These Giants Aren't Friendly

2/16/2015


The biggest stocks proved surprisingly sprightly during the latest leg of the market’s rally last year. Megacaps — defined here as the largest 50 stocks in the S&P 500 Index by market value — averaged a total return of 10.5% in the past six months, exceeding the 8.7% average of all S&P 500 stocks and 6.2% of S&P SmallCap 600 stocks.

But many megacaps operate extensively overseas and have been hammered by the rising U.S. dollar. Operating momentum may not support megacaps’ premium valuations, so investors need to be selective. Do not rely on the strength of the pack to drive your returns.

Though small in number, megacaps have an outsized effect on the stock market. These 50 stocks account for 47% of the S&P 500’s market value. The five biggest by market capitalization — in order, Apple ($125; AAPL), Exxon Mobil ($91; XOM), Google ($538; GOOGL), Berkshire Hathaway ($150; BRKb), and Microsoft ($42; MSFT) — make up 11% of the index’s market value.

GROWTH AND VALUE TOUGH TO FIND — TOGETHER
There is no shortage of companies growing per-share profits and sales. But there is an unsually low number delivering strong growth while trading at a decent price. Just 21 S&P 500 stocks grew 12-month earnings per share and sales by more than 20% in the most recent period, well below the norm of 49 stocks in the 242 monthly periods since December 1994. In fact, just 9% of those 242 periods had fewer S&P 500 stocks growing both metrics by more than 20%. The group of big growers shrinks considerably for investors seeking P/E ratios below 20 — just eight stocks qualify, compared to the average of 25 since December 1994.
Change In Both EPS And Sales,
---------- Last 12 Months ----------
P/E Ratio Below 20,
Change In Both EPS And Sales,
------- Last 12 Months -------
------ Number Above ------
No.
NA
------ Number Above ------
No.
NA
0%
5%
10%
20%
0%
5%
10%
20%
S&P SmallCap 600 stocks
Recent
230
151
84
23
14
119
76
48
17
81
Norm since 1994
301
242
178
84
12
166
131
92
41
83
Recent as % of norm
76
62
47
27
112
71
58
52
41
98
% of months lower since 1994
13
10
5
1
71
15
11
13
6
46
S&P MidCap 400 stocks
Recent
208
149
81
18
9
93
59
33
5
31
Norm since 1994
224
176
123
51
8
125
96
63
23
36
Recent as % of norm
93
84
66
36
117
74
62
51
22
87
% of months lower since 1994
21
21
14
2
62
16
13
11
0
44
S&P 500 (large-cap) stocks
Recent
309
207
105
21
4
162
101
43
8
10
Norm since 1994
291
224
145
49
8
172
127
77
25
37
Recent as % of norm
106
93
73
43
47
94
80
56
33
27
% of months lower since 1994
49
33
19
9
14
39
35
20
7
21
Megacaps (largest 50 in S&P 500)
Recent
31
21
12
4
0
15
8
2
1
1
Norm since 1994
36
28
18
6
0
20
14
9
3
2
Recent as % of norm
87
76
66
66
0
76
56
24
40
65
% of months lower since 1994
16
23
31
26
0
32
28
10
19
37
Buy-rated stocks with 12-month growth exceeding 20%
for earnings per share and sales, plus P/E ratios below 20
S&P 500 (Large-Cap) S&P MidCap 400 S&P SmallCap 600
Corning ($25; GLW) ARRIS Group ($26; ARRS) * Bel Fuse ($23; BELFb) *
Gilead Sciences ($100; GILD) ** Jones Lang LaSalle ($159; JLL) DTS ($28; DTSI) *
Lam Research ($81; LRCX) Minerals Tech. ($69; MTX) * Lannett ($57; LCI) *
Micron Tech. ($31; MU) Trinity Industries ($29; TRN) * Lydall  ($28; LDL) *
Methode ($39; MEI) *
* Recommended by Upside, our sister publication focused on smaller stocks.    
** Gilead qualifies as a megacap.     NA Not available.

The recent rally leaves megacaps looking expensive versus their history, with an average trailing P/E ratio of 19.5, 11% above the group’s 10-year average — a bigger premium than stocks in the S&P 400 or S&P 600, though those stocks are more expensive than megacaps on an absolute basis. Using the P/E on expected current-year earnings, the group looks even more expensive (16% premium) versus historical norms.

Fewer companies are delivering truly outstanding operating momentum these days, regardless of size. For instance, just 18 S&P MidCap 400 companies have grown per-share earnings and sales by more than 20% in the trailing 12 months — less than half of the typical number in the 242 monthly periods since December 1994. In fact, just 2% of those 242 periods had fewer stocks delivering 20% growth in both sales and profits.

Eliminate stocks with trailing P/E ratios above 20, and just five stocks make the cut. Only one month since 1994 has been worse. 

For the S&P 500, the fishing pool is slightly better stocked. Eight large stocks grew 12-month earnings and sales more than 20% and trade below 20 times trailing earnings, including the following four buy-rated picks: Corning ($25; GLW), Gilead Sciences ($100; GILD), Lam Research ($81; LRCX), and Micron Technology ($31; MU).

Of the four growers listed above, only Gilead qualifies as a megacap. While megacaps as a group do not look good, our Quadrix stock-rating system has helped us identify several with attractive fundamentals. In the following paragraphs, we write up four companies, three with impressive Quadrix scores and one for which the scores understate its appeal.

