Introduction
It's time to do what I love most, which is discussing "big picture" developments and actionable ideas.
As I discussed in prior articles, one of the cornerstones of my research is incorporating major developments to establish a "top-down" framework that allows me to establish a dividend (growth) portfolio with a high likelihood of elevated long-term returns.
Using my model, which I will consistently improve and incorporate in my articles, I'll focus on two aspects in this article:
- Macroeconomics.
- Market sentiment/valuation/cycles.
To be precise, I want to highlight recent developments that have made the risk/reward of the market unfavorable and explain why I have become even more value-focused than usual.
After that, I will present a few stocks I am buying and monitoring for future investments, as I believe they offer good value for longer-term outperformance.
So, let's get right to it!
Are We In A Bubble?
Since the fourth quarter of last year, it seems that markets have forgotten what a down day is. Thanks to a strong rally, the return of the S&P 500 over the past twelve months is now 27%. The tech-heavy ETF (QQQ) has returned 47%. NVIDIA (NVDA) has returned 260%, turning into a $2 trillion company!
Whenever these market moves happen, people start to talk about bubbles.
Are we in one?
Honestly, I don't know.
Technically speaking, it is fair to say that people are very bullish. Looking at the data below, we see that the AAII survey shows that sentiment is very bullish, yet not at record levels.
We are seeing similar developments when looking at the net positioning of asset managers who trade the S&P 500 e-mini contract.
Net positioning is very close to prior peaks, yet not at "euphoria" levels.
However, we don't need to be in "bubble" or "euphoria" territory to make the case that we're seeing unusual developments in market sentiment.
Even Nouriel Roubini, also known as Dr. Doom, is now bullish.
While there's much talk of a so-called soft landing, he thinks the economy might not land at all, in a "no landing" scenario that sees growth continuing to reaccelerate.
Goldman Sachs (GS) agrees as it makes the case that this market is not in a bubble.
It just increased its S&P 500 target to 5,200, which is up from 5,100 in January.
I'm bringing all of this up because we are seeing very interesting developments in the market.
As most readers know, equities tend to be driven by liquidity. The more liquidity, the better stocks tend to perform. It's like feeding corn to pigs. The more you feed them, the fatter they become.
This is what the relationship between the S&P 500 and liquidity looks like:
In a recent article, Bloomberg's John Authers noted that as long as liquidity remains abundant on a global scale, particularly favoring U.S. equities, the current market rally may have further room to run.
John Authers noted that in light of expectations of a Fed pivot, financial conditions have eased, reflecting the market's confidence in the central bank's commitment to supporting economic growth.
Believe it or not, but financial conditions haven't been this loose since the Fed started hiking rates!
Essentially, markets continue to believe that inflation will come down quickly, while GDP growth expectations suggest a continuation of the expansion that started after the pandemic.
I do not like this risk/reward at all.
By creating loose financial conditions and rallying markets, we are now creating an environment where it will be harder for the Fed to cut rates.
Even worse, inflation is starting to heat up again - or at least work its way through the economy, which tends to happen after large inflation shocks.
I'm not saying we will get a huge second wave of inflation. However, the market may have to adjust its rate expectations, as a quick return to "normal" is highly unlikely.
On top of that, I believe that if we get an economic demand rebound in cyclical sectors, we could see much higher commodity prices, creating higher inflation in the quarters ahead.
Going back to Mr. Authers' article, he mentioned something very important, something I have mentioned in many articles in the past few months as well.
While we may not be in extreme bubble territory, valuations suggest that investors need to be very careful, as we could be in for potentially subdued returns over the next decade(!).
As we can see in the chart below, the higher the market's valuation, the lower the return over the next ten years.
Right now, numbers indicate a longer-term annual return in the low-single-digit range.
With that in mind, the chart above is purely theoretical.
It's just a simple regression model. While it could be correct, it could also be wrong.
However, in the investing world, it's all about looking at the scenarios with the highest probability, which is why I have become much more careful, mainly investing in stocks that are still attractively valued.
