The Quest For Quality
When fear and anxiety overwhelm the market, a shift toward quality often follows. Given the tepid outlook for the economy, a lasting move into quality growers with solid foundations would not surprise us.
To that end, we screened for high-quality stocks with strong balance sheets, focusing on the following attributes:
• Strong Quadrix scores for Quality (long-term growth record and returns on assets, equity, and investment) and Financial Strength (debt levels and profit margins). Solid scores for Quality often indicate a well-managed business, while Financial Strength scores reflect strong finances.
• Below-average debt loads. Modest debt levels typically imply superior financial flexibility. In addition, as companies trim their debt they cut future borrowing costs and potentially boost profits. We screened for stocks with long-term debt less than one-third of total capital (the average for S&P 500 Index companies excluding financials and utilities). Five of the nine stocks listed on page 5 have reduced long-term debt over the past year.
• Healthy cash cushions. A meaningful net cash position (cash and equivalents minus total debt) represents fuel for dividend hikes, capital and research spending, share repurchases, and acquisitions. In volatile markets, a meaningful cash position can help limit downside risk. To make the cut, we required a positive net cash balance.
• Growth in book value. Increases in book value may imply that management is using assets wisely, and companies that grow book value tend to have higher-quality earnings. In addition, book value can provide a theoretical cushion for a stock price. The nine stocks have delivered at least 10% annualized growth in per-share book value over the last five years.
• Timely collections. Smart corporate managers collect bills (receivables) quickly, which efficiently turns sales into cash. We looked at days receivables, focusing on companies that have improved in recent quarters.
Microsoft's ($25; MSFT) strong balance sheet and enormous cash position provide an enviable platform for growth. The tech stalwart has $40.85 billion in net cash, or $4.79 per share, putting the cash-adjusted trailing P/E ratio at only seven. At 94, the Financial Strength score ranks near the top 6% of U.S.-traded stocks and handily outstrips the peer-group average of 66. The Quality score, currently 94, has not dipped below 80 for at least five years.
Microsoft's deep pockets provide funds for product development and ammunition to defend its patents. The company's retooled operating system, Windows 8, should debut in the fall of 2012. The system will run on on both conventional and tablet computers, and Microsoft plans to launch an "app store" in concert with Windows 8 to provide tablet and smartphone users easy access to inexpensive programs.
Meanwhile, the International Trade Commission (ITC) is reviewing the company's patent-infringement case against Motorola Mobility ($38; MMI), which targets smartphones using Google's ($519; GOOG) Android operating system. If the commission sides with Microsoft, it could restrict imports of Motorola's Android-based smartphones. Microsoft, yielding 2.6%, is a Long-Term Buy.
Oracle ($26; ORCL) is not immune to a slowdown in corporate spending on technology gear and services. But the company has the operational savvy and financial fortitude to outperform in a difficult climate. Oracle holds $28.85 billion in cash, compared to long-term debt of $14.77 billion (27% of total capital). Net cash of $2.50 per share accounts for nearly 10% of the stock price. Over the last five years, book value per share has increased at an impressive 22% annualized rate.
August-quarter results should be announced in mid-September. Wall Street anticipates per-share earnings of $0.47, up 12%, while sales should be up about 10%. For fiscal 2012 ending May, consensus estimates project both revenue and per-share earnings will rise 9%.
Despite its rock-solid financial footing and growth outlook, Oracle looks cheap. The stock trades at 12 times trailing earnings and 11 times estimated current-year profits, a discount of at least 20% to its industry group for both ratios. Based on trailing earnings, shares trade nearly 50% below their own 10-year average P/E of 23. At 3.2, the price/book ratio is less than half of the 10-year norm of 6.6. Oracle is a Focus List Buy and a Long-Term Buy.Â Â
Founded in 1901, Walgreen ($35; WAG) has seen its share of trying economic times. But the company, aided by a sturdy balance sheet and ample cash flow, should post its 37th consecutive year of record sales for fiscal 2011 ending August. In July, the company raised its quarterly dividend a record 29% to $0.225 per share, payable Sept. 12, marking the 36th consecutive annual dividend increase. The company also approved up to $2 billion in share repurchases. In fiscal 2010, Walgreen returned $2.2 billion to shareholders via dividends and stock buybacks.
Walgreen reported a healthy 5% revenue gain and 2.7% higher same-store sales in July. To bolster revenue, the company will launch its Nice! store brand in early 2012 with more than 400 low-priced food and household items. Private-label brands can attract cost-sensitive consumers willing to switch from premium-priced national brands. Walgreen expects Nice! products to cost up to 30% less than national brands.
For fiscal 2011 ending August, per-share profits are expected to increase 13% to $2.62. Revenue should climb nearly 7% to $72.06 billion. For fiscal 2012, the consensus calls for 15% profit growth. The stock earns an Overall score of 83, versus an industry average of 51. At 82, the Quality score is well above the peer-group average of 52. Walgreen, while not a member of our buy lists, is rated A (above average).