One year after Comcast ($58; CMCSa) announced plans to acquire Time Warner Cable ($146; TWC) for $45.2 billion in stock, investors continue to wait on a ruling from U.S. regulators. The deal would combine the two largest U.S. cable operators, giving Comcast close to a 30% share of U.S. cable subscribers and boosting the company’s leverage to negotiate programming fees.

But with the Federal Communications Commission raising the minimum download speed for its classification of high-speed internet, prospects for the deal’s approval may have diminished. That means Time Warner and Comcast would have a larger share of the broadband market — at least 35%. The FCC also proposed tougher internet rules that would regulate the internet like a public utility to insure equal treatment of all web traffic. The commission will vote on the matter Feb. 26.

Investors expect Comcast to provide an update on its pending Time Warner acquisition when it reports December-quarter results Feb. 24. Comcast is a Buy and a Long-Term Buy.


Gilead Sciences ($100; GILD) has a stock-market value of $160 billion, nearly $40 billion more than the next-largest S&P 1500 biotechnology stock. Despite its mammoth size, Gilead is projected to outgrow the biotech market this year, with per-share profits up 18%, versus its peer group’s average of 11% growth. Yet Gilead shares trade at just 12 times trailing earnings and 10 times estimated year-ahead profits — lower than any other stock in the biotech industry, which averages a trailing P/E ratio of 33 and forward P/E of 27.

One reason Gilead trades at a discount to peers is that hepatitis C drugs are expected to account for more than half of its revenue this year. Gilead’s Harvoni and Sovaldi generated a combined $10.28 billion in sales last year — exceeding the total revenue of any other biotechnology company other than Amgen ($153; AMGN). Gilead has elected to offer big price discounts in order to take share in the hepatitis C market, a trend it expects to accelerate in the coming year. To counter investors’ concerns, Gilead has built up its pipeline of promising drugs designed to treat cancer, liver disease, and HIV. Gilead is a Long-Term Buy.


Google ($536; GOOGL) is testing investors’ patience after missing the consensus profit estimate for a fifth consecutive quarter. The stock’s Overall rank has slipped to 61, hurt by middling scores for Momentum (51) and Value (56). If the stock price remains stagnant, Google could risk more defections by employees frustrated with their out-of-the-money stock options. Alternatively, the company could give its share price a jolt via shareholder-friendly moves, such as launching a dividend or stock buyback, similar to what Apple ($125; AAPL) did in March 2012.

While we have tightened our leash on Google, we cannot overlook its dominant position in online search. The core business looks solid, with paid clicks up 14% in the December quarter, while cost per click, or advertising rates, slipped 3%. Moreover, Google continues to generate prodigious amounts of cash, with operating cash flow up 21% to $6.36 billion in the quarter. Google is a Buy and a Long-Term Buy.


A giant among its peers, Union Pacific’s ($122; UNP) market capitalization of $109 billion is three times larger than any other S&P 1500 railroad. Union Pacific generates nearly twice the revenue of its next-largest competitor. Cash from operations rose 8% to $7.39 billion last year, nearly equaling the combined operating cash flow of $7.60 billion of the four other S&P 1500 railroads.

Capital spending is projected to rise by a modest 5% to $4.3 billion this year, giving the railroad flexibility to return more cash to investors. Earlier this month, Union Pacific raised its quarterly dividend 10% to $0.55 per share, payable March 30. With that move, the annual dividend equates to 38% of trailing earnings, which exceeds its targeted payout ratio of 35%. Union Pacific has raised its distribution three times since the start of 2014.

In other news, Union Pacific selected Lance Fritz its new CEO. Fritz, age 52, was formerly the company’s chief operating officer. Union Pacific, yielding 1.9% after the dividend hike, is a Focus List Buy and a Long-Term Buy.

MEGACAPS WE LIKE
Market
Value
($Bil.)
Trailing
P/E
10-Yr.
Avg.
Trailing
P/E
P/E On
Curr.-Yr.
Estimate
12-Month Growth
--------- Quadrix Scores ---------
Company (Price; Ticker)
Market
Value
Rank In
S&P 500
EPS
(%)
Sales
(%)
Momen-
tum
Value
Overall
Apple ($125; AAPL)
734.5
1
16.8
22.9
14.5
29
15
94
73
100
Comcast ($58; CMCSa)
151.2
28
20.5
24.8
19.3
23
7
65
64
85
CVS Health ($103; CVS)
118.2
35
23.2
23.4
22.8
14
10
57
37
68
Gilead ($100; GILD)
159.7
25
12.3
26.2
10.5
297
122
97
84
97
Google ($536; GOOGL)
369.0
3
21.0
29.2
18.7
8
16
51
56
61
J.P. Morgan ($58; JPM)
219.8
11
10.5
18.6
10.1
-4
-3
37
92
68
Schlumberger ($85; SLB)
109.6
36
15.2
27.5
21.2
17
7
35
76
63
Union Pacific ($122; UNP)
108.7
37
21.2
24.5
18.5
22
9
88
42
93
Wells Fargo ($54; WFC)
284.5
7
13.4
19.9
12.9
5
0
47
75
70
Note: Quadrix scores are percentile ranks, with 100 the best.

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