The Barron’s 400 Index completed its semi-annual reconstitution last Friday, once again improving its fundamental profile and, in the process, picking up some bargains courtesy of the ongoing malaise surrounding U.S. equities. True to its growth-at-a-reasonable-price (GARP) methodology, the new batch of companies trade at a much lower average forward P/E of 17.8, compared to 23.0 for the March group, while sporting a much improved growth profile. But before we get into the nitty-gritty of stock valuations and what they may portend for the future direction of the index, we’ll summarize what we think were the most interesting changes that just took place as a result of B400’s reconstitution.
B400 added 167 new companies to its coveted roster, or 41.75% of all constituents, in line with its historical turnover of 42%. 58 of these new names were added to the index for the first time ever, once again illustrating the dynamism in the methodology that powers the index. Yet, 96 companies that made the selection have been members of B400 for at least two consecutive years, providing a sense of continuity to counterbalance the element of renewal that comes with a fresh set of names. Furthermore, of these 96 companies, 51 have been members of the index for at least three consecutive years while 21 have been its members for at least five years in a row. Considering the size of the selection universe (about 4,900 U.S. domiciled companies covered by MarketGrader) and the rigor of our fundamental methodology, this speaks volumes about these companies’ focus on producing superior shareholder returns. Their names appear below along with their MarketGrader scores at the time of selection.
Companies Selected to the Barron’s 400 Index At Least Five Consecutive Years
| Ticker | Name | Overall Grade | Ticker | Name | Overall Grade |
| AAPL | Apple Inc | 88.2 | NKE | Nike Inc | 77.4 |
| BBBY | Bed Bath & Beyond Inc | 66.2 | NUS | Nu Skin Enterprises Inc | 63.7 |
| BEN | Franklin Resources Inc | 66.0 | PCLN | Priceline Group Inc | 65.7 |
| CMG | Chipotle Mexican Grill Inc | 66.2 | PII | Polaris Industries Inc | 74.0 |
| CTSH | Cognizant Technology Sol. | 73.7 | PRAA | Pra Group Inc | 70.7 |
| DLX | Deluxe Corp | 71.3 | RMD | Resmed Inc | 64.9 |
| FFIV | F5 Networks Inc | 76.7 | ROST | Ross Stores Inc | 68.6 |
| FOSL | Fossil Group Inc | 77.8 | TSCO | Tractor Supply Co | 67.5 |
| HD | Home Depot Inc | 76.2 | UNH | Unitedhealth Group Inc | 72.3 |
| MA | Mastercard Inc | 66.7 | UNP | Union Pacific Corp | 75.6 |
| MKTX | Marketaxess Holdings Inc | 67.1 |
Mid caps still make more than half of B400, as is usually the case, despite losing 15 names from the previous list. Thus, on selection day last week, 210 companies, or 52.5% of the index had a total market capitalization between $1 billion and $10 billion. Large cap names, or those with a market cap above $10 billion, lost seven names, yet they remain well represented, comprising 25.5% of the index. Small caps, of course, were the beneficiaries of cutbacks in names above $1 billion in market cap but still remain the smallest size segment of the index with 88 names, or 22%. In summary, there were no surprises or major shifts in size classification for the reconstituted index. Considering that three quarters of the names in B400 have a market cap below $10 billion, it is worth mentioning that these companies are better positioned to benefit from a continued strong dollar and a broad exposure to the U.S. economy than many of the widely followed names regularly mentioned in the financial media.
From a sector perspective, the index had almost no significant allocation changes, with the notable exception of Energy, which is now barely represented in B400 with only 16 names, or 4% of the entire index. In fact, B400 trimmed its exposure to the oil patch by eliminating a net 21 names. In total, it cut 26 Energy companies from its roster but it added five new ones in areas where it’s seemingly finding value. This we find very interesting considering that of the five new names added in the sector, three are in the midstream segment of the industry (pipelines) and the other two operate downstream (refiners). These companies are much less exposed to low crude oil prices than their upstream (exploration and production) peers, yet they have sold off almost on par with them and in sympathy with the entire sector’s collapse in share prices. The two tables below show all the Energy companies deleted and added to the index last week.
