Recap from June’s Picks
Our Most Attractive Stocks (-2.4%) underperformed the S&P 500 (-0.7%) from June 3, 2020 through June 30, 2020 by 1.7%. The best performing large cap stock gained 8% and the best performing small cap stock was up 20%. Overall, 14 out of the 40 Most Attractive stocks outperformed the S&P 500.
Our Most Dangerous Stocks (-3.7%) outperformed the S&P 500 (-0.7%) as a short portfolio from June 3, 2020 through June 30, 2020 by 3%. The best performing large cap stock fell by 19% and the best performing small cap stock fell by 28%. Overall, 18 out of the 28 Most Dangerous stocks outperformed the S&P 500 as shorts.
The Most Attractive/Most Dangerous Model Portfolios outperformed as an equal-weighted long/short portfolio by 1.3%.
Only our research utilizes the superior data and earnings adjustments featured by the HBS & MIT Sloan paper, "Core Earnings: New Data and Evidence.” The successes of these model portfolios highlight the value of our machine learning and AI Robo-Analyst technology[1], which helps clients fulfill the fiduciary duty of care and make smarter investments[2].
13 new stocks make our Most Attractive list this month, and six new stocks fall onto the Most Dangerous list this month. July’s Most Attractive and Most Dangerous stocks were made available to members on July 2, 2020.
Our Most Attractive stocks have high and rising returns on invested capital (ROIC) and low price to economic book value ratios. Most Dangerous stocks have misleading earnings and long growth appreciation periods implied by their market valuations.
Most Attractive Stocks Feature for July: The Hanover Insurance Group, Inc. (THG: $93/share)
The Hanover Insurance Group, Inc. (THG) is the featured stock from July’s Most Attractive Stocks Model Portfolio.
The Hanover Insurance Group has grown revenue by 5% compounded annually and after-tax profit (NOPAT) by 7% compounded annually over the past decade. More recently, The Hanover Insurance Group’s NOPAT has grown by 39% compounded annually since 2012.
The Hanover Insurance Group’s NOPAT margin increased from 1% in 2012 to 7% over the trailing-twelve-months (TTM) while ROIC rose from 1% to 11% over the same time.
Figure 1: Revenue & NOPAT Since 2009
Sources: New Constructs, LLC and company filings
THG Is Undervalued
At its current price of $93/share, THG has a price-to-economic book value (PEBV) ratio of 0.6. This ratio means the market expects The Hanover Insurance Group’s NOPAT to permanently decline by 40% over the remaining life of the firm. This expectation seems overly pessimistic for a firm that grew NOPAT by 2% compounded annually over the past five years and 7% compounded annually over the past decade.
Even if The Hanover Insurance Group’s NOPAT margin falls to 5% (five-year company average vs. 7% TTM) and the firm grows NOPAT by just 1% compounded annually for the next decade, the stock is worth $171/share today – a 84% upside. See the math behind this reverse DCF scenario.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings as shown in the Harvard Business School and MIT Sloan paper, "Core Earnings: New Data and Evidence”.
Below are specifics on the adjustments we make based on Robo-Analyst findings in The Hanover Insurance Group’s 2019 10-K:
Income Statement: we made $116 million of adjustments, with a net effect of removing $94 million in non-operating income (2% of revenue). You can see all the adjustments made to The Hanover Insurance Group’s income statement here.
Balance Sheet: we made $929 million of adjustments to calculate invested capital with a net increase of $419 million. One of the largest adjustments was $539 million in asset write-downs. This adjustment represented 18% of reported net assets. You can see all the adjustments made to The Hanover Insurance Group’s balance sheet here.
Valuation: we made $154 million of adjustments with a net effect of decreasing shareholder value by $154 million. There were no adjustments that increased shareholder value. Apart from total debt, the most notable adjustment to shareholder value was $100 million in deferred tax liabilities. This adjustment represents 3% of The Hanover Insurance Group’s market cap. See all adjustments to The Hanover Insurance Group’s valuation here.
Most Dangerous Stocks Feature: Marvell Technology Group Ltd (MRVL: $38/share)
Marvell Technology Group Ltd (MRVL) is the featured stock from July’s Most Dangerous Stocks Model Portfolio.
Marvell Technology Group’s NOPAT has declined from $385 million in fiscal-year-end (FYE) 2018 to -$171 million TTM. Marvell Technology Group’s NOPAT margin fell from 16% in FYE 2018 to -6% TTM while ROIC declined from 11% to -2% over the same time.
Figure 2: NOPAT Since 2018
Sources: New Constructs, LLC and company filings
MRVL Provides Poor Risk/Reward
Despite its deteriorating fundamentals, MRVL is still priced for significant profit growth and is overvalued.
To justify its current price of $38/share, Marvell Technology Group must achieve a 13% NOPAT margin (above 10-year average of 10% vs. -6% TTM) and grow revenue by 20% compounded annually over the next decade. See the math behind this reverse DCF scenario.
This expectation seems overly optimistic given that Marvell Technology Group’s revenue has only grown by 2% compounded annually over the past five years, and consensus estimates for year-over-year revenue growth for FYE 2021-2023 fall between 11% and 16%.
Even if Marvell Technology Group can achieve margins of 13% and grow revenue by 12% compounded annually for the next 10 years, the stock is worth just $19/share today, a 50% downside to the current stock price. See the math behind this reverse DCF scenario.
Each of these scenarios assumes Marvell Technology Group is able to grow revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is unlikely, but allows us to create best-case scenarios that demonstrate how high expectations embedded in the current valuation are.
Critical Details Found in Financial Filings by Our Robo-Analyst Technology
As investors focus more on fundamental research, research automation technology is needed to analyze all the critical financial details in financial filings as shown in the Harvard Business School and MIT Sloan paper, "Core Earnings: New Data and Evidence”.
Below are specifics on the adjustments we make based on Robo-Analyst findings in Marvell Technology Group’s FYE 2020 10-K:
Income Statement: we made $2.1 billion of adjustments, with a net effect of removing $1.7 billion in non-operating income (62% of revenue). You can see all the adjustments made to Marvell Technology Group’s income statement here.
Balance Sheet: we made $3.3 billion of adjustments to calculate invested capital with a net decrease of $486 million. One of the largest adjustments was $754 million for midyear acquisitions. This adjustment represented 7% of reported net assets. You can see all the adjustments made to Marvell Technology Group’s balance sheet here.
Valuation: we made $2.3 billion of adjustments with a net effect of decreasing shareholder value by $1.2 billion. Apart from total debt, the most notable adjustment to shareholder value was $44 million in outstanding employee stock options. This adjustment represents 1% of Marvell Technology Group’s market cap. See all adjustments to Marvell Technology Group’s valuation here.
This article originally published on July 10, 2020.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation to write about any specific stock, style, or theme.
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[1] Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.
[2] Compare our analytics on a mega cap company to Bloomberg and Capital IQ’s (SPGI) analytics in the detailed appendix of this paper.