Last August, analysis wizards for investment managers AllianceBernstein ran stocks through both a fundamental and quantitative model, aimed at picking the most likely winners in the stock market. They emerged with a list that has since outperformed the S&P 500 by 19% when weighted based on capital, or 12% when the stocks are given equal weight. They have now gone through that process again, creating a list of stocks that the company believes are going to outperform the market over the next six months.
Considering the group’s track record, it made sense to share those recommendations, and the reasons for them, with our readers. They have not been separately analyzed by InvestorPlace writers, although we follow most of these stocks avidly, and I have even owned a few of them from occasionally.
The stocks chosen are in different industries, allowing a prudent investor to spread risks widely. The stocks chosen by Bernstein range in market capitalization from more than a half-billion dollars down to $12 billion.
Your success with this methodology will vary, but Bernstein says that since 2004 the stocks picked in this way have beaten the S&P 500 average by 6.9%. Compound that over 13 years and you get a very handsome return.
Bernstein believes that combining fundamental and quantitative research delivers better results than using either technique by itself.
Bernstein Stocks to Buy: Apple Inc. (AAPL)
The biggest company on the big board may also be your best bet for future profit. At its present price of $144 per share, Apple Inc. (NASDAQ:AAPL) is worth $756 billion. This is, by far, the biggest market cap ever achieved by any stock. To give you some perspective, $756 billion is equivalent to the GDP of the Netherlands. It’s bigger than the GDP of Taiwan; bigger than Saudi Arabia.
It is due to get even bigger, writes Bernstein’s Toni Sacconaghi. Bernstein has set a price target of $160 per share on the stock.
The Bernstein argument on Apple is that the company has outperformed the market, by 16%, during the three to six months before new iPhone introductions, and that the iPhone’s installed base is now nearly 80% larger than it was before the iPhone 6 was installed, as it prepares to introduce the iPhone 8. In other words, there are tens of millions of people with old iPhones, waiting anxiously for the new version. Even an upgrade rate that is slower than that of the iPhone 6 will deliver bigger sales than before. Some analysts are calling this a “supercycle,” but it is just a major replacement cycle.
For Apple shareholders there is also hope under the Trump Administration of repatriating some of its famous cash hoard. The company has a reported $231 billion in cash stashed in other countries, and has been unwilling to move it home due to high U.S. tax rates. Moving that cash to the U.S. could trigger massive repurchases of shares — there are currently 5.25 billion Apple shares outstanding. That would make the remaining shares more valuable.
Finally, Apple remains cheap. The long-term mean of its free cash flow is now just 11.2% of the market cap, compared with 14.8% for International Business Machines Corp. (NYSE:IBM). The figure implies Apple’s cash flow should be flat or declining over time, and that is not happening.
Bernstein Stocks to Buy: American Express (AXP)
Shares of American Express Company (NYSE:AXP) have been underperforming lately. Investors are concerned about competition among card issuers, potential disruption in the payments space and lower credit quality.
Kevin St. Pierre, who follows AXP stock, views those fears as overdone. Amex, as it is known, has been punished enough for the loss of the valuable Costco Wholesale Corporation (NASDAQ:COST) account. He believes the company now can return to 12%-15% earnings growth, sustained by a return on equity of 25%. At some point, Bernstein believes, the market will get better visibility into the scale of the Costco loss and reduce its fears about competitive threats, moving the stock closer to its historic multiple, which would mean a solid gain from present prices.
Despite increased competition in the credit card market, Amex has been gaining 2.7 million new customers per quarter over the last year, beating the average of 2.1 million per quarter acquired from 2011 to 2014. Through its OptBlue program, the company is also closing gaps in its merchant acceptance, and hopes to gain parity with Visa Inc (NYSE:V) and MasterCard Inc (NYSE:MA) in this area by 2019.
