RTX - Compounders And Dividends: Building A Watchlist

Summary

• In this article, I explain how I generate ideas and my methodology of adding companies to my watchlist.
• I also discuss certain areas of my watchlist, including merger arbitrage, semiconductor equipment, and defense contractors.
• I showcase my entire watchlist and discuss the difficult decision of reinvesting in legacy positions vs. adding a new position.

Thank you everyone for the warm reception to my intro article . I appreciate the kind comments and welcome any feedback. As I promised in my inaugural article, here is a look at my ever-shifting watchlist. My watchlist is similar to my reading list, it never gets smaller; I'm constantly adding (and rarely removing) companies. I maintain my watchlist on Seeking Alpha and also maintain it on my excel sheet where I follow my entire portfolio.

I included my total watchlist below, and I'll dig into a few of them. The list consists of some single stocks I like and areas/sectors I find interesting (merger arbitrage, semiconductor equipment, defense contractors, etc.).

One question I wanted to answer from a commenter from my first posting was how I choose the companies I invest in. In order to answer that question, I need to first answer how companies make it onto my watchlist. Companies are added to my watchlist in a variety of ways; below are the most common sources of ideas for me:

1. Articles here on Seeking Alpha from authors/stocks I follow (can come from their own portfolio updates, articles they write on certain companies, or articles about companies mentioned in articles about companies I own)
2. Listening to investors on podcasts (Yet Another Value Pod, Acquired, AMM Dividend Growth, Business Breakdowns, Dividend Cafe, Invest Like the Best, Masters in Business, Odd Lots, and Chit Chat Money are the ones currently in my feed)
3. General business articles, including the WSJ, Financial Times, and Barron's
4. Talking with friends
5. Following 13Fs
6. Listening to my wife/buy what you know

There may be other areas of idea generation, but these tend to be where I get the majority of ideas. One thing I never do is screen stocks for ratios or other technicals. I am looking for great companies, not cheap stocks (insert Warren Buffett quote of choice!) Once I hear/read a pitch on a stock, I'll spend 2-3 minutes trying to quickly understand it. If I find it interesting enough to keep digging, it goes on the watchlist. Once there, I need to spend time to research and understand what the company does and the industry it operates in. I typically start with the 10-K, then rotate to the most recent 10-Q, conference call transcript and presentation.

After digesting information from the company, I'll typically leverage some analyst reports from my broker to get an outside opinion. Sometimes this step will lead me down the hole of looking into a competitor and adding it to my watchlist (which happened with O'Reilly Automotive ( ORLY ) while researching AutoZone ( AZO )). After this, I'll look through Seeking Alpha articles and Twitter to see other investors' takes.

After I've finally wrapped my arms around a company, if I still like them, I'll then begin to try and find an entry range. I'll spend some time with a discounted cash flow to make sure I'm directionally right, but I never rely on it for a concrete price. If I know the company will be returning the vast majority of FCF to me through buybacks and dividends, I typically try to make sure I'm not paying a multiple that is terribly inconsistent with the past, unless there is some crazy growth engine I think the market is missing. If a company historically finds resistance at 13x earnings, I'm not going to sweat paying 14x earnings if I think the company can continue to grow while being shareholder friendly. In general, I'm trying to pay below-market multiples for great companies or slightly above-market multiples for wonderful companies.

As an example (and I'll talk about this in my October writeup), I put the rest of my monthly savings to work to add to my Visa ( V ) position. My back-of-the-envelope math put V at a low 20s P/E with normalized cross-border transactions. I'm happy to pay a low 20s multiple for a company that requires little to no CapEx with fat margins that is returning nearly all of its FCF to shareholders. Winners win, and V has been a winner for a long time.

Areas I'm Monitoring

Here are some high-level areas that I find very interesting and require more research from me. Before diving in, I'll preface that this is not investment advice. While I may be interested in some of these situations, I have not done the research to add these to my portfolio.

Merger Arbitrage

I love merger arbitrage, but I rarely have the spine to pick up pennies in front of a steamroller. Activision Blizzard ( ATVI ) and Twitter ( TWTR ) are not pennies, though. Instead, you're looking at double-digit IRRs for situations that feel better than the implied risk the market is pricing. Both companies have definitive agreements in place (no speculative arbitrage here) with different catalysts.

For ATVI, it's all about the regulatory authorities. The transaction requires a number of antitrust clearances, including the FTC, European Commission, and UK Competitions and Market Authority. Any of those agencies could block the deal, but that doesn't look likely to me. The FTC and UK CMA have both extended their reviews, and the companies remain in pre-notification discussions with the EC. A similar deal that just got done is Bungie/Sony. While not at the size of ATVI, Bungie/Sony presented similar vertical issues and also received an extended review from Lina Khan's FTC. You also have the oracle himself with a position in the deal. The recent loss for the DOJ in the Change Healthcare ( CHNG )/UnitedHealth Group ( UNH ) deal feels reminiscent of the loss the DOJ took in the Time Warner/AT&T ( T ) merger from a few years ago. Right after the DOJ lost its challenge in court, we saw other large vertical deals receive approval, including Aetna/CVS ( CVS ).

On TWTR, much brighter minds have waxed poetic on the merits of Musk's purported termination. I won't repeat the points, but it always felt like the TWTR board was the biggest risk to the deal. Are you going to get $54.20 per share? No clue, but this seems like the situation where you only have to be directionally right to make money.

Semiconductor Equipment

I've been loosely interested in the semi equipment space since Lam Research's ( LRCX ) failed bid to acquire KLA Corporation ( KLAC ) (previously KLA-Tencor) and Applied Materials ( AMAT ) failed bid to acquire Tokyo Electron. The semiconductor equipment space is extremely concentrated, with those four companies being the big players. I love industries with high barriers to entry with decade-long tailwinds. I had previously done the research but didn't dig in enough to get comfortable. I saw one of my favorite investors, Chris Hohn, recently begin starter positions in KLAC, AMAT, and LRCX. That piqued my interest again, and to the watchlist they went!

Defense Contractors

One of my biggest investing regrets was not pulling the trigger on the big defense contractors, including Lockheed Martin ( LMT ), Northrop Grumman ( NOC ) and Raytheon Technologies ( RTX ), last year when all three were trading at cheaper multiples. I previously owned United Technologies and was very excited about the spin-off, but had to exit the position due to compliance reasons at my previous job (you will also see Carrier ( CARR ) and Otis ( OTIS ) on my watchlist). There isn't much to say about these businesses. They are in a concentrated industry with a single buyer flush with cash that the market typically misprices every few years.

What to Buy

The hardest part of managing my watchlist is deciding whether to add a new position or reinvesting into a current position. Right now, I'm focused on adding money into the positions already in my portfolio. While some stocks on my watchlist look attractive, plenty of companies in my portfolio are currently attractive enough to add capital. I'll likely continue to focus on my larger positions (as evidenced by my V purchase this month). When I find that I'm sufficiently overweight companies that I love, I'll try to strike a balance between adding capital to the great companies on my watchlist and some of the smaller weightings in my portfolio.

Below is my watchlist of stocks, grouped by my five buckets:

Conclusion

See something I'm missing? Let me know in the comments some companies I should add to my watchlist. I'd also love to hear how others generate ideas for their portfolio and read any tips for managing a dynamic watchlist.

For further details see: