Stick To A Proven Strategy

8/15/2016


The Focus List has suffered its share of misses on individual stocks this year. It has also been concentrated in pockets of the market largely ignored by investors, who have piled into defensive sectors such as telecommunications and utilities. As we noted in last week's issue, the least-volatile stocks haven't been so expensive relative to the rest of market since at least 1994. We hesitate to chase recent performance and compound the problem by reaching for overvalued stocks.

THE FOCUS LIST
Since Added
----- To List * -----
Company (Price; Ticker)
Date
Added
To List

Initial
Price
($)

Price
Change
(%)
S&P 500
Change
(%)
Industry
Alphabet ($808; GOOGL)
8/11/16
— 
Internet software
CDW ($46; CDW)
8/11/16
Tech distributors
Centene ($70; CNC)
3/10/16
58
21
9
Managed care
Citrix Systems ($86; CTXS)
5/19/16
82
4
7
App. software
Comcast ($67; CMCSa)
6/25/15
61
10
3
Cable & satellite
D.R. Horton ($32; DHI)
7/7/16
33
(2)
4
Homebuilding
Lab Corp. of America
($140; LH)
7/7/16
132
6
4
Health services
Lam Research ($89; LRCX)
8/11/16
Semicond. equip.
Lear ($114; LEA)
8/1/13
69
64
27
Auto parts 
LKQ ($35; LKQ)
5/19/16
31
11
7
Distributors
Mohawk Industries
($212; MHK)
6/23/16
198
7
3
Home furnishings
Owens Corning ($54; OC)
3/10/16
46
18
9
Building products
Southwest Airlines
($37; LUV)
5/19/16
42
(12)
7
Airlines
* Through Aug. 10.

It's understandable to want to switch tactics in hopes of making up for earlier mistakes. But investors who jump from one investing fad to another, as if playing hopscotch, usually end up with little to show for their troubles but a portfolio with high transaction fees and lagging returns.

No investing style works perfectly all the time. One of the biggest challenges of investing is maintaining the discipline to wait for the market to return to your favor.

The fully invested Focus List has declined 6.3% in 2016, while the S&P 500 Index gained 6.4%. However, our Focus List has comfortably outperformed the S&P 500 on annualized basis over the past 10 years and since its 1994 inception. Worth noting: After years when the Focus List lagged its benchmark, such as 2011 and 2008, came consecutive years of strong outperformance. You can find historical annual returns for our Focus, Buy, and Long-Term Buy lists at www.DowTheory.com/Go/Perform. 

As detailed in Portfolio Review, we are making four changes to the Focus List this week, dropping Amerco ($349; UHAL), while adding Alphabet ($808; GOOGL), CDW ($46; CDW), and Lam Research ($89; LRCX).

Our investment style remains focused on stocks with strong fundamentals, as measured by the Quadrix Overall score. We look for solid growth prospects and reasonable valuations. And with income stocks, we emphasize dividend growth over yield. In the nearby tables and reviewed below you'll find Focus List stocks that look especially attractive based on these criteria.

Operating momentum

Laboratory Corp. of America ($140; LH) has grown per-share profits, sales, operating cash flow, and free cash flow at least 8% over the past 12 months. The same can be said of less than 10% of companies in the S&P 500 Index, among them recommended stocks Alphabet ($808; GOOGL), CVS Health ($97; CVS), Lam Research ($89; LRCX), LKQ ($35; LKQ), Mohawk Industries ($212; MHK), and Nvidia ($59; NVDA).

LabCorp's operating momentum stems from a combination of acquisitions and higher demand for its laboratory-testing services. In the June quarter, testing volumes increased 2%, while revenue per requisition climbed 3.5%, due to an improved product mix rather than pricing. Operating profit margin also rose for the first time in the past five quarters.

Management's new 2016 profit-guidance range has a higher midpoint than previous targets, implying 11% growth and not taking into account any stock buybacks. LabCorp says it may resume share repurchases in the second half of the year, presenting potential upside to its current outlook. LabCorp is a Focus List Buy and a Long-Term Buy.

ROBUST OPERATING MOMENTUM
--------------------- 12-Month Growth ---------------------
Company (Price; Ticker)
Per-Share
Earnings
(%)
Sales
(%)
Operating
Cash Flow
(%)
Free
Cash Flow
(%)
CDW ($46; CDW)
14
11
37
85
Lab Corp. of America ($140; LH)
8
32
63
71
LKQ ($35; LKQ)
19
13
20
10

Value

In the days leading up to Centene's ($70; CNC) June-quarter report, the stock had climbed to a 52-week high and traded within 7% of its all-time high. Although Centene, a managed-care provider, topped consensus estimates for both earnings per share and revenue, the report was messier than the headline numbers suggested. The company excluded from its results a $300 million premium deficiency reserve to reflect underperforming contracts at its recently acquired HealthNet business. Operating cash flow also flipped to a negative $420 million, compared to a positive $350 million in the year-ago quarter, as several states postponed premium payments due to the timing of their fiscal year-ends.

