The 6 Most Vulnerable Stocks in the Dow
Ironically, some of the most highly-valued stocks in the Dow appear to hold some of the highest risk. That may come as a surprise when you consider that the broader markets (as measured by the S&P 500) have risen more than 80% from their early 2009 lows. Then again, if the markets need a rest in 2011 after such a strong two-year run, a number of stocks will be ripe for profit-taking.
That’s why I’m looking at the Dow’s richest stocks today. These companies sport relatively high price-to-earnings (P/E) ratios, and more importantly, have a high degree of exposure to foreign markets. That’s a plus if the global economy rebounds in 2011. But it will be a real negative if China [See: “5 Landmines for Chinese Stocks”], Brazil [See: “The Number One Reason Brazil Could be Headed for a Pullback”] or even Europe [“If the Euro Crisis Deepens…”] find tougher sledding in 2011.
Good news priced in
One thing is for sure about the companies in the table above: With the exception of Home Depot (NYSE: HD), all have been performing quite well in recent periods. Yet it’s important to check whether the good times can last. In some cases, cracks are already beginning to appear.
#-ad_banner-# For example, same-store sales growth at McDonald’s (NYSDE: MCD) has begun to moderate. November same-store sales rose 4.8%, down from 6.5% in October. More importantly, sales in foreign markets appear to be weakening even more dramatically. China in particular is starting to weaken, according to Citigroup. And that could be a sign of things to come: when McDonald’s ventured into Latin America in the 1990s, it saw early success. But by 2005, it became increasingly clear that many Latin American economies simply couldn’t sustain the model, as the cost of a Big Mac rivaled a full meal sold elsewhere. As a result, the company closed more than 500 stores in Latin America during 2005 and 2006. These days, it’s fair to wonder if the nascent China slowdown is also a sign that the premium pricing afforded to Big Macs is becoming a problem.
Yet in the United States, McDonald’s has had a very impressive run against key rivals. In 2001, McDonald’s controlled about 14% of the quick-service restaurant (QSR) segment, while Burger King and Wendy’s (NYSE: WEN) held a combined 10% . A decade later, McDonald’s’ share has risen to 17% while its two rivals have seen their collective share slump to 9.5%.
Yet should investors continue to expect Burger King and Wendy’s to keep stumbling? Each of these chains has been able to re-invent themselves in the past, and each is now controlled by funds that know the importance of investing in the brand. Just a little momentum from either of these players could meaningfully blunt McDonald’s’ same-store sales momentum.
Mickey D’s faces another challenge: costs are rising for many basic inputs such as wheat and beef. That could pressure margins. Goldman Sachs notes that “MCD’s company restaurant margins strongly correlate to a weighted basket of 19 commodities.”
Coca-Cola (NYSE: KO)
Coke has always been seen as a premier growth company, which may help explain why it carries the highest P/E ratio of any stock in the Dow. Indeed, the table above notes that Coke is expected to boost sales 23% in 2011. That’s simply because it re-acquired its largest independent bottler. The real growth rate is more sobering: Throughout much of the last decade, sales rose around 4-6% annually. Sales only rose above that rate when Coke made acquisitions.
Many analysts expect Coke to boost sales just 5% to 6% in 2012. Even that forecast may prove optimistic, simply because Coke is heavily exposed to foreign sales, and a more stable global economy has led many to expect the dollar to eventually resume a secular decline that started back in 2006. And a weaker dollar means a drop in repatriated profits.
Action to Take –> After boosting operating margins from 20% in 2005 to 30% last year, the next move for McDonald’s may be down. After surging roughly 45% since February, may have more headwinds than tailwinds in 2011.
of Coca-Cola have lurched ahead more than 30% since July, and it’s simply hard to see how the stock can benefit from any expansion in its forward multiple. At best, look like dead money. At worst, they’re headed back to $50 as investors start to look past the deal-fueled 2011 growth and again see this as a low-growth, long-term .
In addition to McDonald’s and Coca-Cola, investors will need to be even more concerned about Procter & Gamble (NYSE: PG) and Caterpillar (NYSE: CAT) if the global economy hits a speed bump in 2011. Both of these companies are highly-leveraged to foreign sales growth. Caterpillar will be especially vulnerable when investors start to think about the peak of the current mining and construction cycle, which may come in the next year or two.
Cyclical plays like Caterpillar tend to see their forward multiple shrink into single digits when a peak is in sight. Right now, investors must presume that Caterpillar’s can surge from $5.75 in 2011 to more than $10 a share within a few years, as shares already trade for nearly 10 times that very lofty goal. For the record, Caterpillar has never earned more than $5.66 a share in its history.