The Best Stocks in the Dow Jones Industrial Average

The Dow Jones contains some of the biggest and most well known companies in the market. However not all of these blue chips are created equal. The following are what we consider to be the most attractive investment opportunities in the Dow Jones Industrial Average.

A Healthy Boost — Johnson & Johnson (JNJ)

Johnson & Johnson, provider of healthcare products worldwide comes in at number one on our list with a Very Attractive rating. We’ve been bullish on Johnson & Johnson for a while now, with some great results in 2014. While the stock hasn’t gone anywhere since our original call, we think that this is due for a change. JNJ is even more attractive now than it was in November.

By all measures, Johnson & Johnson had a great 2014. The company grew its after-tax operating profits (NOPAT) by 11% and its return on invested capital (ROIC) from 15% to 17%. The company continued its slow and steady pace of revenue growth with over 4% growth last year. Increases in the top and bottom lines helped propel Johnson & Johnson to achieve its greatest annual free cash flow in our model, topping out at almost $15 billion last year.

However, despite this all-around excellent year, JNJ is currently trading at just $100/share. This price gives JNJ shares a price to economic book value (PEBV) ratio of 1.0, which implies that the market expects the company to never grow profits from their current levels.

To understand this discrepancy between the company’s reality and its valuation, we need to look at why Johnson & Johnson shares have been flat since November. Two poor quarterly reports have put pressure on shares. In 4Q14 revenue was $18.3 billion, a decline of almost 1% year over year, and in 1Q15 revenue was $17.4 billion, down 4% year over year.

However, something that cannot be ignored is the impact of the strong dollar on J&J’s sales, 53% of which come from outside the United States. Since we’re primarily concerned with the stock’s long term prospects, we’re really only concerned with the demand for J&J’s products and how well J&J is doing selling them — not with quarter-to-quarter fluctuations in earnings and sales.

When removing the impact of the rising dollar on Johnson & Johnson’s sales, we see that things are business as usual at the health care giant. In 4Q14 currency had a negative impact of almost 5% on J&J’s sales, so operational sales were up 4%. In 1Q15 the negative currency impact was even greater at 7%, so operational sales were actually up 3%. The company had two blockbuster drugs last year — Invokana for diabetes and cancer drug Imbruvica — that helped propel sales and that are a testament to Johnson & Johnson’s strong pharmaceutical portfolio, an asset going forward.

Despite the runaway successes of these two products, it’s important to note a point we made the last time we wrote about J&J: the importance of the company’s incredible product diversity. If a particular product struggles, it is just a drop in the bucket and the company’s other offerings can pick up the slack. Along with its pharmaceutical and medical device business, which will benefit from an aging U.S. population, Johnson & Johnson sells staple products like Tylenol and Band-Aids that will always be in demand. Even if Johnson & Johnson were to stop growing organically, the company’s $32 billion in excess cash also allows it to reinvest freely in research and development, or to snap up smaller pharmaceutical companies to further growth.

If we expect that Johnson & Johnson can grow NOPAT by just 4% compounded annually for the next 10 years — lower than its historical rate of 6% since 2008 — the stock is worth over $121/share, a 19% upside from current levels. If J&J embarks on an acquisition campaign or strengthens its already well-managed drug portfolio, expect shares to be worth even more. We think JNJ is undervalued even when considering its $599 million in owed deferred compensation, its $2.3 billion outstanding employee stock option liability, and its $9.3 billion pension obligation — cash obligations most other research firms don’t even consider.

We think it’s shortsighted to see minimal growth from this extremely well run company going forward. If this analysis hasn’t convinced you, Johnson & Johnson’s 3% dividend yield just might.

Teaching an Old Dog New Tricks — Microsoft (MSFT)

Microsoft, developer and provider of computer hardware and software worldwide comes in second on our list with a Very Attractive rating. We last wrote on Microsoft on Feb. 10 this year, and that call proved to be a good one as the stock is up over 15% since then. However, we still think Microsoft has room to run, and its stock still earns our Very Attractive rating.

