With the U.S. economy in shaky territory, two University of Wisconsin-Madison graduate students say there's one examination every stock should undergo: the stress test.
The subprime mortgage mess and subsequent paralysis in U.S. credit markets have made banks hesitant to lend and investors skittish about stocks. It's unclear how much longer the situation will last, and how much blood will be left on Wall Street when it ends.
That's why John Poehling Jr. and Jason Schultz say stress testing your stocks is so important.
It's good work for a pessimist, or at least someone who worries a lot about risk.
To do a stress test, you build into your estimates for a company the possible effects a deteriorating economy will have on factors like unit volumes, cash flow, debt load, market values for the industry and profit margins.
"In this environment, you really want to look at worst-case scenarios," said Schultz, who like Poehling, is seeking an MBA in finance and is a participant in the UW-Madison business school's Applied Security Analysis Program.
"If you look at a company and say this is the worst case and I still like it from a valuation perspective, you've really got to consider buying it," Schultz said.
Take Goodyear Tire & Rubber Co. (GT).
It came out of Poehling's analysis looking like a very appealing stock, he said.
"A large part of my comfort level with Goodyear comes from stress-testing my model and putting in pretty much the most Draconian scenario I could come up with," he said.
Even if Goodyear's unit volumes dropped 12% and profit margins declined by one percentage point, Poehling would still expect more than $500 million of free cash flow for the Akron, Ohio, tire maker.
Goodyear is targeting $2 billion of annual cost savings by the end of 2009, and all of those savings would flow directly to earnings, he said.
Goodyear's stock is down more than 10% this year, a decline Poehling says is overdone.
The company's management team has done a "tremendous job" of selling assets when it could and reducing high-interest rate debt. Goodyear was first among big companies with legacy issues of unfunded health care and pension funds to strike a deal with its union. It negotiated to buy out unfunded health care obligations at 70 cents on the dollar, Poehling said.
Goodyear has also done a good job expanding abroad and setting up in low-cost production countries. It sees big opportunities overseas where customers want branded products like its own, he said.
The biggest risk Poehling associates with this stock is the possibility that commodity prices could continue rising and Goodyear wouldn't be able to pass all of them on to customers. There's also a chance prolonged economic problems would cause more customers to trade down from Goodyear's premium tires to knockoffs, he said.
The company weathered the worst of his stress test, though, so Poehling says he's recommending his colleagues buy more Goodyear shares for the student-run Long/Short Equity Fund, which bought some Goodyear shares in November. Poehling says these shares could go as high as $35 in the next 12 to 18 months.
CVS Caremark Corp. (CVS) is a company with a reasonable valuation that looks good in a stress test, Schultz said.
CVS bought Caremark in April, nearly doubling its revenue with the acquisition.
Schultz said Wall Street is underestimating the power of CVS Caremark's combined retail pharmacy and pharmacy benefits management businesses, the latter of which manages prescription drug spending for large corporations and other customers and provides about five times more cash flow than the retail pharmacy business, he said.
"From a discounted cash-flow perspective, this company is being significantly undervalued by the market," he said.
CVS Caremark is pioneering the idea of running what it calls "minute clinics" in its stores. The company has nearly 400 of them already and plans to have as many as 700 by the end of this year. Staffed with physician's assistants and nurses, the clinics cater to customers with minor health issues like a fever or the flu, providing services that are quicker and cheaper than visiting a doctor's office, Schultz said.
The biggest risk Schultz associates with the shares is the chance the integrated retail pharmacy / pharmacy benefits management model might not work. There's also political risk that comes from the possibility of government changes in things like Medicare reimbursement, and the possibility Wall Street wouldn't respond well if revenue declined and profits rose because of shifts to generic medications, he said.
This company is a stress-test star, though, and Schultz says he's recommending that both the $500,000 Long-Short Equity Fund and the student-run $1.3 million Long-Only Fund buy its shares, which, he said, could go as high as $55 in the next 12 months.