Amex is also showing success on the cost front, which has long been a trouble spot. The company recently announced plans to remove $1 billion from overall expenses by the end of the year, and it has kept adjusted operating expenses flat since the financial crisis. There is high single-digit growth in the costs of reward and cardmember services, due to competition, so overall expenses are growing at 4% per year. But that is still slower than competitors.
Cutting the company’s share count through share repurchases will also help the returns for those shareholders who remain. Bernstein expects the AXP share count to drop from 935 million last year to just 801 million in 2019. That’s a substantial reduction.
Combine just 6% growth in operating results with a 6% improvement in operating leverage from cost-cutting, then add in the reduced share count and provisions for other losses, and you wind up with 14% growth in earnings per share over time.
Bernstein Stocks to Buy: Hewlett Packard (HPE)
Toni Sacconaghi follows Hewlett Packard Enterprise Co (NYSE:HPE), which recently completed the spinoff and merger of its enterprise services business with Computer Sciences Corp., resulting in a new company called DXC Technology Company (NYSE:DXC), which began trading on April 3.
In the deal, HPE shareholders got 50.1% of the new company, a stake valued at $9.5 billion. Passing the assets along drops HPE’s stock price — about $23.50 at the close of trading on March 31, down to $18.10 per share as trade opened — but HPE shareholders are already in the black. Next, HPE is planning on merging its software business segment into a British company, Micro Focus International plc, closing that deal by the third quarter of this year.
This will let its mature software maximize revenue while HPE itself moves “up the stack,” into cloud hardware, software, and services. Sacconaghi calls what is left of HPE “RemainCo,” and says it is the least expensive stock in the S&P 500. Based on its closing price at the end of March, Sacconaghi estimates HPE shareholders are getting $6 per share of value in DXC, nearly $4 per share from Micro Focus, and about $4 per share in cash. The RemainCo is valued at less than $10 per share, it is trading at just 7.6 times free cash flow, and even if it trades at just five times earnings that could quickly move to $20. Most of its earnings will come from recurring revenue in technology services.
Once the current series of deals are finished, the vision of CEO Meg Whitman for breaking up the original HP, first announced in October, 2014, will be complete. Shareholders who stayed for the ride have a collection of more-focused companies — HP Inc (NYSE:HPQ), Hewlett Packard Enterprise, Micro Focus and DSC — worth far more than the whole was then.
Whitman is not done yet, however.
Even before the ink is dry on divestitures, Whitman is rebuilding HPE through acquisitions. The company announced last month it will buy Nimble Storage for about $1 billion, aiming to improve results in its storage business with flash memory. The company bought SimpliVity, which works on “converged infrastructure” for data centers that combine storage, processing and networking in a simple box for $650 million. It is also circling a Swiss-based back-up software company, Veeam Software.
Investors are often told to buy the jockey rather than the horse. If you believe in Meg Whitman to run assets, buy some HPE stock.
Bernstein Stocks to Buy: Delta (DAL)
David Vernon follows Delta Air Lines, Inc. (NYSE:DAL) for Bernstein, and says that while 2017 will be a year of transition for the company, that bad news is mostly priced into the stock, which was trading at just $46 per share on April 3, a price-earnings multiple of under eight.
The market is worried Delta can’t hit guidance for margins in the high teens, he writes, but he thinks the company will surprise people. He sees the company’s revenue management programs as being better than other airlines. Branding and up-selling all seats, like those with a little extra legroom, could result in $2.7 billion of added revenue by 2019. Capturing parts of the “economy” cabin under names like Delta Comfort lets the airline “upgrade” people at minimal extra cost, increasing brand loyalty.
Delta also signed a new contract with pilots last year that should keep costs per average seat miles down and help increase margins. Past failures to hit margin goals were based in part on the airline’s hedging of fuel costs, which went down instead of up. Jet fuel prices are now heading back up, meaning Delta’s results should improve relative to its peers.
