Stock Exchange: How Durable Is Your Franchise?

The Stock Exchange is all about trading. Each week we do the following:

• Discuss an important issue for traders;
• Highlight several technical trading methods, including current ideas;
• Feature advice from top traders and writers; and,
• Provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some earnings season ideas, please join in!

Review

Our last Stock Exchange took a closer look at big moves in the retail sector, as well as the opportunities and challenges they create. If you missed it, a glance at your news will show that the key points remain relevant.

This Week – Is Your Company’s Franchise Value Changing?

According to Oxford Dictionaries, a franchise is defined as “An authorization granted by a government or company to an individual or group enabling them to carry out specified commercial activities.” Understanding a company’s franchise value can be critically important to traders, particularly when broad market conditions are changing. What might be a terrific franchise in some market environments can be a terrible franchise under different circumstances. More specifically, if your franchise is authorized to carry out only certain activities, but the market is changing so those activities are no longer in demand, then the value of your franchise isn’t what it used to be.

And here is what Warren Buffett has to say about franchise value:

“If you got the right kind of product, you may be paying for taste, you may be paying for a mental association that you have, or service availability. That’s franchise value, then the question is how durable and big is it? I’d say that franchise is basically like a moat around your economic castle.”

However, tastes, mental associations and service availability can all change over time (i.e. they’re not always “durable”). And it is in these periods of change that some of the best trading opportunities can be found.

Expert Picks from the Models

This week’s Stock Exchange is being edited by our frequent guest: Blue Harbinger (also known as Mark Hines). Blue Harbinger is a source for independent investment ideas focused on value and high-income opportunities (for example, check out the ideas in Blue Harbinger’s most recent Blue Harbinger Monthly). And this week’s diverse group of model picks are being tied together under the theme of “franchise value.” In particular, the franchise value of each of this week’s picks is being impacted significantly by current market conditions.

Road Runner: My most recent pick is Electronic Arts (EA). I look for stocks that are at the bottom of a rising trading channel and if you look at the chart below you can see why I like Electronic Arts. It’s been in a steady rising channel since May and has just pulled back in the channel to $116.92. I expect the price of EA to rise back to the top of the channel, but it will only hold that position for so long.

Blue Harbinger: I believe Electronic Arts dominant franchise in sports video games (e.g. Madden18, NBA Live 18, and FIFA 18) will give it a steady flow of healthy cash flows as it continues to release new highly-sought-after versions, year after year. However, I also realize EA is little expensive right now from a price-to-earnings standpoint, especially considering it’s still proving itself in the online and mobile gaming markets.

 

RR: I really don’t care about fundamentals like P/E ratios and cash flows, but I can appreciate that EA isn’t the pick for everyone right now.

BH: Just last week EA lowered sales guidance for 2018, but it’s still expected to grow. I think as long as the company continues to release new versions of its top selling games year-after-year, and assuming consumer preferences don’t change dramatically, the company will be fine over the long-term. I just believe given the recent price rally so far this year, combined with the high P/E ratio, now isn’t the best time for long-term investors to add shares.

 

RR: That’s great that you’re considering the long-term value of the franchise, and our readers might care about that too, but I simply look at the chart and like what I see! How about you, Holmes, what have you got?

 

Homes: This week I like Northern Trust (NTRS). This stock’s dip two weeks ago is the sort of set up I like to see when sniffing out a good deal. From the chart below you can see NTRS is below its 50-day moving average, and reasonably priced relative to its 200-day moving average. It’s also received support at the $87.50-level. The price moving above the 50-day average at $92.40 would be encouraging. With limited downside and plenty of upside potential, I hope I’ve brought the humans a solid pick.

 

 

BH: I believe Northern Trust is a decent buy at its current price for a couple reasons. First, rising interest rates help the business because of an improved net interest margin. And second, a rising stock market also helps the business because a large portion of its revenues depend on assets under administration/management. However, for full-disclosure purposes, I may be biased because I worked at Northern Trust for several years, and I have a positive view of the company.

 

Holmes: Your subjective views and biases are exactly what I have been designed to avoid. Humans can be illogical, my decisions are based on objective data. My style is dip-buying mean reversion, my average holding period is six weeks, I exit when my price target is achieved, and I control risks based on macro factors and stops.

 

BH: I also like Northern Trust because of its strong franchise value. It has a squeaky clean reputation that allows it to maintain its long list of ultra-high net worth wealth management clients. Northern Trust’s reputation is also enabling its continued focus on expanding business in the United Arab Emirates with its recent new branch office in Abu Dhabi.