While these stocks may have underperformed tech stocks, I believe they will put me in a good spot to outperform the market on a longer-term basis, especially if inflation remains sticky.
Bear in mind that while stocks are, generally speaking, fantastic tools to fight inflation, investors have been through prolonged periods of zero returns on an inflation-adjusted basis.
The chart below shows the inflation-adjusted S&P 500. Whenever inflation was elevated (for example, in the 1970s and 1980s), investors often saw multiple decades of flat real returns.
I have to admit that I think about the chart below a lot.
It was even worse for investors who bought when the market was red-hot.
Again, it's theoretical. Inflation could quickly fall, growth could remain high, and tech stocks could continue their rally for another 12 months. Who knows?
What I do know is that the odds have shifted in favor of value stocks, which is where I'm currently deploying most of my cash - in addition to holding an elevated cash position to capitalize on potential market weakness.
RTX Corp. (RTX) - Undervalued Aerospace
When I invest in value, I always try to incorporate companies that also come with growth. After all, God willing, I will have many decades left to invest, which means I will always incorporate some degree of growth.
That's why RTX is perfect for my strategy as it is a perfect blend between growth and value.
Formerly known as Raytheon Technologies, RTX is one of my largest holdings. It's also a holding in every single family portfolio that I (indirectly) manage.
My most recent article on this company was written on January 23, which I highly recommend to investors looking for in-depth info.
What makes this company so special is that it benefits from tailwinds in both defense and commercial markets.
The post-pandemic aerospace industry is in desperate need of new planes and equipment while defense demand is boosted by years of under-investments (especially in Europe) and security threats, like the war in Ukraine and Gaza, and tensions in Asia.
As a result, the company ended 2023 with close to $200 billion in backlog and a book-to-bill ratio of 1.24x, indicating that it gets $1.24 in new orders for every $1.00 of finished work.
Valuation-wise, we are dealing with a stock that is trading at a blended P/E ratio of 17.6x, which is roughly in line with the long-term normalized multiple of 17.4x.
When adding its 2.6% dividend and the fact that analysts expect accelerating EPS growth to 16% in 2025 and 11% in 2026, we get an annual return outlook of more than 13%.
Needless to say, going forward, I'll continue to cover the stock and any new developments.
Pfizer (PFE) - Beaten-Down Pharma
Earlier this month, I wrote an in-depth article on Pfizer.
After being one of the biggest winners during the pandemic, it is now suffering from imploding post-pandemic demand and the fact that it needs to fight patent losses and reshape its drug portfolio.
The stock, which currently yields 6.4%(!), is protected by a 78% payout ratio and the company's commitment to dividend growth - even before investing in its business.
On top of that, it has accelerated investments in future growth, including the acquisition of Seagen, which comes with a highly promising portfolio of oncology assets.
Seagen's in-line medicines are expected to immediately enhance Pfizer's top line growth, and our combined portfolio provides the opportunity to lead genitourinary cancers and be a leader in breast cancer and deliver at least 8 potential blockbuster products by 2030. - PFE 4Q23 Earnings Call
The company expects to grow its oncology business from $3.1 billion in 2024E to more than $10 billion by 2030.
Unless the stock gets into massive lawsuit problems (I don't expect that to happen) or sees failure in bringing its products to market in the years ahead, I believe it is one of the few stocks that may be "dirt cheap."
As I wrote in my prior article, the stock trades at a formalized P/E ratio of 11.9x, with over 20% EPS growth expectations in both 2024 and 2025.
This paves the way for elevated double-digit yields in the years ahead, further sweetened by its juicy yield.
Stock number three is a REIT.
Extra Space Storage (EXR) - One Of My Favorite REITs
Technically speaking, REITs may not be the best place to be when inflation is expected to be sticky. After all, many have annual rent escalators close to 2-3% and expenses that are tied to labor and material inflation.
Most also rely on cheap funding.
However, there is great value in the REIT space.
One of my favorites is Extra Space Storage, a company that owns self-storage assets (I know, it's obvious).
