Value bets: Chevron & Wells Fargo

by Richard Moroney, editor Dow Theory Forecasts

Smart shoppers consider an asset’s value before buying. Rather than chasing performance, buy stocks tinged with a healthy dose of pessimism.

And no matter how compelling a company’s story, don’t buy unless you’re paying a reasonable price. Below, we examine two value situations  stocks with healthy businesses that appear cheap from multiple angles: Chevron (CVX) and Wells Fargo (WFC).

Of course, value investing can test a shareholder’s fortitude. An undervalued stock may remain so for some time.

Worse, a stock may continue its downward slide, driving out all but the most stubborn investors until it forms a bottom, an inflection point that becomes obvious only in hindsight.

Nevertheless, history and logic suggest that picking a diversified portfolio of high-quality stocks with attractive valuations provides the best odds of success.

Headwinds have stalled Chevron shares, which returned just 2% over the last 12 months. After ten straight quarters of sales growth, Chevron reported declines of 10% in the June and September quarters, hurt by soft fuel prices and production problems.

Chevron must also contend with a $19 billion verdict awarded to plaintiffs in Ecuador last year. A judge in Argentina put an embargo on Chevron’s assets held there — valued at roughly $2 billion — until the oil giant pays the entire verdict.

However, the company considers the Ecuador verdict fraudulent and unenforceable. Chevron generated operating cash flow of $26.03 billion in the first nine months of 2012 and has $21.58 billion in cash on its balance sheet.

Chevron expects production to grow in the December quarter as new projects ramp in Australia and Africa. The company anticipates strong cash generation in coming years; and earlier this month, management said the dividend is the company’s “single highest priority of cash use.”

The quarterly dividend, raised at an annualized rate of 9% over the last five years, is $0.90 per share, equating to an annual yield of 3.4%. Chevron is a Buy and a Long-Term Buy.

Wells Fargo earns Quadrix scores above 80 for both Value and Momentum, a rare combination offered by less than 4% of the stocks in our research universe of more than 4,500 companies.

Wells Fargo shares have lost some luster after getting dragged through a spate of lawsuits stemming from the housing bubble.

In the September quarter, the bank maintained its high-end estimate of lawsuit losses at $1.2 billion in excess of its current reserve — roughly 1% of the cash and marketable securities held on its balance sheet.

Perhaps more of a concern is low interest rates squeezing profitability, leaving the company with fewer attractive places to invest its rising deposit base.

But underlying trends for the mortgage business remain positive, as household formation begins to pick up speed.

Even considering interest-rate concerns, Wells Fargo shares look unduly cheap at just 10 times trailing earnings, 37% below their five-year average and 22% below the average bank in the S&P 1500 Index. Wells Fargo is a Focus List Buy and a Long-Term Buy.

Learn more about this financial newsletter at Richard Moroney's Dow Theory Forecasts.

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