Librarian Capital's Monthly Ranked Top Buys - September 2023

Portfolio Strategy

Introduction

This is the September edition of our "Monthly Ranked Top Buys“ series, designed to present a model portfolio based on a selection of our most-preferred stocks. Two months have lapsed since the last edition in July, and during this period we have continued our research and made several changes in our actual portfolios. The changes to the “Select 15” model portfolio outlined in this edition reflects what we have done in real life in recent months.

We have also modified the layout of this newsletter significantly, bringing it much closer to what we use in our actual portfolios. (The transition is incomplete as we are still backfilling past data.) This will allow us to use the same systems for everything and should ultimately be more efficient; we also hope the new format is more informative and user-friendly.

Performance Update

The “Select 15” model portfolio is currently up 17.5%. Beginning with a notional $1m at the start of 2023, its total value now stands at $1.175m, gaining a further 3.8% since the last edition of this newsletter on July 9:

The current holdings, in descending order of size listed along with their realised and unrealised returns, are as follows:

Realised returns are significant for Microsoft, Admiral and Philip Morris because we have made partial exits in previous months; they are smaller for other stocks where the only realised returns to date are dividends.

For completeness, below are the three positions we have exited in the past, all at significant profits:

Portfolio Changes

We are making changes to our list of most preferred stocks, replacing two entirely and reordering others:

The “Select 15” model portfolio we construct from this list follows some simple rules, with a 10% weight for each of the top 5 stocks, 6.5% each for the next 5 stocks and 3.5% each for the last 5 stocks (but no automatic rebalancing).

The changes in our list shown above therefore imply the following portfolio changes:

• Exiting Charter and JPMorgan completely

• Reducing Mastercard from 10.1% to 6.6%

• Increasing Philip Morris from 6.5% to 10.0%

• Increasing Diageo from 2.7% to 6.5%

• Initiating Estée Lauder as a new 3.5% position

• Initiating British American Tobacco as a new 3.5% position

We are exiting Charter after shares have gained 24% year-to-date and following the breakdown of contract discussions with Disney last week, which led to the first programming “blackout” of scale for Charter since at least 2010. While we still see Charter shares as attractive, the higher share price and elevated risks mean we now see better risk/reward elsewhere. We do expect the dispute to be resolved eventually and in Charter’s favour, but it may delay management’s ongoing efforts to reaccelerate growth and have an outsized P&L impact due to operational leverage.

We are exiting JPMorgan after shares have gained 17% (including dividends), in order to reduce the weight of Financials in our portfolio ahead of Basel III regulatory changes and a potential U.S. recession. Compared to Bank of America, the other U.S. bank in our portfolio, JPM has a higher valuation and a lower forecasted return.

We are initiating Estée Lauder (“EL”) as a new position after shares hit their lowest level since March 2020, at the start of the COVID-19 outbreak in the West. EL is a great business, with a history of growing EPS at 10%+ annually, but recently laid low by both macro in China and bad management, and consequently now trades at the valuation of an average business. Execution may take time to improve and there may be some bad news left, but we believe structural demand growth and the underlying strength of EL’s franchises will ensure the business recovers eventually.

With shares at $156.58, our forecasts indicate a 49% total return (15.6% annualized) by June 2026, mostly driven by a its Non-GAAP EPS returning to $7.47 in FY26 (compared to $7.24 in FY22), helped by the P/E re-rating from 21.6x (relative to FY22; 29.6x relative to FY23) to 30.0x and dividends, which currently represent a 1.7% yield.

We are initiating British American Tobacco (“BAT”) as a new position after shares hit their lowest level since November 2021. With a 6.9x P/E and an 8.9% Dividend Yield, we believe shares are currently priced for a severely adverse outcome that is unlikely due to BAT’s broad franchise, including in Reduced Risk Products. Next to Philip Morris, BAT has the only sizeable global Heated Tobacco franchise (glo); BAT also leads Vapour globally with Vuse, which is also #1 in the U.S. Vapour market. The main risk is regulatory, with fears that the FDA will not approve BAT’s main Vuse products and/or will succeed in banning menthol cigarettes; the former is not necessarily negative for BAT (as any attack on Vapour would protect its cigarette sales), and both are low-probability. A related fear is on disposable e-cigarettes, which have low barriers to entry and can be negative for sector profitability, but we similarly expect rational regulation to ultimately prove to be positive for BAT. H1 2023 results included sharp volume and revenue declines in the U.S., but we see these as the result of over-aggressive prior-year cigarette price increases and believe things have normalized.

