Barron's Streetwise - D.A. Davidson's Top Stocks

Episode Date: October 6, 2023

Plus, a few words on bond yields, Hammurabi, and Buffalo Bill. Learn more about your ad choices. Visit megaphone.fm/adchoices

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Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard, that's Tom Diffley. He's the director of research at D.A. Davidson, an investment bank, and in a moment we're going to talk to him about his firm's new list of top stock picks. They're called Best of Breed Bisons. Bison. I think it's bison. Bison is already plural, right? Bisons. Bison.

You can't say bisons. It's like two bison. One bison, two bison, three bison. Bison sounds like it should be without an S. If it's 200 bison, that's technically a bicentennial. Oh, stuck the landing. Laughed at my own joke like a pro. Listening in is our audio producer, Metta.

Hi, Metta. Hi, Jack. We'll get to our Bison business in a few minutes. First, I want to say a few words about bonds and rising yields and whether that's bad for stocks. bonds and rising yields and whether that's bad for stocks. The 10-year treasury note has been flirting with a 5% yield. Who knows, by the time you listen to this, it might be higher. And that has created some wobbly days for the stock market, including some selling in the big tech stocks that have been driving gains all year. There is plenty to worry about if you're looking for stuff to worry about. That 10-year yield last I checked, it was between a 4.7 and a

4.8 percent. That's up from 3.8 percent in just mid-July and less than 1 percent for much of 2000. It's the highest yield since 2007. There's a lot of selling in treasuries by both the Federal Reserve and China. And the word on Wall Street is that buyers of treasuries who've been complacent about the amount of U.S. debt for a long time, they're suddenly worried about the debt. And so they have to be tempted into buying bonds with ever higher yields. And those rising yields could hamper stock returns. That's according to different strategists like Goldman Sachs and Morgan Stanley and JP Morgan. Not everyone feels that way. We heard this past week in this podcast from Savita

Subramanian at Bank of America Securities, and she remains bullish on U.S. stocks. We'll come back to that too in a moment. I just want to make three points for investors who are looking for a little emotional support for holding onto their portfolios of stocks and bonds right now. Point number one is that yields are higher, but they're not especially high. We have 10-year treasury yields going back to 1962, courtesy of FRED. That's the Federal Reserve's Economic Data Service. And the average daily yield is 5.9%. That's more than a point higher than where we are today. How about mortgage rates? The 30-year mortgage rate, the average is about 7.3% right now. That has shot up. But the long run average going back to 1971

is 7.7%, four tenths of a percent higher. Now you can say that those averages were pulled higher by the early 1980s when there was a big anti-inflation crusade. And that's true. Back then mortgage rates were over 15%. anti-inflation crusade. And that's true. Back then, mortgage rates were over 15%. But the averages are also pulled lower by a much longer period that started after the global financial crisis, and it lasted through early last year. And interest rates got so low then that the Treasury at one point had to update its software to allow for negative yield bidding on T-bill auctions. That's something it just hadn't thought about before. Now, Fred might only go back to 1962

on 10-year notes, but we can go back much further on long-term interest rates in general. Around that same year, in 1963, there was a book that came out called A History of Interest Rates. It was by an analyst and historian named Sidney Homer, who worked at Salomon Brothers. And he goes almost as far back as the history of civilization. For example, about 1800 BC, Hammurabi. My pronunciation meta? It's got to be Hammurabi.

What else do you say there? I only ever see it written. I've never heard someone say it before. You're not going to go Hammurabi, right? Hammurabi. Hammer. Let's just call him Hammer. The king of the first dynasty of ancient Babylonia, I'm reading from the book, gave his people the earliest known formal code of laws. A number of the chief provisions of this code regulated the relation of debtor to creditor, the maximum rate of interest was set at 33 and one third percent per annum for loans of grain, repayable in kind, and a 20 percent per annum for loans of silver by weight. There's a shout out in the book to Brutus, as in Caesar's

Brutus. He tried to charge the city of Salamis. I'm not, we're not saying salamis for that, right? We're saying salamis. Yes. Try to charge 48% for a loan. And he had to be reminded that the legal limit at the time was 12%. Anyhow, I mentioned this book because many monetary historians believe that the period that we just went through this decade plus period of ultra low interest rates, was the lowest rate period in 4,000 years of data. And so yields are now rising quickly, sure, but they're rising quickly from those levels. So what exactly is normal? It's difficult to say, but one thing you can be pretty confident about is that yields are moving toward normal, not away from it. Higher bond yields are mostly a good thing.

