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Five Stocks For An Era Of Slow Profit Growth - From Validea

September 02, 2009 | About:

John Reese - Validea.com

If robust rates of profit growth become hard to find, then these five stocks will become even more valuable to investors.

Ever since the collapse of the financial markets last fall, one of the biggest buzz terms hovering over the investment world has been the "new normal." With the days of huge leverage gone, many are saying that investors shouldn't expect the same kind of profit growth--or investment returns--that we've enjoyed over the past couple decades.

Bill Gross, managing director of bond giant PIMCO, has said, for example, that "it is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect 'new normal' GDP growth rates of 1%-2% not 3%+ as we used to have. … Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets."

Of course, no one knows for sure whether we are indeed headed to a "new normal." Others say that this is another example of "this-time-is-different" thinking that has so many times turned out not to be true. But given Gross' track record--he was one of the few strategists who warned of the credit crisis and market trouble in advance--it's worth considering what stocks you might be able to count on if profit growth becomes precious.

With that in mind, I decided to look for stocks using the tools on my investment research web site, Validea.com, that have the following four qualities:

--They to have the fundamentals to pass one or more of my Guru Strategies--computer models each based on the approach of a different investing great;

--The companies must have upped their earnings per share in at least nine of the past 10 years;

--They must have manageable debt, which I defined by low debt-to-equity ratios or the ability to pay off debt using profits in a reasonable timeframe (i.e., under two years);

The idea is that if profits become more scarce, your best bet will be companies that have solid balance sheets, have long track records of being able to increase profits through good and bad market conditions, aren't weighed down by debt and are giving you a solid dividend payout. Firms that meet all those criteria are few and far between--so those that do deserve your attention. Here are a few that made the grade:

Fastenal Company ( FAST - news - people ): This unheralded Minnesota-based firm is the largest distributor of fasteners in the U.S., and also makes an array of other industrial tools and supplies. It has 12 distribution centers in the U.S. and more than 2,300 stores, and a market cap of about $5.4 billion. Fastenal gets high marks from my Warren Buffett-based Guru Strategy, in part because of its exceptional earnings history. The firm has upped earnings per share in all but one of the past 10 years, with the lone dip coming eight years ago.

My Buffett-based model also looks for firms with enough annual earnings that they could, if need be, pay off all their debt in less than five years. Fastenal doesn't need five years; it doesn't even need five days. It has no long-term debt, a great sign. Two other qualities Buffett has been known to look for in stocks are a "durable competitive advantage" and strong management, and one way he has measured both of those is by looking at return on equity. My Buffett-based model likes companies to have a ten-year average ROE of at least 15%, and Fastenal, at 20.1%, easily makes the grade.

One more reason to like Fastenal: It's paying a decent 2.02% dividend yield.

Special Offer: Warren Buffett bought Goldman Sachs at $110 with a 10% yield. Which financial and steel stocks appeal to Buffett's strategies right now? Click here to try the Validea Hot List for a complete model portfolio of guru buys.

China Mobile Ltd. ( CHL - news - people ): This Hong Kong-based cellular service giant ($205 billion market cap) is China's leading mobile services provider and has the world's largest mobile network and subscriber base. As of the end of last year, it had more than 450 million subscribers, and its market share was about 72% in Mainland China.

China Mobile is another favorite of my Buffett-based model, in part because it has grown EPS in each of the past 10 years. The firm also has annual earnings of more than $16 billion, meaning it could pay off its $1.45 billion in debt in a matter of months. And, CHL has an excellent 23.1% average return on equity over the past decade. The Buffett model isn't the only one that likes CHL, which is paying a handsome 3.54% dividend yield. The strategy I base on the approach of mutual fund great Peter Lynch considers the stock a "fast-grower"--Lynch's favorite type of investment--because of its 24.42% long-term growth rate (I use an average of the three-, four- and five-year EPS figures to determine a growth rate). To identify fast-growers selling on the cheap, Lynch famously used the P/E/Growth ratio, and the model I base on his writings considers P/E/Gs below 1.0 good values. By dividing CHL's 12.63 P/E ratio by its growth rate, we get a very solid P/E/G of 0.52.

While the Lynch model considers it a fast grower, the value model I base on the writings of James O'Shaughnessy also gives China Mobile high marks. This method looks for large firms with strong cash flows and high yields. China Mobile's $60 billion-plus in trailing 12-month sales, $6.74 in cash flow per share, and 3.54% yield all make the grade.