With BAT shares at 2,583.5p, our forecasts indicate a total return of 115% (29.7% annualized) by 2026 year-end, largely driven by the P/E returning to 10.0x and dividends; we assume EPS will only grow with a 5.4% CAGR across 2022-26.

We are adding to our Philip Morris and Diageo positions because share price movements have made the two stocks relatively more attractive. Diageo, in particular, is at its lowest level since April 2021 and has a 19.5x P/E, in our opinion due to investor concerns about a near-term reversal in global Spirits demand. We believe Diageo did not over-earn in materially in FY23 and expects any market slowdown to be temporary; related to fears about consumption in China, we note that Greater China generated less than 5% of Diageo’s Net Sales in FY23. Similarly, we are reducing Mastercard for valuation reasons. (See the appendix for a reminder of the investment cases for all of these.)

The actual transactions to be carried out, including the numbers of shares and prices, are as follows:

The “Select 15” portfolio, at present and after the trades outlined above, looks as follows:

Existing Holdings Update

Below is an update on each of our existing holdings that remain in the portfolio, in the order of their latest ranking:

Visa continues to be on track. For July and August 1-28, its U.S. Payments Volume was at 155% and 154% of 2019 levels respectively, and its Cross-Border ex. Intra-Europe volume was similarly at around 150% of 2019 levels for both months. For April-June (its Q3 FY23), it reported strong results where Net Revenues grew 11.7%, Non-GAAP Net Income grew 7.0% and Non-GAAP EPS grew 9.5% year-on-year (the latter two lagging due to a higher tax rate).

Alphabet is progressing as expected, with revenue growth currently below long-term trends due to an advertising slowdown (particularly for e-commerce and SMBs), but cost efficiency improving and earnings growth strong as reported (helped by an accounting change that has reduced equipment depreciation). During Q2 2023, total ad revenues grew 3.3% in dollars (likely around 5% in constant currency), Google Cloud revenues grew 28.0%, and total revenues grew 7.1%. Group EBIT grew 12.3%, or 7.3% excluding the accounting change.

Admiral’s investment case has progressed faster than we expected. H1 2023 results showed prices have been raised decisively and the benefit is now materializing in the P&L. U.K. Motor Profit Before Tax (“PBT”) was 2.5% higher year-on-year, with a slightly worse Loss Ratio Before Reserve Releases (310 bps worse, to 92.7%) more than offset by higher reserve releases and higher Investment Income. The number of vehicles fell 7.4%, but the business is becoming more competitive as peers increasingly follow with their price increases. Group PBT was 4.1% higher year-on-year, as most other businesses also improved; the perennially disappointing (but small) U.S. business is now under review.

Microsoft had strong Q4 FY23 (April-June) results, with its two enterprise-focused segments (Productivity & Business Processes and Intelligent Cloud) growing revenues by 10.2% and 15.3% in dollars year-on-year respectively. (Sales in the lower-margin More Personal Computing fell 3.8%, due to a weak PC market.). Group Adjusted EBIT grew by 18.1% (with 4 ppt from an accounting change). Full-year FY23 Adjusted EPS growth was 6.5% in dollars and 12% excluding currency, despite the time lag in cutting costs. Q1 FY24 guidance implies a 12% EBIT growth year-on-year. Efforts to secure regulatory approval for the Activision acquisition seem to be making progress.