Bernstein also likes Delta’s balance sheet. Delta could generate more than $9 billion in free cash flow over the next three years, should market conditions hold as expected. Delta is now the least-leveraged among the network carriers, with less debt than earnings before income, taxes, depreciation and amortization, a measure known as “Ebitda.” That cash could be returned to shareholders in the form of higher dividends and/or stock buybacks. Add in tax reform, from which he expects Delta to benefit more than peers, and the skies look clear.
At its current price, Delta stock is selling for just nine times its expected 2017 earnings, its estimates are easily achievable, and besides, Warren Buffett likes it, having recently taken a $3 billion stake, nearly 10% of the company’s current $34 billion market cap.
Delta earns better margins than its air network peers, like United Continental Holdings Inc (NYSE:UAL) and American Airlines Group Inc (NASDAQ:AAL). It brings in more free cash flow than these rivals as a percentage of revenue. Assuming the economy doesn’t crash, Delta should do better than expected, and that’s what investors are looking for.
Bernstein Stocks to Buy: Marriott (MAR)
David Beckel follows Marriott International Inc (NASDAQ:MAR), calling it a (relatively) safe consumer stock with clear upside. Marriott is a best of breed lodging company, he writes, delivering a healthy 6% yield based on its estimated 2018 free cash flow. This could take the stock up 35% to 40% during the next year.
Most people think of Marriott as a chain, or a collection of chains, but it’s more like a collection of franchises operating with a “revenue light” business model. With last year’s acquisition of Starwood Hotels and Resorts, Marriott now has 30 different brands in over 110 countries, and most of its income comes from licensing brands to independent hotel owner-operators.
This license revenue is typically calculated as a percentage of total room revenue, sometimes on operating profits. In exchange, Marriott is responsible for maintaining brand standards and leveraging shared service costs, as well as marketing and technology, with the owners picking up some of these costs.
The catch is that fee revenue can go up and down based on the lodging cycle. When the economy is rolling, hotels are good investments, and when it’s not they’re not — a bed that is unslept in makes no money. Economic assumptions can cause investors to question management’s views on the sustainability of rising revenue per room growth.
Hotels are now in the eighth year of their growth cycle, and while growth is slowing it is still positive. The key to Bernstein’s positive view on Marriott is based on this “revenue light” business model. The brand manager focuses on maintaining standards and increasing profitability, while third parties handle the risks of the lodging cycle. Marriott has been working for years to sell off properties to third parties and spin off its vacation business. A decade ago, half its revenue was cyclical, subject to the ups-and-downs of the economy. Today, just one-quarter of its revenue is cyclical.
Being the largest hotel brand also carries advantages. Hotels want to affiliate with Marriott brands, meaning it can extend its “revenue light” model over more properties. Marriott will maintain steady Ebitda even if revenue per room falls 2%, because unit growth offsets the operating cyclicality.
Scale begets scale, Bernstein believes, meaning Marriott can continue to operate as it has been operating and prosper. It’s a virtuous cycle, with scale making properties profitable and more properties wanting into the brand to increase their profits. Bernstein thinks Marriott is undervalued. When its enterprise value over Ebitda is compared with that of the rest of the market, it’s below the company’s historical average despite its having better growth prospects than rivals and less leverage.
It adds up to a recipe for a higher stock price. Should the economy turn around, Marriott is a safe place to be. Should growth continue MAR stock will benefit more than other hotels. Heads you win, tails they lose.
Bernstein Stocks to Buy: Southwest Airlines (LUV)
Southwest Airlines Co (NYSE:LUV) was trading on April 3 at $53 per share. Bernstein’s David Vernon has a $65 price target on the stock. Thanks to a unique point-to-point route structure, Southwest is the most profitable U.S. airline, earning about 20% more per unit of capacity than network airlines such as Delta. That’s why Southwest carries a price-earnings number of 15, against 8 for Delta. Southwest now accounts for 12% of the industry’s revenue and 16% of its profits, moving 23% of the nation’s passenger traffic despite having just 13% of its capacity.
