If you're wondering what type of economic recovery Wall Street's movers and shakers see coming this year, consider the following three stocks that investment funds were buying in 2020's fourth quarter. Aerospace supplier TransDigm (NYSE:TDG) will excel if the commercial aviation sector rebounds as expected. At the same time, home-improvement retailer Lowe's (NYSE:LOW) and home-comfort and security products company Resideo (NYSE:REZI) are both well-positioned to benefit from the surging housing market.
As mentioned, all three were on fund managers' shopping lists late last year. Are these stocks still worth buying almost a third of the way through 2021?
The aviation supplier is probably the best one to start with because its stock has notably underperformed the other two and the S&P 500 so far this year.
TransDigm is often viewed as a go-to stock to play a recovery in commercial aviation, and it's not hard to see why. Its industry-leading profit margins come from a business model proven highly successful over the last decade.
In a typical year, the commercial aviation market delivers around two-thirds of TransDigm's revenue, with the rest coming from defense. It tends to sell relatively low-ticket price products -- the type of components that even airlines focused on cost-cutting might not be making an effort to bargain-hunt for. Moreover, it's highly acquisitive and has an excellent history when it comes to deals -- making it a geared play on a recovery.
That said, there are a couple of reasons for investors to be concerned. First, while the commercial aviation market is in recovery mode, airlines are still under heavy financial pressure. That may lead them to start trying to seek lower prices for TransDigm's products, and competitors may attack the company's margins by cutting their own prices. Second, TransDigm is not a cheap stock by any valuation metric you may want to use.
All told, it's a great company, but there are better ways to play a commercial aviation recovery.
This security and home-comfort products company came to the market as a spin-off from Honeywell International in late 2018. Its CEO resigned in 2019 following disappointing earnings reports and guidance cuts, and shareholders suffered as the share price slumped. The coronavirus pandemic initially appeared to make things even worse in 2020, but since the broader market bottomed out last spring, matters have improved fairly steadily for Resideo.
The pandemic created an ideal environment for companies selling home improvement solutions. Consequently, the stock quickly recovered, and management raised cash by issuing equity in November.
In the future, the key to the investment case will be if Resideo can meet its 2024 targets or not. Resideo is really two different companies in one. Its ADI business is a global distributor of security, home controls, communications, and audio/visual products. Meanwhile, its products and solutions business makes higher-margin residential climate controls, security products, water, and energy controls. Management sees an opportunity to sell more connected products and take advantage of the trend toward products that incorporate Internet of Things technology in the home.
Regarding the specific 2024 targets, management forecasts that operating income margin will expand from 6.1% in 2020 to 14% in 2024 and that revenue will grow at an annualized rate of 6% to reach $6.43 billion. Given that operating cash flow is forecast to be $600 million in 2024 with capital expenditures in the range of 2% to 3% of revenue, that implies a free cash flow (FCF) of around $440 million. Based on those forecasts and its current market cap of $4.14 billion, Resideo is trading at just 9.3 times its expected FCF in 2024 -- a very attractive valuation.
If the company can hit these targets, it looks like an excellent investment. However, the question is what kind of growth rate will it have after the dust settles from the stay-at-home spending boom? Something to keep an eye on.
The investment case for buying Lowe's stock is relatively simple. The key idea is that CEO Marvin Ellison can expand his chain's margins to get them close to those of chief rival Home Depot (NYSE:HD) while taking advantage of the solid underlying trends in home-improvement spending. It should help Ellison in this effort that he formerly was the executive vice president of U.S. stores for Home Depot, so he should be perfectly aware of what it will take to get Lowe's there.
The evidence suggests that Lowe's is starting to close the gap while both companies continue to benefit from higher sales, driven by the fact that so many people are still spending so much more of their time at home. In fact, the chart below shows the gap between Home Depot's twelve-month trailing operating margin of 13.8% is now only around 3 percentage points (the figure of 3.068 in the chart) ahead of Lowe's comparable margin of 10.8%
While these kinds of growth rates are not sustainable -- not least because state governments are continuing to ease their anti-pandemic measures -- the underlying housing market remains buoyant. Moreover, sales to professionals should increase as consumers get more comfortable allowing contractors into their homes. As such, Lowe's remains a decent value investing option.