International Developed Market ETF (ACWX) - Thesis

iShares MSCI ACWI ex U.S. ETF (ticker: ACWX)
Expected Return: 8.5% per year
Expected Volatility: 20.0% per year
Rating: BUY

Thesis:
As long-term investors, we believe the equity markets will increase over time, and the international (non U.S.) developed market (countries with developed economies) portion of the equity markets will increase at a similar rate as the U.S. markets, however they provide very important diversification benefits that are not available by investing in U.S. markets alone.  The iShares MSCI All Country World Index (ACWI) ex U.S. ETF (ticker: ACWX) offers reliable exposure to the returns of international markets while avoiding the many pitfalls that are common among other ETFs and among other equity investments in general.

Holdings:
ACWX invests in over 1,100 non-U.S. stocks from twenty-one developed market countries.  At least 90% of its assets are invested in securities of the MSCI ACWI ex U.S. Index.  The fund may invest the remainder of its assets in certain depository receipts and derivatives such as futures, options, swap contracts and cash equivalents.  The index is one of the most commonly followed equity indices in the World, and is largely considered the standard benchmark for non-U.S. developed market stocks.  The performance of ACWX has historically matched the performance of the MSCI ACWI ex U.S. Index very closely, and it should continue to track closely in the future because of its construction methodology.  Investors cannot purchase the actual index, and ACWX is the next best thing.

Volume and Liquidity:
As a standard ETF, ACWX has significant volume and liquidity (total ACWX assets exceed $1.8 billion).  Because of the volume and liquidity, the bid-ask spread is small (the bid-ask spread is the difference in price at any given time for someone buying the security and someone selling it.  There is a difference because the middle man takes a very small cut).  A small bid-ask spread is good because it saves you money when you trade.  Second, ACWX trades very close to its net asset value (NAV) because of the large volume and liquidity.  NAV is the actual value if you add up the value of all the securities held within ACWX.  For many less liquid ETFs, the NAV may vary from its actual market price (the price the ETF trades at in the market).  This makes ACWX much less risky for investors compared to other ETFs that may vary widely in price versus NAV.  Additionally, small investors don’t have to worry about some big investor coming in, buying or selling an enormous amount of ACWX, and subsequently adversely moving the market price away from its NAV because the volume of ACWX is already so great that this risk is essentially non-existent.

Low Fees:
The net expense ratio on ACWX is currently 33 basis points (0.33%).  This is extremely low for international market exposure; it is good for investors because it allows them to achieve better returns on their investment.  For comparison, international mutual funds (a common competitor to ETFs) may charge over 200 basis points (2.0%) per year, and they tend to deliver worse performance over the long-term.  Additionally, there is no expensive sales charge or separate investment advisor fee because ACWX can be purchased directly through a discount broker (e.g. Scottrade, E*TRADE, TD Ameritrade, Interactive Brokers, etc.).  The discount broker may charge you a one-time trading fee of $8 or less, but this is much better than the 2-5% sales charge/management fee you’d get charged by a full service financial advisor.  Additionally, there is no hidden 25 basis point (0.025%) annual 12b-1 fee paid to someone for “servicing your account.”  The bottom line here is that ACWX is a very low cost way to get great exposure to the equity market and to build considerable wealth over the long-term.

Dividend Reinvestment:
One last point of consideration, ACWX pays a quarterly dividend (around 2.93% per year), and this dividend is NOT automatically reinvested back into ACWX (this is standard protocol for ETFs and stocks).  This means you’ll build up a cash balance in your account if you don’t withdraw it or manually reinvest it.  As a long-term investor, cash is generally a drag on investment performance.  Unless you plan to withdraw and use the cash, we highly recommend you develop a process to reinvest it.  Most discount brokers (Scottrade, Interactive Brokers, etc.) offer automatic dividend reinvestment programs.  We highly recommend you sign up for these programs to avoid the situation where cash builds up in your account and becomes a drag on your long-term investment performance.  Reinvesting dividends is important.

Conclusion:
ACWX is a very low cost, relatively low risk, security that allows investors to build significant wealth over the long-term.  We consider ACWX to be a basic building block for long-term wealth, and we rate ACWI as a “Buy.”  For more information, you can view the fact sheet for this ETF here.

Union Pacific (UNP) - Thesis

Rating: BUY

Current Price: $95.55

Price Target: $136.20

Thesis:

We own Union Pacific because it is a great business and the stock is currently undervalued.  It’s a great business because Union Pacific has a significant amount of pricing power, access to strategic ports, room for increased efficiency and it will grow as the US economy grows.  It is currently undervalued because of a decline in coal shipments (natural gas’s current price makes it a cheap substitute) and because of an extended west coast port shutdown.  However the decline in revenue from coal is temporary because if coal shipments don’t revert to higher levels then Union Pacific will replace it with shipments of other goods.  Also the west coast port shutdown is mostly temporary.

We value Union Pacific at $136.20 per share using a 50/50 combination of discounted cash flow analysis and a valuation formula first published by Benjamin Graham (Warren Buffett’s mentor) in the 1940’s.

Pricing Power:

According to Warren Buffett “the single most important decision in evaluating a business is pricing power,” and Union Pacific has a tremendous amount of pricing power over its customers.  Buffet claims “if you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”  Through its fuel surcharge program, Union Pacific has the power to raise the price of its railroad services according to fuel prices, and this is one of the reasons UNP is a very good business.  Additionally, there is more railroad demand than there is supply (people often use trucks and barges when they can’t use railroads), and this also gives UNP pricing power.  When demand for one line of UNP’s business softens (for example coal) UNP can offset the softening with another line of business (for example Agricultural products). 

Access to Strategic Ports:

UNP also has access to strategic Pacific Coast and Gulf of Mexico ports which are barriers to entry for competitors, as well as serving all six major gateways to Mexico (also a barrier for others to reproduce).  Union Pacific’s railways are an integral part of the United States transportation infrastructure, and conveniently connect to a variety of other railroads and modes of transportation.

Room for Increased Efficiency:

Even though railroads are already a more efficient and less expensive form of transportation than trucking (another common form of transportation), there is still room for increased efficiency.  According to the CEO of another US railroad company, Burlington Northern Santa Fe, long-haul trains are three times more fuel efficient than trucks.  Additionally, “William Nickle, supply chain and operations management professor at Rutgers University Business School MBA Program, explained… “One of the biggest differences between roads and railroads is that the infrastructure for trains is financed by private individuals, and the infrastructure for trucks (roadways, bridges, etc.) is financed by the government. A government that is as in as much debt as ours has not been able to invest enough to revitalize and resolve all of the current issues with the infrastructure the trucking industry relies upon.” Of course, there is still a need for intermodal transport, such trucks (and some trains) to take the freight the final leg of its journey to its destination. 

Valuation:

Discounted Cash Flow (DCF) Analysis

A DCF analysis suggests Union Pacific is worth $145.66 per share.  Union Pacific’s 2014 Free Cash Flow was around $3.14 billion (We're calculating this as Cash from Operations (+$7.385) minus Capital Expenditures (-$4.346) and adjusting for other Investing Cash Flow Items (+$0.097)).  We're assuming UNP’s required rate of return is 7.5% (this is essentially a long-term equity market assumption).  We also assume UNP can grow about 3.5% per year organically, and it’s FCF per share outstanding can grow another 1.5% per year simply by way of continued share repurchases resulting in higher future free cash flow per share because there will be less shares outstanding: FCF / (r-g) = $3.2 billion / (0.075 – (0.035 + 0.015)) = $128 billion.  $128 billion / 0.87878 billion shares outstanding = $145.66 per share.

Ben Graham Formula:

We also like to use a valuation formula first published by Benjamin Graham (Warren Buffett’s mentor) in the 1940’s:  EPS x (8.5 + (2 x growth)).  Assuming 2016 earnings per share (EPS) of $6.85 (taken from 29 professional analyst estimates on YahooFinance), and a growth rate of 5% (this is the same growth rate used in the DCF model above.  This results in a share price of $126.73 = 6.85 x 8.5 + 2 x 5.

Risks:

Union Pacific outlines a variety of risk factors in their annual report, and it is worth reviewing some of them here.  First, UNP explains:

“We Must Manage Fluctuating Demand for Our Services and Network Capacity.”  This risk is apparent in the slowdown in coal transport demand in the first half of 2015 which negatively impacted the stock price, and created a more favorable entry point for “would be” buyers of the stock.  UNP must now manage this risk by either waiting for coal business to revert back upward to historical levels, or make the changes in the mix of shipments to replace lost revenues.

“We Are Subject to Significant Environmental Laws and Regulations.” In some sense, this risk may have been reduced by the recent Supreme Court ruling against the Environmental Protection Agency which said the agency didn’t take into enough consideration the cost impact of new regulations.  While this ruling doesn’t directly impact UNP, it does impact coal plants, and it does create a regulatory environment less hostile to business. 

“Strikes or Work Stoppages Could Adversely Affect Our Operations.” This is a big one as a large percent of the workforce is unionized which can lead to significant work stoppages.  Also, this can impact shipments that UNP makes to strategic West Coast ports.  The Wall Street Journal reported “The labor dispute that caused months of gridlock at West Coast ports may be over, but the disruption is expected to redraw the trade routes that goods take to reach U.S. factories and store shelves… This is bad news for West Coast ports, truckers and railroads already worried that the expansion of the Panama Canal, due for completion next year, would begin to divert more business to the East Coast. Already it is expected to take three to six months for West Coast ports to return to normal.” (Wall Street Journal, March 5, 2015)

“We May Be Affected By Fluctuating Fuel Prices.” This noticeably impacted the company in 2014 as oil (and subsequently diesel fuel) prices declined sharply.  This was a good thing for UNP, but volatile fuel prices could move higher and hurt UNP’s profits.

Conclusion:

Union Pacific is a bet on the US economy.  As an integral part of the US economy, Union Pacific will grow as the economy grows.  As a strong free cash flow generator, UNP also has the ability to return cash to shareholders (via dividends) and increase earnings per share (by reducing the number of shares outstanding with share repurchases).  UNP’s share price has underperformed the broader stock market in 2015 due to temporarily lower revenue from coal shipments, lower revenue due to West Coast port shutdowns, and volatility in fuel costs.  The decline in share price has created an attractive entry point for investors.  We own shares of Union Pacific (UNP).

Accenture (ACN) - Thesis

Rating: BUY

Current Price: $99.48

Price Target: $116.40

We own Accenture stock because we believe the market continues to underestimate the company's ability to deliver results.  We expect the stock price to consistently outperform the market in the future because of Accenture's workforce, culture, business model, balance sheet, pipeline, relationships, brand name, management and valuation. 

WHAT DOES ACCENTURE DO?

Accenture is a management consulting, technology services and outsourcing company with over 300,000 employees and offices and operations in more than 200 cities in 56 countries.  Accenture does NOT produce any products, but rather provides business and consulting services to help clients improve business performance.  The types of services Accenture provides to its clients are difficult for many investors to understand (which is part of the reason we believe the company is undervalued).  Here are a few examples of the types of services Accenture provides: Accenture helped:

HarperCollins Publish Their Entire Catalogue of about 36,000 Books on a New Digital Platform. More from Accenture.

Shell Implement a New Logistics Strategy, Improving Service Levels and Lowering Costs Up to 25%.  More from Accenture.

The London Police Force Fight Gang Crime with Analytics. More from Accenture.

Gas Natural Fenosa Transforms Their HR Practice, Improving Employee Satisfaction by 26 Percent in One Year. More from Accenture.

AN IDEAL BUSINESS MODEL:

We love Accenture’s business model.  It is ideal because its workforce has the ability to change dramatically, quickly and smoothly to meet demand.  Much of the global workforce is still stuck on this idea that a company hires a person, that person works for 40 years, gets a gold watch, and then retires.  That model is not efficient or even realistic for much of today’s world.  Accenture is hired by companies for a specific time period (often several months at a time, to several years at a time) to complete a specific project or task, and that’s it.  It’s often unrealistic for companies to hire full time employees just to complete a specific project because the company has no need for them when the project is complete.  Accenture solves this problem because when a project for one company is complete, Accenture sends its people to work on a project for another company (many Accenture people travel domestically and internationally on a regular basis).  It’s this adaptable, mobile workforce that enables Accenture to meet the needs of its clients, and it is an ideal business model for today’s rapidly changing business environment.

ACCENTURE’S VALUE PROPOSITION:

Accenture brings high quality people with specialized skills to complete specific client projects, and then the Accenture team gets out.  It prevents the client from hiring full time employees and then laying them off, and it allows the client to benefit from the very specific skill sets and experiences that Accenture people bring.  Accenture is not cheap, but client companies regularly find Accenture’s services worthwhile from a dollars and cents perspective.  Management is willing to pay for Accenture because of the improvements and successes they are able to achieve with the help of Accenture.

EXCEPTIONAL PEOPLE AND CULTURE:

Accenture’s greatest asset is its people.  The company’s diverse and inclusive workforce combined with its opportunities for upward career advancement enables Accenture to attract some very bright people.  The typical Accenture employee is in their twenties or early thirties, enjoys living in one of the large cities where Accenture offices are typically located, and is willing (even excited) to travel domestically or internationally to client sites.  Obviously, not all employees fit this typical description (some are older, and many positions don’t require travel) but many of them do, and it fits well within the workforce.  There tends to be a pyramid shaped workforce where younger workers make up the majority of the bottom of the pyramid, and there are a lower number of employees as you move up the ranks.  This works well for Accenture because as many employees get older and want to settle down with families they depart Accenture for less demanding jobs.  This natural attrition helps Accenture manage its workforce when demand is low because natural attrition is generally easier and cheaper than layoffs.  And when demand increases, Accenture’s culture and business model enable it to quickly attract additional high caliber, hard-working, determined people.  The high quality workforce model also enables Accenture to perform at a higher level than many other companies, which is part of the reason we believe the company is such a great investment.

BRAND NAME:

Having a strong brand name is one of the most valuable assets in business because it allows you to attract employees and customers, and it allows you to charge a premium for your services.  Accenture is not usually a recognizable name to the average person walking down the street, but within the ranks of corporate America, Accenture is a very strong brand name.  A long history of delivering exceptional performance to clients is the number one reason Accenture’s brand name is strong (the Accenture brand name has been around since 2001, but the company existed long before that).  There are other important contributors to Accenture’s strong brand name such as the diverse and inclusive workforce which often receives praise from the media.  For example, Accenture was named one of the 100 best companies to work for in 2015.

According to its website, Accenture takes: “the widest possible view of inclusion and diversity, going beyond gender, race, religion, ethnicity, abilities, sexual orientation and gender identity and expression to create an environment that welcomes all forms of differences. Every employee is a respected member of our team; we value individual similarities and differences, recognizing them as the thousands of diverse pieces—or tiles—that contribute to our entire mosaic.”

According to Chief Executive Officer, Pierre Nanterme, Accenture: “gives clients access to a rich range of talent, representing different styles, perspectives and experiences. This diversity is a critical strength that we work hard to maintain and foster. It makes us a better company on every dimension.”

ACCENTURE’S FINANCIAL STRENGTH:

A quick look at Accenture’s balance sheet reveals it has almost zero long-term debt.  This demonstrates the company hasn’t required debt to grow its business recently, but they do have the ability to take on debt in the future if need be.  Since the company does not produce actual products (it’s a service company) there is no need for large capital expenditures to enable growth (other than an occasional office upgrade – Accenture had only $322 million of capital expenditures in fiscal 2014 on an enormous $3.2 billion in free cash flow).  It’s nice to know the company is not burdened with massive amounts of debt.  Accenture also has $4.9 billion of cash on hand to meet liquidity needs.  The strong balance sheet and cash flow also allows Accenture to comfortably maintain its 2% dividend and repurchase shares as management stewards capital.

FUTURE GROWTH:

Accenture’s estimated earnings growth rate over the next five years is 10.13% according to 28 professional analysts covering the stock.  This exceeds the 7.28% those analysts are forecasting for the S&P which suggest they believe Accenture will grow faster than average.  We tend to agree Accenture will grow faster than the market, but we also believe it will grow faster than these analysts’ estimates.  Wall street consistently underestimates the value of this company because they do not have a strong enough appreciation for Accenture’s business model, it’s exceptional workforce & culture, and it’s powerful brand name within corporate America.  We also believe Accenture’s business is difficult for many people to understand, which causes them to avoid and under appreciate the stock. 

Near-term growth is expected to be generated across Accenture’s business groups, however Accenture Digital is the “hot” area right now.  According to Accenture’s 2014 annual report, the company recently launched Accenture Digital by combining their capabilities in digital marketing, analytics and mobility.  With more than 28,000 professionals, Accenture Digital is the world’s largest end-to-end digital capability and works with many industry leaders—including all of the top 10 global pharmaceutical companies as well as all of the top 10 consumer products companies.  In our view, there is a new “big thing” at Accenture with every market cycle (this time it seems to be digital).  However, it’s Accenture’s dynamic and adaptable workforce that enables it to profit from the market’s needs across market cycles.

VALUATION:

Ben Graham Formula:

We use a modified version of the valuation formula published in the 1930’s by Benjamin Graham (Warren Buffett’s mentor) to value Accenture at $116.55 per share.  Using Graham’s original formula (assuming a 5% growth rate), Accenture is worth only $101.97 per share [share price = EPS x (8.5 + 2 x growth) + cash per share = 5.18 x (8.5 + 2 x 5) + 4.9/0.79758.  However, we bump the growth rate up to 7% ($116.55 = 5.18 x (8.5 + 2 x 7) + 4.9/0.79758) because the company’s strong free cash flow will allow it to consistently strengthen EPS growth incrementally (as needed) with share repurchases, and we believe management is incentivized to do this as their compensation is tied to the stock price.

Discounted Cash Flow (DCF) Model:

Using a discounted cash flow model, we value Accenture at $116.25 per share.  Our model assumes Accenture can grow its 2014 free cash flow of $3.2 billion by 5% for the next five years and then 3% into perpetuity.  We assume a CAPM-derived required rate of return of around 8.3% and a long-term equity market return assumption of 7.5%.  We used a discount rate of 3%, and factored in the $4.9 billion of cash on hand.

RISKS:

The number one largest risk to Accenture’s business is anything that could hurt its brand name.  Because it doesn’t actually produce products (it’s a services company), a lawsuit or bad publicity could destroy the company’s ability to attract new business.  Accenture knows this lesson very well because of its history. Accenture was formerly part of Arthur Andersen, an accounting firm that was completely destroyed a little over a decade ago when the fraudulent actions of a few partners destroyed the company’s reputation and forced it to lay off thousands of employees and go completely out of business.  Accenture separated from Arthur Andersen several years before the scandal.  Accenture was known as Andersen Consulting when it first separated and then brilliantly changed its name to Accenture before the Arthur Andersen scandal allowing it to avoid unnecessary fallout from Arthur Andersen.  As another example of Accenture’s extreme aversion to bad publicity look to the Tiger Woods example.  Tiger Woods was paid huge sums of money to be the face of Accenture’s advertising and marketing initiatives, until a few years ago when news of Tiger’s indiscretions hit the news.  Tiger’s face had been pasted all over Accenture’s website and advertisements around the world, but within hours of the news Accenture’s leadership decided to drop Tiger Woods and remove his image from everything as quickly as possible.  This is a perfect example of how committed Accenture’s leadership is to protecting its pristine brand name, and of the lengths it will go to defend it.  Accenture leadership gets it.

CONCLUSION:

Accenture is a well-run, highly-profitable business, with a workforce well-suited for a rapidly evolving marketplace.  Its stock price is also inexpensive relative to its value.  We believe the market continues to underappreciate Accenture’s ability to deliver and its overall value.  We own shares of Accenture stock.