While Delta faces growing competition on long-distance international routes from Middle East and Asian flag carriers such as Emirates, Southwest’s international expansion has been to vacation destinations in the Caribbean and Latin America that line up well with its domestic routes. The company uses just one type of airplane, the Boeing 737, and will soon take delivery of longer models that could bring it more flexibility, and thus, more traffic through locations such as Ft. Lauderdale. For Southwest, international expansion is an opportunity, not a threat.
The airline sector went through a host of bankruptcies and consolidations in the past decade, with the result that price competition has been reduced. This is especially true for Southwest, which has less competition in its major markets than rivals. This gives it more control over pricing and load factors — a structural advantage that cannot be changed overnight.
Southwest’s low costs have also established its brand in the market, as a customer-friendly low-cost carrier with standard plane configurations, using 7% less fuel for each dollar of revenue than other airlines. Then there is the potential for tax reform. A 20% federal corporate tax revenue, with capital expensed 100% in the first year will benefit Southwest enormously. It has normalized incremental cash flow of about $900 million each year, and will be able to immediately put money to work on a tax-advantaged basis while its rivals, which must first burn through past losses before they can take advantage.
Finally, there is Southwest’s clean balance sheet. The company has more cash on its balance sheet than debt, and it does not have a pension liability, instead matching contributions to employees’ 401k accounts. This increases the probability that excess cash is returned to shareholders, or invested in projects that bring immediate revenue, improving its computer systems and the customer experience.
Over the next three years, Bernstein thinks the company will be able to buy back 15% of its stock while adding to its dividend, putting a floor under the stock and allowing its value to increase steadily.
Bernstein Stocks to Buy: HP (HPQ)
HP Inc (NYSE:HPQ), the printer and PC divisions of the old Hewlett-Packard, is expected to rise in value, like Hewlett Packard Enterprise, writes Bernstein analyst Toni Sacconaghi. Growth won’t be as strong as it has been. The stock is up 46% over the past year and nearly 20% in 2017. But the risk-reward balance remains attractive. The stock is also cheap compared to its peers, selling at 11 times earnings, and management is continuing to return cash to shareholders, with a dividend that is currently worth 3.1%. Management also plans to buy back 3% to 4% of shares outstanding for about $1 billion.
While the company was not expected to do well after the split with HPE, it has proven it can make money and return cash to shareholders, and that bullish set-up remains in place. Last year’s numbers should be easy to beat, and it could beat its own estimates on free cash flow. The company drew down inventory significantly last year — important because technology products tend to rot in warehouses like fresh fruit — and a build of inventory should make it easy to meet earnings estimates.
While some see HP’s growth as challenged, Bernstein notes that the company’s purchase of Samsung Electronic’s (OTCMKTS:SSNLF) printing business and the growth of 3D printing should provide growth opportunities. There remains a bear case, which is worth looking at. There is a fear that as interest rates rise HP’s yield will look less attractive. There is a fear that HP’s plans to increase growth of supplies while at the same time drawing down inventory will prove unrealistic. That would mean the company’s estimate that it can deliver $2.9 to $3.2 billion in free cash flow over the next three years, offered at the time of the 2015 split, may prove unrealistic.
Still, the company trades at just 10 times forward earnings, and the market cap is just nine times its long-term free cash flow, a valuation that implies free cash flow is declining indefinitely. This is also unlikely to happen. HP is never going to trade on the leading-edge of technology, where P/E ratios of 30 are common.
But its present level is cheap, and while it sells what are generally considered commodity items, it has growth prospects in additive manufacturing and a strong position within its chosen niches.
