At this time last year 10-year Treasuries paid less than 2% interest, and yields on 30-year Treasuries had dipped back below 2.9% after a winter rally briefly sent them peaking above 3.2% in March. Low interest rates sent frustrated investors in search of alternatives to bonds, and a lot of retail money seemed to be landing in stocks instead. The S&P 500 gained 11% during the first three months of 2013. Over the last twelve months, the index has gained 23%, including dividends. With both interest rates and stock valuations now higher, the market isn’t finding the going nearly as easy in 2014. The market gained just 2% in the first three months of 2014, with significant volatility as well.
Thanks largely to ultra-low, and falling, interest rates the housing sector was showing some excellent growth last year, accounting for all of Q4 2012’s 0.4% GDP increase. In fact, if not for housing GDP would have fallen slightly for the last three months of 2012. Early 2013 showed continued improvement for the sector. February home prices increased 10%. New home construction activity was accelerating. In the May 2013 issue of Investor Advisory Service we called the housing sector “the real star of this recovery.”
Flash forward twelve months. With 10-year yields now up to 2.75% and 30-year yields rising to 3.6%, the housing sector no longer enjoys the tailwind that came from falling interest rates. Looking at the current housing data, a lot of starch seems to have come out of the housing recovery, evidenced by lower sales of existing homes and a decrease in refinance activity. This year’s starkly lower refinance activity may drag down consumer spending as well, which bodes poorly for overall economic growth. No wonder the market is having more trouble making gains lately. Still, the show goes on, and we keep searching for superior investments to show our subscribers.
Each month we feature three companies that we think are especially interesting and timely. Let’s take a look back at one of our three May 2013 features, Cognizant Technology Solutions (NDAQ: CTSH) to see how the stock has fared in the twelve months since we first presented it to our subscribers.
Cognizant Technology is an outsourcing company providing technology consulting and business process solutions for a global client base. Like many outsourcing companies, most of its employees are in India. Outsourcing is hardly a new idea, but it still remains one of the great global economic megatrends. We said in our original writeup that we think investors spend too much time trying to predict the next big thing and not enough time aligning themselves with the ongoing trends. Cognizant has been one of the industry’s strongest growers for more than a decade, but the stock often traded at a sky-high valuation in the past. The political winds seemed to be against outsourcing at the time, however, and shares had finally come down to a valuation that we considered reasonable.
Trading at a split-adjusted price of $36.53 twelve months ago, Cognizant offered prospects for 15% compound earnings growth at a forward P/E of about 18. Those kinds of bargains aren’t easy to come by in this low-growth economic environment. We modeled an upside/downside ratio of 4.9-to-1 based on a 15% compound earnings growth and a potential future P/E range of 14 to 27. That’s quite a wide range, but it’s actually somewhat conservative relative to a stock whose P/E’s has often been above 40 in the past. Cognizant has grown too large to support those kinds of outsized valuations. Big companies just can’t grow that fast.
This pick was a little slow to get going. Overhang from the political debate over limiting work visas for foreign workers, combined with a summer pause in the stock market rally, kept this stock stuck in the mud until July when the company reported that Fiscal Q2 revenue that increased 20% with a 21% increase in EPS. With the stock in bargain territory relative to its historical valuation range, that quarterly report created a nice pop for investors, and the stock went on to rally from there. That rally added fuel in October when Fiscal Q3 showed a 22% increase in revenue. Q4 results showed revenue up 21%. For the full fiscal year, revenue increased 20% and EPS increased 17%. 2014 guidance contemplated revenue growth of at least 16.5% with EPS growth slightly below that figure. Guidance is usually conservative, so it’s possible Cognizant will be able to do 20%+ revenue growth again this year with similar gains in EPS. Shares split 2-for-1 in March. All prices shown here are split adjusted.
At a recent price of $51.67, shares have gained 41% in the past twelve months, almost double the S&P 500’s strong gain. We continue to think the outsourcing industry provides long-term growth, and we think Cognizant is one of its strongest players. Now trading at a low- to mid-20’s P/E, the stock is no longer quite the bargain it was twelve months ago. Investors should also be aware that Indian outsourcing companies pay a lot of costs in rupees, while collecting in other currencies. Some of the currency exposure can be hedged, but those hedges are never perfect. After two years of declines against the dollar, the rupee has strengthened somewhat recently, which removes a modest tailwind to growth.