August performance recap

The most attractive stock (-4.6%) outperformed the S&P 500 (-4.8%) by 0.2% from August 3, 2022 to August 31, 2022. The best performing large-cap stocks were up 7% and the best performing small-cap stocks were up 26%. Overall, 22 of the 40 most attractive stocks outperformed the S&P 500.

The riskiest stocks (-2.6%) underperformed the S&P 500 (-4.8%) as a short portfolio by 2.2% from August 3, 2022 to August 31, 2022. The top-performing large-cap short was down 24%, and the best-performing small-cap short was down 22%. Overall, 19 of the 36 riskiest stocks outperformed the S&P 500 as a short.

The most attractive/riskiest model portfolios underperformed the equally weighted long/short portfolio by 2.0%.

Ten new stocks made the most attractive list this month, and 22 new stocks also made the most dangerous list. The most attractive stocks have a high and growing return on invested capital (ROIC) and a low price-to-economic book value ratio. Most Dangerous stocks have misleading earnings and long growth appreciation periods resulting from their market valuation.

The most attractive event for September: Eni SpA

Eni is a recommended stock from the September portfolio of the most attractive stock models.

Eni has increased net operating profit after tax (NOPAT) by 60% annually over the past five years. Eni’s trailing 12-month (TTM) NOPAT margin increased from 1.5% in 2016 to 13%, while capital employed turnover increased from 0.6 to 1.2 over the same period. Rising NOPAT margins and capital employed turnover drive the company’s return on invested capital (ROIC) from 1% in 2016 to 15% over TTM.

Figure 1: NOPAT as of 2016

Eni is undervalued

At the current price of $23/share, E has a price to economic book value (PEBV) ratio of 0.1. This ratio means that the market expects Eni’s NOPAT to fall by 90% on a sustained basis. That expectation seems overly pessimistic for a company that has grown NOPAT by 60% annually over the past five years.

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Even if Eni’s NOPAT margin fell to a 10-year average of 5% (vs. 13% TTM) and NOPAT declined by 8% per year over the next decade, the stock would be worth $35+/share today – a 52% increase. Check out the math behind this reverse DCF scenario. If Eni grows earnings more in line with historical levels, the stock will see even more upside.

Critical details found in financial records using my company’s Robo-Analyst Technology

Below are details of the adjustments I made based on Robo-Analyst’s findings in Eni’s 10-Q and 10-Ks:

Income Statement: I made adjustments of $12.1 billion with the net effect of eliminating $3.1 billion in non-operating expenses (4% of revenue).

Balance Sheet: I made $47.5 billion in adjustments to calculate invested capital with a net decrease of $3.1 billion. One of the most notable adjustments was the $16.5 million in asset write-offs. This adjustment represented 15% of reported net assets.

Valuation: I made adjustments of $44.8 billion with a net dilutive effect to shareholder value of $20.0 billion. Aside from total debt, the most notable adjustment to shareholder value was the $6.7 billion in excess cash. This adjustment represents 16% of Eni’s market capitalization.

Most Dangerous Stocks Feature: Eaton Corporation PLC

Eaton Corporation PLC (ETN) is the lead stock from the September model portfolio of the riskiest stocks.

Since the acquisition of Cooper Industries, Eaton’s economic profits, the actual cash flow of the business, have fallen from $922 million in 2012 to -$22 million TTM. Eaton’s NOPAT margin fell from 10.9% to 10.5%, while returns on invested capital fell from 0.9 to 0.6 over the same period. Declining NOPAT margins and invested capital turnover drive Eaton’s ROIC from 10% in 2016 to 6% TTM.

Figure 2: Economic gains since 2012

Eaton provides low risk/reward

Despite its poor fundamentals, Eaton stock is valued at significant earnings growth and I believe the stock is overvalued.

To justify its current price of $143/share, Eaton needs to improve its NOPAT margin to 13% (an overall high compared to 11% TTM) and grow NOPAT by 10% annually for the next ten years. Check out the math behind this reverse DCF scenario. Given that Eaton’s NOPAT has declined by 3% annually over the past five years, I believe these expectations are overly optimistic.

Even if Eaton could maintain its TTM NOPAT margin of 11% and NOPAT growth of 5% per year for the next decade, the stock wouldn’t be worth more than $80/share today — a 44% decline from the stock’s current price. Check out the math behind this reverse DCF scenario.

Each of these scenarios also assumes that Eaton can increase sales, NOPAT and FCF without increasing working capital or fixed assets. This assumption is improbable, but it allows me to create truly best-case scenarios that demonstrate how high the expectations are embedded in the current valuation.

Critical details found in financial records using my company’s Robo-Analyst Technology

Below are details of the adjustments I made based on Robo-Analyst’s findings in Eaton’s 10-Q and 10-K:

Income Statement: I made $1 billion in adjustments with the net effect of eliminating $204 million in non-operating income (1% of revenue).

Balance Sheet: I made $8.6 billion in adjustments to calculate invested capital with a net increase of $4.6 billion. One of the most notable adjustments was $3.6 billion in other comprehensive income. This adjustment represented 14% of reported net assets.

Valuation: I made adjustments of $11.2 billion with a net reduction in shareholder value of $11.2 billion. Aside from total debt, the most notable adjustment to shareholder value was the $963 million in underfunded pensions. This adjustment represents 2% of Eaton’s market capitalization.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini receive no compensation for writing about any particular event, style, or topic.