The Dow Jones Industrial Average Second 10 Best Performers
There is a lot of discussion taking place today about whether or not stocks are good long-term investments. Most of it is slanted towards the negative with dire forecasts of poor future returns. Implied in these forecasts of doom are opinions that stocks are overvalued today. We have written extensively about the importance of valuation and its impact on long-term returns. Much of our effort has focused on how overvalued stocks have been since the late 1990s.
We believe that this has changed, and that stocks are actually very attractively valued on balance today. In the first article in this series we talked about the relative valuation of the S&P 500. Contrary to the views of many we alleged that this broad index, on an absolute or current basis, is historically undervalued. But the truth of the matter is, we don’t like forecasting general markets. Instead, we believe in building portfolios one company at a time. Therefore, we are more inclined to focus on analyzing individual stocks than we are indices.
In part one of this series we looked at the 10 top performing stocks in the DJIA since 1995. In this part two, we will review the second 10 best performing stocks since 1995. As we review these 10 Dow companies, the thesis that it’s a market of stocks, not a stock market, will be vividly expressed in graphic form. Therefore, at a glance the reader will be able to instantly see the significant differences between individual companies.
Interpreting the Earnings and Price Correlated F.A.S.T. Graphs™
The ability to look deeper into specific stock valuations beyond a mere market average is one of many reasons that motivated us to develop our F.A.S.T Graphs™ (Fundamentals Analyzer Software Tool™). We wanted specific research, rather than relying on often miss-leading statistical references. Our F.A.S.T. Graphs™ allow us to evaluate the specific sources of long-term investor returns on over 17,000 symbols.
We use three formulas for determining valuation: For companies growing earnings at 15% or better, the graphs utilize a PEG ratio (PE equal to Earnings Growth Rate) calculation for value (marked PEG in orange ink). For companies growing earnings at 5% or less, the graphs use Ben Graham’s formula for value. These graphs are (marked GDF in orange ink) followed by the number that represents the value PE ratio. For companies growing earnings between 5% and 15%, the graphs use a modified version of the first two (marked in orange ink GDF-EDMP) then again followed by the number representing the calculated value PE ratio.
Therefore, the orange line with white triangles represents fair value for each respective company. In other words, when the black price line touches the orange earnings justified valuation line, the stock is theoretically in value. Prices above the orange fair value line indicate overvaluation and prices below the orange fair value line indicate undervaluation.
Keep in mind that fair value does not necessarily imply high or good returns. Slow earnings growers, even when bought in value will, all other things being equal, generate lower returns than faster growing companies bought in value. However, and most importantly, notice how price and earnings correlate on each graph over time (i.e. the trend line movement of price follows earnings).
A Snapshot Summary of Valuation
The following table lists the second 10 best performing Dow stocks in order of highest to lowest performance since calendar year 1995. For each company the table shows the annualized total return, dividend yield, current price earnings ratio, and for a first perspective on valuation, the normal PE ratio that the market has historically applied to the company.
For a second perspective on valuation the table is color-coded by each company's current valuation. When a stock is considered fairly valued, it means that its price is at or near its orange earnings justified value line, and therefore it's colored orange. When a stock is considered undervalued, it means that its price sits below the orange earnings justified value line thereby falling into the green shaded earnings area, and therefore it's colored green. If the stock price is above the orange earnings justified value line, it's considered overvalued and color-coded red implying danger.
Therefore, from the table below it can be gleaned that there are three companies in this universe that are fairly valued, six that are undervalued, and only one that appears overvalued.
Therefore, the score after reviewing 20 of the 30 DJIA stocks adds up as follows: 14 of 20 are undervalued, 4 of 20 are fairly valued and only 2 appeared overvalued. Of the two that appear overvalued, McDonald’s Corp. (MCD) and Coca-Cola (KO), both are only modestly so based on fundamentals.
A Pictorial View of Valuation: Second 10 Best Performing Dow Stocks Since 1995
A review of the second 10 best performing Dow stocks since 1995 show fewer names with consistent earnings growth and a greater percentage of cyclical examples. This should be no surprise to those that understand that long-term shareholder returns are a function of business performance, i.e. earnings results.
By reviewing each company’s earnings and price correlated F.A.S.T. Graphs™, evidence behind the principle that it’s a market of stocks not a stock market reveals itself. Not all stocks perform the same, because not all businesses behind the stocks are the same. And it’s also a fact that not all stocks precisely follow the markets. Instead, in the long run, price follows earnings.
Wal-Mart Stores Inc. (WMT)
Number 11 on our list of best performing DJIA stocks is Wal-Mart Inc. (WMT). We believe this company represents a poster child on the importance of valuation. For whatever reasons, the market dramatically overvalued this blue-chip retailer starting in 1997 before peaking in 1999. Then it took approximately eight years for the stock price to come back to fair value (touching the orange line).
Operating earnings were consistently rising during all of this which indicates that the market was behaving both badly and irrationally. Today, with no change in earnings growth, the market now sees fit to undervalue the king of retailers. Consequently, we feel that Wal-Mart offers the best potential for shareholder returns than it has since 1997.
Even though it appears very undervalued today, Wal-Mart’s excellent operating record was still able to reward the patient long-term owner. However, it seems counterintuitive to have owned this stock during the overvaluation phase.
American Express Co (AXP)
Number 12 on our list, American Express, like most financials, reported moderately consistent earnings growth until earnings fell sharply during the recession of 2008. Stock price followed earnings down, but have subsequently recovered as earnings have recovered.
Although American Express (AXP) does pay a dividend, its record has been somewhat spotty. During the great recession of 2008, they did maintain their dividend, but did not grow it. Nevertheless, a double-digit total return including dividends was achieved.
Procter & Gamble Co. (PG)
Lucky number 13 on our list is Procter & Gamble Co. (PG), clearly a blue-chip that the market has normally liked to fully value. In most years, the market appeared to price their stock in alignment with earnings plus dividends. In contrast to the Wal-Mart example, after becoming irrationally overpriced in 1999 their stock almost immediately came back to its normal valuation. Today for the first time in decades the market is pricing the stock in line with earnings giving no apparent credit to their dividend.
Procter & Gamble (PG) is one of the few DJIA stocks that was moderately overvalued in 1997 which impacted long-term returns considering that it appears undervalued today. Nevertheless, shareholders still enjoyed a market-beating double-digit return since 1997.
Pfizer Inc. (PFE)
Number 14 on our list is our first look at a major pharmaceutical company, Pfizer Inc. (PFE). For many years pharmaceuticals like Pfizer were very consistent earnings generators. However, since 2001, that changed and these blue-chip pharmaceuticals have become much more cyclical. The impact on stock price has been extraordinary.
As Pfizer (PFE) has become much more cyclical, the impact of erratic earnings has also manifested in their dividend record. This once steady-Eddie dividend growth stock is no longer. This is an important lesson for the dividend growth investor relying on an increasing dividend income stream. It’s important to diligently monitor your holdings.
Home Depot, Inc. (HD)
Number 15 on our list, Home Depot (HD), was once the leading high-flying home improvement retailer until the collapse in the housing industry changed everything. However, even though the company is showing signs of cyclicality today, to compensate, it has also become a better generator of dividend income.
During the great recession, Home Depot (HD) maintained their dividend after first increasing it in 2007. Even without increasing the dividend during the recession they still were able to modestly outperform the S&P 500 since 1995.
JP Morgan Chase & Co (JPM)
Number 16 on our list, JP Morgan (JPM), is a classic example of a cyclical stock. One great investing lesson that cyclical stocks like this teach is the relationship between earnings and stock price over time. Although earnings fluctuate more in the short run, a longer-term trend moves up and down in correlation to earnings.
It should be of no surprise that a company as cyclical as JP Morgan (JPM) has also produced a volatile record of dividend income. Since dividends are paid out of earnings, the relationship of dividends to earnings is exposed. In the long run, JP Morgan did produce a credible level of total dividends; however, recent cuts were painful to those relying on the income.
