On Markets & Investing

Monthly Stock Idea Lab: March 2023

2 April 2023
In this post, I introduce a new format: Monthly Stock Idea Lab
Every week, I come across a dozen stocks that look initially interesting. I find them by reading the financial press, other investor blogs and letters, annual reports, listening to podcasts, speaking to fellow investors, doing periodical screens, and other sources.

I filter them to keep just one or two with the best risk/reward profiles. By the end of the month, I have between 5 to 10 stocks that I add to my watchlist. I wait for a better price or a stronger conviction depending on a particular case, before deciding to invest in a company. In most cases, a stronger conviction usually comes from a deep dive that I do later or if I address the critical issue behind the share price drop.

In case you have not read them, here are my three posts on this subject:

  • A New Investment Opportunity? My First Five Questions (Part 1) - Link
  • How to Analyse a New Investment Opportunity (Part 2) - Link
  • Investment Checklist: My Key Points of Focus - Link

In most cases, these stocks remain on the watchlist, but the knowledge compounds over time.

Here is the list of seven exciting stocks for March 2023. To be clear, these are work-in-progress ideas that have passed some initial filters. These are not investment recommendations. More work is needed on each of them.

I. [Available to subscribers only. Please SUBSCRIBE to receive the full details by email in the future.]
II. [Available to subscribers only. Please SUBSCRIBE to receive the full details by email in the future.]
III. Alibaba
IV. Walgreens Boots (h/t Value Investors Club)
V. Charles Schwab
VI. Kistos Plc
VII. Barrick Gold (h/t to a long-term subscriber)

III. Alibaba

Ticker: BABA US
Share price: $102.2
Market Cap: $264.8bn
EV: $208.0bn

There have been two important developments in Alibaba’s investment case recently.

Firstly, Jack Ma, the company’s founder, has finally returned to China. There are reports that he could have struck a deal with the government. WSJ has pointed out that the new PM, Li Qiang devoted much of his first news conference last month to reassuring entrepreneurs of Beijing’s support for the private sector.
“Although Mr. Ma has been absent from the spotlight, his every move has made headlines, and he still casts a long shadow over China’s business environment. His fortunes are viewed at home and abroad as a barometer of Beijing’s attitude toward private enterprises.”
As you may recall, most (although not all) problems for Alibaba started when Jack Ma openly criticised the regulators back in October 2020. He has not been seen in public pretty much the whole time afterwards. Afterwards, Alibaba had to pay a $2.8bn antitrust fine, removed forced exclusivity for merchants (which negatively impacted its profitability) and scrapped the idea of building a single super-app / one eco-system. Its financial arm, Ant Financial, had to cancel its IPO, while the company.

In this context, the news that Jack Ma is back in China and is now ‘visible’ again may suggest that his conflict with the regulators is largely over.

The second news was the company’s plans to split into six independent businesses that could seek separate IPOs. The hope here is for the traditional sum-of-the-parts argument to drive the share price higher.

Alibaba is trading at a 13x PE ratio. However, its earnings are significantly under-reported since several of its business units are still generating losses in pursuit of higher growth (e.g. International Commerce, Logistics) or earning well below their long-term potential (e.g. Cloud’s EBITA margin is just 2%).

If the same 13x PE multiple is applied to its core Chinese e-commerce business while other businesses are valued separately, there could be at least a 50% upside to the latest share price ($102).

Alibaba has fallen to 13x PE partially due to negative sentiment and higher risks that investors associated with China. The recent developments could improve sentiment.

The three major risks are growing domestic competition, the health of the Chinese economy, and geopolitics (US-China relations, China’s strategy towards Taiwan).

IV. Walgreens Boots

Ticker: WBA US
Share price: $34.6
Mkt Cap: $29.8bn
EV: $41.7bn
This is one of the largest pharmacies in the US, which is now available at 8x forward PE and 12% FCF yield (one of the lowest levels in its history). The company should deliver a strong recovery in earnings in the second half of the year. If its valuation discount narrows from the current 53% to a historical average of 10%, the stock could be worth $70 (almost a 100% gain from the current price).

Besides, the company owns 34mn shares of its competitor, AmerisourceBergen (ABC), with a market value of $5.4bn (18% of $WBA’s market cap).

Here is a summary of its historic performance:
You can read the full write-up on Value Investors Club’s website (requires a free account to login).

V. Charles Schwab

Ticker: SCHW US
Share price: $52.4
Mkt Cap: $95.6bn
Charles Schwab is the leading retail broker in the US, which has been in business for almost 50 years. Its current CEO, Walt Bettinger, has been with the company since 1995 and owns 2.6mn shares of Schwab. The founder of the company, Mr Schwab, remains its chairman and owns 6.1% of the company.

Charles Schwab has generated tremendous value for its shareholders (18% annual return, not including dividends) over the past 34 years. During 2002-2022, it has achieved a 21% EPS CAGR, having operated across various cycles and under different macro conditions.
It is known for one of the best customer services and constant innovations to offer the best products. In 2019, it announced a merger with one of its key competitors, TD Ameritrade.

$SCHW share price is down 40% as its bond portfolio is facing severe mark-to-market losses.

It earned $3.9 EPS last year and is expected to generate $4.4 EPS in 2023, which puts it under 12x on current PE, based on consensus estimates.

As the company stated in its latest 10-K:
“ to access new Federal Home Loan Bank advances or roll over existing advances, our banking subsidiaries must maintain positive tangible capital, as defined by the Federal Housing Finance Agency. Larger unrealised losses on our available for sale (AFS) portfolio due to higher market interest rates could negatively impact our tangible capital.”
Its Tier 1 leverage ratio was 7.2% at the end of 2022 (7.3% for the banking subsidiary).

At the end of 2022, the company had $15.6bn unrealised losses arising from the difference between the book value of Held-to-maturity securities and their market value. Its total equity was $36.6bn.

So the two key questions are:

  • Whether the company will need to raise new capital to fight the deposit outflow (most of it is going into money-market funds and other high-yield products offered by Charles Schwab itself).

  • How much its earnings will compress as the company replace cheap deposit funding with more high-cost options.

At first glance, the company should be able to avoid raising new capital because:

  • Under the newly established Bank Term Funding Programme (BTFP), it can exchange US Treasuries, agency debt and mortgage-backed securities, and other qualifying securities at par for 1-year loans from the Fed. In other words, instead of selling bonds at market prices below book value, Charles Schwab can sell them to the Fed at nominal value.

  • It generates $100bn of cash flow from its cash assets on hand as well as net new assets it plans to realise over the next twelve months.

  • Charles Schwab estimates that it has over $8bn in potential retail CD issuances per month.

  • The company also estimates it has over $300bn of incremental capacity with the Federal Home Loan Bank (FHLB).

One way to improve the liquidity position for Charles Schwab is to slow down new loans and investments and let the incoming interest accumulate on its balance sheet.

Moreover, it has successfully navigated previous crises, including in 1987, 2000 and 2008. In his autobiography, Invested, Schwab discusses in detail previous episodes.

As long as the company can maintain enough liquidity, its mid-term outlook looks strong. The broker benefits from higher interest rates as it can focus more on clients’ cash balances (low rates during the past decade were a significant headwind). Besides, the full integration with TD Ameritrade will be completed by 2024, which should positively impact its operations.

VI. Kistos Plc

Ticker: KIST LN
Share price: £2.98
Mkt Cap: £259mn
EV: £230mn
The main reason to consider investing in Kistos is its CEO and shareholder, Andrew Austin. He has had an excellent track record in building small-scale E&P companies in Europe and selling them at a premium to strategic shareholders.

Andrew Austin listed his previous company, RockRose Energy, in January 2016 at 50p. The company was acquired for 1,850p in summer 2020. IPO investors earned a staggering 42x return in just 4.5 years if dividends are included.

Kistos focuses exclusively on producing assets with low geological risks and strong cashflow generation in shallow waters of the North Sea and onshore Netherlands. It seeks to acquire predominantly mature assets which are of little interest to large players like BP or Shell. Such assets have high atonement costs and often mask the asset's true value.

Suppose an asset has 10mn boe of remaining reserves with an NPV of $10/boe. The asset is worth $100mn but may carry $90mn of abandonment costs, leaving $10mn as equity value.

However, if the asset life can be extended through additional drilling and higher oil recovery from existing wells, then the NPV of reserves can be increased. At the same time, the NPV of future costs to abandon the field may be lower due to the time value (more years before the field is shut down). Besides, the company can reduce decommissioning liability by finding more cost-efficient solutions.

With higher production, the asset could be worth $150mn (+$50mn more). At the same time, a potential reduction in decommissioning liabilities from $90mn to $50mn, for example, boosts the asset's equity value from a meagre $10mn to $100mn - a tenfold boost.

The key risks include spot gas prices and extra tax burden (windfall taxes).

VII. Barrick Gold

Ticker: GOLD US
Share price: $18.6
Mkt Cap: $32.6bn
EV: $32.9bn
This idea was flagged by a long-term subscriber to this blog, who preferred to remain anonymous.

Here is his summary:

  • Great gold mining assets
  • Growth copper assets
  • A very well-run company able to grow its asset base
  • Strong financial position with the capacity to buyback shares
  • Will benefit once oil price comes down
  • The current price is cheap and protects the portfolio against additional inflation

I have briefly looked at the company, and here are my thoughts.

Barrick is probably the world’s best operator of gold assets, the largest gold producer in the US and one of the leading producers globally. It has the largest portfolio of tier-1 gold assets in the world.

The company has returned c. 5% cash to shareholders via dividends and buybacks with plans to increase distributions in the future. Importantly, the company has paid back almost $4bn of net debt since 2019 and now has essentially a zero net debt position.

At spot prices, it generates around $4bn of FCF (including $850m dividends from equity investments), on my estimates. With a market cap of $32.5bn, Barrick’s FCF yield is about 12.5%, on my back-of-the-envelope estimates.

There are two main reasons to own Barrick:

1. Hedge against inflation and financial instability.

2. Growing copper production (c. 25% of the business in the future).

Bear in mind that gold stocks have historically traded at a 2-3% FCF yield, as investors were happy to hold them as an option on future growth in gold prices/inflation. Today, inflation is rising, and gold prices have started to move higher (up over 20% since October 2022).
The reader has summarised his views in the following way:
“The company is essentially stronger than in 2019 as their reserves are higher for both gold and copper, and the price of gold is much higher. Yet, its share price, having reached $30 in 2020, is now back to 2019 level ($15-18).

In the Worst case, the stock will trade laterally with a decent dividend yield supported by their buyback if gold comes down towards $1,300-1,500/oz.

The Best case is a 75%-100% upside if gold and copper stay at today's levels, supported by the downward price of oil cost and cheaper energy sourcing from renewables.

I am grateful to the subscriber for sharing his recent investment idea (he asked me not to reveal his name).

Thank you for reading this article. It would be great to hear your feedback on any of these names. Feel free to drop an email to ideas AT hiddenvaluegems.com or leave a comment below this post.

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Disclaimer: This publication is not investment advice. The primary purpose of this publication is to keep track of my thought process and improve my decision-making. Readers should do their own research before making decisions. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. The author could have held a position in any of the stocks discussed above at the time of writing. Please read the full version of Disclaimer here.