Streetwise

Lauren Rudd

Sunday, March 10, 2013

Long a Matador to the Bulls, 3M Has Returned to the Arena

According to Barron’s, portfolio managers are urging clients to become more risk-tolerant and subsequently more open to equity investing. Yet, still rattled by the recession of 2008, many resolutely ignore the advice.

Do you find yourself in the same position, reticent to act, perhaps because you are still in mourning over some previous loss? Remember that 40 years of statistical data confirms an average annual compounded total rate of return for equities of about 11 percent.

Yes, I am eminently familiar with the statement by famed economist John Maynard Keynes, “In the long run we are all dead.” More pertinent is Chinese philosopher Lao-tzu’s advice, which I paraphrase as, every journey begins with a single step.

Unfortunately, market volatility, when combined with a fear of the unknown, readily foments paranoia. Nonetheless, your task is to remain undeterred in your resolve to uncover true value.

As Barron’s so adroitly went on to write, the shift toward stocks will become more pronounced “when investors realize a secular bull market will be the story for the next three to five years.”

It's not that wealth managers are ignoring risk, such as that posed by Europe, our domestic debt crisis, or the tensions in the Middle East. Rather there is a shift towards looking at the glass as being half-full rather than half-empty.

Therefore, in addition to cutting back on bonds, many wealth managers are sharply reducing their holdings of cash. One major brokerage house cut its recommended cash position in half to 10 percent, while a major bank reduced client's cash positions to 1 percent from 6 percent.

Although a perennial bull, I fully agree that the tea leaves currently point to equities over fixed income. At the same time, I deny only revisiting companies where I have successfully projected annual performance and share price appreciation.

This is not true. While I try to only discuss companies where my analysis portends potential capital gains, not every idea is a winner. This was clearly illustrated by my ebullient forecasts versus the historical share price trend of 3M (MMM).

As a result, I resisted further analysis of 3M, relenting two years ago because as Barron’s once pointed out, the world’s population continually interacts with the company’s products, from fiddling with Scotch tape, to leaving urgent messages on Post-its, to parking their posteriors on Scotchgarded furniture.

So why write about 3M today? The answer is simple; I believe 3M has excellent potential going forward and I attribute a less than exemplary historical share price performance to conditions beyond the company’s control.

A year ago when I wrote about the company, my earnings estimate for 2012 was $6.30 per share with a 12-month price target on the shares of 96, for a potential capital gain of 13 percent. So how did the company perform? Earnings for the year came in at $6.32 and the shares recently closed at $104.66.

Delving into the company’s 2012 performance, 3M posted record sales of $29.9 billion, up 1.0 percent year over year. Organically, sales grew 2.6 percent and acquisitions added another 0.8 percent. Adverse foreign currency translation reduced sales by 2.4 percent. Full-year 2012 earnings increased 6.0 percent with an operating margin of 21.7 percent and a return on invested capital of 20 percent.

3M also reaffirmed its 2013 full-year performance expectations. Earnings per share in 2013 are anticipated at $6.70 to $6.95, with organic sales growth of 2 to 5 percent. 3M also expects free cash flow conversion (free cash flow divided by net income) to be in the range of 90 to 100 percent.

The intrinsic value of the shares using a discounted earnings methodology is $125, while the more conservative free cash flow to the firm model yields an intrinsic value of $167, as compared to the previously mentioned recent close of 104.66.