(This content was originally published as an Action Alerts PLUS Alert on June 28, 2016. Stock prices, shares held and portfolio positions may have changed.)
We received a great question in the Forum recently asking why we would potentially violate our rule and purchase Thermo Fisher (TMO) above our cost basis.
This is a great question and we wanted to take the opportunity to explain, in a broader sense, when a situation would arise where we would be comfortable violating our basis. Importantly, TMO and Dow Chemical (DOW) are the two names we are watching currently for which we would be willing to purchase above our cost basis, roughly $129 for TMO and $45 for DOW.
First, yes, our rule is to not buy above your cost basis.
This allows us to buy into a name with a starter position (low amount of shares) and then slowly build the position, if the stock price falls, while lowering our average cost in the name. By following the rule, we ensure that we remain disciplined and grounded and avoid purchasing a stock at its peak after it has rallied.
But there can be special circumstances where we analyze a position on a case-by-case basis and decide, for instance, that the company-specific story has changed substantially, adding to our conviction in the long-term story. We also, of course, incorporate our macro views and judge the overall sentiment permeating through the broader market as we evaluate what types of names can outperform in a given environment. From this sense, the constant search for yield given the Brexit fallout, for example, has put a premium on quality companies paying safe, solid dividends. DOW, which currently yields around 3.7%, fits the bill.
On the company-specific side, a change in conviction can typically also see an increase in our price target. For TMO, we recently raised our price target to $170 from $155. Price target revisions, at their core, are either due to a change in underlying estimates (typically earnings, or, depending on the multiple used, EBITDA, sales or another metric) or a belief that a company's multiple will either expand (in the case of a price target increase) or contract (in the case of a price target decrease).
While either of these cases (a change in estimates or multiple) can occur as a result of several different events, we typically look at acquisitions (which are either accretive or dilutive to earnings), quarterly results, significant changes in underlying end markets, specific upcoming catalysts (company-specific or industry-wide), or things of that nature as reasons to either revise our estimates or believe in a potential multiple change.
Using TMO as an example, we raised our price target two times in the last couple of months, first to $155 from $150 and then again to $170 from $155. In each of these cases we kept our expectations around a fair-value multiple the same (around 19x), but adjusted our estimates to reflect the acquisition of AFFX (see here for the Alert detailing the acquisition) and more favorable end markets.
At this point, we now see additional upside in the name, making levels above our cost basis more attractive, especially given the low multiple that is currently being attributed to the stock. So, we believe the name becomes very interesting below $140, where it would be trading just slightly over 15x 2017 earnings. We have been looking for an opportunity to add back to the position since we trimmed in the mid-$140s in April (see the Alert here) and this was even before we revised our estimates upward.
On DOW, we continue to love the long-term story as a standalone company or as a combined entity with DuPont (DD) . With the deal (see our Alert here outlining the initial agreement), we see great potential for synergy capture (both on the cost and growth side) and trust that the eventual separation into three individual SpinCos will unlock incredible value for each segment. To put the icing on the cake, we believe that Dow is getting DuPont at a very reasonable price.
That being said, we recognize that any merger of this size comes with regulatory risk, so we cannot rule out the possibility that the deal could be blocked. But we believe that Dow is set up for a large capital deployment program should the deal have to be called off. In addition, we believe the consistent flight to quality makes Dow's 3.7% yield highly attractive. Ultimately, with or without the merger, we believe Dow is well positioned to benefit from growth in key end markets, including auto, construction and industrial verticals and, increasingly, seeds and crop protection.
In addition, we view the company's announcement this morning, raising its cost savings targets to $400 million from $300 million on the Dow Corning restructuring (announcement here) as an incremental positive. We believe the company is working diligently to scrub its various units to best position itself to capture synergies in the DD merger.
With the stock receiving a downgrade this morning from J.P. Morgan analysts -- who, we point out, noted that "we do not believe that Dow's longer-term business dynamics have materially altered" -- we will be watching the trading action very closely to see if we are given an opportunity and we would consider buying around or below the $49 level.
To sum it up, there are certain circumstances where violating your cost basis can make sense, but these are the exceptions, not the rule. The last consideration we make is to also look at the weight a position currently holds in our portfolio. When looking to maintain a diversified portfolio, we believe it is important to ensure that no one stock has too much influence on the direction of the portfolio. This helps protect from large swings in individual stocks. In the case of TMO and DOW, both are at our around 3% of the portfolio (DOW at just around 3% and TMO at just over 2%), leaving room for us to add to the positions without worrying about being too levered to either one.