Extra8/25/2009 12:01 AM ET
12 blue chips ready to rally
Many blue-chip stocks that were left behind in the market's recent upswing are worth buying. This handpicked dozen could rise 20% in the next year.
[Related content: Exxon, Berkshire Hathaway, Microsoft, Abbott, Wal-Mart]
By Barron's
This time, the cream isn't rising to the top.
The historic rally that has lifted the Standard & Poor's 500 Index ($INX) by 50% from its March lows has been led by economically sensitive and lower-quality stocks, including such sectors as financials, basic materials, retailers and industrials. By contrast, high-quality stocks like Abbott Laboratories (ABT, news, msgs), Exxon Mobil (XOM, news, msgs) and Procter & Gamble (PG, news, msgs) generally have lagged, with many showing outright losses this year.
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The rush by investors for cyclical, economically sensitive stocks has only increased as the outlook for the global economy has brightened. But now a shift may be at hand. Quality stocks soon could start to shine.
Several factors are working in their favor, including relatively low price-to-earnings multiples, decent growth outlooks and strong financial positions. The run in economically sensitive stocks has left many of them trading at very high P/E ratios for 2009 and even 2010 -- to the extent they have any profits at all this year. Investors now can grab best-in-class companies such as Berkshire Hathaway (BRK.A, news, msgs), Microsoft (MSFT, news, msgs) and Wal-Mart Stores (WMT, news, msgs) at attractive prices and for little or no premium relative to their lesser brethren. (Microsoft publishes MSN Money.)
Jeremy Grantham of GMO, a Boston investment-management company that evaluates a range of domestic and overseas asset classes, argues that U.S. blue-chip stocks now represent some of the best investments in the world.
Barron's has picked a dozen quality stocks that look ready to rally. The stocks trade for an average of 12 times projected 2010 earnings, excluding Berkshire Hathaway, which tends to get valued based on its book value rather than reported profits.
Each of our dozen could rise 20% in the next year, and most have secure dividends of 2% or more. The major market indexes may rise more grudgingly in the months ahead, following the biggest rally since the late 1930s. The S&P 500 Index now is valued at about 15 times projected 2010 operating profits, a premium to most of the blue chips on our list. And if the economy unexpectedly weakens, quality stocks are apt to offer greater downside protection than most of the market averages.
The bull case for the cyclicals, including many financials, rests on hoped-for 2011 or 2012 profits, but those might not materialize if the economy sputters. The investment outlook for Caterpillar (CAT, news, msgs), Ford Motor (F, news, msgs), Dow Chemical (DOW, news, msgs), Paccar (PCAR, news, msgs) and a range of other economically sensitive stocks hinges on distant earnings. New investor favorite Ford, whose shares have more than tripled this year to $8, isn't expected to earn much money until 2011. And who knows what the economy and global auto market will look like then?
"The easy winner of the cheapest-equity subcategory is still high-quality U.S. blue chips," Grantham wrote in a recent market commentary. "They were really trashed on a relative basis by the second-quarter rally in junk. I understand a rally in junk after the record decline, but this was excessive and based apparently on unrealistic hopes for a strong, sustained economic recovery."
In fact, it's one of the biggest issues confronting professional investors: Should one stick with the stocks that have been doing best -- the cyclicals -- in the hope that the rally continues or start buying quality issues?
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Numerous measures illustrate the outperformance of economically sensitive and lower-quality stocks. The Morgan Stanley index of cyclical stocks is up 48.6% this year, led by Ford, Goodyear Tire (GT, news, msgs), Freeport-McMoRan Copper and Gold (FCX, news, msgs), Sears (SHLD, news, msgs) and Ingersoll-Rand (IR, news, msgs). The Morgan Stanley Consumer Index, by contrast, is up 7.5%, held back by double-digit percentage declines in Safeway (SWY, news, msgs), Abbott Labs and Procter & Gamble.
Given its high-quality composition, the Dow Jones Industrial Average ($INDU) is one of the worst-performing U.S. market indexes this year: It has gained just 6% while the S&P 500 has risen 11%, the technology-heavy Nasdaq Composite Index ($COMPX) 27% and the S&P 400 Midcap Index ($MID.X) 21%. The energy sector has badly lagged the big gain in oil prices, as Dow components Chevron (CVX, news, msgs) and Exxon actually are in the red.
Continued: A dozen stocks to consider
Here's a rundown of the dozen stocks on our list:
1. Abbott Laboratories
Due to its diversified business mix, Abbott has been one of the better investment stories in the tough pharmaceutical sector in recent years. Abbott shares, however, have fallen 17% this year, to about $45. A key issue is Wall Street's fears about the slowing growth of Abbott's top drug, Humira, which is used to treat auto-immune diseases such as rheumatoid arthritis. Humira generates nearly 20% of Abbott's $30 billion in annual sales and accounts for most of its revenue growth.