Philip Morris’s “(“PM”) share price has been weak since July. This is likely due to currency headwinds, with the U.S. Dollar rising by around 5% against the Euro and 6% against the Japanese Yen since mid-July. Operationally, PM is on track, with strong Q2 2023 results where Adjusted EBIT grew 9.6% year-on-year in dollars (helped by the Swedish Match acquisition) and 6.9% organically. PM’s lead in Reduced Risk Products is strengthening, with its Heated Tobacco and Nicotine Pouches each growing volumes by strong double-digits year-on-year (26.6% and 13.8% respectively) and gaining further category share (around 75% by volume in Heated Tobacco; 77% by value in U.S. Nicotine Pouches).

Mastercard also continues to be on track. Its more recent volume growth is likely to be as strong as the solid trends reported by Visa (described above). For Q2 2023, its Net Revenues grew 14.2%, Adjusted EBIT grew 15.7%, though Adjusted Net Income grew only 10% due to a higher tax rate. Adjusted EPS grew 13% year-on-year after buybacks.

Bank of America’s (“BAC”) share price is down 13% from a peak it reached on July 24 (the week after Q2 2023 results), though down just 1% from our last newsletter on July 9. Its Price / Tangible Book Value is now back to 1.22x. The most likely explanation is that investors now have lower expectations for interest rates and see this as negative for BAC. (This view is too simplistic, as BAC’s investment banking franchises will benefit from lower rates.) The pending finalization of Basel III rules, currently expected to imply a 19% increase in capital requirements for large banks, can also be a factor. Q2 results were strong, with a Return on Tangible Common Equity of 15.5%; deposits were broadly stable, Net Interest Income fell 2% sequentially but was guided to be more stable in H2.

RTX (formerly Raytheon) shares are currently at their lowest level since October 2022, falling 10% on the day of Q2 2023 results (July 25) and losing another 4% since. The culprit was a “powdered metal” issue disclosed with the results.

This was a production issue (“microscopic” contaminants) confined to a limited period (Q4 2015 into Q3 2021) that only matters in a certain part in one particular engine type (high-pressure turbine disc in GTF engines) and has been known since 2021. Until July, all parties were content to let the issue be resolved naturally over time (by replacing the part as each engine comes in for routine inspection), but new data from a December 2022 incident resulted in a change of mind. Because of this, RTX expected to spend $500m to inspect 200 “suspect” engines (subsequently revised down to 137) by mid-September, with another 1,000 potentially to be inspected “within the next 9 to 12 months”.

The inspections and related repairs are relatively simple and cheap; the main potential cost is compensation RTX will have to pay to airlines for disrupting their business. Data from the first 200 inspections will also determine what happens on the other 1,000. As such, the total costs are hard to predict, but certainly manageable for RTX (which generated $6bn of Free Cash Flow in 2019 and had expected to generate $9bn in 2025) and may not even affect 2025 FCF.

While this is a negative development, we see it as an unavoidable risk for all aerospace companies, and do not believe it significantly changes the long-term RTX investment case.

PayPal shares are currently down 16% year-to-date, having recovered in June-July but subsequently falling back. We believe the turnaround is heading in the right direction, but progress is inevitably slow and evidence is mixed. Q2 2023 showed good volume growth of 11%, with a mix shift towards lower-margin though strategically important unbranded processing. Year-on-year comparisons look worse due to prior-year one-offs, including merchant compensation payments and currency hedge gains. Management stated that Net Transaction Revenues grew at a low-single-digit excluding one-offs and there was no Take Rate pressure on a like-for-like basis, which showed the business was at least stable. The next CEO has been identified (long-time Intuit executive Alex Chriss) and we consider him a good fit.

Diageo shares are back to levels last seen in April 2021. The weakness is sector-wide and can also be observed in other Spirits stocks including Pernod Ricard and Rémy Cointreau. We believe investors are fearful of a near-term reversal in global Spirits demand following strong growth during the pandemic years. Diageo reported strong growth for full-year FY23, with organic growth exceeding 6% for both Net Sales and Adjusted EBIT. While this implies a deceleration from H1 (when organic growth exceeded 9% for both), year-on-year comparisons are much less meaningful this year because of supply chain disruptions and other inventory moves last year. We believe increasing Spirits demand and premiumization remain powerful structural trends, and draw assurance from Diageo’s FY19-23 Net Sales CAGR (of 8%) being geographically broad-based and only slightly above long-term trends.