Long-term savers, they need to get decent yields on bonds in order to properly diversify their assets. We just saw how nutty things get when you can't get decent returns on bonds. At one point, people were buying cartoon ape faces, right? And they were convincing themselves that the cartoons were valuable. They were calling them non-fungible tokens and saying that they were unique, one-of-a-kind things that were powered by the blockchain, which is the future of money and so on and so forth. Speaking of non-fungible tokens, NFTs. Less than three years ago, the New York Post read, I apologize in advance for this one. The New York Post published a headline that read,

NYC man sells fart for $85 cashing in on NFT craze. That, I think, encapsulates the risk of leaving rates too low for too long. Let's hear it. Let's hear it. Were you offended that they called you an NWC man? I moved to Westchester years ago. Come on. And the third point, and this brings us back to Savita and Bank of America, is that higher bond yields don't have to be so painful for stock investors. From 1985 to 2002, if you look at bond yields, inflation-adjusted bond yields, they were

higher on average then than they are now, and stocks during that stretch returned 15% per year on average. Now, that doesn't mean we're going stretch return 15% per year on average. Now that doesn't mean we're going to get 15% a year from here. It just means that stocks can continue to perform okay, even with higher bond yields. And Savita, if you remember, pointed out that companies have prepared for this moment by doing away with some of the variable rate debt that they had and securing fixed rate debt at lower yields. And they've also been getting more efficient. So companies can make changes to adjust for the times.

So I don't think the higher yields are a call to dump stocks. I do think that they are a call to buy bonds. If you're someone who a few years ago, you were disgusted by bond yields, you felt that there was no point in settling for those paltry yields. So you took that money and you parked it in, let's say, a money market account or some sort of short-term cash vehicle. And now you've got that money and your money market might be paying 5%. I think it's a good time to take that money and lock in some of these longer bond yields. I don't know that bond prices are done falling and the yields are done rising, but I'm of the general belief that the best predictor for future bond returns is today's

yield. Right now you can lock in an inflation-adjusted treasury over 10 years, paying 2.3%. So you'll know that you're going to beat inflation by 2.3%. That's not terrible as a diversifier for your stock. So if you're light on bonds, it might be time to buy. And that's it. I think we covered it, right, Matt? Bonds, stocks, the NFT guy. Grain, silver.

You want to make a grain trade? It's got to be in kind. What do you want to trade? Quinoa. Is that the little one that's kind of pasty or is that the one that's gritty? It's the one that doesn't taste good. Okay.

I neither eat nor can spell either one. So no thank you. Let's get to the bison meta. Cue us up with your best bison impression, please. Moo! I want to tell you that's ridiculous, but I've never heard of bison either. So you know what? You could be right.

It's kind of like cow. No? You got to ask Montanans. They've got bison in Montana and plenty of Davidson offices too. D.A. Davidson is an investment bank that traces its roots to Montana and the bison is its logo as of about 2016. And by the way, is anyone else wondering which is the one that's extinct? Meta, do you know? I'm going to guess the buffalo is extinct. Yeah, well, it's a trick question because it turns out everyone uses the words bison and buffalo interchangeably. But apparently they're totally different animals.

Apparently the ones with the giant shaggy heads that live in North America, those are bison. And buffalo live on entirely different continents. There's the African or Cape buffalo, and there's the wild Asian water buffalo. Those are only distant relatives of the American bison. Wow, what was going on with Buffalo Bill? He got it completely wrong. Yeah, I'm reading this from the Illinois Department of Natural Resources. So I assume they know. But they didn't have the internet

back then. So no one could tell him, I think is what happens. He was an American soldier, bison hunter, and showman. Where are you reading that? On Wikipedia. They wiki nailed it. They wiki-nailed it. Okay, so DA Davidson, as I said, introduced its Best of Breed Bison Initiative, and it explains in a report that it's an exclusive list of the highest quality names under coverage at DA Davidson. And Maddie, you were saying that sometimes you hear from listeners who want stock picks. Yeah, I have been hearing that here and there. Yeah, sometimes I mention stocks in passing. I don't do it a lot in a podcast because I don't really think of it as a sort of stock picky type of forum, but what better opportunity than this

new list to talk about some stocks? And a few of the stocks on the list are giant companies, but a number of them are smaller ones that listeners might not be familiar with. We'll run through them. I reached out to Tom Diffley. He's the director of research at Davidson. You've got a new stock picking list out, and these are called best of breed bisons. Why did you want to create this list now, and what were your thoughts about how to put it together? First of all, we have a new head of equities that came in about six months ago, Liam Healy, many, many years at William Blair. They have a bit of a quality bend to them. And