But Humira isn't fading. Sales of the drug could rise 20% this year and 15% or more in 2010. Unlike many drug stocks, Abbott still is a growth story, with profits expected to rise 11% this year to $3.69 a share and another 11% to $4.10 a share in 2010. Abbott looks reasonable at 11 times next year's projected profits. Morgan Stanley drug analyst David Lewis sees the stock hitting $55 within a year.
2. AT&T
As a classic defensive stock, AT&T (T, news, msgs) has lagged in the market rally along with rival Verizon (VZ, news, msgs). For both companies, the story has been growth in wireless revenue and profits offset by erosion in their formerly core land-line phone operations. Wall Street worries about a saturated wireless market and continued land-line losses as consumers "cut the cord." There were signs in the second quarter that land-line losses may be moderating while AT&T benefits from its exclusive relationship with Apple's iPhone.
AT&T's valuation is low. The stock around $26 a share, trades for 12 times projected 2009 profits of $2.08 a share, but earnings are penalized by about 40 cents for noncash goodwill amortization from acquisitions. AT&T's P/E based on its "cash" earnings, excluding the goodwill impact, is just 10, and the stock yields 6.4%. The dividend looks secure. Morgan Stanley telecom analyst Simon Flannery carries a price target of $32.
3. Berkshire Hathaway
Warren Buffett's company is emerging from the economic downturn in good shape, thanks to ample earnings from its large insurance and utility operations. Some of Buffett's smart investment moves in the past year, including the purchase of $8 billion of Goldman Sachs (GS, news, msgs) and General Electric (GE, news, msgs) preferred stock yielding 10%, are producing higher investment income.
Berkshire Hathaway's Class A shares, at $102,000 each, appear reasonable, trading for about 1.3 times our estimate of the company's current book value of $79,000 a share. Book value stood at just under $74,000 on June 30 and has risen since then as stock and bond markets have climbed. Given that many of its wholly owned businesses are linked to the housing market, Berkshire should get a nice profit boost in a recovery. Berkshire shares could hit $125,000 in a year.
4. Comcast
The country's largest cable TV operator has seen its shares fall 11% this year, badly trailing its closest peer, Time Warner Cable (TWC, news, msgs), whose stock is up 26%. This hasn't helped management's standing on Wall Street. Despite competition from the Bells, Comcast (CMCSA, news, msgs) is holding its own and seeing moderate revenue growth.
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Comcast now is valued at 14 times projected 2009 profits of $1.10 a share -- a figure that could go higher because first-half earnings were 60 cents. Capital spending is down, and free cash flow is up. A more shareholder-friendly Comcast sports a dividend yield of nearly 2% and is starting to buy back stock. Bernstein analyst Craig Moffett sees the stock, now about $15, hitting $20 in a year.
5. Exxon Mobil
The oil giant is the industry's clear leader, with the highest returns, strongest balance sheet, best management and most stable earnings among the "supermajors." Exxon shares normally command a sizable premium to those of such peers as Chevron, Royal Dutch Shell (RDS-A, news, msgs) and BP (BP, news, msgs), but that gap has shrunk this year as Exxon shares have fallen 14%.
Exxon doesn't look cheap, trading for 18 times projected 2009 profits of about $4 a share. The stock, however, looks more reasonable based on 2010 earnings. The consensus calls for $6 in earnings next year, but one energy maven tells Barron's that profits could hit $7 merely if futures-market expectations for energy prices pan out. A forward P/E of 10 isn't bad for one of the world's best-run big companies.
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6. Microsoft
Despite fears about a threat from Google (GOOG, news, msgs), Microsoft dominates the desktop, and its Windows 7 operating system, set to hit the market in a few months, is getting good pre-release buzz. Although earnings declined in its fiscal year ending in June, Microsoft is a financial powerhouse with enormous free cash flow.
The stock, up 22% this year to about $24, trades for a moderate 14 times projected fiscal 2010 profits of $1.68 a share. Those earnings have been depressed by low yields on the company's large cash holdings of $31 billion and losses on its online business, including MSN, that should benefit from the company's new Yahoo partnership. Cost control has never been a priority at Microsoft, giving the company a lot of room to trim expenses. Research and development, for instance, totaled $9 billion last year. The stock could top $30 a share in the next year.
