Stick With What Works

12/16/2013


When your system is working, keep working your system. Our Focus List has outperformed the S&P 500 Index in four of the past five years and in seven of the past 10 years. Its annual performance has also topped the S&P 500 by more than five percentage points six times in the past decade.

We delivered those returns by identifying stocks with encouraging growth prospects and buying them at good prices. Quadrix, our quantitative stock-rating system, helps us stick to that winning strategy.

In the last dozen rolling 12-month periods, S&P 500 stocks scoring above 80 for Value have averaged excess returns of 8% higher than the average stock in the index. Value is also the top-performing Quadrix category over the past five and 10 years, and since 1990.

Value's consistent strength is worth keeping in mind as investors face the temptation to pay a premium for year-ahead growth. S&P 500 stocks projected to grow earnings per share at least 20% trade at an average of 20 times estimated earnings, as shown in the table below. Meanwhile, stocks expected to increase profits 10% to 15% fetch 18 times estimated earnings.

S&P 500 SECTOR SNAPSHOT
All numbers are equal-weighted averages.
------ 12-Month Change ------
Est. EPS
Growth,
Next 12
Months
(%)
----- P/E Ratio -----
S&P 500 Sector
(No. Of Cos.)
EPS
(%)
Sales
(%)
Cash From
Operations
(%)
On
Trailing
Earnings
On Est.
Year-
Ahead
Earnings
YTD
Total
Return
(%)
Cons. Discretionary (84)
19
8
12
11
21
19
42
Consumer Staples (40)
9
4
9
10
21
19
32
Energy (44)
20
10
15
19
23
18
23
Financials (80)
17
6
NM 
12
19
19
36
Health Care (55)
16
8
5
9
24
19
41
Industrials (63)
6
5
17
10
21
18
36
Materials (31)
18
2
15
15
21
18
21
Technology (66)
8
5
5
10
23
17
35
Telecom Services (6)
(12)
5
13
9
29
16
7
Utilities (31)
0
8
NM
3
18
15
13
Average S&P 500 stock
13
6
11
11
21
18
33
NM Not meaningful because too few companies provide cash-flow data. 

We reveal our top picks for year-ahead gains — the best of our Focus List — in the table below. All seven of these stock fit our strategy of buying strong growth at a reasonable price. For instance, Lear ($82; LEA) trades at just 12 times estimated year-ahead earnings, which are projected to surge 20% from the year-earlier period. Schlumberger ($87; SLB) is expected to grow profits 23% in the year ahead, yet the shares cost just 16 times estimated earnings. Both stocks look like bargains, considering what investors must pay for stocks with similar growth targets.

Of course, investors shouldn't blindly accept consensus profit estimates. We prefer focusing on companies with a track record of strong operating momentum, as well as catalysts to maintain or increase growth.

Lear, Schlumberger, and our other five best ideas for capital gains are reviewed below.

Apple ($566; AAPL) should return to growth in fiscal 2014 ending September, with per-share profits projected to rise 10% following a year when earnings slumped 10%. Profit estimates could move even higher following a report that China Mobile ($54; CHL), which has the world's biggest base of wireless subscribers, planned to begin taking preorders for the iPhone Dec. 12. Meanwhile, analysts seem encouraged by early holiday sales of the iPhone 5S and iPad Air, as production catches up with demand.

Shares have rallied 47% since their April low and are now up 6% for the year. But they still look cheap at 13 times projected year-ahead earnings, a 22% discount to the average for S&P 500 technology stocks. This month, activist investor Carl Icahn trimmed his buyback proposal to $50 billion of stock from his earlier request of $150 billion. Apple expects to repurchase $100 billion of shares by 2015. Apple is a Focus List Buy and a Long-Term Buy.


Capital One Financial ($73; COF) lacks the growth profile we usually seek for our favorite picks, with per-share profits projected to slide 7% to $6.98 in the 12 months ending September 2014. The decline partly reflects expectations for lower credit-card balances. However, consensus profit estimates have drifted higher in the past 60 days. Shares trade at just 10 times estimated year-ahead earnings, lower than 95% of stocks in the S&P 500 Index.

Complementing its credit-card business, Capital One holds the fifth-largest base of deposits among U.S. banks. As one of the biggest providers of car loans, Capital One has exposure to the improving auto industry. Further stacking the odds in its favor, Capital One scores above 80 for six of the 10 most effective factors in Quadrix over the past year — just six S&P 500 stocks score above 80 for more of these top factors. Capital One is a Focus List Buy and a Long-Term Buy.


Helmerich & Payne's ($79; HP) per-share profits are projected to rise just 1% in fiscal 2014 ending September. But analyst estimates look conservative, as onshore drilling activity in the U.S. appears to be improving. Management says pressure on pricing has begun to ease and interest in its new rigs has picked up. Higher prices, combined with cost improvements, could help H&P widen its operating profit margins in the year ahead. H&P's operating margins, currently 41%, have risen in eight of the past 11 quarters and exceed the average for S&P 1500 oil and gas drillers by nearly two percentage points.