Energy Companies Deleted From B400 In Latest Rebalance
| Ticker | Name | Overall Grade | Ticker | Name | Overall Grade |
| TPLM | Triangle Petroleum Corp | 26.7 | EXLP | Exterran Partners LP | 55.1 |
| MTDR | Matador Resources Co | 30.5 | FANG | Diamondback Energy Inc | 37.8 |
| NBL | Noble Energy Inc | 32.8 | FET | Forum Energy Technologies Inc | 46.4 |
| NR | Newpark Resources I | 33.5 | RES | RPC Inc | 42.3 |
| NOG | Northern Oil and Gas I | 25.2 | HAL | Halliburton Co | 44.8 |
| OAS | Oasis Petroleum Inc | 54.3 | HOS | Hornbeck Offshore Services Inc | 58.3 |
| CLR | Continental Resources I | 42.8 | HP | Helmerich and Payne Inc | 48.6 |
| CRZO | Carrizo Oil & Gas Inc. | 47.1 | SM | SM Energy Co | 53.7 |
| CAM | Cameron International C | 42.0 | GPOR | Gulfport Energy Corp | 50.4 |
| AXAS | Abraxas Petroleum Corp | 50.8 | VNR | Vanguard Natural Resource | 19.5 |
| FTI | FMC Technologies Inc | 61.4 | UPL | Ultra Petroleum Corp | 52.4 |
| FTK | Flotek Industries Inc | 34.9 | SWN | Southwestern Energy Co | 33.5 |
| PER | SandRidge Permian T. | 62.8 | SYRG | Synergy Resources Corp | 59.3 |
Energy Companies Added To B400 In Latest Rebalance
| Ticker | Name | Overall Grade |
| VLP | Valero Energy Partners Lp | 69.4 |
| TSO | Tesoro Corp | 65.0 |
| TEP | Tallgrass Energy Partners Lp | 64.9 |
| PSX | Phillips 66 | 66.1 |
| ALDW | Alon Usa Partners Lp | 68.4 |
Industrials and Financials have the two highest sector allocations in the newly reconstituted B400, both reaching the 20% maximum allowed sector allocation (or 80 names), according to the index’s rules. Consumer Discretionary at 19.3%, Technology at 13.8% and Health Care at 10.3% round out the top five sectors by weight in the new B400.
As is always the case, by design, of course, the overall fundamental grade profile of the new selection batch is much improved from the six-month period just ended. The average MarketGrader score for all companies in the March 2015 selection, as of last week’s rebalance date, was 62.99 while the median was 64.15. The average grade of the new list of constituents, on the other hand, is 68.30 and the median is 67.01.
Outgoing companies, as is to be expected, have much lower grades, with the 165 companies that are leaving having an average score of 53.28 and a median of 56.20. The companies replacing them (and the two that had left the index earlier in the period through corporate actions) have an average grade of 66.29 and a median of 65.25.
Average Return on Equity improved from 29.7% for the March group to 32.8% for the new selections while average debt to total capital remained largely unchanged, at an average of 33.6% for the new group compared to 33.2% for the previous selection. Average market cap fell from $19.07 billion to $18.28 billion and median market cap fell from $3.8 billion to 3.29 billion. This is consistent with the increase in small cap names from 64 to 88 stocks, as mentioned above.
Not surprisingly, the growth profile of the collection of companies in the reconstituted index is across the board better than for the previous selection, especially considering that two quarterly financial reports have been produced by all companies since the March selection. Growth improved pretty much across the board when looking at one and three-year growth rates in revenue, operating income and net income. The table below summarizes the average and medians for both sets of companies.
Growth Rate Comparisons Between September and March 2015 Selections
| Growth Metric | September 2015 Selections | March 2015 Selections |
| Revenue 1Yr Chg. – Mean | 71.6% | 13.1% |
| Revenue 1 Yr. Chg. – Median | 9.3% | 8.5% |
| Revenue 3Yr Chg. – Mean | 120.1% | 100.4% |
| Revenue 3 Yr. Chg. – Median | 29.5% | 32.5% |
| Op. Income 1Yr. Chg. – Mean | 102.7% | 88.0% |
| Op. Income 1 Yr. Chg. – Median | 18.3% | 11.5% |
| Op. Income 3Yr. Chg. – Mean | 153.9% | 234.7% |
| Op. Income 3 Yr. Chg. – Median | 54.5% | 49.7% |
| Net Income 1 Yr. Chg. – Mean | 72.7% | 10.2% |
| Net Income 1 Yr. Chg. Median | 21.5% | 13.2% |
| Net Income 3 Yr. Chg. – Mean | 199.3% | 173.3% |
| Net Income 3 Yr. Chg. Median | 71.3% | 61.6% |
What’s Next for B400?