Bernstein Stocks to Buy: Synchrony Financial (SYF)
Synchrony Financial (NYSE:SYF) is the former General Electric Co. (NYSE:GE) credit card unit that was finally spun out of the company in November 2015, with shareholders being given the option of keeping all their General Electric Company (NYSE:GE) shares or getting some Synchrony shares instead. Those who took Synchrony, starting with its initial 15% spin-off, have done very well. The shares are up nearly 47%, while the parent company is up just 13%.
Kevin St. Pierre follows Synchrony for Bernstein, and he has an “outperform” rating on the stock with a price target of $38 per share, against the $34 per share it was trading at on April 3. In his analysis, he notes that Synchrony has one-third of the private credit card market, and 38% of the market’s outstanding balances. These are credit cards that are branded to a specific retailer. They used to be called “store” cards but now are offered by groups other than retailers. Synchrony represents the largest pure play in this space. It is a growing space. The percentage of balances held by private cards has been growing steadily since 2010 and now represents 11.8% of all such balances.
There is concern about net charge offs, or bad loans, which have been rising lately as merchants become more aggressive in offering credit, but the new levels are sustainable, St. Pierre believes. The growth of non-charge backs on Synchrony loans is up by 0.2% over the past 24 months, but that is in the range of Discover Financial Services (NYSE:DFS) and American Express, which aren’t growing nearly as fast, and nothing compared to the 1.3% rate suffered by Capital One Financial Corp. (NYSE:COF), which is growing balances at a rate similar to Synchrony’s.
Right now, St. Pierre writes, Synchrony has the highest capital ratio in the entire credit card industry, 17%, meaning it has the financial strength to sustain losses. Capital return expected during fiscal 2017, which for Synchrony ends in June, is below peers in the industry, but Bernstein expects those to rise over time, which means more capital returns are ahead.
Synchrony currently trades at a P/E ratio of 12.5, much lower than that of the rest of the market. Bernstein expects that to rise to the level of the rest of the market, and as it does shareholders will be the winners.
Bernstein Stocks to Buy: YUM (YUM)
Yum! Brands, Inc. (NYSE:YUM) was on previous Bernstein lists and disappointed, but it’s back. Sara Senatore follows Yum for Bernstein and writes that, like McDonald’s Corporation (NYSE:MCD), Yum is moving to a 98% franchised operation with an “asset light” structure. That translates into faster growth, Ebitda expansion and more cash flow, resulting in a compound annual growth rate of 15% through 2019. Her price target on the stock is $78 per share. It was trading at $63.25 on April 3.
Through fiscal 2019, Senatore writes, refranchising will drive YUM margins higher, increasing earnings before interest and taxes by 15% or more. Franchised stores generate higher margins per unit, and require a lot less expense. Just shifting from the present 94% franchise model to 98% will double Ebit margins, to 52% by 2019.
Moving to a franchise model will reduce capital expenditures, which will be taken up by franchisees, resulting in 40% growth in free cash flow over three years. That could mean $6.5 billion to $7 billion going to shareholders, 30% of the current market cap. Refranchising also tends to improve the performance of restaurants, as the franchisees have more of a stake in the game, so Yum’s 7% growth “stretch target” could be within reach. More efficient capital allocation leads to better comparable-store sales and higher profits per unit, which in turn means faster growth in the number of stores.
That’s not just a guess by an analyst. It is precisely what happened at other companies that have done this, including Wendys Co (NYSE:WEN), Restaurant Brands International Inc. (NYSE:QSR), which owns Burger King and Tim Horton’s (and just bought Popeye’s Fried Chicken) and Jack in the Box Inc. (NASDAQ:JACK) which owns Qdoba.
Bernstein Stocks to Buy: Motorola (MSI)
Don’t confuse today’s Motorola Solutions Inc (NYSE:MSI) with the cellphone company that was sold to Alphabet Inc (NASDAQ:GOOG, NASDAQ:GOOGL) in 2014. This is the infrastructure and software company that was left after that sale was complete.
