As investors roll into 2014 with the wind at their backs, one thing is certain (or as certain as can be expected in the investment business): America is back.
Pundits and pessimists may grumble about lack of leadership in Washington, rising interest rates and a tepid economic recovery. But the nation has adapted in the aftermath of the financial crisis.
Corporate America got lean and mean, cleaned up its balance sheets and learned how to operate in the new and challenging environment. Households followed suit by shedding debt and consuming more responsibly (much to the disappointment of many financial services companies).
Doubters may think the market's run-up since its bottom in 2009 is done. But as I wrote last month in the first part of this series, the American Renaissance has legs, and the run can continue.
Johnson Controls (NYSE: JCI) is a textbook example of what I consider an American Renaissance stock. Best known for manufacturing automotive interior components and as the largest automotive battery operation in North America, Johnson Controls has morphed from an automotive industry-centric business into a multi-industrial global powerhouse. JCI spent most of last year on a certifiable tear:
With shares already up more than 60% in that time, does it make sense to buy JCI at this level? Yes -- and here's why.
The bottom line is earnings. Since the bottom of the financial crisis and the Great Recession, Johnson Controls has seen its annual earnings per share (EPS) grow at a staggering average annual rate of 89%. Much of that growth came between 2009 and 2010, but the fact that EPS growth has been consistent since then is the real story.
How has the company accomplished this? By cleaning up its balance sheet and reinventing itself. Johnson Controls reduced its long-term debt-to-capital ratio from a peak of 36% in 1999 to a more manageable 25% last year. Cash flow has grown at an astonishing 88% annual rate over the past four years, from $407 million during the depths of the Great Recession to more than $2.1 billion today.
That cash has been put to good use, with a 16% boost in the quarterly dividend, to $0.22 a share, and plans to buy back $3.65 billion in stock. But while Johnson Controls has done an exemplary job of returning value to shareholders, the company has focused itself on evolving into a multi-industrial force. This strategy is key to its long-term viability as a growth business.
Johnson Controls' automotive business contributes 51% of total revenue, and with the growth in global automotive sales and the fact that the average age of an automobile in the U.S. at 11 years, that line of business likely will continue to prosper. But the real growth potential lies in its building efficiency division, which the company plans to make a more important component of its corporate profile.
That segment -- which makes energy management and safety controls systems for non-residential facilities -- now accounts for 34% of total revenue, and the company has a backlog of building systems and services contracts worth $4.8 billion. Two key drivers of the business are the growing trends of facility management outsourcing and energy efficiency programs for government buildings, and Johnson Controls is well positioned to profit.
'Plug And Play' Properties
One of my qualifications for an American Renaissance company is an ability to recognize and successfully serve a growing trend. Digital Realty Trust (NYSE: DLR) also fits that profile.
A builder and owner-operator of technology-related real estate, Digital Realty has long been one of my favorite real estate investment trusts (REITs). The value the stock offers and the company's unique business model are what makes it a core American Renaissance holding.
For example, if a company needs an offsite space for its computer servers, Digital Realty will either lease an existing pre-wired property or develop one for them. The company is also now offering design and implementation services to clients that want to own their own data centers.
As you can see from the chart, DLR spent most of 2013 underperforming. There are a couple of reasons for this.
Interest rates: The yield on the 10-year Treasury bottomed out around 1.6% last spring. It was around this time that the Federal Reserve began hinting at tapering its bond-buying stimulus program. Naturally, this spooked financial markets, sending the yield on the 10-year up from 1.6% to 2.6% over a two-month period. Companies that rely on capital markets, especially REITs, were affected by this, pressuring their stock prices.
Execution: Digital Realty had a disappointing third quarter, with $1.10 a share in funds from operations (FFO, a key performance measure for REITs) missing expectations of $1.20. Digital Realty reduced its FFO growth forecast for 2014 to low to mid-single digits from above 9%.
But the news wasn't all bad. The third quarter also saw Digital Realty sign new leases worth $47 million of annualized rent, the third-highest quarter for new business in the company's history. The board also approved a share repurchase plan of $500 million. Lastly, management is committed to increasing the dividend for 2014 and expects to boost it by 5% to 6%.
As computing continues to migrate en masse to the cloud, the need for Digital Realty's facilities and services appears quite sustainable. The recent price weakness offers investors a great opportunity to purchase shares of a high-quality growth business that pays an attractive dividend yield -- over 6%.
Risks to Consider: A weak economy is the biggest, most obvious risk to both stocks. The new year is still young, and some less than exciting data are starting to trickle in. Automotive sales in particular are coming in a little weaker than expected, which could prove troubling for Johnson Controls. Long-term interest rates also continue to tick up with yields on the 10-year Treasury piercing 3%, which likely will put pressure on REITs.
Action to Take --> Both Johnson Controls and Digital Realty qualify as American Renaissance stocks based on their focus on technology and infrastructure build-out and management. JCI is trading just over $50 with a dividend yield of 1.7%. DLR is trading just under $50, a 32% discount from its 52-week high of $74, and offers a 6.3% yield.