Microsoft, once a company that remade entire industries, has a long history of growing profits, even if this growth has slowed as the company has matured. The company is now remaking itself under the leadership of Satya Nadella, and while quarterly profits have been weak, the company is positioning itself well for the future.

On a trailing 12-month basis in our system (excluding the most recent quarter), Microsoft’s NOPAT is down 9%, and this trend continued with the company’s latest 10-Q — issued just a few days ago — in which net income was down another 12%. However, revenue is up by 13% on a TTM basis (including the most recent quarter), indicating strong growth in at least some areas.

In its most recent report, Microsoft notes strong growth in its new hardware, namely the Windows Phone and Surface areas, offset by declines in Windows licensing revenues. Hardware made up around 41% of revenue. The best product here is the Surface Pro 3, Microsoft’s newly released tablet, which saw revenue jump 44%. Save for the Xbox, consumers have not had this positive a response to a piece of Microsoft hardware in some time.

Furthermore, the overall decline in the Hardware segment was offset by 5% growth in the company’s Commercial segment, which makes up the remaining portion of Microsoft’s operating revenue. There were expected declines in the company’s Office licensing revenue from the weak PC market, but the company’s server revenue was up 10%. The big winner last quarter though was the company’s cloud segment (“Commercial Other”), which saw revenues jump 45% year over year.

The cloud segment really is the backbone of the future at Microsoft, and the company already has a leading market share of 10% behind the dominant Amazon (AMZN). However, Microsoft focuses less on the infrastructure of the cloud, and instead provides higher margin cloud services in its Office 365 and Azure products. CEO Satya Nadella is off to a great start in his turnaround efforts, and the future looks bright at Microsoft.

At its current price of $47/share, MSFT has a PEBV ratio of 1.0, which implies that the market expects the company’s profits to never meaningfully increase over the rest of its corporate life. This seems awfully pessimistic considering both Microsoft’s long and more recent histories. While it may feel like you missed the train on MSFT after last week’s jump, we think there’s still upside to be had here. If Microsoft can grow NOPAT by just 4% compounded annually for the next 10 years, the stock is worth $62/share, a 32% upside.

We think that given the company’s shifting identity, its success so far in becoming less dependent on legacy products, and its immense resources, 4% annual NOPAT growth is a conservative estimate and certainly achievable. If the company can surprise the market like it did last week, the stock will be worth even more.

The Future of Computing? — Intel Corporation (INTC)

Intel, maker of numerous computing devices and technology solutions, comes in at number three on our list with a Very Attractive rating. Intel produces and sells computing devices and is known for its processers for desktop computers, laptops, ultraportable devices, and mobile devices. The company also focuses efforts into data centers, providing products for server, network, storage, and cloud computing platforms. Rounding out its segments, Intel is currently developing technologies for use in many applications in the “Internet of Things” movement, which focuses on connecting physical devices and machines with a public, business, or home network.

These three segments, known respectively as Client Computing Group, Data Center Group, and Internet of Things (IoT) Group, made up 91% of Intel’s revenue in 1Q15. Intel also reports a software and services segment and “all other” revenue. In March of this year, Intel issued downward revised guidance for 1Q15 due to lower than expected PC sales. However, after looking into this quarterly report, and current market developments, Intel could be poised for a solid second half of the year.

Intel’s stock price is actually up 6% after this downward guidance, which gives us hope that investors are approaching Intel rationally and intuitively. In its 1Q15 report, Intel reported that overall revenues were unmoved from the prior year. However, the weakness in its Client Computing Group was more than offset by strong growth in other segments. The Data Center Group saw revenues grow 19%, while IoT segment revenues increased 11%. The growth of these two segments will be paramount for Intel going forward as the global PC market is expected to continue its low to negative overall growth.

The makeup of these two segments — Data Center and IoT— provides Intel a unique advantage. Much of the processors in the IoT can be reworked from existing Intel technologies, cutting down on initial expenses. At the same time, the growth of the IoT will lead to increased data usage and storage which would strongly benefit Intel’s Data Center segment.

