The 3 Best Stocks in the Dow

Investing in large companies with diversified revenue streams is a strategy that can let you sleep soundly at night. Most firms in the Dow Jones Industrial Average, an index of 30 of the largest and most dominant firms in the world, use size to their advantage.

Size allows these companies to push for better deals with suppliers, which in turn can help them offer high quality products and services at a lower cost than smaller competitors. Geographic diversification is also important, as it can lessen overreliance on one economy or region. Large firms also use their dominance to expand into faster-growing overseas and emerging markets that might be too risky for smaller rivals to enter.

These three Dow components stand out as leaders in their respective industries and have above-average growth prospects, decent dividend yields and downside protection, given their modest valuations.

1. International Business Machines (NYSE: IBM)
Business: Information technology product and service provider
Forward P/E: 12.6

IBM is a play on growing demand for information technology (IT). Due to its size and geographic breadth, the company counts as a technology bellwether and is a leading indicator of industry trends. Fortunately, the trends are favorable as firms around the world need help running their data centers and performing other system-critical IT functions. Cloud computing is a relatively new industry growth driver, and IBM has been active in acquiring market share in this field as well as for the purpose of boosting internal growth.

The investment story on IBM is about as straightforward as it gets. By 2015, the firm has committed itself to reporting $20 in earnings per share. Based on the current share price, that is a forward P/E of just over 7. Yes, it will take five years, but it means that the share price should post double-digit gains in each of the years leading up to 2015.

Placing a conservative price-to-earnings (P/E) multiple of 10 off the future earnings (10 x $20 EPS) means the stock can appreciate nearly 40% (based on a recent stock price of about $145). If you apply the current P/E of about 12.5 on those future earnings, it suggests a share price of more than $250, or about 75% ahead of the current share price. This implies annual shareholder returns of more than +14% per year, which includes a decent annual dividend rate of 1.8%. 

2. McDonald’s (NYSE: MCD)
Business: World’s largest fast-food chain
Forward P/E: 16.8

McDonald’s is currently crushing the fast-food competition in terms of growing sales at its existing base of restaurants. Product innovation and customer service are resonating with its customers and have combined to boost same-store sales, a key metric for sales at existing stores also known as comparable store sales (comps for short), consistently up in the low single digits. It may not sound like much, but many competitors have been seeing negative comps, as its loyal customer base of blue collar workers is struggling with high unemployment figures. McDonald’s is growing just as robustly overseas and recently reported European comps of 4.9%, which matched U.S. comps.

At the current P/E multiple, the shares are hardly a steal. The stock has performed very well during the past year, and though this means multiple expansion (a higher stock price) in the form of a higher P/E is less likely, the company should have no problem leveraging high single digit sales growth into double-digit earnings growth, as it has on average each year for the past decade. Throw in a current dividend yield of 3.1%, and shareholders should be able to garner high single-digit to low double-digit stock returns in the coming years.

3. Wal-Mart (NYSE: WMT)
Business: World’s largest retailer
Forward P/E: 13.4

IBM is a global technology titan, McDonald’s rules the international fast-food arena, and Wal-Mart effectively runs the world in terms of low-cost retailing. In truth, the company is much more dominant in the United States, where nearly 75% of sales stem from, but it is counting on overseas to keep its growth prospects moving forward. The most recent announcement was the offer to acquire 51% of Massmart, a highly successful mass retailer that currently operates in 14 countries in Africa.

Wal-Mart continues to be one of the fastest growing firms in the Dow. In the past decade it has managed to grow both sales and earnings close to 20% annually. This growth will undoubtedly slow in the next decade, but shareholders can reasonably expect low double-digit growth on average going forward. A current dividend yield of 2.2% is also quite respectable and should grow along with the overall operations. 

Action to Take —> Investing in each of the above firms represents a relatively low-risk strategy to earn solid stock returns as well as respectable quarterly dividend payments for income-minded investors.