I would say really after two or three years of the SPAC world, the pendulum has swung back. We want to focus more on quality over time. And so we look at 12 different criteria to determine quality. Some of them are about the business. Some are about the moat. Some are the financials. Some are the management team. And then at the very end, we have kind of a risk reward or valuation, if you will. Okay. I noticed Warren Buffett got a shout-out in the initiation report you put out in this process. What is it about Warren Buffett's style that you think is a good fit for what you folks do? So I think he kind of epitomizes the looking of or the search for quality companies that are going to be around for a long time. And that will outpace the market over time.

And so I think that was just a great way to start is to go through all of his readings, all of his evaluation metrics and figure out exactly where he starts, what he looks at. And then we, with 20 analysts here with 20 years of experience each, we've kind of modified his methodology to match us. I think some investors out there think, well, okay, I want to be a value investor like Warren Buffett. So I want to look for things that are cheap. So I've heard that the price to earnings ratio is a way to tell whether a company is cheap. So I'll just look for the stocks out there that have low price to earnings ratios and I'll buy those. What all goes into telling whether a company is attractively priced? What we're doing is we're setting a quality standard for the company to be able to outperform its market over time. We're not necessarily saying

that the valuation is attractive today. We actually have a few neutrals in this list. But these are companies that we think over the next five years will outperform. And so the ones that you should pay attention to. And so when we look at the actual attractiveness of the stock, we believe it has to be trading at a discount to the intrinsic value. And we go through that process in each of our reports. The ones that are trading at a nice discount to intrinsic value, those are the ones that we think are buys today and are very attractive today.

Whereas the ones that are not, those are names that you should continue to watch, even if their prices are a little bit high today. Take advantage of any kind of dislocation in the marketplace and pick them up when things are slow. You mentioned the importance of a company moat. and pick them up when things are slow. You mentioned the importance of a company moat. I wrote a column for Barron's and I mentioned some of your stock picks

and on the list is Bank of Hawaii. I didn't go into great detail about it, but a reader emailed me and he said, Bank of Hawaii literally has the biggest moat of any of these companies. I guess he's making a joke about it being on an island. That's not what you mean by moat. What do you mean by moat? It actually turns out for the Bank of Hawaii, it's almost true where the Pacific Ocean is their

moat. It's very much people in Hawaii want to use Hawaiian banks. It's been very difficult for mainland banks to make inroads there. And so they literally have the moat the size of the Pacific Ocean that helps them maintain their share over time. Matt, is this a good place for a break while everyone's thinking about Hawaii? Sure. Okay. We've mentioned one stock. There are 17 in total. We'll give some bullets on a few more and then run through the rest of the list when we come back. Welcome back. Let's get back to stock picks and spray lube. That'll make more sense in a moment. Back to the conversation. WD-40 is on the list. That's a name that everyone probably has sitting

in their garage right now. That's one of those where it doesn't have a particularly low price to earnings ratio, but it's done very well over time. When I think about world-beating stocks, spray lubrication is not the first thought that comes to my mind. What is it that makes this such a good business? When you think about a sticky door, it is the first thing that comes to your mind. That's true. It's just an incredible business where they completely dominate the market. They completely dominate the mindshare of what they do.

And they're doing a few things where they're moving up market. They have specialty spray nozzles now. They have different types of packaging that's going to get better margins over time. And so they're just in a really good position where they're dominant today. They're growing through adjacencies. And it's one of those names that there'll be times when it's overvalued and we would be neutral at that point. And there are times when it's undervalued and we'll be buyers.

