I always keep an eye out for appealing investment opportunities. That is quality businesses which are on sale. Unfortunately quality is rarely on sale. The reason is that people usually accept to pay a premium for a great product. Let it be suits, cars or stocks. Luckily every now and then, we are able to find some good bargains. With recent volatility, Mr. Market has served a tempting opportunity to invest in two high-quality companies. On November 16, I’ve initiated a position in BlackRock Inc (BLK), acquiring 4 shares for a total investment of €1,403.22 ($1,585.63). Following the same day, I’ve also purchased 7 shares of General Dynamics Corp (GD) for a total investment of €1,108.85 ($1,253.00). Both are new positions in my SF portfolio. In the following, I would like to shed more light on these two acquisitions.
With $6.444 trillion in AUM (Assets Under Management) BlockRock is the largest asset manager in the world. Primarily we know BLK through its iShares ETF family. Overall the company is benefiting from the trend towards passive managed products, which begun roughly two decades ago. Their business model is pretty straightforward though. BLK earns money by charging fees on the investments the company manages for its clients. Easy and clear. Furthermore BlackRock delivers strong fundamentals across the board.
BLK managed to grow its earnings from $13.68 in 2012 to $22.60 in 2017. This equals a CAGR of 10.56%. Beyond that the revenue has increased from $9.34 Bil. to $12.49 Bil. in the same period, which is a CAGR of 5.98%. Not overwhelming, but solid organic growth. The operating performance has been outstanding, however. BLKs 5-Yr. average operating margin is sitting at 41.06% and has been growing steadily over the course of the past five years. This indicates a strong economic moat. In addition the 5-Yr. average return on equity is 12.90%. A decent value, especially when considering the low debt/capital ratio of 13%. BLK has a wide-economic-moat rating according to Morningstar and Standard & Poor’s assigns a fantastic AA- credit rating. All in all, there is a lot to like about this well-run business.
On top of that, the dividend metrics are promising. BlackRock is a dividend contender with 9 years consecutive dividend hikes. The 5-year dividend growth rate is 10.8%, which is more or less in line with the earnings CAGR. BLK offers a compelling dividend yield of 3.10%. With the current payout ratio being at 45%, there is plenty of room for further dividend increases.
BLK is trading at a significant discount to its own historical valuation. FastGraphs shows a current P/E ratio of 15.3, compared to the normal 5-Yr. based P/E ratio of 18.7. We derive the degree of undervaluation by using both figures: 15.3/18.7 = 0.82 (Price/Fair Value ratio). So from this perspective, BLK is 18% undervalued. Morningstar, an independent investment research company, uses the DCF-method fo calculate the fair value. It awards BlackRock a 4-star rating, with a fair value estimate of $540. So according to Morningstar, BLK is 23% undervalued.
An investment in BlackRock comes not without risk. Please consider following major risks, when initiating a position in BLK:
- Dependency from economic cycles/interest rates. Dramatic market movements, linked to an economic slowdown, might have an impact on BLKs earnings and cash flows. Since 85% of the annual revenue is derived from fees on the AUM, any substantial fund outflow hurts BLKs profits. This was the case in mid-October, when institutional clients sent down the stock price by withdrawing money from index and active fund in total value of $24.8 billion.
- Increased competition in the ETF segment. We observe an intensifying competition among the ETF providers over the recent years. While this is good for clients, it is rather challenging for businesses engaged in this field. Asset manager have to keep expense ratios at a very low level if they want to compete with a growing field of rivals. However fees represent a major source of revenue for companies like BlackRock.
General Dynamics is a Virginia-based aerospace and defense company. GD produces submarines, armored vehicles, business jets and a wide range of information systems and technology. I like the large diversification of their operations. GD runs five segments: aerospace (24% of revenue), combat systems (16%), marine systems (23%), information technology (25%), and mission systems (12%). Moreover GD is not a pure defense constructor. With its famous Gulfstream business jets, the company enjoys a leading position in the corporate jet market. In 2018, GD acquired CSRA, a manufacturer of IT and mission support solutions, to strengthen its information systems and technology segment. Without further ado, let’s have a look on the fundamental aspects of the business.
GD increased its earnings from $6.48 in 2012 to $9.95 in 2017, which is CAGR of 8.96%. In the same period the revenue was basically flat – 2012: $33.99 billion VS. 2017: $33.97 billion. It would be great to see at least some low single-digit organic growth, no doubt about it. Let’s observe how efficient GD has used its capital to generate earnings. The 5-Yr. average operating margin is 13.10% and shows a positive trend over the course of the past five years. In addition the 5-Yr. average return on equity is 24.23%. This is outstanding, considering the very low portion of GDs 25% debt in relation to total capital. GD earns a wide-economic-moat rating according to Morningstar and an excellent A+ credit rating by Standard & Poor’s. Those are some high-quality aspects.
Beyond that, GDs dividend characteristics are quite strong. The company has managed to increase its dividend 27 years in a row. That qualifies GD as a dividend champion. Moreover the dividend growth rate of the past five years is 10.4%. The chances are good that GD will continue with double-digit growth, since the payments are easily covered by a low payout ratio of 35%. GDs offers a decent forward dividend yield of 2.10%.
When looking at the historical valuation, GD seems to be a fair deal. According to FastGraphs the current P/E ratio is 16.2. The normal 5-Yr. based P/E ratio is 15.9. Doing the math we get a Price/Fair Value ratio of 1,02 (=16.2/15.9). This implies that GD is fairly priced at the moment. Morningstar, which is using a DCF-based method, comes to a different result. The research powerhouse awards GD a four-star rating, saying that the stock is 17% undervalued.
It is important to be aware of the risk that is linked to a certain investment. Overall, I see the following major drawback in this case:
- Political uncertainty. The U.S. Department of Defense (DoD) decides about spending and thus about the demand for defense products. Therefore any major reduction in U.S. defense budget might have a negative impact on GDs earnings and cash flows.
Both BLK and GD are great companies. I perform a quality rating to observe the fundamental strength of a business. BLK scored 80 points (out of 100), while GD achieved 77 points (out of 100). This qualifies both firms as attractive four-star stocks (good quality) in my grading system. In addition both candidates appear to be undervalued. BLK to a larger degree than GD. Of course there are risks that could justify the undervaluation. BLK, as well as other U.S. based asset managers, had a difficult year so far. Fund outflows and general concerns about the economy and raising interest rates have weighed on the stock. In terms of GD, investors worry about political uncertainty and defense spending. In fact, we might see further drops in share prices due to volatility of the whole market. But for a long-term investor, the current prices offer an attractive opportunity to invest in two high-quality businesses.
Disclosure: I’m long BLK and GD.