Living large with Quadrix
Large-company stocks have been good to us.
The Forecasts will recommend shares of smaller companies occassionally, but we focus on larger midcaps and large-capitalization stocks. Of the 39 stocks on our Buy List and Long-Term Buy List, 90% have market values of at least $5 billion.
Our strategy for selecting quality large-cap stocks revolves around the Quadrix® stock-rating system. As the table on page 4 shows, the large-company stocks in the S&P 500 Index earn slightly higher Quadrix Overall scores than the average for smaller stocks, in large part because of high Quality scores. The Quality score — primarily reflecting growth in dividends, sales, profits, and cash flows — also considers returns on equity, assets, and investment.
Quadrix works well for large-cap stocks. In rolling 12-month periods since 1990, the top one-fifth of S&P 500 stocks as measured by Quadrix Overall scores outperformed the average S&P 500 stock by an average of 3.9%, topping the average return nearly three-fourths of the time.
In an effort to unearth a few choice large stocks, we looked at the effectiveness of each of the more than 100 statistics used to generate Quadrix scores. We found that six statistics — long-term estimated earnings growth, six-month total return, price/earnings ratio, price/book ratio, enterprise value/EBITDA ratio, and current-quarter profit-estimate revisions — were particularly effective for large stocks.
Stocks with high growth potential, rising profit estimates, and strong recent returns tend to be expensive, so most stocks that earn high scores in some of the metrics listed above score poorly on others. Listed in the table above and reviewed below are stocks with above-average scores in all of the key metrics.
Exxon Mobil ($82; NYSE: XOM), the largest publicly traded oil company in the world, has been aggressively repurchasing shares. Since 2003, the oil giant has spent more than $99 billion on share buybacks and reduced its share count by 19%. With the pace of purchases up to more than $8 billion per quarter, Exxon could potentially buy back all its stock by 2020. At the end of March, the company had more than $41 billion in cash and just $7.2 billion in long-term debt, providing plenty of flexibility to continue repurchasing shares and boosting its dividend.
While oil prices have nearly doubled over the last year, Exxon’s share price has fallen 8%. Concerns about growth and profitability in the refining business have weighed on the shares, but consensus estimates project a 32% increase in per-share earnings this year. Over the last three months, the 2008 consensus has risen 15%.
Even that optimistic profit target may prove conservative if oil prices remain elevated, as the Wall Street consensus estimate for oil prices calls for a decline of at least 25% by the end of this year. With 12 major new projects starting this year and more slated for launch over the next several years, Exxon seems well-positioned for continued profit gains. Trading at a reasonable nine times projected year-ahead earnings, Exxon is a Long-Term Buy.
Qualcomm’s ($47; NASDAQ: QCOM) courtroom battle with handset maker Nokia ($25; NYSE: NOK) begins this month. The litigation has some investors worried, and any resolution that provides some clarity could boost Qualcomm’s share price. A positive result from the trial could increase Qualcomm’s earnings.
Nokia, which is disputing the amount it owes in fees for using Qualcomm’s patents, stopped making payments altogether last year. Most analyst estimates for Qualcomm exclude a revenue contribution from Nokia, but most industry watchers expect the handset maker will have to pay something for its use of Qualcomm’s intellectual property. Nokia has suggested a 0.5% to 1% royalty rate as reasonable, and a ruling that establishes royalties at the low end of that range should lift Qualcomm’s per-share earnings by about 3%. Most of Qualcomm’s customers pay royalties of about 4%. If Nokia ends up paying 4%, Qualcomm’s per-share earnings could increase by at least 15%.
With use of Qualcomm’s third-generation technology expected to grow 30% next year, the company should thrive even if the current economic turmoil bleeds over into 2009. Consensus estimates are on the rise, and Wall Street expects Qualcomm to grow per-share earnings 14% in fiscal 2009 ending September. Qualcomm is a Focus List Buy and a Long-Term Buy.
In recent months, Transocean ($145; NYSE: RIG) has signed a string of ever-more-lucrative contracts for its deepwater oil rigs. A deal struck early this month for five years of rig rental at $652,000 per day may be the highest rate ever for an existing deepwater rig. Another rig contract will bring in $564,000 per day starting in 2009. Those high rates, coupled with Transocean’s growing backlog of $34 billion, should support strong earnings growth over the next few years.
Rig-rental rates should continue to rise through 2012 as capacity to build new drillships lessens. Brazilian oil giant Petrobras ($61; NYSE: PBR) announced earlier this year that it would order 12 new rigs, which Transocean believes will nearly max out manufacturing capacity worldwide for the next four years. With no new ships available, oil companies will have to pay premium rates for any available deepwater rig. Earlier this month, Petrobras agreed to pay $3 billion to rent four of Transocean’s rigs for a combined 22 years.
Transocean owns seven of the 16 ultra-deepwater rigs that will be available by 2010 and should capture a generous share of the revenue from this lucrative market segment. Industry experts predict most of the richest oilfields still awaiting discovery are under more than 7,500 feet of water, and Transocean is well-positioned to take advantage of the long-term need to find and produce oil in the few untapped ocean regions. Transocean is a Focus List Buy and a Long-Term Buy.
Three myths about large-caps
Sometimes large-caps get a bum rap. In the following paragraphs, we tackle three common investment myths about large-cap stocks.
Large-caps have underperformed: As the top chart below shows, the S&P 500 Index has lagged the midcap and small-cap indexes, but in this case the forest obscures the trees. The bottom chart on below illustrates that the average S&P 500 component has delivered performance comparable to the average stock in the S&P midcap and small-cap indexes.
Large-caps can’t grow profits: While the S&P 500 Index is expected to deliver anemic profit growth, as shown in the chart below, the table at the bottom of the page shows that analysts expect the average large-cap stock to deliver double-digit growth in per-share profits in the current fiscal year and annually over the next five years.
Large-caps are expensive: S&P 500 members earn Quadrix Value scores comparable to those of stocks in the midcap and small-cap indexes — and are cheaper as measured by trailing price/earnings ratios.