Rightmove shares have bounced back since late-June lows, but remain nearly 29% below their December 2021 peak. Investors fear the impact of a weaker U.K. residential property market, with house prices having fallen for 5 consecutive months as of August (to 4.6% lower year-on-year). In reality, the relationship between Rightmove earnings and U.K. house prices is far from linear, as a weaker market requires developers and estate agents to spend more on marketing; Rightmove also has a growing business serving the lettings market, where rents have continued to rise strongly. H1 2023 results provided a good example of these dynamics, with revenues growing 10.3% and Underlying EBIT growing 8.8%. New CEO Johan Svanstrom also presented his strategy and reiterated the goal of double-digit growth.

Otis’s operations are on track. On an adjusted basis (excluding Russia), Q2 2023 Net Sales grew 7.7% (9.5% organically) and EBIT grew 9.1%. Maintenance & Repair sales grew 9.1% organically, helped by a 4.2% unit growth in its install base. Across H1, Adjusted EPS grew 6.2%. FY23 outlook was raised slightly, with Adjusted EPS growth now expected to be 9-10%.

NatWest shares have now fallen 16.0% year-to-date, following a tumultuous last few months which ultimately saw the departure of CEO Alison Rose. The immediate cause for her exit was a controversy around NatWest withdrawing services from a U.K. rightwing politician (Nigel Farage), but it is a symptom of the political pressure that U.K. banks are under, worse in NatWest’s case because the U.K. government still owns a 38.7% stake. Other government populist interventions have included a  voluntary agreement to pause mortgage repossessions and a FCA initiative to boost interest rates on consumer deposits, though these seem to have little real impact. Falling U.K. house prices is also a negative for U.K. banks. Operational performance has remained solid so far, with a Return of Tangible Equity at 18.2% in H1 and guided to the “upper end” of 14-16% for the full year, broadly stable deposits, Q2 Net Interest Margin rising 7 bps sequentially and Net Interest Income falling just 2.7% from Q1.

Most of the bad news were within our expectations (except the Nigel Farage controversy), and in our view has been priced into NatWest’s low valuation (currently at 0.87x Tangible NAV). We expect to make money in NatWest shares over time by being patient investors, despite the short-term pain from recent share price movements.

Appendix: Summary of Investment Cases

Below is summary of the investment cases for all of the stocks in our latest “Select 15” list. Note the forecasted returns are illustrative only and reflect base-case scenarios, which come with different probabilities for different stocks. A higher forecasted return thus by no means imply a better investment.

1.     Visa

Our investment case on Visa is that EPS growth will be at mid-teens or higher, driven by growth in electronic payments in consumer expenditures, new payment flows and value-add services. We assume the exit P/E will be 35x.

With shares at $246.16, our forecasts indicate an 84% total return (22.3% annualized) by September 2026, mostly driven by a ~14% EPS CAGR, helped by an upward P/E re-rating (from the current 30.8x) and the 0.7% Dividend Yield.

2.     Alphabet

Our investment case on Alphabet is that its EPS growth will average low-teens over time (but with a flattish 2023), driven by Google Advertising growing faster than GDP, operational leverage, as well as Google Cloud reaching more normal margins and some of the Other Bets also turning profitable eventually. We assume an exit P/E multiple of 30x.

With (Class C) shares at $135.37, our forecasts indicate a 59% total return (15.0% annualized) by 2026 year-end, mostly driven by a ~12% EPS CAGR, helped by the P/E re-rating upwards from the present 28.9x.

3.     Admiral

Our Admiral investment case is it will resume its long-term mid-to-high single-digits EPS growth once cyclical headwinds (elevated inflation and the time tag for the entire customer base to reprice to new rates) have passed. Normal earnings growth will largely be driven by the U.K. Motor business, from a combination of industry volume growth, moderate price increase and Admiral market share gains. Admiral’s U.K. underwriting margin is underpinned by its cost advantage over competitors. We expect Admiral’s P/E to recover to 20x.

With shares at 2,404p, our forecasts indicate a 57% total return (15.4% annualized) by 2026 year-end, driven by earnings recovery then growth, helped by the 4.2% Dividend Yield, but offset slightly by the P/E falling from 20.9x (relative to H1 2023 EPS).