After buying Life Storage, it now owns 3,714 properties in 42 states. It's also an S&P 500 member with a BBB+ rating from Standard & Poor's.
What I like so much about self-storage is flexibility.
Not only do self-storage companies benefit from the ever-increasing demand for storage, the often good location of self-storage assets, and the ability to allow investors to buy assets in bulk, but also the fact that whenever someone moves out, operators can adjust prices.
If inflation remains sticky, I see pricing power in this segment, even if lower consumer sentiment is a potential headwind for storage demand.
As we can see below, self-storage has consistently been among the best performance in the REIT universe.
As of December 31, 2023, EXR has been the second-best performer in the entire REIT universe, returning more than 440% since 2013. It has also beaten its two biggest competitors by a wide margin.
The stock currently yields 4.5%. This dividend comes with a five-year CAGR of 14.0% and 13 consecutive annual hikes.
Please note that EXR did not cut its dividend last year. It briefly started paying more than four annual dividends after buying Life Storage. The dividend was briefly broken up. The total amount did not change.
Valuation-wise, we are dealing with a company that trades at a blended P/AFFO (adjusted funds from operations) ratio of 18.3x, two points below its long-term normalized multiple.
While 2024 is expected to see just 2% AFFO growth, analysts expect 6% growth in both 2025 and 2026, potentially paving the road for +12% annual returns in the years ahead.
Since 2007, EXR has returned 14.5% per year.
Even if this number turns out to be lower in the future, I believe the company is a great value dividend stock in this market.
The next stock could potentially cause some controversy in the comment section.
Canadian Pacific Kansas City (CP) - The Wide-Moat Rail
CP is a stock I'm planning on buying much more of this year after having been an aggressive buyer in recent years.
My most recent article on this company was written on January 31, when I went with the title "Canadian Pacific Kansas City: The More It Drops, The More I Buy."
CPKC is the first North American railroad that connects all three North American nations through a single operator.
It's my biggest supply chain play, as it gives me exposure to bulk shipments like energy and agriculture and massive re-shoring opportunities in the South of the U.S. and Mexico, where companies from Europe and China are moving.
I expect these benefits to last for many years and provide CPKC with opportunities that other transportation companies do not have.
It is also one of the best-managed railroads in North America, with a very low accident rate and subdued operating ratio, indicating efficient operations.
While its dividend yield is less than 1%, the company is expected to reach its post-merger leverage target by the end of this year or early 2025.
Hence, I expect that CPKC will aggressively buy back stock in the years ahead and start hiking its dividend on a consistent basis.
With that in mind, when I said that this pick may cause controversy, I was thinking about its valuation.
As the goal of this article was to present deep-value plays, I now have to explain why I included a company that trades at a blended P/E ratio of 29.9x!
See, CPKC is expected to maintain high-single-digit annual revenue growth through 2028. This is expected to result in double-digit annual EPS growth.
As such, CPKC isn't that expensive.
While everyone is focused on secular growth industries like artificial intelligence, I'm buying re-shoring stocks with elevated growth potential.
Using the data in the chart below, analysts expect CPKC to grow its EPS by 13% this year, potentially followed by 20% next year and 17% in 2026.
Applying a 26x multiple, we get an annual return outlook of more than 12%.
Sure, CPKC is only a deep-value stock if we incorporate its growth outlook beyond the next two years.
However, I believe in re-shoring and expect that CPKC will continue to deliver strong results.
In a market where the AI trend won't last forever, I will happily buy more of these stocks before the market starts to rotate.
Takeaway
While the current market euphoria might tempt some to chase high-flying tech stocks, I urge caution and make the case for a value-focused approach.
By focusing on stocks like RTX Corp., Pfizer, Extra Space Storage, and Canadian Pacific Kansas City, I seek to buy undervalued opportunities with strong growth potential.
Despite the allure of tech, I remain committed to stocks that offer a blend of value and growth, confident that this approach will position me for long-term outperformance in a market that is likely to see subdued returns over the next decade.
Please let me know in the comments below what you are buying and if you agree or disagree with my thesis.
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