Pierre Ferragu follows MSI for Bernstein, and his current price target on the stock is $96 per share. It was trading below $85 per share on April 3. Today’s MSI focuses on public safety, where it has roughly 80% of the U.S. market and 50% of the international market. About 60% of revenue comes from products like 2-way radios, and 40% comes from managed services, including maintenance.
This market is difficult to get into, considering that there are thousands of police departments, fire departments and emergency medical jurisdictions. There are complex sales cycles and Motorola’s huge installed base is also a benefit, as such departments don’t like to change vendors, ripping out their old stuff to install the new. Over the past 10 years, MSI has grown revenues in the 3% to 4% range. Growth comes from new digital infrastructure, regular refresh cycles and Motorola’s pricing power due to its dominance of the market. As such, the company has the best position to become the lead integrator of most initiatives and maintain its pricing power.
Since leaving the mobile space, MSI has averaged total shareholder returns of about 20% per year, and has cut its share count by over 50%. Its backlog of orders exceeded $8 billion in 2016 after it bought Airwave, operator of the world’s largest public safety network. The Airwave acquisition solidifies Motorola’s role as a chief solution provider in the market.
Bernstein sees a new Next Generation Public Safety market emerging that could be worth $5 billion over time, against current revenue of $1.883 billion, with Motorola acting as the industry reference platform. New LTE cellular technology should also lead to more growth, as it replaces older LMR equipment. There is risk, however, in FirstNet. The First Responder Network Authority, authorized in 2012, recently chose AT&T Inc. (NYSE:T) to build and manage its infrastructure. Motorola’s role will thus be limited to competing with the new network, and the shares lost 1.6% in the wake of the announcement.
Despite this, Bernstein values Motorola Solutions at a forward price-earnings multiple of 15.5, in line with its industry peers. It expects earnings per share to reach $6.26 per share in fiscal 2018, which is why it has the $96 per share price target, 15% higher than the current price.
Bernstein Stocks to Buy: Centene (CNC)
Centene Corp (NYSE:CNC) has been a major winner from Obamacare. It operates managed care facilities that take Medicaid patients. It gets a fixed amount for these clients, then uses technology and preventive care to try to keep these people out of the hospital, generating savings that go straight to its bottom line.
Lance Wilkes follows Centene for Bernstein, and has an outperform rating on the stock, with a price target of $78 per share. That is close to the April 3 price of $71.37, but his analysis remains upbeat. Following the acquisition of HealthNet, Centene now has 11.5 million members, and is especially strong in California.
Centene’s growth is predicated on growth of its Medicaid business, and two-thirds of those patients are not yet in managed care, a business model with clear cost and profit advantages. Centene is also trying to get into the Medicare Advantage market, the so-called “Medigap” policies, by leveraging its Medicaid managed care business. Over the long run, government healthcare is moving to the managed care model, which generates enormous savings, especially in the long-term care space. Wilkes is not worried about a possible repeal of Obamacare, and has based his analysis on an assumption that some reform is coming.
With a P/E ratio of 22.77, Centene seems fully priced, but the growth of managed care as a business model almost assures it will eventually become an acquisition target, possibly for Aetna Inc. (NYSE:AET), Cigna Corporation (NYSE:CI) or Humana Inc (NYSE:HUM), which all recently lost the ability to merge with one another and will be looking for a merger partner that can fuel their growth.
Beyond that, Wilkes does not believe that Centene’s current valuation reflects the long-term prospects for Medicaid. Managed care has been growing at 11% per year, compared with Medicare Advantage growth of 5.6%, but since November the company has been trading at a discount to other managed care providers.
As this readjusts, the growth of Centene will be more recognized by the market and the price of the stock should increase.
Dana Blankenhorn is a financial and technology journalist. He is the author of the sci-fi novella Into the Cloud, available at the Amazon Kindle store. Write him at firstname.lastname@example.org or follow him on Twitter at @danablankenhorn. As of this writing he owned shares in QSR and AAPL.