 

Holmes: That’s all great, but I’ll stick to the hard data instead of the touchy-feely stuff.

 

Felix: Seagate Technologies (STX) looks extremely “out of favor” right now, and to me, that’s what makes it attractive. The continued pullback since late April is signaling a bottom. As a long-term investor, that’s a very important factor. Have a look at this chart of the past 12 months.

 

I’ll admit this does not read as a success story, though I still think it provides a useful entry point. I could easily see some recovery back up to the $37.50 mark, especially with my extended time frame.

BH: Felix do you even know what Seagate does? Seagate is basically a hard disk drive producer, and with the ongoing proliferation of cloud computing and data centers, Seagate’s desktop and notebook PC hard disk drives seem like a very unattractive investment. This is a franchise that was very powerful only a few years ago, but with the continuing slow death of the PC and hard disk drives in favor of mobile and cloud-based computing, Seagate looks anemic to me.

Felix: Okay, that’s interesting. However, I can tell you that I like the current price as an entry point and that I would be looking for a long-term holding. There are plenty of companies and stock prices that have made turnarounds, and I’d much rather buy something on sale than pay full price.

BH: I can appreciate your frugalness, and I agree that companies can and do make turnarounds. In fact, Seagate is trying to capitalize on the big growth in data centers. Specifically, Seagate is investing in high-capacity storage devices to support cloud-based infrastructures. However, I just don’t think it’s going to be enough to offset the declining PC market. Seagate isn’t going out of business overnight, but unless something dramatic happens, it has a very uphill battle ahead.

Felix: Fair enough, we shall see.

Oscar: This week I bought into the healthcare sector, via the healthcare sector ETF (XLV). I like the sector because it has been exhibiting strong momentum, and based on recent volatility I can see some upside.

BH: Healthcare has been interesting over the last 5 years starting with the US supreme court’s 2012 decision to uphold the Affordable Care Act, followed by more recent efforts to “repeal and replace” the law. We’ve even seen a lot more choppiness in the price of XLV very recently as Congress has tried and failed to change the law.

Oscar: I typically hold these position for about six weeks, and I usually exit by rotating into another sector.

BH: If we consider the healthcare sector according to our earlier definition of a franchise (i.e. as “an authorization granted by a government or company to an individual or group enabling them to carry out specified commercial activities”) then the recent volatility you have described makes perfect sense. There is a lot of uncertainty in the healthcare sector right now, and based on how the laws change (or do not change) there will be winners and losers in the sector. For example, if efforts by some members of Congress to slow the growth in Medicaid reimbursement are successful, this will hurt some companies in the sector more than others. However, the overall demographics-driven need for healthcare continues to rise, and healthcare is likely a fairly decent long-term bet.

Oscar: That’s an interesting story, but again, I typically hold these position for only about 6-weeks, and the objective data is currently attractive. Based on momentum, XLV looks like a winner.

Conclusion

Knowing the strengths (and weaknesses) of your franchise can help you understand the near-term moves and long-term direction of your trades, especially in the light of changing market conditions. However, it’s the model’s job to not be influenced by market narratives that can be subjectively interpreted. It’s the model’s job to follow its technical indicators carefully and to remain consistent.

Stock Exchange Character Guide

Background on the Stock Exchange

Each week, Felix and Oscar host a poker game for some of their friends. Since they are all traders, they love to discuss their best current ideas before the game starts. They like to call this their “Stock Exchange.” (Check it out for more background). Their methods are excellent, as you know if you have been following the series. Since the time frames and risk profiles differ, so do the stock ideas. You get to be a fly on the wall from my report. I am usually the only human present and the only one using any fundamental analysis.

The result? Several expert ideas each week from traders, and a brief comment on the fundamentals from the human investor. The models are named to make it easy to remember their trading personalities.

 

Getting Updates

We have a (free) service for subscribers of our Felix/Oscar update list. You can suggest three favorite stocks and sectors. Sign up with email to “etf at newarc dot com”. We keep a running list of all securities our readers recommend. The “favorite fifteen” are top ranking positions according to each respective model. Within that list, green is a “buy,” yellow a “hold,” and red a “sell.” Suggestions and comments are welcome. Please remember that these are responses to reader requests, not necessarily stocks and sectors that we own. Sign up now to vote your favorite stock or sector onto the list!