News Analysis date published New: 
Wednesday, March 20, 2013 - 10:00
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Wednesday, March 20, 2013 - 10:10
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Wednesday, March 20, 2013 - 10:00

These 3 Dow Stocks Can Bring You Surprising Value

Wednesday, March 20, 2013 10:00 AM

The Dow Jones Industrial Average recently exceeded the previous record of 14,164 reached in October 2007. Of course, a number of components in the index returned to their peak much sooner and are now handily above levels seen in 2007. The best stocks of the Dow since then include:

  • The Home Depot (NYSE: HD), up 108%
  • IBM (NYSE: IBM), up 75%
  • McDonald's Corp. (NYSE: MCD), up 67%
  • Wal-Mart Stores Inc. (NYSE: WMT), up 63%
  • The Walt Disney Co. (NYSE: DIS), up 59%
  • Travelers Cos. Inc. (NYSE: TRV), up 53%

If the Dow was only composed of outperforming stocks such as these, then we would have already surpassed 20,000. Of course, the index also has its share of dead weight. In fact, 12 of the Dow's 30 companies remain underwater when compared with that 2007 peak (prior to the inclusion of dividend payments). It's not a pretty list:

On the face of it, these stocks have little in common. Alcoa Inc. (NYSE: AA), for example, is an extremely well-run company that is suffering from a global slump in aluminum prices. The company is arguably much healthier than it was in 2007, thanks to a series of streamlining moves, so it could be poised for great gains once the aluminum market strengthens.

But stocks such as Bank of America Corp. (NYSE: BAC), Hewlett-Packard Co. (NYSE: HPQ) and Merck & Co. Inc. (NYSE: MRK) deserve the beat-down they've gotten. These companies failed to adapt to changing times and instead lurched into new businesses that simply weighed them down.

But is it unfair to characterize Merck as a loser when all of Big Pharma has suffered from patent expirations? Well, Pfizer Inc. (NYSE: PFE) and Johnson & Johnson (NYSE: JNJ), both Dow components, have seen shares rise by double digits since that late 2007 peak. These companies are nicely diversified and don't completely depend on blockbuster drugs for their sales and profits. Still, it's useful to look at this group of losers to see which are capable of regaining lost luster. Of the 12 laggards listed on the table above, three of them stand out as solid values.

1. Cisco Systems Inc. (Nasdaq: CSCO)
I recently spelled out why I see Cisco as a rejuvenated company, noting that its significant cash-flow generation provides ample downside support in case the market swoons anew. As for upside, a number of Cisco's end-markets have been constrained, but should look healthier in coming years, which could help this stock shed its ultra-low valuation metrics.

2. The Boeing Co. (NYSE: BA)
I also remain a big fan of the world's largest airplane maker, even after huge setbacks for its new Dreamliner plane, and a new era of smaller defense spending.

As I wrote in October 2012, Boeing generates very strong cash flow, which should help to support higher dividends and share buybacks. Since I looked at Boeing five months ago, shares are up 23%, and would likely have done even better were it not for the Dreamliner's exploding battery problems.

Now that Boeing appears to have fixed the Dreamliner's battery technology, shares are taking off. Investors can again see what kind of free cash flow Boeing can generate, now that the plane's production lines are ready to gear up anew. Boeing is on track to generate more than $6 billion in free cash flow this year, and that figure could approach $7 billion by 2015 if the worst-case scenario of defense cuts is avoided.

3. Bank of America Corp. (NYSE: BAC)
I noted earlier that this stock deserved every ounce of punishment. Indeed, during the past few years, I repeatedly wrote about the virtues of better banks in the space such as Citigroup Inc. (NYSE: C), which has managed to win back many lost fans.

Yet it's time to look ahead as it increasingly looks as if Bank of America will take a page out of the Citigroup playbook. Citigroup came out of the recession in bloated shape and moved too slowly to pare costs to bring margins back up. New management has taken a more aggressive approach to Citigroup's expense structure, which is a big factor behind the stock's rebound.

Now it's Bank of America's turn. Although revenue will likely be flat from 2013 to 2014 at about $90 billion, the bank's management has laid out plans to pare roughly $5 billion in operating expenses. That's why analysts see earnings jumping around 30%, to $1.30 a share; and in the context of a slightly firmer economy in 2015, Bank of America should boost profits at a double-digit pace yet again. After all, the operation remains a top mortgage lender nationally, and should benefit from a firming housing market.

Meanwhile, shares trade at about 85% of tangible book value. I look for tangible book value to grow by 10% during the next two years, and the price-to-book ratio eventually to move up to 1. That should help provide 25% upside for the stock during that time frame.

Risks to Consider: Profit forecasts for these Dow components are predicated on a resurgent U.S. economy; it's unclear if the current issues in Washington will derail the economy's momentum.

Action to Take --> With many stocks posting considerable gains, it's time to pivot to stocks that haven't been fully appreciated. These Dow laggards have begun to rise in price in recent quarters, and as they move back into favor, further upside lies ahead.

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