Economists often like to remind us that the U.S. stock market is not the U.S. economy and, we have to admit, currently they have a point. By this they usually mean that healthy stock market gains can often co-exist with poor or mediocre economic growth (witness the current recovery and the bull market that has accompanied it since 2009); but it also means that a healthy economy does not always spawn a rising stock market. On both of these points we agree. However, when a healthy economic environment leads a lagging stock market, from our fundamental vantage point, it is only a matter of time before prices catch up to the fundamentals, assuming economic gains translate into healthy corporate earnings growth. We believe this describes the current opportunity set in U.S. equities.
A recent research piece by the excellent KKR Global Institute caught our attention, not only because of its usual insight and clarity but also because their macro conclusions tend to coincide with what we have been seeing from a corporate earnings perspective. However, before we break out the champagne, it is worth providing some context to KKR’s optimism about U.S. equities. For starters, they admit that the current cycle, both the ongoing economic expansion and the favorable equity environment are now running above historical norms. In fact, the current economic expansion is 75 months into its current cycle, well above the historical median of 37. And the current favorable cycle in U.S. equities, through the end of 2014, had a duration of 68 months from the March 2009 trough, also well above the historical average of 41.
This notwithstanding, KKR makes a strong argument for why they think the current economic expansion could last well into 2017, in no small part as a result of the extraordinary expansion in the U.S. monetary base, with the Fed’s balance sheet now at over $4 trillion USD. Furthermore, their research points to several structural improvements in the U.S. economy that have been largely absent from the current recovery and should be conducive to further gains in equities, especially those tied to the most innovative parts of the economy and to select areas of consumer spending. The primary reasons they provide for such constructive view on U.S. equities include, 1) The current state of the U.S. consumer after a long deleveraging process, including repaired balance sheets and much improved savings rates; 2) The return of a healthy rate of household formation in the U.S., which had fallen of a cliff during the recession; 3) Their belief that the current long-term rate environment will continue well into the future; 4) Reduced drag to GDP growth from a contraction in government spending, at local, state and federal levels; 5) The ongoing rate of innovation in the U.S. economy, especially in technology, health care and energy, and 6) A defensible currency that will continue to provide strong purchasing power to the U.S. consumer.
From MarketGrader’s perspective, several of these themes seem to be playing out for certain segments of U.S. equities, particularly those with robust growth. In our last Newsletter published a month ago, we made the case for how B400 offered equity investors the best trade-off between growth and value (GARP) in U.S. equities. With B400’s most recent rebalance, the argument is even more compelling when measured by the new constituents’ earnings growth.
For starters, we looked at consensus estimates for all companies in B400 for their next fiscal year. All companies, of course, have different fiscal year end points, although the majority of them end it on December 31, to match the calendar year. Of the current 400 companies in the index, 326 have a “next” fiscal year that ends between now and Dec. 31, 2015. This means that for the majority of companies in B400, more than half of the “next” fiscal year is already in the books, making the resulting consensus estimate more accurate than if we were looking a full year ahead. FactSet, by the way, collects all estimates used in our analysis.
On average, FactSet’s consensus estimates have all B400 companies increasing earnings per share for the next fiscal year by 32.4%. The median fiscal year estimate is 25.0%. When we look only at the 326 companies whose fiscal year ends by the end of the current calendar year, the numbers are almost identical: expected average growth of 33.6% and median growth of 25.0%. Should B400 share prices grow in line with the expected median growth rate of 25%, this would put it up 19% for the year, which, we admit, is unlikely to happen. Nevertheless, it illustrates the dichotomy between what bottom-up economic figures are telling us, in the form of earnings, and what the market is saying, in the form of prices.
A more modest approach is to look at the implied growth rate of earnings based on PEG ratios for the current B400 constituents. Trading at an average forward P/E of 17.8 and with an average PEG ratio of 1.61, this implies an earnings growth rate of 11.1%. Assuming B400’s prices were to match this lower implied growth rate, this would translate into a year-end gain for the index of 6.4%, or roughly 11% from where it closed on Wednesday. While this seems more palatable than a 19% gain through the end of the year, the number seems excessively low given the apparent health of companies in the index. Thus, a simple back-of-the-envelope calculation of a midpoint between these two growth rates would put the index up 13% through the end of the year. While many investors would logically question how that is possible amid the current malaise and predictions of stock market doom, we think that should KKR’s logic hold and our bottom up estimates prove half accurate, such gains are more achievable than many think
