Real Answers To Fake Questions

6/27/2011


I'm no mind reader. But after 22 years at this newsletter, I can anticipate some of the questions we're likely to get about our recommendations. So, here are answers to questions from readers just like you, except you actually exist.

Q Aflac ($46; AFL) and J.P. Morgan Chase ($41; JPM) have been sluggards this year, and neither earns outstanding scores in the Quadrix® stock-rating system. Do they really deserve to be on the Focus List?

A Not anymore. We want some exposure to the beaten-down financial sector, and Aflac and J.P. Morgan represent two of the best values among big financials. But the Focus List is reserved for our favorite 12 to 15 names for year-ahead gains, and neither stock clears that hurdle.

J.P. Morgan is being retained as a Buy and a Long-Term Buy, largely because of its modest valuation and its financial strength relative to peers. The stock trades at nine times trailing earnings, versus 15 for the average financial stock in the S&P 1500 Index. The stock also trades at a discount to its historical median P/E ratios — 14 over the past 10 years and 13 over the past five years.

J.P. Morgan, one of the few major U.S. banks to stay profitable throughout the financial meltdown, has a solid balance sheet and strong positions in investment banking, asset management, and commercial banking. But the mortgage business faces considerable uncertainty, while higher capital standards and tighter regulations will limit revenue growth. All things considered, J.P. Morgan seems like a good rebound play, though not one of our favorite 15 picks.


Aflac has been pressured by concerns regarding the disaster in Japan and the potential financial meltdown in Europe. Big losses in Aflac's bond portfolio seem unlikely, but the risk of a default by Greece or another European nation could weigh on Aflac shares in the short run. The stock's Quadrix scores for Performance and Earnings Estimates have dropped below 20, partly because Aflac provided lower-than-expected guidance for 2012 earnings in May.

While Aflac no longer has everything we look for in a stock, its valuation, track record, and market position suggest it has superior 12-month and long-term potential. At eight times trailing earnings, Aflac trades at a discount to the insurance-industry average of 10 and its own 10-year historical norm of 18. Aflac is a Buy and a Long-Term Buy.

Q Are you adding a stock to replace these names?

A Yes, we're adding Dover ($64; DOV) to the Focus List based on its strong Quadrix scores and operating momentum, reasonable valuation, and solid profit-growth prospects. Dover, a broadly diversified manufacturer, has delivered impressive growth in sales, earnings, and cash flow over the past year. Some slowdown is likely in the industrial markets Dover serves, but broad-based sales growth seems likely to continue. While a quick return to the 10-year average P/E ratio of 20 seems unlikely, a move to the five-year average of more than 15 would put the stock at $76 in early 2013 if Dover matches consensus profit estimates.

Q What's wrong with Apple ($325; AAPL)? The company's Quadrix scores and recent growth rates are impressive. But the stock has underperformed, reaching a seven-month low this month before a recent bounce.

A Some of the selling reflects uncertainty over the release dates of the next iPhone, expected to come out this fall, and iPad, expected to arrive in time for Christmas. Apple also lost its retail chief, who is taking the helm as CEO at J.C. Penney ($36; JCP). But Apple has a deep bench of talent, and its stable of products seems practically capable of selling itself.

Also, recent weaker-than-expected results from Nokia ($6; NOK) and Research In Motion ($29; RIMM) have raised concerns regarding the smartphone market. On June 9, however, researcher IDC raised its 2011 growth forecast for the global smartphone market to 55%, up from the 49% estimate it had issued less than three months earlier. IDC sees Apple taking an 18% slice of the market (up from its previous 16% estimate), while Google ($493; GOOG) is expected to take a leading 39% share (down from 40%).

In our view, Apple shares have probably been hurt by profit-taking. The stock has more than doubled over the past two years, and its stock-market capitalization of $300 billion ranks second to Exxon Mobil ($81; XOM). While Apple shares could feel continued pressure in the near term, we view the pullback as a buying opportunity. The stock's Quadrix Value score has jumped to 79, up from 38 a year ago. At roughly 15 times trailing earnings, the stock trades at a huge discount to its five-year norm of 23 and 10-year norm of 34.

Q Why are you sticking with Hewlett-Packard ($35; HPQ)? The Overall score is down to 70.

A With the benefit of hindsight, we should have sold H-P in February, when the stock slumped on disappointing guidance for the April quarter. In May the technology giant issued another disappointing forecast, pushing its shares to a two-year low.

While we seldom recommend stocks simply because they are cheap, we will sometimes stick with a name that seems undervalued and due for a bounce. H-P, trading at seven times the lowest Wall Street estimate for current-year earnings, seems capable of reaching $40 to $45 over the next six months.

Expectations for personal-computer sales seem unduly pessimistic, and investors don't appear to expect much from H-P's new products and streamlining efforts. While H-P seems unlikely to command a trailing P/E near its 10-year average of 18 or its five-year average of 14 anytime soon, the stock would sell for $50 with flat earnings and a return to the one-year average P/E of 10.


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