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Thursday, March 20, 2014 - 14:30

Are These The Dow's Top Bargains?

Thursday, March 20, 2014 2:30 PM

After a five-year bull market, can investors still find inexpensive blue-chip stocks?

Perhaps that's the wrong question to ask. Some companies such as AT&T (NYSE: T) may hold value, by traditional metrics, but that doesn't make shares a bargain. The company's competitive positioning spells tough days ahead, making this Dow component more of a value trap.

Still, it's interesting to see where AT&T and its peers stand in terms of value metrics. Though many of them have risen sharply in the past five years, a firming U.S. economy could take them well higher over the next half-decade. So to rephrase their earlier question: Which stocks in the Dow currently hold the most appeal, based on both value and growth metrics?

First, let's look at the value side of things. Simply looking at price-to-earnings (P/E) ratios, based on projected 2015 profits, reveals a group of companies facing either low growth prospects or volatile earnings patterns that typically justify a lower multiple. (All data supplied by ThomsonReuters.)

To be sure, telephone service providers are seeing a profit-sapping pricing environment that is unlikely to go away, and major oil companies are having to spend rising sums of money to tap into remaining global oil fields. So those groups may be dead money for a while, at least until industry dynamics change.

In many respects, earnings per share (EPS) and P/E ratios aren't great measures. They may penalize companies that are in the midst of a high level of investments, or have high levels of depreciation. So it helps to look at how the Dow components look in the context of trailing cash flow.

This group is similar to the group above, though with a few notable differences. Industrial firms such as Boeing (NYSE: BA) and United Technologies (NYSE: UTX), which should always be viewed in the context of cash flow generation, appear to hold solid value by that metric. (Industrial firm Caterpillar (NYSE: CAT) just missed out on the top 10, with a price-to-cash flow ratio of 8.4.)

It shouldn't come as a surprise as some of the most operationally-challenged Dow components also sport the highest dividend yields. If you're a fan of the Dogs of the Dow strategy, then these are the stocks for you. But most of these firms may be hard-pressed to generate any reasonable dividend growth in the years ahead.

Though these are respectable yields, the stock market has risen a lot faster than dividends have, so these yields aren't nearly as appealing as they were a few years ago. AT&T's seemingly appealing dividend carries real risk, as I recently noted.

Growth Still Matters
Almost all of the Dow components are faced with the sobering global economic landscape. Most of them are on track to generate modest sales growth in 2014 and 2015, perhaps in the mid-single digits. But excellent companies find ways to boost per-share profits at a better pace, through tight expense controls, reduced share counts, and increased use of automated production processes. Notably, there are a handful of Dow components that are expected to boost EPS at a double-digit pace in 2015 and 2016.

United Healthcare (NYSE: UNH) and Wal-Mart (NYSE: WMT) deserve honorable mention as they are poised to deliver double-digit EPS growth, on average, over the next two years.

The Winners
As beauty is in the eye of the beholder, investors will always find appeal in a range of Dow stocks. So declaring a winner can be somewhat subjective. Yet simply going by the current valuations and long-term industry growth prospects, two companies stand out.

Flickr/Dave Sizer
Boeing still looks like a great long-term holding, even if 2014 proves to be a slightly challenging year as the Dreamliner problems get fixed.

The first is Boeing, which has pulled back roughly 15% since late January, on concerns that hairline cracks have emerged on the wings of around 40 787 Dreamliners. That may impede near-term profits as the issue gets resolved. Indeed, 2014 and 2015 EPS forecasts have been modestly trimmed. First-quarter results are also unlikely to be a catalyst: Boeing built 30 Dreamliners in the quarter, according to Deutsche Bank, but delivered only 12, impacting cash flow.

But you can't ignore Boeing's stunning eight-year backlog of orders, which I covered in depth last September. Since then, shares have only risen around 10% (after that recent pullback) but this still looks like a great long-term holding, even if 2014 proves to be a slightly challenging year as the Dreamliner problems get fixed. Trading at less than seven times trailing cash flow sure looks like a solid entry point.

My other favorite Dow component is more controversial, considering it has underperformed its benchmark, the Nasdaq, by roughly 150 percentage points over the past five years. That's because Cisco Systems (Nasdaq: CSCO) hasn't boosted sales at a double-digit pace since fiscal (July) 2010, despite a broad slate of acquisitions. Sales are on track to actually fall this year and rise less than 5% in fiscal 2015.

So why do I stick with this company? First, its free cash flow generation remains remarkable, which is fueling ongoing buybacks and a solid dividend. Second, Cisco is more of a victim of tough end markets, and not poor execution or improper industry positioning. For example, as the Internet's reach expands into many devices and machines, Cisco's software and hardware should play a key role.

Clearly, standing by this once-great company while the rest of the tech industry has seemingly moved forward has been an unwise strategy in recent years. But Cisco still has so many attributes, and financial metrics are so compelling, that investors can't afford this stock anymore. (For another perspective, my colleague Adam Fischbaum recently gave an even more bullish outlook on the company.)

Risks to Consider: The biggest risk for these and other Dow components is the relative age of the bull market. If the market delivers more tepid gains in the next few years (a gnawing concern as the S&P 500 is up just 1% year to date), then these stocks may take several years to deliver solid upside.

Action to Take --> Boeing and Cisco are the rare stocks that represent value now and good growth prospects in the future. In today's market, it's hard to find both. Neither of these stocks are poised for imminent robust gains, but they are shaping up to be great long-term holdings.

P.S. Investing doesn't have to be complicated. If you invest in simple businesses that dominate their industries and return billions of dollars to investors through dividends and buybacks, you stand to make a killing in the market over time. It works. In fact, the stocks in our latest report, "The Top 10 Stocks For 2014," have delivered a total return of 237% over the past five years following this simple strategy. To learn more about our top picks for 2014 --including several names and ticker symbols -- click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of T in one or more of its “real money” portfolios.