Continued: The Exxon of the food industry
7. Nestlé
The Exxon of the food industry has the largest market value, the highest sales and one of the best growth outlooks, due in part to long-standing positions in the developing world. The U.S.-listed shares of Nestlé (NSRGY, news, msgs), which trade on the pink sheets because the company doesn't care for a Big Board listing, fetch around $40, or 14 times this year's estimated profits of $2.76 a share. The effective P/E on Nestlé's core food business is about 13 because the company owns valuable stakes in richly valued Alcon Laboratories (ACL, news, msgs), a large provider of eye-care products, and France's l'Oréal, a cosmetics concern.
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Tough conditions in bottled water dampened Nestlé's first-half organic sales, which rose 3%, about a percentage point less than what analysts had expected. That disappointment doesn't dim the Swiss company's robust outlook. Bernstein analyst Andrew Wood calls Nestlé "the strongest and most balanced company" among its European food peers. Wood carries a $48 target on the U.S-listed shares.
8. Novartis
Like most of the major drug companies, Novartis (NVS, news, msgs) has a low P/E, with its U.S.-listed shares trading for around 12 times this year's estimated earnings. Unlike many of its peers, Novartis has a strong pipeline of new drugs that should allow the company to sail through a series of patent expirations on key drugs in 2011 and 2012, as Barron's noted recently in a bullish write-up on the company.
Bernstein analyst Tim Anderson ranks the major drug companies by projected growth in earnings and revenue between now and 2015 -- and Novartis is at or near the top of his lists. He projects more than $5 of earnings in 2015. Novartis shares, around $45, carry a nice dividend yield of 3.8%.
9. PepsiCo
A vaunted management team has suffered some knocks this year owing to double-digit sales-volume declines in its Gatorade sports-drink business, which used to be one of the company's best franchises. Fixing Gatorade may take time, but it is probably less than 10% of total sales.
The focus on PepsiCo's (PEP, news, msgs) beverage operation, including a recent $8 billion deal to buy out public shareholders of two Pepsi bottlers, is understandable but ignores the snack-food business, which generates more than 50% of the company's profits. Bill Pecoriello of Consumer Edge Research wrote recently that he remains "very optimistic" about the snack-food division because of commodity-price declines, international opportunities and innovation. Pepsi shares, around $57, now trade for about 14 times projected 2010 profits of $4.06 a share. Pecoriello carries a $71 price target. Archrival Coca-Cola (KO, news, msgs) also looks attractive. (See "Coke's fortunes are set to pop.")
10. Procter & Gamble
A company long known for consistent profit growth has stumbled as its push to premium-priced products in beauty care and laundry, including Tide, collided with increasingly frugal consumers. The stock recently fell 8% to about $54 in the wake of a disappointing quarterly-profit report.
Like Pepsi, P&G has lost some luster lately, yet the company is still in great shape due to its impressive brand portfolio, including Gillette, and overseas growth prospects. Operating profits for the year ending in next June are expected to be little changed from a year earlier, at about $3.75 a share, as management moves to reinvigorate sales. P&G, however, probably is capable of high-single-digit growth in earnings per share in the long term. The stock looks attractive, trading for under 14 times projected fiscal 2010 profit, and it carries a very secure 3.2% dividend. One of P&G's fans is Warren Buffett, whose Berkshire Hathaway is among the largest shareholders.
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11. Safeway
The grocery sector hasn't lived up to its defensive billing in the current recession, as shares of Safeway and rival Kroger (KR, news, msgs) are down 20% this year.
Safeway last month cut its 2009 earnings forecast to a range of $1.70-$1.90 a share; the consensus had been more than $2. The company is being stung by thrifty consumers, deflation in dairy products and fresh produce, and its sizable exposure to the West Coast, notably California, where unemployment is high.
The stock, around $19 a share, may look washed out, trading for 11 times this year's estimated earnings and for little more than book value. But bulls see the stock hitting $25 in the next year, assuming a rebound in profits to $2 a share in 2010.
12. Wal-Mart Stores
Love it or hate it, the company is the country's largest, most powerful and best-run big retailer. Management has gotten more shareholder-friendly by reducing domestic store growth, which has freed up money for a large share-buyback program and permitted a higher dividend, providing a yield of 2% at the current share price of about $51. A defensive stock that was one of only two members of the Dow industrials to rise in 2008, Wal-Mart is down this year as investors seek retailers such as Nordstrom (JWN, news, msgs) that have more leverage to upscale consumers and to an economic recovery.
Wal-Mart's second-quarter profits beat expectations, and the company's fast-growing international operations now produce almost 25% of sales. A clearly above-average retailer, Wal-Mart trades at a discount to many of its peers, with a P/E of 14 based on current-year profit estimates. Wal-Mart's free-cash-flow yield of almost 6% is one of the highest among major U.S. retailers. Lazard Capital Markets' Todd Slater sees the stock topping $62 a share in the next year.
This article was reported by Andrew Bary for Barron's. |
