You might have heard analysts and investors saying the U.S. stock market is in the “late innings” of the bull cycle.
Tom Plumb, who runs the Plumb Balanced Fund, says instead that the market is “bifurcated” into “haves” and “have nots.” The “haves” are companies that “generate tremendous free cash flow with recurring revenue streams,” he said. (Free cash flow is cash flow after planned capital expenditures.)
The “have nots” include slow growers, even if they are considered value stocks, and the cyclical companies that have been replaced “as the most important movers of the markets,” he said in an interview Feb. 27.
He made it clear that the “haves” are still where investors should look for profitable investments.
He also made the point that levels of high-yield, or junk, debt are increasing, while the group of “haves” that have dominated the S&P 500 Index SPX, -0.28% during this long growth cycle — Microsoft MSFT, +0.01% Apple AAPL, +0.01% Amazon AMZN, +0.04% Alphabet GOOG, -0.01% GOOGL, -0.11% and Facebook FB, +0.01% — “shows debt-to-EBITDA levels of 1.57 now versus 3.9 20 years ago.” EBITDA stands for earnings before interest, tax, depreciation and amortization.
Together, the above companies make up about 15% of the S&P 500’s market capitalization. That dramatic decline in debt to EBITDA underlines how important cash-flow generation has been to those tech giants’ success. The Plumb Balanced Fund PLBBX, +0.16% held positions in all of the above companies except for Apple and Facebook as of Dec. 31.
“Apple is in the process of trying to establish recurring revenue streams and going form a hardware company to a software and subscriptions company. They have a long way to go, but obviously the most profitable company in the world has the potential to do it,” Plumb said.
He considers Alphabet (Google’s holding company) and Facebook to be a “duopoly,” but sees greater political and regulatory risk to Facebook in a “new environment” when it comes to user privacy.
“They may prevail, but we are avoiding Facebook,” he said. He says Alphabet “doesn’t quite have the same level of political risk that Facebook has. They have the potential to be more of an international player.”
An update
Plumb spoke with MarketWatch in May, when he said he favored credit-card transaction processors, including Visa V, +0.61% Mastercard MA, +0.09% and Discover Financial Services DFS, +0.51% Here’s how they performed from May 14 (the day before the previous article was published) through Feb. 26:
A period of less than a year is, of course, a relatively short one for a long-term investor, but there is no question that Discover has lagged behind the others. Despite running its own card-transaction-processing business, Discover is quite different from Visa and Mastercard because it is also a bank holding company — it makes credit-card loans. Plumb said that during 2018, Discover’s loan portfolio was “continuing in high single digits, but their charge-offs [loan losses] and delinquency rates seemed to be going up.” He also said Discover’s profits suffered as the company paid more than it expected to merchants to accept its cards.
“The dialogue in the fall was the U.S. going into recession,” Plumb said. “But, now, we look at a company with an 8 or 9 price-to-earnings (P/E) ratio and think it is pretty darn attractive.”
He is “very positive” on Discover this year, because “charge-off rates are coming down again” and loan growth remains “robust.”
Discover’s shares trade for 8.1 times the consensus earnings estimate for the next 12 months, among analysts polled by FactSet. That is very low when compared with forward P/E ratios of 25.9 for Visa and 28.9 for Mastercard. But the higher valuations for Visa and Mastercard are in line with what investors expect for rapidly growing businesses that are much less capital-intensive than banks, including Discover. Here’s how the three companies’ forward P/E valuations have fluctuated over the past year:
Plumb also remains committed to Visa and Mastercard, which are the two top holdings of the Plumb Balanced Fund PLBBX, +0.16% and the Plumb Equity Fund PLBEX, -0.35% The balanced fund has a five-star rating, the highest, from Morningstar, and the equity fund has a four-star rating.
When asked about the potential for Visa and Mastercard to be threatened by competing transaction processors and new technology over the long term, he said that the companies, with their bank partners, “offer us a limit on our liability if there is fraud or hacking. That is huge and still a significant backbone.”
Unusual approach for a balanced fund
Managers of balanced funds believe that overall risk can be reduced by having a mix of stocks and bonds in a portfolio, while not giving up very much performance potential when compared with an all-equity portfolio.
Plumb said his style differs from those of many other balanced-fund managers.
“Some take a fair amount of risk in the fixed-income area and have value-oriented or more conservative equity strategies. Our perspective is take the volatility in your stocks rather than add risk with bonds. This means looking for growth companies, [while being] more conservative in our debt exposure than our competition.”
Comments about other companies
Plumb spoke about several more companies, focusing on business models that led to rapid increases in recurring revenue, with the first three tied to “the digital revolution,” and the fourth a very long-term play on emerging markets:
Disney
Walt Disney DIS, +0.05% is preparing to launch its own streaming service to compete with Netflix NFLX, -1.31% It’s a tall order to go toe-to-toe with the streaming pioneer, but Plumb said that after the turmoil in video-content distribution plays out, “content will be king again and no one has more content offerings than Disney.” Disney’s content includes not only its own live-action and animated movies, but Pixar, Marvel Entertainment, the Star Wars franchise, ESPN and ABC.
Plumb emphasized that “Netflix continues to have negative cash flow.” Disney’s strong financial position means it can eventually “become a meaningful player” in the disruptive internet entertainment distribution industry, he said.
PayPal
Plumb likes PayPal PYPL, +0.21% because it is “growing in the high teens at the revenue line,” and its cash flow “equals one-third of revenue.” The company’s sales increased 18% during 2018. Plumb cited the company’s success with Venmo and said its valuation at 32.6 times forward earnings “doesn’t reflect the size and potential for the digital and mobile peer-to-peer and peer-to-business marketplace.”
Adobe
Adobe ADBE, -0.15% has been making a very successful transition to subscription revenue from the old packaged-software distribution model. The company’s total sales increased 23% in 2018, while its subscription sales were up 29%. Earnings per share were up 37% last year (boosted by the cut in the top federal corporate income-tax rate to 21% from 35%). For 2019, the consensus among analysts is for Adobe’s earnings to increase by 16%, followed by a 24% increase in 2020.
Shares of Adobe trade at a forward P/E of 31.6. “When you look at the growth rate and the predictability because of the subscription model, I think people will pay 30 times earnings for quite a long time,” Plumb said.
Boeing
Plumb made an interesting point about Boeing BA, +1.04% : “Every time our president travels some place, part of that trip involves a quantification or new order for Boeing airplanes.” Sure enough, on Feb. 27, after President Trump arrived in Vietnam to meet with North Korean leader Kim Jong Un, Bamboo Airlines of Vietnam confirmed a $3 billion order for 10 787-9 Dreamliners and a $12.7 billion order for an additional 100 737 MAX airplanes.
One of many fascinating facts about Boeing is how long some of its product life cycles can be. The company rolled out its first 737 model in 1967 and delivered 580 of them in 2018, up from 529 in 2017 and 490 in 2016. And the company’s back orders continue to increase.
Boeing’s commercial sales tend to make the headlines, but Plumb said the company continues to score new international deals for military hardware and said the U.S. Air Force’s plan to buy upgraded F-15X fighters from Boeing illustrates the health of the company’s military business. The first F-15 model was introduced into service in 1972.
Boeing’s free cash flow per share over the past four reported quarters has totaled $23.55, according to FactSet. Plumb believes it can climb to $30 a share by 2020.
