My Favorite Megacaps

7/25/2011


About five months ago on this page, in a column headlined “Now is the time for megacaps,” I argued that the largest U.S. stocks were the least expensive and listed 10 attractively valued blue chips. While those 10 stocks have performed roughly in line with the average U.S. stock, megacaps have narrowly underperformed.


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S&P 1500 Index
(All Cap)
S&P 500 Index
(Large Cap)
Largest 50
in S&P 500
Median trailing price/earnings ratio
Current
17.9
16.9
16
Norm since 1994
17.9
18.1
20.8
Median year-to-year change in per-share profits in most recent quarter
Current (%)
13.7
14.7
15
Norm since 1994 (%)
9.4
9.9
12.7
Median Quadrix Overall score
Current
58
64
77
Norm since 1994
60
61
67
Notes: All ratios based on trailing results, with negative ratios and those above 75 excluded. All comparisons based on month-end numbers. The median is the number that divides a set into two equal-numbered groups.

Does that mean my reasoning was faulty? Not necessarily. My headlines may need a bit more circumspection, but the case for megacaps remains intact. In fact, as shown below, the largest 50 stocks in the S&P 500 Index are not only cheap but also had above-average earnings momentum heading into June-quarter results. Still, the experience of the last five months holds some valuable lessons:

First, valuation ratios do a poor job of timing entry and exit decisions. Cheap stocks can always get cheaper — and they often do until a catalyst of some sort highlights their appeal. The truth is nobody knows when large stocks will regain favor. But buying stocks at a discount to the broad market has been a winning strategy over the years, especially when you can also get stocks at a discount to their own historical norms.

Second, a cheap valuation alone has not been enough to attract investors lately. From the market’s March 2009 bottom until August 2010, valuation ratios like
price/earnings and price/sales were by far the most effective metrics in our Quadrix rating system. But since then top Value scorers have lagged the average stock modestly, while top scorers for Momentum, Earnings Estimates, Performance, and Overall have outperformed. With investors likely to remain cautious regarding the economic outlook, we expect our growth-at-a-good-price approach to remain effective.

Third, even when playing a broad theme like megacaps, it pays to be selective. Instead of listing 10 stocks selected based on valuations, as I did in February, today I am highlighting five attractively valued megacap stocks with solid track records, strong operating momentum, and good growth prospects. All five, listed below, earn Overall scores of at least 90, Momentum and Earnings Estimates scores of at least 65, and Performance scores of at least 48. Our two favorite megacaps, both of which posted robust June-quarter results, are reviewed below.

Apple ($377; AAPL) said earnings per share soared 122% to $7.79 in the June quarter, crushing the consensus by $1.99. Revenue leaped 82%. Apple sold 20.34 million iPhones, up 142%, and 9.25 million iPads, up 183%. Notorious for its conservative guidance, Apple issued a September-quarter earnings outlook well below analyst expectations, but the stock rallied on the report. In other news, Apple reportedly plans to add its iPhone to the network of China Telecom ($67; CHA), China’s third-largest telecom carrier, by year-end. Analysts also expect a deal with top dog China Mobile ($47; CHL) and its 600 million subscribers. Apple is a Focus List Buy and a Long-Term Buy.


IBM ($185; IBM) earned $3.09 per share in the June quarter excluding special items, up 18% and $0.06 above the consensus. Revenue grew 12% to $26.67 billion, also ahead of analyst estimates. The services backlog rose 12% to $144 billion. IBM raised its full-year profit guidance to at least $13.25 per share, $0.03 above the consensus at the time of the announcement. The stock, which jumped nearly 6% on the strong performance, is a Focus List Buy and a Long-Term Buy.

Company (Price; Ticker)
Quadrix
Overall
Score *
Apple ($377; AAPL)
99
Exxon Mobil ($84; XOM)
97
IBM ($185; IBM)
90
Intel ($23; INTC)
99
Oracle ($33; ORCL)
97
* Percentile rank, with 100 the best.

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