On top of strong growth in the two segments above, which now represent 33% of total revenues, Intel was able to increase its gross margin to 61% from the prior year. Despite the lowered guidance, Intel’s overall business is continuing to chug along, even if it is slower than initially expected. The worries of the beginning of this year could very well be short-term concerns. It will be up to management to capitalize on the Data Center and IoT initiatives, and so far they are proving more than capable of doing so.

Taking a step back and looking at Intel from a distance, it remains one of the strongest companies in the market, let alone in the Dow Jones. In 2014, Intel grew NOPAT by 24% over the prior year, increasing its pretax margin to 29%. The company increased its ROIC to a top quintile 20%, highlighting its ability to effectively manage the capital being put into the company. The company ended the year with over $7.3 billion in free cash flow and continued its long history of generating positive economic earnings.

With the introduction of new processors in 1Q15, including products for the PC, tablet, data storage, and IoT markets, Intel has positioned itself as part of the backbone of a changing technological landscape. This potential is not being priced into the business at its current price of ~$33/share, as the market has failed to look past Intel’s reputation as a traditional PC component provider. At its current price, Intel has a PEBV ratio of 1.0, which implies that the market expects Intel’s NOPAT to never meaningfully increase from current levels. Even in 1Q15, which was deemed a “down quarter,” Intel was able to continue growing. Expecting the company to never grow profits again is beyond pessimistic.

If Intel can grow NOPAT by just 5% compounded annually for the next seven years, the stock is worth $42/share today –– a 27% upside. Add in the 3.1% dividend yield and INTC becomes even more attractive.

A Blast From the Past — Cisco Systems (CSCO)

Cisco, producer of Internet Protocol (IP) networking products and services, is number four on our list with a Very Attractive rating. Cisco offers switching products, storage products that provide connectivity to end users, workstations, IP phones, wireless access points, and servers. It also produces routers and servers for business and personal use. A small but growing part of Cisco’s business involves data center storage, wireless solutions, and security solutions. As we pointed out back when Cisco was our Stock Pick of the Week, these three product segments may very well represent the future of Cisco.

Cisco divides revenues into multiple different segments, with the largest being its Switching segment. This segment includes its many different network switches that provide networks across campuses, offices, and data centers. This segment was 40% of total revenues in Cisco’s most recent 10-Q. The next largest segment is NGN Routing, which comprises 19% of total revenues and includes virtual routers and routing systems that provide networks for mobile, data, voice, and video applications.

These two segments are widely considered to be Cisco’s “legacy” segments, or those that face many headwinds as the world moves towards the IoT, Cloud Data, and wireless solutions. To address these concerns, Cisco also has products in Data Center, Wireless, and Security segments. These three segments represent Cisco’s focus on developing past the older technologies that made it the company it is today.

In its most recent 10-Q, Cisco reported great results across all of its product segments. Switching and NGN Routing revenues were up 11% and 2% respectively. These segments had seen revenue declines in 2014 so a return to growth is certainly a positive. On the other hand, Data Center revenue was up 40% and Wireless revenues were up 18%. Overall, the growth in Cisco’s “future segments” remains strong. As a whole, Cisco grew revenues 7% year over year and decreased its expenses. As a result, operating income increased 57% for the quarter.

This excellent growth is a great sign after the company’s NOPAT declined by 10% in 2014, and Cisco is effectively returning to the growth company the market expects it to be. Cisco’s ROIC is currently a top quintile 16%, and the company has generated over $9 billion in free cash flow on a TTM basis. It appears as if the down 2014 was just a blip on the radar of this excellent company.

However, the market has failed to recognize the true value of this company and despite its stock price increasing 5% so far this year, it is still significantly undervalued. At its current price of ~$29/share, Cisco has a PEBV ratio of 1.0. As we saw with Intel and J&J above, this ratio implies that the market expects Cisco to never grow NOPAT for the life of the company. This expectation ignores the track record of this venerable company, as well as its most recent quarterly results.

If Cisco can grow NOPAT by just 6% compounded annually for the next decade, the stock is worth $36/share today –– a 24% upside. This scenario also ignores the bonus of the company’s current 3% dividend yield.

Disclosure: David Trainer, André Rouillard and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.

 


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