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Don't let sequestration fears influence your investment decisions

Friday is the big day that sequestration will hit. And yes, I think it will go into effect, but I don’t think it will be a bad thing.

This may be a little uncomfortable for the market in the short term, but this is a positive long term. This will cut $1.2 trillion from spending until 2021 — many are unhappy about this or unhappy about that, but rarely is everyone happy about any type of cuts.

There are cuts in defense and agriculture, but they will manage, and rest assured you will hear how bad this or that is going to be. My feeling is we could cut more, but this is a good start. This is not the first time we have gone through a sequestration. It happened back in 1985 under the Gramm-Rudman-Hollings Deficit Reduction Act, which balanced the budget for one year. Point being, that was 28 years ago and here we still are and at that time the S&P 500 stood at 181.18, had you invested $10,000 back than you would now have an $82,901 portfolio.

Don’t worry about the government. Look at the businesses you own in your portfolio.

Speaking of sequestration, Jack, who has held shares of Raytheon (NYSE: RTN) for 18 years as a result of his employment there, is looking for an analysis due to the apparent cuts in defense spending. A few things to consider: while the U.S. government is probably the company's biggest client, it is not its only client, and second, many of the contracts it has now will last for years to come so the effect on them won’t be immediate.

With the stock trading at $53.94, almost at the middle of the 52-week high of $59.34 and low of $49.03, it cannot be called expensive, trading at a forward PE of 9.7. This is based on $5.56 per share using the mean of 19 analysts for the year ending December 2014. The earnings estimate for December 2014 has been cut by 4.3 percent over the last 90 days, so the analysts just like you and I are aware that defense companies could be making less going forward.

The company has a nice 3.7-percent dividend using only 35 percent of its earnings to pay that out, so I don’t see any dividend cut in the near future. Over the last 12 months the company did return 23 percent on its equity, beating the industry average of 19.1 percent.

While sales declined by 1.5 percent year over year, the earnings per share did climb by 7.9 percent while the industry saw an 8.1 percent drop in EPS. Raytheon has a good profit margin of 7.8 percent, above the industry mean of 5.9 percent.

The debt to equity of 58.95 is better than the industry average of 74.19, however both the industry and the company have a price to tangible book value of zero, which means if you take away all the intangible assets, there is no equity value to this company.

What could happen here is the company may have to do some asset impairments down the road because maybe some of the assets it holds are not worth as much due to the defense budget cuts.

Jack, I would be careful. Overall the company looks okay, and I don’t think the budget cuts will have that much of a long-term effect on the company. Check the allocation that Raytheon has in your overall portfolio. If it is more than 15 percent, I would say, at the very least, lighten up on the stock just to be on the safe side.

Remember, there are other companies out there that are in better shape with no looming budget cuts.

Willis, who has attended a couple of my workshops and said he found them to be informative, wants me to look at Schweitzer-Mauduit International (NYSE: SWM). He says he thinks it’s a buy; let’s see if I can agree with him.

Willis, I see you must have taken some good notes at the workshop. There is a lot to like about this company, but there are some areas to be aware. On the bright side, the forward PE is only 8.9, and using a PE multiple of 16.5 you get a target sell price of $68.80, well above the current $37 per share.

The balance sheet looks good with a current ratio of 2.8 and a total debt to equity of 34.3. Both of these are better than the industry average. The company also pays a 3.2 percent dividend using only 11.5 percent of the earnings to generate that yield.

Sales growth looks good, climbing 5.1 percent year over year when the industry experienced a 1.5-percent decline. Earnings per share look even better, climbing 86 percent when the industry EPS fell 93 percent.

A few things worry me about this company. First, the $4.17 earnings-per-share estimate for the year ending December 2014 is based on a mean of only three analysts. I like to see at least five or more.

One must also wonder how a company can grow earnings 86 percent when sales were only up 5 percent. This high earnings number could be pushing down the PE to an artificial level and next year the PE could rise, causing the stock to look expensive.

This theory was backed up when looking at the valuation ratios, because price to sales, price to tangible book value and price to cash flow all exceed the industry average while the PE ratio is below the industry average. This is where having a good understanding of the accounting can save investors from holding a sick company.

Willis, I’ll give you a grade of a “B” — watch the details, they can hurt you down the road.

Have a question or a company you'd like me to take a look at? Email me at brent@wilseyassetmanagement.com.

Wilsey is president of Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.

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