Three Great Buys Amid the Ruins of Brexit

By now, almost every investor is familiar with Brexit, the decision by voters in Great Britain to leave the European Union. As the votes were being counted last Thursday night, traders seemed to realize the politicians who organized the campaign to leave weren’t discussing their plans. Leaders almost seemed surprised by the victory and the lack of a clear roadmap for negotiations sent markets around the world sharply lower. The chart below shows us what we need to know from a trading perspective, which is that the initial selloff was clearly an overreaction.

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  • Brexit provided a demonstration of the efficient market hypothesis (EMH) in action. The EMH is an academic theory that says market prices reflect all of the known information about a stock. For example, if traders know with certainty a stock will earn $10 a year for the next 20 years, adjusted for inflation, and pay a constant inflation-adjusted dividend of $4 a year they can construct a discounted cash flow model to determine the net present value of that stock to the penny. In the real world, no one trader knows everything about but the EMH holds that as a group, all of the potential buyers and sellers in a stock do possess all of the available information about a stock. Collectively their actions discount all of the information and the current market price should be the true value of a stock at that moment.

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  • When news arrives, including earnings reports, traders instantly analyze that information and move the current price to the correct value. This explains why gaps are so common after earnings announcements, since traders are adapting to new information contained in the quarterly financial statement.

    In the case of Brexit, polls showed the election was close but market participants seemed to believe voters would choose to remain in the European Union (EU). Watching after-hours trading action that night, prices drifted higher as results started coming in showing a slight edge for remain. By the time 3% of the vote was counted, analysts changed their opinions and announced Great Britain would leave the EU. Markets around the world plunged on the news and the selling continued into Monday as traders evaluated the new information.

    In hindsight, it appears the selling was overdone and stock prices around the world now seem to be retracing the decline.

    Recent behavior of the market is fully in line with the EMH. Brexit provided new information for the markets to evaluate. It is a complex problem that will take months and possibly years to fully understand. Selling is a natural response to unexpected news and it will almost always go too far. In the short term, meaning for next three months or so, Brexit is not likely to change anything. Changes will come slowly and be revealed to traders after the EU and Great Britain start negotiating the exit.

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  • Until the world actually changes, and it will at some point in the future, we should look at selloffs like we saw as a buying opportunity. The question is what stocks are the best buys for now. We found three stocks that fell at least 10%, offer value and are expected to grow earnings over the next two years.

    American Equity Investment Life Holding Company (NYSE: AEL) develops and sells fixed index, fixed rate annuity products and single premium immediate annuities throughout the United States.  AEL offers these products through about 40 national marketing organizations as well as approximately 35,000 independent agents.

    American Equity recorded about $1.7 billion of fixed-indexed annuity sales in the first quarter, ranking second in the U.S. behind Allianz, a much larger company. Those annuities typically give investors returns linked to the performance of a stock market index and can offer some protection against market declines. Often the product will guarantee a minimum rate of return and allow for limited upside in bull markets. For example, if the market loses 20% the annuity value might be unchanged or gain some minimal amount like 2%. If the market gains 20%, the annuity value might increase just 8-10% since annual gains will be capped. These products can be very profitable for issuers and are especially popular when investors are nervous.

    In the past seven years, AEL’s revenue grew an average of 24% a year while earnings per share (EPS) grew an average of 34% a year over that time. Analysts expect a decline in EPS to $2.13 this year from $2.42 last year before a new high of $2.53 next year and $2.92 in 2018. EPS growth is expected to average 10% a year. Despite the growth, AEL has been declining on concerns that new rules from the Department of Labor on fiduciary standards will hurt earnings.

    Annuities could be less attractive under the rules which will require disclosure of the high costs of the product. The company is addressing that and should be able to fine tune its sales pitch to highlight the risk of loss while disclosing the fees.

    Historically, annuity companies have traded at 90% of their book value, offering a price target of $24.47 for AEL. The 52-week low provides a nearby stop-loss level. Those prices are highlighted in the chart above.
    Action to take: Buy AEL on confirmed strength with a move above $13.93. The long-term price target is $24.47 and the initial stop is $12.60 presenting an unusually favorable potential reward-to-risk ratio.

    Penske Automotive Group, Inc. (NYSE: PAG) operates retail automotive and commercial vehicle dealerships primarily within the United States and Europe.  The company also distributes commercial vehicles, diesel engines, gas engines and power systems in New Zealand and Australia.

    Penske’s selloff is easy to understand. The company reported $6.4 billion of its $19.3 billion in revenue last year (33%) came from the United Kingdom. At the end of this year’s first quarter, the company had 170 of its 349 franchises outside the U.S., with most of those in the U.K. The U.K. was the fasting growing market in the first quarter with sales of new vehicles up 14% in the country but flat in the U.S.

    A strong dollar could hurt PAG and analysts have been incorporating that into their earnings estimates. In 2017, the consensus estimate of 12 analysts covering the stock is for EPS of $4.25. The most pessimistic analyst sees EPS of $3.90 and growth averaging 9% which is below the consensus view of 10.3%. Using the pessimistic forecast, the stock could be worth about $35.10 with a P/E ratio of 9. A more realistic price target is $38, about 19% above the current price. This is ten times the worst case earnings estimate for 2018.

    Action to take: PAG is a buy at $32.44 or above. Consider a stop at $24.42. The initial price target is $38 and the long-term price target is $51.49 based on the chart pattern.

    Tenneco Inc. (TEN) designs, manufactures and sells clean air and ride performance products for light vehicle, commercial truck, off -highway and other vehicle applications worldwide. In addition, TEN offers vehicle emission control products and systems.

    TEN is a multi-national corporation with 89 manufacturing facilities in 26 countries located on 6 continents with major centers of operations in North America, Europe, Australia and Asia. Its products are sold to over 500 after-market customers including more than 25 auto makers, including Audi, Chrysler, Fiat, Ford, General Motors, Honda, Jaguar Cars, Mazda, Nissan and Volvo. Traders seem to be focused on the customers and facilities in the U.K. which includes two factories in Wales.

    As a multinational, TEN is positioned for global turmoil and should be able to recover from Brexit quickly, no matter what the outcome is. After the recent selloff, the company is trading at just 11.3 times earnings, about 12.5% below its average valuation over the past five years. With EPS expected to increase about 15% a year, the stock could deliver a total return of more than 25% as the multiple expands and earnings growth is factored into the stock price.

    Action to take: TEN is a buy at $46.32 or higher. The initial price target is $57.50. The initial stop is at $38.65.


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