We just think that over the long period of time, this one will be an outperformer. There's a name on the list called Trex. Now this one I get. I know I've spoken with one or two CEOs. I think the CEO retired some years ago and they have a new CEO. They make lumber alternative, I guess you would say. It's kind of like they wouldn't want me to call it plasticky wood, but it's wood with some kind of resin mixed in with it that makes it stand up well to the elements. So you build a deck with

it and your deck lasts for a long time and you don't get splinters and all that sort of thing. Is that the type of business that you think is well protected from competitors or you see that as a growing market? It's the leader in a space that continues to gain share over time. I think the synthetic woods are roughly 25% of the market today. They're gaining 100, 150 basis points of market share every year. And so it's just the leader in a space that we think has many years of growth ahead. There's another company in the space, Azix, that we actually like more right now, just based on relative valuations.

But we think the space is great and Trex is the leader. And that's the name recognition dominant player that over time will outperform the market. Interesting. So that's a case where one might have a more attractive valuation or what have you for the next year. When you have those buy and neutral ratings on stocks, you're kind of thinking about the next year, right? Whereas when you're putting this list together of these bisons, you're thinking about the next five years or longer. Have I got that right? Exactly right. Yeah. We have a 12 to 18 month price target, which is our official price target. But anything on our best to breed Bison list is an assumed buy over a five year period. I got it. Let me ask you about one more. I'm intrigued by Encore Wire because when I think

about moats and competitive advantages, I mean, it's tempting to think, well, the company has to do something fancy that other companies can't do, or maybe it has patents or maybe it has this and that. And I think wire, how differentiated could wire be? But this is a company that's done very well over time. What's attractive about Encore wire? A couple of things. very well over time. What's attractive about Encore wire? A couple of things. It's the type of wire, the really large wire that they can make. But also a lot of this is their supply chain of

getting the copper. And right now, you hear things like there's only one or two days of excess supply of copper in the industry. And so just their ability to lock down supply with some of their large copper suppliers and their ability to make these supply with some of their large copper suppliers and their ability to make these large diameter wires and be able to be the one-stop shop for a lot of these really large construction sites, they're just in a really good position. And our big picture view is that with the EV revolution, copper over the next five, 10 years becomes quite scarce or the supply demand gets out of whack. And they're just in a really good position to benefit when that happens.

Meta, let me butt in here to get all the company names in. So we just mentioned three. Those were Bank of Hawaii and Encore Wire and Trex, right? Oh, and WD-40, so four. Now there are some giant companies on the list. There's Deere, the tractor maker. Microsoft is on there. Workday, that's the software maker. And Booking Holdings, the travel company. One more pretty big one, CrowdStrike Holdings, they do cybersecurity. There are a number of smaller banks on the list. Axos Financial, of smaller banks on the list access financial cullen frost bankers fnb corp service first bank shares there's nordson don't think nordstrom the retailer this is nordson which does industrial machines for extrusion molding filling encapsulating measuring controlling processing insulating, measuring, controlling, processing, compounding, all sorts of squirty type stuff with like viscous materials. That sounds that's they're not going to want to use that for a tagline,

but you get the idea. Who else? There's Jack Henry and Associates. They do software for banks and oh, Brunswick. Can't forget Brunswick. Brwick brunswick is i think more than 150 years old well it dates back to the 19th century they make boats and they make boat motors and they have a dominant share in boat motors meta i'll give you 90 guesses what brunswick started making. 90? Yeah. It'll be a long podcast. My first guess is cookies. It's a good guess. I bet you someone there did make cookies at one point, probably like an office party.

But the answer is billiard tables and bowling pins, all sorts of stuff for bowling. But they're out of bowling now, just boats and motors. And that's the whole list. Now, before I let Tom go, I had to ask for his thoughts about the broad stock market. What we see in these times is just a lot of volatility. And this is almost the perfect time, we think, to upgrade your portfolio. And what better way to do that

than to go to higher quality names that we think are going to be winners over the longer period of time. So we would use any kind of dislocations to start looking at names similar to the ones that we outline in our Best of Breed program. Thank you, Tom. And thank you everyone for listening. If you have a question for the podcast, just tape it on your phone, use the voice memo app

and send it to jack.how, that's H-O-U-G-H, at barons.com. Metta Lutsoft is our producer. She's a best of breed audio bison. If you ask me, you're saying I have a big shaggy head. Definitely not.

I meant it as a qualitative statement. You look nothing like a bison and I will take issue with anyone who says different. Thanks Jack. Subscribe to the podcast on Apple podcast, Spotify, or wherever you listen. If you listen on Apple, please write us a review. See you next week.