United Technologies ( UTX - news - people ): This manufacturing firm makes a range of heavy equipment, including Carrier heating and air conditioning, Hamilton Sundstrand aerospace systems and industrial products, Otis elevators and escalators, Pratt & Whitney aircraft engines and Sikorsky helicopters.

The Hartford, Conn.-based company has a market cap of more than $56 billion, and it's increased EPS in every year of the past decade. Because of its high sales and moderate 16.65% growth rate, my Lynch-based model considers UTX a stalwart, the kind of large, steady stock that will often offer protection during a downturn or recession. Since stalwarts often pay nice dividends, Lynch adjusted the "G" portion of the P/E/G ratio to include yield. Thanks in part to its solid 2.58% yield, UTX has a yield-adjusted P/E/G of 0.71, easily passing this model's most important test. Lynch also liked firms with manageable debt, and my model requires stocks to have debt/equity ratios below 80%. At 62.24%, UTX has a fair amount of debt, but it doesn't appear to be overleveraged.

Since July 2003, the S&P 500 is down 2.1%, but the Validea Hot List is up 105.5%. Click here to get the latest Hot List portfolio of stocks that pass muster with strategies of the all-time investing legends like Buffett, Benjamin Graham, Peter Lynch, and more.

General Dynamics Corporation ( GD - news - people ): This Virginia-based firm is one of the U.S.'s largest aerospace and defense firms, making battle tanks and assault vehicles, armaments and munitions, battleships and nuclear submarines and military information technology systems. It has a $22.6 billion market cap, and is paying a decent 2.6% yield.

General Dynamics is one of the highest rated stocks in the market right now according to my strategies. It gets approval from four of my models, including the strategy I base on the writings of hedge fund guru Joel Greenblatt--which is up more than 50% this year. Greenblatt's simple, highly successful strategy looks only at two variables: earnings yield and return on capital. GD's earnings yield of 14.94% ranks 95th of the thousands of stocks in my database, while its return on total capital of 59.13% ranks 85th. Combined, those two figures make GD the 14th most-attractive stock in the market, according to my Greenblatt-based model.

My Lynch model is also high on GD, which it considers a fast grower because of its 20.21% growth rate, and loves the firm's 0.46 P/E/G ratio. My Buffett-based model, meanwhile, likes that GD has upped EPS in nine of the past 10 years, with the lone dip coming six years ago, and that it has enough earnings to pay off all its debts in less than two years. GD also impresses the Buffett model with its 10-year average return on equity of more than 20%

Another model that gives GD high marks is the strategy I base on the early writings of Kenneth Fisher. Fisher pioneered the price/sales ratio as a way to identify undervalued stocks, and my Fisher-based model requires noncyclical companies like GD to have P/S ratios below 0.75. At 0.72, GD makes the grade. The Fisher-inspired model also likes the firm's manageable 35.59% debt/equity ratio and 7.9% average three-year net profit margins.

Johnson & Johnson ( JNJ - news - people ): This New Jersey-based health care giant is one I've mentioned recently, but as one of the few firms that meet all my "new normal" criteria, it's definitely worth another look. Johnson & Johnson, whose brands include Tylenol, Band-Aid and Neutrogena, gets high marks from three of my models. My Buffett strategy likes that JNJ has upped earnings in nine of the past 10 years, and that it has more annual earnings than debt.

JNJ also has a 25.9% 10-year average return on equity. My O'Shaughnessy-based value model likes JNJ's size--it has a $167 billion market cap and more than $61 billion in annual sales--as well as the firm's strong cash flow per share of $5.65, and its solid 3.23% dividend yield.

Finally, my Lynch-based model considers JNJ a "stalwart" because of its moderate 12.7% growth rate and high sales. With a yield-adjusted P/E/Growth ratio of 0.84, JNJ looks like a good buy according to this model. The five stocks above appear to be solid picks for the "new normal" that PIMCO and Gross envision, they should appeal to investors regardless of what the future "normal" looks like. With strong fundamental, track records of increasing earnings through good and bad times, manageable debt, and decent yields, they're worth a look no matter what future financial landscape you envision.

John P. Reese is founder and CEO of Validea.com and Validea Capital Management, and co-author of the new investing bookThe Guru Investor: How to Beat the Market Using History's Best Investment Strategies(John Wiley & Sons). He is also co-author of The Market Gurus: Stock Investing Strategies You Can Use From Wall Street's Best. Click here for more of Reese's insights and analysis, and to subscribe to the Validea Hot List.At the time of publication, John Reese was long on FAST, CHL and JNJ.

Rating: 3.0/5 (3 votes)


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