Bullish on Graco

When making fundamental trade recommendations in my weekly newsletter EPIC Insights, there are two main variables. The first is what we think a stock is worth. This number is under our control and allows for creative thinking to derive the fair value of the operating business. Regardless of what is occurring in the economy and the markets, we can create an estimate of value. While this part of the equation is of our own making, the other piece is not. That piece is what the market believes a stock is worth.

Since buying a stock represents an ownership interest in an operating business, one would imagine that market prices are dependent on evolving business dynamics. Although this is a piece of the puzzle, there are many more pieces. All of us have seen prices react to rumor and emotion as opposed to business development. Therefore, market prices do not always reflect true value.

Meshing these two factors into a trade idea requires patience and discipline. When markets were collapsing earlier in the year, this section of the newsletter nearly wrote itself. We were able to purchase blue chip stocks such as Coca Cola (KO), Procter & Gamble (PG), and Microsoft (MSFT) well below their true value. Such trades allowed for large gains that were accompanied by little risk.

Currently, things are much different. With the market higher and investors more optimistic, the low-hanging fruit has been picked. The brand name companies at bargain prices have all risen as investors favor size and familiarity. This does not make finding new trades impossible, but harder. We now must dig deeper to find investments that offer attractive businesses and reasonable dividend income, yet still trade below their true value. Searching for these three factors uncovered my newest idea-Graco (GGG).

GGG is an industrial company whose main business involves designing, manufacturing, and selling systems that are used for applying paints and coatings, cleaning equipment, and maintaining motor vehicles. Rereading this last sentence, most readers' eyes will glaze over for lack of excitement. However, the search for the exciting is one factor that often leads investors astray. When allocating capital, our goal is not to find the most thrilling companies to buy, but to find opportunities to make the most money with the least risk.

On the risk versus return front, GGG excels. Many of the lines of business in which the company operates are highly specialized with strong potential. Although their end markets are cyclical, GGG has done an excellent job of maintaining profitability and high return metrics. With a current return on equity (ROE) of 58% and an average return on total capital of 51% over the prior six years, GGG has consistently operated efficiently and returned value to its shareholders.

With dependable businesses and large economic moats, we would expect GGG to trade at high prices and have an enthusiastic following. Instead, the market is apathetic. Of 22 independent research firms, 10 rate the stock a hold, seven recommend selling, and only five think the shares should be bought. Against its peer group, GGG has underperformed on a three-month, one-year, and year-to-date basis.

Turning to valuation, GGG's earnings are cyclical and expected to decline as the economy contracts. However, just as we should never value a cyclical company based on peak-year earnings, we should avoid drawing conclusions on trough-year earnings as well. This requires us to take a more blended view of future earnings power and eliminates traditional price/earnings (PE) and divided discount models (DDM). Instead I will opt for an earnings yield approach that accounts for the uneven nature of future earnings and derive a fair value estimate of $32. With its current price at $28.53, GGG is selling at a 12% discount to fair value. Combining this discount with the current 2.7% dividend yield, we have a company with strong economic underpinnings that is unloved by the analyst community, offers a reasonable dividend stream, and is priced below fair value. Excited by this no-frills opportunity, I recommend a position in GGG as this week's fundamental trade.

Note: At the time of this article I am long GGG.

Related Stocks:  GGG