4.     Microsoft

Our investment case on Microsoft is that its EPS growth will be at low-teens (lower than the 20%+ in FY17-22), driven by technology spend growing at 2x GDP, Microsoft gaining market share, and operational leverage. We assume the P/E multiple will be 35x at exit.

With shares at $332.88, our forecasts indicate a 47% total return (14.7% annualized) by June 2026, mostly driven by a ~12% EPS CAGR but helped by a 0.8% Dividend Yield, offset by a small de-rating (from the current 36.3x P/E).

5.     Philip Morris

Our Philip Morris investment case is that future EPS growth will be 8%+, driven by the traditional tobacco earnings algorithm, and potentially much higher if IQOS Heated Tobacco growth accelerates, including by entering the U.S. market in 2024. ZYN nicotine pouches may also surprise on the upside. We assume an exit P/E multiple of 20x.

With shares at $93.55, our forecasts indicate a 71% total return (18.9% annualized) by 2026 year-end, driven by an EPS CAGR of 7% (in dollars), dividends (currently a 5.4% yield) and a P/E re-rating (from 17.5x now).

6.     Mastercard

Our investment case on Mastercard is similar to that on Visa (outlined above), except we see a slightly higher EPS growth (but both around mid-teens) and assume a higher exit P/E (36.5x vs. 35x) for Mastercard.

With shares at $413.18, our forecasts indicate a 61% total return (15.6% annualized) by 2026 year-end, driven by a ~14% EPS CAGR and slightly helped by the 0.6% Dividend Yield, offset by the P/E de-rating from 38.2x to 36.5x.

7.     Bank of America

Our Bank of America (“BAC”) investment case is based on Return on Tangible Common Equity averaging 15% across the cycle, with BAC’s cheap deposits helping its Net Interest Income and its wholesale franchises helping its Non-Interest Revenues, while the Cost/Income ratio again improves. We assume the P/E multiple re-rates to 13.5x.

With shares at $28.39, our forecasts indicate a 103% total return (24.9% annualized) by 2026 year-end, driven mostly by a re-rating from the current 8.8x P/E. EPS growth (from earnings retained and buybacks) as well as the current 3.4% Dividend Yield, both add to returns. Our forecasts have not factored in potential higher capital requirements from Basel III, but BAC’s position behind other stocks with higher forecasted returns already reflects conservatism on the forecasts.

8.     RTX

Our RTX investment case sees high-single-digits long-term EPS growth, driven by recurring aftermarket sales in aerospace and long-cycle product sales in defence. Growth in the next few years should be modestly higher, as aerospace sales continue to recover from COVID-19. We base our forecasts on Free Cash Flow (“FCF”), and we expect this to recover then grow from $4.88bn in 2022 to $10bn in 2026. We assume a 5.3% FCF Yield (equivalent to a 19x multiple) at 2025 year-end.

For the “powdered metal” issue, we have included a $500m impact in 2023 (per management) and added a further $2bn impact in 2024, and also reduced our buyback forecasts for both 2024 and 2025 (by 1.5% and 1.0% respectively).

With shares at $83.51, our forecasts indicate a 74% return (19.0% annualized) by 2026 year-end, driven by FCF growth but offset by a FCF Yield expansion (from the current 3.4%), and helped by the 2.8% Dividend Yield.

9.     PayPal

Our PayPal investment case is for EPS growth to return to around 10% and for its P/E multiple to recover. Revenue growth will be driven by e-commerce market growth, historically at about 10%. PayPal should maintain or grow its share, and its EBIT margin should rise, including from ongoing cost efficiency. We assume investors will continue to value PayPal on Non-GAAP EPS, and use an exit P/E of 22.5x.

With shares at $62.80, our forecasts indicate a 136% total return (29.5% annualized) by 2026 year-end, driven by Non-GAAP EPS growing to $6.59 in 2026 (compared to $4.13 in 2022 and $4.95 guided for 2023) and a P/E re-rating (from 15.2x). The high forecasted return is offset by PayPal being a turnaround where success is highly uncertain.