3M Co. (MMM)
Number 17 on our list, 3M Co. (MMM), is another reasonably consistent grower of earnings that the market has typically applied a premium valuation to. Until 2007, stock price correlated more closely to earnings growth plus dividends than it did earnings alone.
3M has generated moderately above-average earnings growth which has rewarded shareholders moderately better than the market. Although the dividend growth rate has not been high, it has consistently increased. 3M shareholders have enjoyed moderately above-average dividend income and moderately above-average capital appreciation.
Boeing Co. (BA)
Number 18 on our list, Boeing Co. (BA), is a classical example of a cyclical stock. On the other hand, although growth has been very lumpy, it has slightly exceeded average. Once again we see the long-term relationship between earnings and stock price. As earnings go up and down, so does stock price.
Although Boeing (BA) does pay a dividend, due to the cyclical nature of its earnings growth, there have been historical droughts where the dividend has not grown. Over the long run, and in spite of a lot of earnings volatility, Boeing has produced only slightly above-average long-term shareholder returns.
General Electric Co. (GE)
Number 19 is General Electric (GE), once considered one of the bluest of all blue-chips. However, an aggressive commitment to financial services made them vulnerable to the financial-induced recession of 2008. Both price and earnings fell precipitously, and earnings have yet to fully recover.
When earnings collapsed, General Electric (GE) was forced to cut their dividend in half followed by a second cut in 2010. Consequently, a long record of dividend increases was broken. Although capital appreciation since 1995 was significantly below average, thanks to collapsing earnings, their total dividend record was still better than the S&P 500.
Coca-Cola Co. (KO)
Number 20 on our list, Coca-Cola Co. (KO), may be a surprise to many readers due to its great reputation as a Warren Buffett long-term holding. The earnings and price correlated graph on Coca-Cola offers a couple of important lessons:
First, it was one of the few stocks that was overvalued in 1995 which attributes greatly to its sitting at the bottom two-thirds of Dow 30 performance. Second, chronic significant overvaluation has contributed to stock price underperforming its business results. This is true even though it is the only company on this list that remains overvalued today.
Thanks to its consistent record of earnings growth, Coca-Cola (KO) has put together a steadily increasing stream of dividend growth. However, chronic overvaluation relegated their above-average operating history (earnings growth) to only producing average shareholder results.
So far after dissecting the 10 best performing of the Dow 30 stocks in part one of this series, we saw a lot of really strong companies producing consistent above-average operating results, followed by respectively similarly strong shareholder returns. Remember, that we chose a starting period, 1997, when the majority of stocks in general were fairly valued.
Now, with this article we are looking at the second 10 best performing Dow stocks, and we have continued to see a lot of good companies producing good shareholder returns. However, as we have gone deeper down the list, we have begun to see more examples of cyclical companies and companies that have not had as stellar a record of operating performance. Therefore, it stands to reason that these less successful businesses have also produced lower shareholder returns. Also note that Procter & Gamble (PG) and Coca-Cola (KO) were two examples of modest overvaluation in 1997, which reduced their long-term potential.
We believe it’s important for prospective investors to realize how different specific companies can perform regardless of the general state of the market. Furthermore, we feel it’s important to recognize that stronger operating results likewise produce better shareholder returns overtime, assuming valuation and price is aligned. Once again, this is true regardless of how the quote, unquote, stock market in general performs. It’s truly a market of individual companies.
As we move on to article three in this series, it should be of no surprise that the list of 10 worst performing members of the DJIA will simultaneously have the most cyclical, inconsistent and often slower earnings growth than we saw with the majority of the 20 best performers. Therefore, the moral of the story is straightforward; that it is a market of stocks, not a stock market. And as such, it’s imperative that the individual investor pay more attention to what they own specifically, than the attention they pay to what the market in general may or may not do in the future.
Disclosure: Long PG, HD at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.