A few days ago, I profiled an eight stock selection of the Dow Jones Industrial Average (DJIA) that I felt would outperform the DJIA over the next couple of years.The selection was based on using a strategy similar to the Dogs of the Dow, wherein I used high yields to favourably indicate the potential for mispriced stocks in the Dow. I chose eight out of the 16 highest yielding stocks, names that included drug and health care companies, telecommunicators, as well as Coca-Cola, Procter & Gamble, and General Electric. I felt these stocks in the aggregate, would produce a total return greater than the DJIA over the next few years.
Generally, drug companies (Pfizer, Merck) selected have had a long cold winter in relation to any positive changes in share prices, despite numerous predictions and suggestions that these offered good value, relative to their moat and prices. Also, payouts are generally at the high end of the earnings range, indicating limited ability for further upward payouts, itself a negative signalling factor about the intermediate future prospects of earnings growth. While Johnson & Johnson doesn't strictly fit into the same criteria, it's greatest revenues are from it's pharmaceutical division, and therefore the share price growth might be stifled by association.
To some extent, the telecommunications companies have had limited payout increases over the past few years, and this can indicate that their earnings growth isn't as robust as it once was.
This leaves, in my mind, three candidates as offering the best combination of safety, dividend yield and potential growth, and potential share price appreciation.
Procter & Gamble has the lowest dividend yield of the remainders (and in fact was in the bottom half of the Dow 30), and also one of the highest PE's of this group. Therefore, it is felt to be more susceptible to share price pull-backs than some others in the group.
This leaves Coca-Cola (KO), and General Electric GE).
Over the past twenty years, Coke (KO) has been one of the most attractive businesses on the planet. It has proven its long-term sustainable competitive advantage, has enormous brand recognition, and achieved very, very, high returns on equity (30-33% over the past five years) over very long periods of time, with minimal use of leverage. Further, earnings growth, while rarely dramatic, is highly visible going forward.
It currently provides a yield in the upper end of the Dow with, in my opinion, far, far, lower than DJIA average business risk. Wall Street consensus estimates suggest that the earnings in 2009 will be $3.36, versus $2.57 in 2007. The business derives 27% of its net income from the US, with 26% from investments in bottling operations likely adding to that figure marginally - suggesting that somewhere in the order of 2/3 of net income is derived from elsewhere on the planet - a nice hedge if you are concerned about the long term stability of the USD.
The dividend payout ratio has varied over the past five years between 50-57%, with 2007 clocking in at 53%.
All-in-all, Coca-Cola has fallen (earnings risen) to become a relative value proposition, and a potential cornerstone building block for a portfolio.
At a different end of the investment spectrum, we have General Electric (GE). It has been priced by the market as if it is a regional bank employing bank-style leverage and with all the attendant troubled homeowner loans. One only needs to look at the current/forward PE ratio at around 13 in either instance, and the yield of 4.5%, to suggest that the market is pricing it like a bank. I suggest that this diversified giant has been egregiously mispriced by the market.
While the company does have a finance division, the retail finance portion (mortgages, credit cards, etc) comprised only 15% of revenue/net income in 2007, and there is a commercial finance division accounting for 20% of revenue/net income in 2007. In total, only 35% of the company looks like or smells like a bank of any sort and certainly the commercial division can't be considered like a retail bank.
Of the remaining revenues and net income, some 35% of the revenue/net income of GE comes from its infrastructure division - hello market, I thought the world infrastructure market still has a "long-tail" of growth?!
Ten percent of revenues relates to health care, also a growth industry, considering the rapid aging of the Western World in particular, but really, now much more of the world since population growth rates are decelerating world-wide.
Finally, the Industrial division (appliances, industrial equipment) at 10% of revenues, and NBC Universal (10%) make up the balance.
Furthermore, 50% of its revenues are derived outside of the United States.
Sorry, tell me again why this is priced and is yielding like a regional bank?
In seriousness though, earnings have continued to rise nicely over the past five years, from $1.55 per share to $2.20 in 2007, with 2008 consensus estimates at $2.21 and $2.34 for 2009.
Dividend payout ratios have ranged tightly from 50-53% in the past five years and, when measured against cash-flow, even tighter from 34.3% to 35.9%. Dividends have risen nicely over that five year period, with substantial raises every year; five years ago they were $0.77 and in 2007, $1.15. Today, they're at $1.24. Returns on equity are very good, ranging between 17-22% over the past five years.
Overall, this isn't a bank, and it's not a highly cyclical stock warranting a low PE. Two different CEO's have proven it's a pretty good business over the past couple of decades.
In summary, I believe that the GE stock is the most obviously undervalued of the two, but that the business dynamics of Coke provide exceptional long-term peace of mind.
In either case, a dealer's choice of outperformance for the next few years, I believe.
Disclosure: Long GE.