H&P remains committed to growing its dividend, raised three times since the start of December 2012. Earlier this month, H&P said it would increase the quarterly distribution 25% to $0.625 per share, payable March 3. Recall, the company paid out just $0.07 per share last December. Despite the higher dividend, H&P's strong cash flow continues to pack the balance sheet with cash, up to $472 million from $125 million a year earlier. H&P, scoring above 70 for all six Quadrix categories, is a Focus List Buy and a Long-Term Buy.


Lear's ($82; LEA) stock has delivered a total return of 77% so far in 2013. But despite the run-up,  Lear's growth profile makes the valuation look attractive. The maker of seating and electrical systems for automakers relies on Ford Motor ($17; F), General Motors ($40; GM), and BMW for about half of its revenue. Last month, U.S. auto sales rose at their fastest pace in six years, with BMW up 2%, Ford up 7%, and GM up 14% from year-ago levels. North America accounts for 38% of Lear's sales.

More than one-third of Lear's Quadrix factors score above 80, including four of the 10 most effective factors in the past 10 years for the S&P 500 Index. Shares trade at 14 times trailing earnings and just 12 times projected year-ahead earnings, both ranking among the best 25% of our research universe. Lear is a Focus List Buy and a Long-Term Buy.


Magna International ($80; MGA), like Lear, is well-positioned to ride the rebound in the automotive industry. The company supplies a wide range of auto parts, with 52% of sales and 80% of earnings before interest and taxes coming from North America. In the first nine months of 2013, Magna managed to deliver 15% sales growth in a soft European market (41% of sales) through niche acquisitions and the launch of new automotive programs with Ford and Mercedes-Benz.

At 12 times trailing earnings, the shares enjoy a 22% discount to their five-year average and a 41% discount to the median for S&P 1500 stocks in the auto parts and equipment industry. Magna also trades at just 0.5 times trailing sales, ranking among the lowest 15% of stocks in our research universe on price/sales ratio. Price/sales is one of the three most effective Quadrix factors in the past one-, five-, and 10-year periods for S&P 500 stocks. Magna, scoring above 95 for Overall score in 12 straight months, is a Focus List Buy and a Long-Term Buy.


Qualcomm ($73; QCOM) shares have generated a total return of 21% this year, lagging the average return of 35% for S&P 500 technology stocks. Central concerns facing the stock include profit margins eroding because of slower growth in high-end smartphones, yet the worries seem overblown. A rich patent portfolio should keep Qualcomm a dominating presence in mobile computing as faster wireless networks roll out. Beyond tablets and smartphones, Qualcomm is positioned to benefit from new technology creeping into other markets, such as cars and medical devices.

Despite a favorable growth picture, Qualcomm's trailing P/E ratio of 16 hovers near its lowest level in more than a decade. The stock also trades at 14 times estimated 12-month earnings, a 14% discount to its sector average. Earnings per share are projected to climb 14% in fiscal 2014 ending September on sales growth of 9%. Qualcomm is a Focus List Buy and a Long-Term Buy.


Schlumberger's ($87; SLB) broad geographic footprint — about 70% of sales come from overseas — and massive scale help insulate the company from inherently volatile energy prices, which can vary from region to region. Schlumberger, an oilfield-services company, generated $2.87 billion in free cash flow for the 12 months ended September, compared to a negative $220 million in the year-earlier period. Management's plans for that cash, in order of priority, are reinvestment in the business, dividend growth, acquisitions, and share repurchases. Schlumberger appears bullish about deepwater drilling in the upcoming year as a wave of new rigs comes on line. Management expects per-share profits to grow by double digits for a fourth consecutive year; the consensus targets 23% growth.

Schlumberger's P/E ratio has expanded to 19 times trailing earnings in the past year but still seems reasonable — in line with the median for S&P 1500 energy equipment and services stocks and 12% below its own three-year average. Should Schlumberger meet the consensus profit estimate of $5.58 per share for the 12 months ending September and its trailing P/E ratio stay at 19, then the stock will rally 25% over the next 10 months. Schlumberger is a Focus List Buy and a Long-Term Buy.

TOP SEVEN PICKS FOR YEAR-AHEAD GAINS
------- 12-Month change -------
Est. EPS
Growth,
Next 12
Months
(%)
----- P/E Ratio -----
- Quadrix Scores -
Company (Price; Ticker)

EPS
(%)

Sales
(%)
Cash From
Operations
(%)
On
Trailing
Earnings

On Est.
Year-
Ahead
Earnings

YTD
Total
Return
(%)
Value
Overall
Sector
Apple ($566; AAPL)
(10)
9
6
10
14
13
9
90
97
Technology
Capital One Financial
($73; COF)
42
13
67
(7)
10
10
28
91
96
Financials
Helmerich & Payne
($79; HP)
26
7
0
1
14
14
44
77
98
Energy
Lear ($82; LEA)
15
9
26
20
14
12
77
82
99
Discretionary
Magna International
($80; MGA)
12
12
26
12
12
11
63
86
98
Discretionary
Qualcomm ($73; QCOM)
36
30
46
14
16
14
21
76
97
Technology
Schlumberger ($87; SLB)
10
9
53
23
19
16
28
72
95
Energy
Note: Quadrix scores are percentile ranks, with 100 the best.

 


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