted that the number of stocks that are big winners is quite small, and, consequently, an investor should hold onto those winners. They are few and far between. It explains how the small number of big winners among all stocks and the presence of the phenomenon known as persistence of a rising stock price support the argument for holding on to winners. It also discussed the implications of data on the trading practices of the large number of individual investors as well as research into how people react to gains and losses.

In short, it provided general portfolio management advice that works, and it explains why it works. That posting was followed by a posting on December 15, 2017, entitled “Let Hitters Swing For The Fence”. That second posting did nothing more than take a number of examples, three to be exact, and explained why the strategy of “letting winners run” will probably work with respect to those three stocks. The three stocks were Boeing, McDonald’s, and 3M. The only general portfolio management discussion concerned a common approach to managing concentration risk: Frequently, there are references to not letting any particular stock represent more than 5% of one’s holdings. In discussing those three stocks, the posting made the point that while 5% is a reasonable target for a maximum portfolio weight, it shouldn’t automatically imply selling winners.

Now, here’s what I find so curious. More than twice as many people read the posting that addressed how to manage positions in only three stocks as read the posting that discussed the general principle that applies to all stock holdings. The question is: Does that imply that investors are more focused on individual gains and losses from a specific holding than how to improve their overall portfolio performance? If so, this posting which focuses on four individual stocks should attract a reasonable readership.

One other thing is worth noting: While many postings will argue that a stock is a buy or a sell, this posting places a major emphasis on identifying when stocks are a hold. Inaction such as just holding a stock should be the result of a conscious decision, not neglect or a focus on an alternative situation. All four of the stocks discussed in this posting are a hold, but hopefully identifying why they are being held is valuable to investors. If nothing else, it implies that, for me, they are neither a buy nor a sell. That’s quite different from the brokerage hold identification which is often nothing more than an acknowledgment that they can’t recommend buying the stock but they’re afraid to recommend selling. The hold in this posting was actionable not a placeholder. I am long all of the positions mentioned in this posting and have handled them exactly as described.

However, as should be clear from the presentation, my decisions to hold the stocks are based upon a total portfolio and a long-term approach. Every investor should undertake his or her own due diligence in deciding what stocks to buy or sell. The same should be equally true of which stocks to hold.

Disclosure: I am/we are long JNJ,MSFT, HON, PPG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This posting describes how positions in these four stocks have been managed. The stocks are a part of a larger portfolio of about 40 stocks.

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