Streetwise

Lauren Rudd

Sunday, September 23, 2012

Be Number One With Your Investments

Vince Lombardi’s famous “Number One” soliloquy epitomizes the way you should look at your investment portfolio. Lombardi said, “There is no room for second place. There is only one place in my game, and that's first place. ...There is a second place bowl game, but it is a game for losers played by losers.”

These are not harsh words, rather they are pertinent to what your investment strategy should be; a selection of only the best investment candidates with judicious attention being paid to profitability and intrinsic value.

Keep in mind that I am directing my comments at investing and not trading, a polite word for speculation. A speculator is about as much an investor as a Las Vegas gambler. Whenever there is a profit to be made by successfully picking the correct outcome of a random event there will be those wanting to bet on the outcome, regardless of risk.

And as in every game of chance there will be winners and losers, with the latter often occurring far more frequently than the former. Yet, speculators do provide market liquidity. Flash trading, as rapid fire computerized trading is referred to, is the ultimate form of speculation. Unfortunately, while flash trading does bring liquidity it is accompanied by both a degree of disingenuousness and market instability.

An investor, as opposed to a speculator, minimizes risk through diligent research and the utilization of a reasonable time horizon. The time factor is critical because trying to forecast short-term economic trends and their effect on Wall Street is like trying to herd cats, a great idea but one with little probability of success. Being patient will not only alleviate minor share price fluctuations, but it also enables you to benefit from a continual compounding of profits.

A good example of a company that has rewarded investor patience with a trailing 12-month 38 percent increase in share price is the Eaton Corporation (ETN). Never before discussed in this column, Eaton chalked up record second quarter earnings of $1.12 per share, an increase of 15 percent over the $0.97 earned in the second quarter of 2011.

If you remove acquisition expenses, operating earnings per share in the second quarter of 2012 were a record $1.15 compared to $0.97 per share in 2011, an increase of 19 percent. However, sales for the second quarter were $4.1 billion, a number slightly below a year ago. Operating cash flow was a record $469 million.

Digging a little deeper, we find that the all-important organic sales growth during the quarter i.e., before adding in acquisitions, was 3 percent, while acquisitions added an additional 1 percent. However, this growth was largely offset by a negative 5 percent foreign exchange factor, largely from the lower value of the euro and the Brazilian real.

While sales for the year will likely grow 3 to 4 percent that is a reduction from the 5 percent guidance of last April. At the same time the impact of foreign exchange rates on revenue will be more negative than previously estimated. Fortunately, the company’s improved margins and lower tax rate are expected to partially offset those factors. As a result, operating earnings per share in the third and fourth quarters will likely continue at record levels.

Management’s guidance for operating earnings, which excludes charges to integrate recent acquisitions, is $4.20 to $4.50 per share, or about 10 percent above the 2011 number. Net income is expected to be between $4.09 and $4.39 per share, while 2012 sales are projected to show a 4 percent increase.

The intrinsic value of the shares, using a discounted earnings model with an earnings growth rate of 10.50 percent applied to earnings of $1.4 billion and a discount rate of 15 percent, yields an intrinsic value of $69 per share. The more conservative free cash flow to the firm model produces an intrinsic value of $100 per share. The shares recently closed at $48.52.