Shares slumped on the report but have started to recover lost ground. Management vowed to improve its HealthNet business by increasing prices and scaling back in some troublesome markets. Some analysts were skeptical Centene could turn things around as quickly as promised. However, plenty of skepticism appears already embedded in the share price. The stock trades at 18 times trailing earnings, 28% below its five-year average and 6% below the median managed-care stock. Centene is a Focus List Buy and a Long-Term Buy.

COMPELLING VALUES
---------- Trailing P/E Ratio ----------
-- Forward P/E Ratio --
Company (Price; Ticker)
Recent
Dscount
To 5-Yr.
Median
(%)
Discount
To Industry
Median
(%)
Recent
Discount
To Industry
Median
(%)
Centene ($70; CNC)
18
18
6
16
5
Citrix Systems ($86; CTXS)
17
52
27
17
35
Owens Corning ($54; OC)
16
21
39
16
32

Earnings estimates

Analyst estimates for Mohawk Industries ($212; MHK) have ticked higher in the days since the flooring manufacturer posted strong June-quarter results and gave upbeat guidance for the current quarter. Mohawk earned $3.47 per share excluding special items, up 29% and $0.10 above the consensus. Sales climbed 13% to $2.31 billion on growth across all three business segments. Operating profit margin expanded for the 18th straight quarter, a trend management expects to continue. Mohawk has topped the consensus profit estimate in 17 of the past 18 quarters.

Management anticipates September-quarter earnings per share of $3.40 to $3.49, implying 14% to 17% growth. The consensus was $3.37 per share at the time of the announcement. Mohawk also noted strong booking trends for July and said recent price hikes should help offset currency headwinds. Shares rallied on the results and are now up 12% for the year. The stock still appears reasonably valued at 18 times trailing earnings, 5% below the median S&P 1500 home-furnishing stock and 16% below its own five-year median. Mohawk is a Focus List Buy and a Long-Term Buy.

RISING EARNINGS ESTIMATES
EPS Estimate,
--- Current Quarter ---
EPS Estimate,
--- Curr. Fiscal Year ---
Company (Price; Ticker)
Estimated
Growth
(%)
Change In
Est., Past
90 Days
(%)
Estimated
Growth
(%)
Change In
Est., Past
90 Days
(%)
Quadrix
Earnings
Estimates
Score
Alphabet ($808; GOOGL)
17
3
16
2
96
Lear ($114; LEA)
14
2
22
5
92
Mohawk Industries ($212; MHK)
16
3
22
2
88
Note: Quadrix scores are percentile ranks, with 100 the best.

Dividend

Southwest Airlines ($37; LUV) yields 1.1%, lower than most other dividend-paying airlines in the S&P 1500 Index. But its dividend growth, at least 25% in each of the past five years, is unrivaled in its industry. Rising cash flow should support future growth. For the 12 months ended June, cash from operations more than doubled to $3.89 billion, while free cash flow more than tripled to $1.74 billion.

Favorable cash-flow trends benefit from lower fuel expense. Management expects fuel costs to fall 7% to $2.05 per gallon in the September quarter. The estimated dip in fuel prices may prove conservative, considering U.S. oil prices have declined about 16% from their 2016 high, set in early June. Southwest may also become more aggressive about raising airfares after matching a rival's price hike in late July.

Although analyst estimates have fallen in the past 90 days, Southwest shares trade at a reasonable 10 times the most bearish 2016 profit estimate. Southwest Airlines is a Focus List Buy and a Long-Term Buy.

DIVIDEND GROWERS
Company (Price; Ticker)
Indicated
Dividend
($)
Yield
(%)
5-Year
Annualized
Dividend
Growth
(%)
Payout
Ratio
(%)
Latest
Dividend Hike
Comcast ($67; CMCSa)
1.10
1.6
21
34
10%, Feb. 2016
D.R. Horton ($32; DHI)
0.32
1.0
15
14
28%, Nov. 2015
Southwest Airlines ($37; LUV)
0.40
1.1
78
10
33%, May 2016

Quadrix

Lear ($114; LEA) earns a Quadrix Overall score of 99, tied with Owens Corning ($54; OC) for the highest rank on the Focus List. Its Overall score has exceeded 80 for at least 24 straight months and topped 90 every month in the past year. The stock has been volatile — returning 7% including dividends in the past month but losing 7% for the year — amid concerns of slowing growth in the U.S. auto market.

Few stocks are cheaper than Lear, which earns a Value score of 97. Lear trades at nine times trailing earnings and eight times estimated 2016 profits; both P/E ratios rank among the lowest 10% in our research universe. If Lear matches the 2016 consensus profit estimate of $13.58 per share and its trailing P/E ratio rises to 10 (still well below the median of 13 for S&P 1500 auto-parts suppliers), the stock will rally 19% by early 2017. Lear is a Focus List Buy and a Long-Term Buy.

QUADRIX STUDS
----------- Quadrix Scores -----------
Number
Of Months
Overall
Above 80
(Out Of 24)
% Of
Factors
Above 80
Company (Price; Ticker)
Overall
12-Factor
Sector
Reranked
Overall
Lam Research ($89; LRCX)
96
89
98
24
59
Lear ($114; LEA)
99
93
94
24
58
Mohawk Industries ($212; MHK)
95
59
91
18
60
Note: Quadrix scores are percentile ranks, with 100 the best.

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