Streetwise for April 18,  2010

Streetwise

Lauren Rudd

Sunday, April 18, 2010

Check Out The "Goldilocks" Recovery

Before you decide to become a card carrying member of the Chicken Little league, as a result of listening to the soothsayers of doom predict economic Armageddon, consider that a funny thing happened on the way to Wall Street. It seems that the April edition of the Bank of America/Merrill Lynch Fund Manager Survey indicates increasing support for the hypothesis that we are now in a “Goldilocks” recovery.

In analyzing the views of a panel of managers responsible for managing assets totaling over $546 billion, there is a rising confidence level with regard to the proposition that we are facing a robust global recovery. As a result the panel is becoming more bullish, not only on macro economic growth but also on the abilities of companies to increase profitability over the next 12 months.

Inflationary fears remain subdued with 42 percent of the respondents expecting no interest rate hike from the Fed before 2011. For the first time ever, the European manager survey revealed that 57 percent of the respondents do not expect the European Central Bank to raise interest rates this year.

At the corporate level, the panel is increasingly bullish on rising corporate operating margins and subsequent profits with 71 percent forecasting a rise of 10 percent or more in corporate earnings over the next year, while 42 percent believe companies can expand operating margins.

In other words, we are facing a period where inflation remains subdued and growth picks up briskly; yet not too hot or not too cold. As a result, the managers surveyed appear willing to take on increasing amounts of risk.

So how do you participate in this utopian recovery? Well you could open a new box of tea bags and brew yourself a cup as you wait for the gods of chance to look favorably upon your lottery ticket. Or you can create a list of companies you trust and whose products you understand and then simply select those with whom you wish to dance.

So how many names should be on your dance card? If you can conjure up a modicum of uncanny luck, in conjunction with some supernatural analytics, then investing in just one stock should reserve your seat in Valhalla. However, as Clint Eastwood was so fond of saying in his Dirty Harry movies, “A man has got to know his limitations.” Therefore, most of us are going to need to invest in a minimum of 12 companies and a maximum of about 30.

So where do you begin your search? One answer is to look for companies that show a symbiotic relationship with the affairs of state, preferably on a global basis. A good example is Raytheon (RTN).

When I wrote about the company a year ago, my 2009 earnings estimate was $4.70 per share with a projected share price of $48. Earnings came in at $4.89 per share and the shares recently closed at $58.20, so I was a bit light as the company exceeded even my expectations.

The intrinsic value of the shares, using a discounted earnings model is $84 per share. To arrive at that number, assume that earnings of $2 billion grow at a rate of 8.40 percent. You then discount those future earnings at a rate of 15.00 percent to arrive at a net present value for the company's next 10 years of earnings of $14.7 billion.

To account for potential earnings beyond the 10th year, I used a growth rate of 6.00 percent and a discount rate of 12.00 percent, resulting in a continuing value of $19.6 billion. Add those two numbers together, subtract out long-term debt of $2.33 billion and divide by the 378 million outstanding shares. The result is the per share intrinsic value of $84.

The more conservative free cash flow to the firm model, which can be found at www.ValuePro.net, yields an intrinsic value of $144 per share. Meanwhile, Raytheon’s shares have chalked up a 13 percent gain so far this year.