10.  Diageo

Our Diageo investment case is that its EPS will grow at around 9% annually, driven by structural growth in the premium spirits market, Diageo market share gains, and modest margin expansion. We assume an exit P/E multiple of 25x.

With shares at 3,175.5p, our forecasts indicate a 67% total return (20.5% annualized) by June 2026, mostly driven by the 9% EPS CAGR, helped by a P/E re-rating (from the current 19.5x) and the 2.5% Dividend Yield.

11.  Rightmove

Our Rightmove investment case is for EPS to resume a 10%+ growth from 2024. Price increases and upgrades on the core product should generate a high-single-digit revenue growth through Average Revenue Per Agent, and customer volume should be stable to growing over time. Rightmove is also generating increasing revenues from other businesses, including commercial real estate listings, data services and mortgage referrals. EBIT margin should be stable at 70-72% (compared to 73.8% in 2022) after a step change from new investments. We assume a 27.5x P/E.

With shares at 565.20p, our forecasts indicate a 69% total return (17.3% annualized) by June 2026, mostly driven by an 9% overall EPS CAGR, helped by a P/E re-rating (from the current 23.7x) and the 1.5% Dividend Yield.

12.  Otis

Our Otis investment case is that its EPS will grow at high-single-digits in the long term, driven by structural growth in the install base, the rising value of services and annual price increases. EPS growth will be higher in the medium-term, thanks to post-spin-off work on cost savings and the tax rate. We assume an exit P/E multiple of 28x.

With shares at $84.39, our forecasts indicate a 60% total return (15.5% annualized) by 2026 year-end, mostly riven by a ~10% EPS CAGR, and helped by the 1.6% Dividend Yield and a P/E re-rating (from the current 26.3x).

13.  Estée Lauder

Our Estée Lauder (“EL”) investment case is that is a great business, with a history of growing EPS at 10%+ annually, but recently laid low by both macro in China and bad management, and consequently now trades at the valuation of an average business. Execution may take time to improve and there may be some bad news left, but we believe structural demand growth and the underlying strength of EL’s franchises will ensure the business recovers eventually.

With shares at $156.58, our forecasts indicate a 49% total return (15.6% annualized) by June 2026, mostly driven by a its Non-GAAP EPS returning to $7.47 in FY26 (compared to $7.24 in FY22), helped by the P/E re-rating from 21.6x to 30.0x and dividends, which currently represent a 1.7% yield.

14.  BAT

Our British American Tobacco (“BAT”) investment case is that its broad franchise, including in Reduced Risk Products, will protect its business in almost all scenarios. We believe it can grow Net Income at around 3% annually and that buybacks will resume in 2024, lead to a 6% EPS growth thereafter. We assume its P/E multiple will return to 10.0x.

With shares at 2,583.5p, our forecasts indicate a total return of 115% by 2026 year-end, largely driven by the P/E re-rating (from 7.0x at present) and dividends (which currently represent an 8.9% Dividend Yield).

15.  NatWest

Our NatWest investment case is that NatWest’s cheap deposits and improving Cost/Income ratio make it a solid business, while the stock is attractive even on relatively conservative assumptions. We expect a Return on Tangible Equity (“ROTE”) of 12% (compared to management target of 14-16%) and an exit P/E multiple of 10x.

With shares at 227.9p, we expect a total upside of 30-60% in the next few years, from dividends worth nearly 6% annually at present, a total benefit of about 50% from the P/E re-rating to 10x and EPS growth worth 5-10% annually (including from share buybacks).

Ends

Stocks mentioned: V 0.00%↑ GOOG 0.00%↑ ADM LN MSFT 0.00%↑ PM 0.00%↑ MA 0.00%↑ BAC 0.00%↑ RTX 0.00%↑ PYPL 0.00%↑ DEO 0.00%↑ RMV LN OTIS 0.00%↑ EL 0.00%↑ BTI 0.00%↑ NWG 0.00%↑ CHTR 0.00%↑ JPM 0.00%↑. We are long all the names listed in our “Select 15” portfolio.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.