Friday, March 23, 2007

Fab Five

Sometimes when we are diligently searching for wonderful ideas, we miss what is right in front of our noses. There are times when the best investment ideas are not found by digging through the 10-Ks of obscure pinksheet companies but rather are found right out in the open among the largest, most prominant companies. This may be one of those times.

Which five Dow stocks have negative returns over the last year as well as the last five years?

Ticker Full Name PE 10-y Ann. Growth Div. Yield Div. Growth
JNJ Johnson & Johnson 16.2 13% 2.5% 16.5
PFE Pfizer 10.0 9% 4.5% 14.4
WMT Wal-Mart 17.8 17% 1.8% 24.6
AIG AIG 12.7 12% 1.0% 24.7
HD Home Depot 13.7 21% 2.3% 23.7
Average 14.1 14.4% 2.42% 20.8

All five are considered to be among the highest quality companies in the world (nearly all Dow stocks are). Companies like this are what the financial writer George Goodman (aka "Adam Smith") has termed super-currency. They are more reliable than any currency, resistant to inflation and accepted everywhere as a store of value. When the world is caught up in panic over the next crisis, these kind of stocks hold up the best. JNJ PFE and AIG are practically recession proof and this five stock portfolio is fairly well diversified across a few major industries: health care, retail and insurance/financials.

Their growing dividends are very attractive to income investors (i.e. the massive wave of retiring boomers) and their recognition factor will be attractive to all the new foreign investors (like in Asia) looking for an alternative to their less established stocks and overall turbulent markets. They have little real downside risk from here. All should have a sustainable long term growth rate above 10% (for at least 15 years). All of these are suffering from the fact that they were incredibly over-valued when the 90's bull market came to an end.

What would the expected return be over the next ten years for this five stock portfolio?

Let's assume the average growth rate slows from the 10 year average of 14.4% to G=12.0%. The average dividend yield is 2.42%. We will assume that dividend grows at the same rate as earnings (despite the fact that dividends are growing a lot faster at 20.8%). The annual return will then be R=G+Y = 14.42% assuming that the valuations don't change. That is a pretty good return for no-hastle investing. If the valuation grows from the average PE of 14.1 to 17.0. This might be expected as they become more favored. This is ΔV =20% expansion of valuation. If it comes over ten years that adds another 2% to the annual return. For the mathematically challenged, the annual change is ΔVA = [1+&DeltaV]^(1/N) -1 where N is the number of years it takes to expand.

This gives us a ten-year expected return of R=G + Y + ΔVA = 16.4%. If this valuation expansion happens faster; say in three years (not unrealistic) , then the return is R(3-year) = 21% which would be spectacular. You can fiddle with the numbers and get different results either better or worse. However, It seems almost impossible (short of a depression happening) that this portfolio wouldn't return at least 9% over 5-10 year times scales. Since dividends are growing at 20.8% and these stocks are buying back shares, it would not be surprising for these stocks to return more like 25%.

I own the first three JNJ PFE WMT and may soon buy the other two. I have a few other good investing ideas but feel that there aren't too many good places to invest in this market. In the meantime I will put money into the Fab Five and keep some cash around in case things change.