For deep value investors, the U.S. stock market offers slim pickings. A quick glance at the Russell 1000 Value Index will tell you that large capitalization, U.S., companies are not cheap at a price-to-earnings ratio of 19 times. The S&P 500 is up almost 2.8% since the beginning of February and up over 8% since Donald Trump was elected President. Consequently, it is important to focus on stocks with two characteristics: an attractive relative valuation and sensitivity to policy changes. Two stocks that fit these requirements are General Dynamics and CVS Health Corp.
The Trump administration has promised to cut corporate regulations and tax rates, and engage in massive fiscal stimulus. Assuming those policy changes can be implemented they are naturally bullish for the stock market. The key is to find companies that are likely to be benefit asymmetrically for those policy changes and which do not already carry unreasonable valuations.
General Dynamics Corp (ticker: GD) is one such a company. GD currently trades at an 18.9 times trailing 12 month PE multiple and a forward 12 month PE of 19.2 times. That may sound pricey, but it is cheaper than competitors Lockheed Martin Corp (ticker: LMT) and Raytheon Co (ticker: RTN). The company has also increased its standardized EBITDA over the past five years. The chart below shows the PE ratio, revenue and earnings of the company.
Admittedly, the company has posted lousy cash flows in the last several years and there remain questions as to profitability and margins. There are definite fundamental risks with GD. However, this analysis isn't just about fundamentals.
General Dynamics is likely to be one of the main beneficiaries of the current efforts to modernize and upgrade the U.S. armed services. The Trump administration is on the record, multiple times, making the case of upgrading the military. "Upgrading" is code word for increasing the annual budgetary spend on defense and related services. The entire effort is being led by Arizona Senator John McCain which increases the chances of bipartisan support.
Senator McCain has already submitted a proposal for the military revamp. That proposal calls for 4% annual budget increases over the next five years. That's a huge, new amount of fiscal spending to be directed towards the defense industries after years of stagnate budgets. General Dynamics is likely to be a prime beneficiary. Unlike some defense companies which specialize in a certain area (e.g., aerospace), GD has a broad portfolio of businesses. The company's four main segments are information technology (think slightly scary AI programs for the military), aerospace, marine systems and combat systems.
The company is broad and deep and if the U.S. government intends to upgrade our existing military, you can bet that General Dynamics will be called upon for part of the assignment. Just yesterday it was announced that GD had received a $126 million contract to provide advanced submarine materials to the Navy. That's a small contract, but it is these types of repeated successes, in greater numbers, that provide a policy catalyst for General Dynamics over the next several years.
Another company with both relatively favorable fundamentals and a policy tailwind is CVS Health Corp (ticker: CVS). Yes, the company has been caught up in pharmacy benefits manager - Affordable Care Act ("Obamacare") - drug pricing issues and it has taken its lumps. It currently trades just below $80 a share yet it traded well over $100 a share just nine months ago. That is precisely why the company is attractive from a relative valuation standpoint.
CVS is valued at 14.6 times its current trailing 12 month earnings per share and 13.6 times its forward 12 month earnings per share. Both earnings and revenue continue on an upward trajectory. In addition, the company's return on common equity has been increasing over the last several years. The chart below shows the PE ratio, revenue and earnings of the company. Note how valuation (PE ratio/orange line) and earning and revenue of de-correlate since the middle of 2016.
Like General Dynamics, CVS is not pristine from a fundamentals or valuation standpoint. Net income and gross profit margins have stalled and the company does have $27 billion of debt outstanding. Also like GD, the CVS story is much more than mere financial ratios.
CVS Health Corp is likely to be one of the primary beneficiaries of changes in U.S. corporate tax law. Similar to increasing defense spending, there is broad support in the U.S. Congress to lower the corporate tax rate. That is fantastic news for CVS because it has had one of the highest effective rates. Over the past five years, CVS has paid an average 39% tax rate. Ouch! Combine a potentially much lower tax rate with the fact that all CVS sales (revenues) are in the U.S. and you have a potentially huge catalyst for increasing earnings.
Both General Dynamics and CVS Health have solid "relative valuations." Additionally, General Dynamics is less expensive than its peers and CVS Health is less expensive than its recent history. Combine these factors with the potential for hugely beneficial policy changes and both companies look attractive for longer term capital.
