Holly Cook: Hello and welcome to the Morningstar series, "3 Stock Picks." Joining me today to give me his stock picks is David Keir. He is co-manager of Saracen Global Income & Growth Fund.
David, thanks for joining me.
David Keir: Good morning.
Cook: So, let's go straight into it. What's your first stock that you are particularly interested in at the moment?
Keir: First stock pick is, General Electric (GE), which actually is now one of the biggest positions in the fund today. We came across General Electric earlier this year. General Electric, as we all know, is one of the biggest industrial companies in the world. It was a great attraction to us because it has a lot of characteristics we look for, namely, revenue growth, strong operating margins, a very strong balance sheet. Actually, the company pre the Alstom deal, which was announced yesterday, has net cash on the balance sheets and obviously has a very strong dividend yield of over 3% which we expect to grow over time.
The main attraction of the stock to us was its positioning within industrial space, but also secondly, it became very clear that management finally go to the investors neither wanted nor valued the GE Capital part of the business and management will make setting a stall to reduce the earnings exposure to GE Capital part and we expect that to continue and we expect that the business to be 90% industrial, 10% GE Capital as we look out and we expect management as they sell down GE Capital to return about $90 billion of funds to shareholders through share buybacks and dividends and we think it's a very attractive investment over the long-term.
Cook: That certainly would sound appealing to any shareholder. But what would be an associated risk with this stock in your view?
Keir: Well, I mean, we are trying it too for the industrial side of the business and clearly, global IP is a big driver, but GE makes 80% of its industrial earnings come from the aftermarket, the services side, which is much higher-margin and much more stable and steady. So, we think that will counterbalance the google IP risk of a slowdown.
Cook: Let's move on. What's your second stock pick?
Keir: Second stock pick, the stock we bought recently is Rio Tinto (RIO). Historically, we've had no exposure to the mining sector in the fund at all, but we were on proprietary screens and Rio Tinto and Billiton both appeared on our screens earlier this year and we turned to Rio Tinto because of the cash-generative nature of the business.
Even at today's depressed commodity prices, which are already down, for iron ore down to 50% to 70% of its peak, Rio Tinto still enjoy an EBITDA margin of over 50%, which is pretty incredible. It's got a very strong balance sheet and as the management team, the new management team are committed to taking costs out, cutting CapEx, generating free cash flow and obviously, progressive shareholder returns. The shares currently yield nearly 6% and actually management increased the dividend by 12% with the results there in the summer. So we think the risk/reward is very attractive over the long-term.
Cook: And the company's earnings relationship with commodity prices and obviously, potential weakness, would that be a concern for you?
Keir: Absolutely. We've historically shied away from mining sector because they are price takers. We don't look investing in price-taking companies. However, having said that, what they can control they are doing very, very well, i.e., cut the costs, reduce CapEx, generating cash. What they can't control, the commodity prices clearly, the commodity prices have already fallen a considerable amount, 50% to 70% off their peaks already and we think as we look out over the five years, the demand/supply imbalance of certainly commodities, particularly copper, are very, very attractive.
Cook: And then last but not least, what's your third stock pick?
Keir: The stock we've brought recently is IBM (IBM), the big U.S. tech gorilla I guess. It's been around for nearly 100 years and over those 100 years it has always invented itself and always delivered consistent revenue growth. At the moment, it's going through the doldrums. It's just reported I think 14 quarters in row of reduction in revenue. But we are attracted to it because the valuation is very low; it's got a strong balance sheet and the yield because the shares have been so poor is now north of 3%, which is a key threshold for us.
We can see signs in the business and some of the, they call, new wave areas, data analytics and cloud, et cetera, where actually that part of the business is growing between 20% and 30% per annum. That is now an increasing part of the business. It will be 40% of the business by 2017. So, we think the top-line will inflate on a sort of two, three-year view, and when it does inflate, the earnings inflate and the shares will re-rate.
In the meantime, we will be handsomely rewarded to wait with our patience with the dividend yields and obviously, management actually has increased the dividend by 18% over the last quarterly number. So, we think the market has completely given up on IBM and history would tell us that actually that's a wrong attitude.
Cook: So, you are seeing light at the end of the tunnel there, but is there anything that would be sort of a warning signal to you?
Keir: We think the key is the traditional old way of business in terms of the rate of decline lessens. The rate of decline is still declining. We hope that rate of decline will lessen and the new wave will come through. If the traditional business continues to decline at an increasing rate, that will be a massive warning to us.
Cook: David, thanks very much for sharing three big company names with us today.
Keir: No worries.
Cook: For Morningstar, I'm Holly Cook. Thanks for watching.
