2 U.S. stocks to watch

By Sarah Cunningham-Scharf | June 1, 2017 | Last updated on June 1, 2017
4 min read

It’s hard to identify stocks set to outperform, but Paul Roukis has his eye on two U.S. names with positive key indicators.

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Roukis, who’s managing director and portfolio manager at Rothschild Asset Management in New York, says those two picks are Bank of America and Dow Chemical, and he explains why.

Banking on bank earnings

First, “Bank of America is our favourite stock among the diversified banks at this point of the cycle,” he says, referring to the bank’s relative valuation and operating leverage. The bank is one of the largest in the U.S., and, with investment banking and wealth management, it has global reach.

“Think Merrill Lynch,” a subsidiary of the bank, says Roukis, whose firm manages the Renaissance U.S. Equity Value Fund.

As such, “The market recognizes Bank of America’s leverage to higher interest rates, particularly at the short end of the curve,” he says, adding that if rates rise 100 bps, the bank would likely add more than US$3 billion to its net interest income over the next 12 months, which is significant. (All figures are in U.S. dollars.)

“Most of that benefit would fall right to the bottom line,” says Roukis.

Read: Room for upside in U.S. corporate earnings

Also, Roukis says the market underappreciates Bank of America’s operating leverage regarding cost savings and organic revenue growth. For example, he refers to the bank’s mistimed purchase of Countrywide Financial in early 2008 — an acquisition that “came with a laundry list of liabilities” when the financial crisis hit, says Roukis.

“After many years of playing defence, the [bank] can finally move forward from the consequences of the financial crisis, and again focus on selling, which it has done very well over time,” says Roukis.

Almost a decade later, “Bank of America now is in a position to drive its efficiency ratio to the low 60s this year and possibly below 60% in years thereafter,” he explains. That operating efficiency, in addition to the benefit that higher interest rates will have on net interest margin, will drive earnings.

In fact, “Earnings are projected to grow 20% in 2017 to $1.80 per share,” he says. “We could see another 20% jump in 2018 if the economy remains on stable footing.” In turn, ROE would increase, which should drive valuation multiple expansion, he adds.

And it’s not just greater earnings that will boost ROE. “Bank of America [is] well positioned to be more generous with capital allocation,” he says, “and thus more efficient as it relates to the denominator, [too], of the ROE equation.”

The positive outlook doesn’t end there. “Regulatory reform for the financials could be material, as would tax reform,” says Roukis. “These are big ifs, but they [would] have a significant influence on profitability in future years.”

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Valuation also looks good. As of late April, Roukis said the stock was trading “at less than 13× 2017 estimates and 11× 2018 earnings estimates,” and that it had “only a 1.3× tangible book value.” He concluded, “Valuation looks really reasonable to us at this point.”

However, he offers a caveat: “Banks are cyclical, and we’re mindful of credit cycles […]. Those are really the main risks to the Bank of America story, as well as [to] all financials.”

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Finding the right chemistry

Dow Chemical is another U.S. stock favoured by Roukis. “It’s one of our bigger positions in the portfolio,” he says. He expects the stock to be a top performer in 2017, boosted by a proposed merger with DuPont.

“These are big producers of chemicals that go into just about everything [consumers] buy, from autos to pesticides, to consumer good and even food,” he says. The two companies have “big footprints across many end markets.”

Once the merger is completed, “The combined company will support a market capitalization of roughly $150 billion — one of the bigger companies in the marketplace,” he says. “This is a situation where one plus one will equal three.”

Though the deal is more certain now that it has received EU regulatory approval, “it’s still not 100%,” acknowledges Roukis. “As much as we like the stock, we recognize there’s some risk from a synergy and an execution standpoint […].”

The merger, expected to close in Q3 of this year, would lead to $3 billion in cost savings and a further $1 billion in revenue synergies. These estimates are “the floor and not the ceiling,” he adds, noting that the combined company, which plans to split into three different businesses — agricultural, materials and specialty products — will benefit from such things as plant consolidations and procurement synergies.

And, with a “reasonable” merger timeline, “70% of the cost savings [are] expected […] within the first year, and 100% within two years,” he says.

Further, as of late April, “Dow’s stock look[ed] reasonably priced at about 15× 2017 estimates and 14× 2018 earnings estimates.” However, he again warns of cyclical risk, especially since the companies could be considered proxies for the economy and “couldn’t sidestep any downturns in the market.”

Still, he says, “Global growth prospects look reasonable [… and] the company has the benefit of self-help cost synergies that are reflected in the current valuation.”

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Sarah Cunningham-Scharf