By Philip van Doorn, MarketWatch
You might have heard analysts and investors saying the U.S. stock market is in the “late innings” of the bull cycle.
Tom Plumb, who runs the Plumb Balanced Fund, says instead that the market is “bifurcated” into “haves” and “have nots.” The “haves” are companies that “generate tremendous free cash flow with recurring revenue streams,” he said. (Free cash flow is cash flow after planned capital expenditures.)
The “have nots” include slow growers, even if they are considered value stocks, and the cyclical companies that have been replaced “as the most important movers of the markets,” he said in an interview Feb. 27.
He made it clear that the “haves” are still where investors should look for profitable investments.
He also made the point that levels of high-yield, or junk, debt are increasing, while the group of “haves” that have dominated the S&P 500 Index /zigman2/quotes/210599714/realtime SPX +0.0020% during this long growth cycle — Microsoft /zigman2/quotes/207732364/composite MSFT +1.84% , Apple /zigman2/quotes/202934861/composite AAPL -0.81% , Amazon /zigman2/quotes/210331248/composite AMZN +0.22% , Alphabet /zigman2/quotes/205453964/composite GOOG +0.51% /zigman2/quotes/202490156/composite GOOGL +0.49% and Facebook /zigman2/quotes/205064656/composite FB +1.06% — “shows debt-to-EBITDA levels of 1.57 now versus 3.9 20 years ago.” EBITDA stands for earnings before interest, tax, depreciation and amortization.
Together, the above companies make up about 15% of the S&P 500’s market capitalization. That dramatic decline in debt to EBITDA underlines how important cash-flow generation has been to those tech giants’ success. The Plumb Balanced Fund /zigman2/quotes/208164852/realtime PLBBX -0.09% held positions in all of the above companies except for Apple and Facebook as of Dec. 31.
“Apple is in the process of trying to establish recurring revenue streams and going form a hardware company to a software and subscriptions company. They have a long way to go, but obviously the most profitable company in the world has the potential to do it,” Plumb said.
He considers Alphabet (Google’s holding company) and Facebook to be a “duopoly,” but sees greater political and regulatory risk to Facebook in a “new environment” when it comes to user privacy.
“They may prevail, but we are avoiding Facebook,” he said. He says Alphabet “doesn’t quite have the same level of political risk that Facebook has. They have the potential to be more of an international player.”
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Plumb is the CEO of Wisconsin Capital Management, which has a about $180 million in assets under management.
He shared his thoughts about a number of other large-cap growth stocks.
Plumb spoke with MarketWatch in May, when he said he favored credit-card transaction processors, including Visa /zigman2/quotes/203660239/composite V +0.38% , Mastercard /zigman2/quotes/207581792/composite MA +0.29% and Discover Financial Services /zigman2/quotes/208747867/composite DFS -0.68% . Here’s how they performed from May 14 (the day before the previous article was published) through Feb. 26:
A period of less than a year is, of course, a relatively short one for a long-term investor, but there is no question that Discover has lagged behind the others. Despite running its own card-transaction-processing business, Discover is quite different from Visa and Mastercard because it is also a bank holding company — it makes credit-card loans. Plumb said that during 2018, Discover’s loan portfolio was “continuing in high single digits, but their charge-offs [loan losses] and delinquency rates seemed to be going up.” He also said Discover’s profits suffered as the company paid more than it expected to merchants to accept its cards.
“The dialogue in the fall was the U.S. going into recession,” Plumb said. “But, now, we look at a company with an 8 or 9 price-to-earnings (P/E) ratio and think it is pretty darn attractive.”
He is “very positive” on Discover this year, because “charge-off rates are coming down again” and loan growth remains “robust.”
Discover’s shares trade for 8.1 times the consensus earnings estimate for the next 12 months, among analysts polled by FactSet. That is very low when compared with forward P/E ratios of 25.9 for Visa and 28.9 for Mastercard. But the higher valuations for Visa and Mastercard are in line with what investors expect for rapidly growing businesses that are much less capital-intensive than banks, including Discover. Here’s how the three companies’ forward P/E valuations have fluctuated over the past year: