Cautious Optimism

Candy Chrisman |

Since our letter on the coronavirus and the markets in mid-March, unprecedented and quick action from the Federal Reserve System and Congress, temporarily at least, has instigated a stock market rally in late March. Although any news and data put to print quickly becomes outdated, our original perspective on the virus’ impact on the market remains the same. (See “Coronavirus and the Markets” )

The key to recovery with any natural disaster is enabling businesses to survive until the crisis has subsided.  

The speed of events that took the U.S. economy from its longest expansion in history – with low inflation and a 50-year low in unemployment – to an economic disruption of a potentially deep recession is without modern precedent. Unlike previous shocks to the economy, the Federal Reserve has reacted with far greater speed and scope than ever before. The Fed quickly cut rates to near zero, purchased huge quantities of debt to generate liquidity and provided a backstop to money market funds. These moves reassured the equity and credit markets of sufficient liquidity. In addition, the fiscal response by Congress and the Administration has been unparalleled. 

The degree and duration of the downturn will depend primarily on two factors. The primary wild card factor is obviously the virus itself. How long will it take health officials to significantly slow and or stop the pandemic? Or for science to develop drugs or a vaccine to treat or mitigate the virus? As of this writing, the disease is continuing to spread with cases in nearly every country.  The other factor is whether the fiscal and monetary stimulus is enough to keep businesses and individuals afloat in the meantime. The actions by Congress and the Administration are different from those of previous downturns that focused on unemployment benefits. This package includes direct, forgivable loans to businesses conditional on preserving payrolls and minimizing layoffs. The stimulus bill includes not only direct payments to individuals and families but designated funds for corporate and small business aid with extension of unemployment benefits.

The markets likely will see additional volatility depending on the progression of the disease and the actual dislocation to the economy. This current period is unlike any other market downturn and economic recession where consumers and businesses were unwilling to spend. It resembles a natural disaster in which economic participants are unable to spend. The key to recovery with any natural disaster is enabling businesses to survive until the crisis has subsided. 

At Delta, we’ve been measured in our purchases. We will continue to exercise a long-term perspective, which means potentially adding new names or adding to existing positions when there are significant valuation differences between current prices and estimated intrinsic value. We also will adhere to our discipline of not selling at valuations that we feel are not representative of the long-term potential of the investment.

Although hurdles remain for the economy and the markets, we will continue to employ our investment process to further our clients’ goals and objectives, and we remain optimistic on the resiliency and inherent attributes of the U.S. economy.

Company Comments

Comments follow regarding common stocks of interest to clients with stock portfolios managed by Delta Asset Management. This commentary is not a recommendation to purchase or sell but a summary of Delta’s review during the quarter.

The Goldman Sachs Group, Inc.  { GS }

Drawing on 150 years of experience, Goldman Sachs is a global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base. Clients include corporations, governments and both high- and middle-income individuals. Founded in 1869 the firm is headquartered in New York and maintains offices in all the major financial centers around the world. Goldman converted to a bank holding company in 2008 and is regulated by the Federal Reserve.

Goldman’s brand reputation and size provides a competitive advantage for securing investment banking deals and recruiting top talent. The company’s global footprint and scale give it the capability to vie for large cross-border deals that smaller brokerages cannot handle. The firm’s nimble capital allocation is executed with an intense focus on risk management and a long-term outlook. This strategy was key to Goldman’s emergence from the financial crisis in a position of relative strength versus most competitors. 

David Solomon was appointed CEO in 2018 after serving as chief operating officer and co-head of investment banking. Since becoming CEO, he already has made important changes in the management, including selecting a new chief financial officer and chief operating officer. The company recently hosted its first ever investor day and with considerable detail laid out its three-to-five year financial plan.

Since the Great Recession of 2008, investment banks have faced increased regulation and higher capital requirements. In response to the new regulatory requirements, Goldman has strengthened its balance sheet by reducing debt, building capital and raising liquidity. 

The new strategy entails broadening the customer base to include a younger, millennial demographic while lowering the cost of funding by seeking deposits. The bank will expand its commercial and consumer banking segment through consumer loans, credit cards and deposits. Efficiency should be enhanced with greater automation and e-banking. A central part of this strategy is developing a more global and diverse workforce while increasing staffing in financial engineering and operations.

An example of the new strategy is the firm’s online de novo bank named Marcus by Goldman Sachs, launched in 2016 to appeal to tech savvy consumers. By January 2020, deposits at Marcus have surpassed $60 billion. The firm expects to double that deposit base over the next three to five years. Goldman recently co-launched a credit card with Apple. Credit card loans were $2 billion at the most recent quarter-end, up 8% year-over-year and 7%, sequentially.

The firm has a deep talent pool made possible by its partnership structure. This unique model does not rely on any one individual rainmaker. Goldman imposes equity ownership requirements on all its partners, which helps align their interests with those of common shareholders. Goldman’s leadership and legacy in its field attracts a high caliber, diversified group of talent each year. The firm is attracting and hiring a more global and diverse workforce. Half of the newest class of analysts are women and two-thirds are from ethnic minorities.

Since the Great Recession of 2008, investment banks have faced increased regulation and higher capital requirements. In response to the new regulatory requirements, Goldman has strengthened its balance sheet by reducing debt, building capital and raising liquidity. The increased capital will aid management in negotiating the current Covid-19 Pandemic and volatility. Goldman also has reallocated capital away from riskier, proprietary investments toward its more client-driven businesses such as investment banking and asset management. 

A criticism of Goldman is that it has been slow to respond to a decline in trading revenue and changes in the financial markets brought on by new regulatory requirements. Other banks were quicker to materially change their operations by increasing their wealth management operations and de-emphasizing trading. Being identified as a systemically important financial institution with inherent backing by the government brings increased oversight of the company’s operations and restrictions on activities. The offset is that Goldman has gained access to the Federal Reserve lending facilities, which would be especially useful should future shocks to the financial system renew liquidity concerns.

Goldman has maintained a leadership position in most of its activities and is financially stronger and less burdened by irrational competition than it was before the financial crisis. This standing will be somewhat mitigated by slower global growth, higher regulatory capital requirements and reduced leverage. We believe Goldman will be able to grow revenue in the low single digits on market share gains and expansion in emerging markets. We expect Goldman can generate return on equity of over 10% over the next decade. Based on these assumptions our financial model indicates that at the current stock price, Goldman Sachs’ stock offers a potential long-term annual return of approximately 16%.

Lowe’s Companies, Inc.  { LOW }

Lowe’s is a leading home-improvement retailer in North America with over 2,233 stores (209 million square feet), including 510 stores in Canada. The company’s stores offer a wide selection of home improvement products and services aimed at do-it-yourself and professional customers as well as commercial business clients.

To help drive incremental growth and improve profit margins, the company is redoubling efforts to improve in-store execution and operating efficiency. Lowe’s is adding customer-facing employees, improving inventory management, and significantly shrinking its operating cost structure.

Lowe’s has proven to be an effective retail operator with a culture built on exceptional customer service. Over many years, the company has developed a highly automated distribution system that links its suppliers, distribution centers and company stores on a single network, driving operating efficiency. Lowe’s significant scale combined with its efficient distribution system creates a cost advantage. The company has been very proficient at using this cost advantage for maintaining low prices to generate higher sales volumes, while producing solid free cash flow. 

The U.S. home improvement retail market is mature and has become fully saturated with stores. After years of rapid expansion, Lowe’s new store growth will slow as quality locations become increasingly limited. To help drive incremental growth and improve profit margins, the company is redoubling efforts to improve in-store execution and operating efficiency.

Lowe’s is adding customer-facing employees, improving inventory management and significantly shrinking its operating cost structure. The company also plans to increase its proprietary products and further penetrate the professional market. With Lowe’s and Home Depot, Inc. together controlling approximately 40% of industry market share, the retail home-improvement industry remains fragmented. Lowe’s competitive strengths and new products and services should drive further market share gains from smaller competitors.

While there are some signs of competitive pricing between Lowe’s and Home Depot, it is one of the more rational areas of retailing, which is in part due to less pressure from online web retailers like Amazon. The project nature of the purchases at the home centers have enabled them to maintain pricing better than other areas of retailing. Lowes is working on a complete redesign of its website as well as rolling out a new point-of-sale system in its stores in 2020.
The company also has committed to investing $1.7 billion over the next five years to open new distribution centers and modernize its supply chain with digital technology.   

A focus of growth for Lowe’s is the professional customer, who makes up about 30% of Lowe’s revenues. The professional customer business has grown faster than do-it-yourself business for the past two years. Lowe’s is ramping up its inventory geared to professionals and providing more tailored services. “Lowe’s for Pros” was launched in 2015 to make it easier for professionals to manage products at multiple jobs and to purchase and pick up items nationwide. Lowe’s has a compelling 5% back credit program for professionals. Pro customers now can go online to create custom catalogs for recurring purchases and to access purchase history reports.

Lowe’s named Marvin Ellison as President and CEO effective July 2018. He was the Chairman and CEO of Penny’s and has previous experience as an executive with Home Depot. His goal is to reduce the performance gap with Home Depot and to enhance Lowe’s supply chain and product offerings.

Given minimal expected store expansion, we have assumed Lowe’s can grow revenues approximately 2% over the next decade. At this pace of growth and given improving in-store execution, we believe average cash flow margins will improve gradually to just over 10% during this period. Based on these assumptions, our stock valuation model indicates Lowe’s current stock price offers a long-term average annual rate of return over 10%.


SGS is the world’s leading testing, inspection and certification company. The company creates value for a wide range of entities by monitoring and improving their productivity, quality, safety, efficiency, speed to market and risk management. The Swiss-based company has more than 95,000 employees and operates a network of more than 2,400 offices and laboratories around the world. 

The overall unifying concept of SGS is that there is the need for testing, inspection, and certification of products, services, and systems by engineering experts that have a reputation of reliability and trustworthiness.  

SGS has a very diverse portfolio of businesses both in terms of end-markets and geographies. The three main lines of business are testing, inspection and certification (TIC) services. These services are applied across a number of industry sectors, including agriculture, minerals, construction, oil/gas/chemicals, automotive and food to name a few. The TIC industry is diverse, encompassing activities as disparate as certifying adherence to government standards, operating testing or inspection systems for corporations, testing products for safety and reliability and inspecting products to make sure they meet performance standards. The overall unifying concept of this business is that there is the need for testing, inspection and certification of products, services and systems by engineering experts that have a reputation of reliability and trustworthiness.

SGS’ revenue patterns tend to be relatively stable since a big portion is generated from recurring contracts. Customer retention is high as it can be expensive and time consuming to switch from one TIC company to another. Furthermore, many TIC services are highly specialized and can only be delivered by a limited number of certification companies.
Another competitive barrier to entry is global scale. Size is a key advantage to capturing the largest and most complex contracts. Clients often seek TIC providers with appropriate financial strength and the ability to mobilize large teams to perform short duration projects. SGS’s global network and increasingly strong brand facilitates continued market share gains from smaller local competitors. SGS is well-positioned to deliver profitable growth going forward.

SGS, with its approximate 15% global market share, is the leading company in an attractive industry. The TIC industry is a beneficiary of a number of global trends, including increasing government regulations, environmental and safety concerns and outsourcing. Standards have been applied with growing intensity as more products are being manufactured overseas creating a need to trace product origin and maintain quality. Increasing concerns around the environment, safety, quality and performance in all industrial and consumer products and foods should continue to drive increased product testing.

SGS does face challenges today as Covid-19 slows global production of goods and services. The company is broadly diversified across nearly all industries and regions and will be impacted by cyclical ups and downs of the global economy. Its broad diversity and growth in remote inspection and testing, life sciences and medical testing should help limit its downside. Further risks include a potential slowdown in international trade, increased protectionism, reputation risk and country risk.   

We believe organic growth and market share gains should allow SGS to grow its revenues nearly 5% annually over the next decade. In addition, through cost efficiencies and adequate pricing, operating margins should average 16.5%. Our model indicates the company’s stock offers an average long-term annualized rate of return of 9%.   

Eaton Corporation PLC  { ETN }

Eaton, formed in 1911 as a manufacturer of truck axles, has transformed its portfolio through a stream of acquisitions in the past two decades. It is a diversified global industrial company that manufactures components, systems and services that manage electrical and mechanical power. The company is a virtual pure play on the industrial economy, primarily selling to and providing services to original equipment manufacturers (OEMs). Eaton offers energy-efficient products and services in a wide variety of markets, including, agriculture, data centers, military contracting, manufacturing, aviation, commercial and residential construction and healthcare; and it continues to position its systems and services toward less cyclical, faster growing, higher margin end markets.  

Eaton is one of the leading global providers of electrical components and systems for power quality, distribution and control. After the acquisition of Cooper Industries in 2012, Eaton’s Electrical Group now accounts for 60% of total revenues. Though its electrical businesses have a slower growth profile versus its industrial businesses, long-term we believe the electrical equipment market has good growth opportunities due to the need for power capacity, regulatory changes driving energy efficiency and power quality and safety. In addition, Eaton should benefit from the growing demand to control power and mechanical systems remotely for electrical grids, factories and data centers. Management is also driving stronger through-the-cycle profitability and free cash flow through product line optimization, multi-year productivity plans and raising the overall level of operational excellence.   

Eaton should benefit from the growing demand to control power and mechanical systems remotely for electrical grids, factories, and data centers.

Through the years, Eaton has either innovated or acquired many forms of power management and distribution, focusing on highly engineered motors, drives and hydraulic systems used in various industrial end markets. The firm’s industrial businesses (aerospace and vehicle), which make up 25% of total company revenue, are market leaders with competitive advantages, including its manufacturing scale, cost advantages and high customer switching costs. These businesses have vast installed bases that grow primarily through innovation. Eaton’s installed bases require significant customer capital investment, which leads to good recurring aftermarket revenue streams. Its after-market services also serve to protect long-term customer relationships.

Eaton, along with its industrial peers, is facing some near-term operating headwinds. The global capital spending environment is being weighed down by uncertainty due to Covid-19 and heightened geopolitical risks. Some of the company’s domestic and international end-markets are tied to aerospace, vehicle and various commodities. If a downturn in these end markets deepens, earnings will be negatively impacted and reduce its return on invested capital. We believe these challenges are primarily short-term with long-term tailwinds, particularly in aerospace and electric vehicles. Management’s current strategy, focused on structural cost reduction throughout the organization, should continue to lead to higher long-term operating profitability as these end-markets recover. 

We believe the company’s leadership position, extensive installed base, recurring after-market service revenues and long-term customer relationships should provide support for long-term growth and higher profitability. We expect Eaton will grow revenues in the low single-digits on average with cash flow margins of nearly 19% over our 10-year modeling period. Based on these assumptions, our stock valuation model indicates Eaton’s current stock price offers an average annual long-term rate of return of approximately 11%.

Dated: March 31, 2020

Specific securities were included for illustrative purposes based upon a summary of our review during the most recent quarter. Individual portfolios will vary in their holdings over time in relation to others. Information on other individual holdings is available upon request. The information contained herein has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy. The opinions expressed are subject to change from time to time and do not constitute a recommendation to purchase or sell any security nor to engage in any particular investment strategy. Any projections are hypothetical in nature, do not reflect actual investment results and are not a guarantee of future results and are based upon certain assumptions subject to change as well as market conditions. Actual results may also vary to a material degree due to external factors beyond the scope and control of the projections and assumptions.