Stock of the Week
July 4th 2016
Reviewing our assessment of 2106, so far things are going as expected. Wall Street analysts weren't predicting much from 2016. On average analysts were expecting 5% to 7% returns if that and so far the markets are obliging with nearly 3% moves for the Dow and S&P 500. The Russell 2000 is only up a percent while the Nasdaq and techs and biotechs in general are in the red for the year. After a negative 2015, the good news is only twice in the last 25 years has the S&P 500 followed up a negative year with another negative year. Both times were 2001 and 2002 when the S&P 500 was working off the tech bubble of the 90s when the S&P 500 PE rose to 25 times earnings. Currently, the S&P 500 is trading for 17 earnings, but earnings should get a boost in the second half of the year thanks to the surprise bounce in the price of crude oil. This is also an election year and it's been a long time since we've had negative election year. The biggest concern for the second half of the year and 2017 isn't the Brexit vote, but if the Brexit vote can cause a further slowdown in global growth. Interest rates around the world continue to move toward zero and even dropped below zero in the case of Japan. Stagnation seems to be gripping more and more countries worldwide.
If stagnation and lower for longer interest rates are here to stay, then income and dividend paying stocks should remain in favor. Currently the three best dividend yielding sectors Telecom, Utilities, and Consumer Staples are the three top performers in 2016. As we started the year, we indicated the safe bet would be blue chip dividend paying stocks. While the US economy has struggled to accelerate, many of our US S&P 500 companies continue to churn out strong cash flow since the financial crisis. Thanks to strong cash flow, companies continue to raise dividends, buy back stock and pare down debt or reduce their debt payments thanks to lower interest rates. Our telecom picks performed very well with AT&T (T) up 25% and Verizon (VZ) up 22% not including the hefty dividends of 4% and 5% respectively. Similar yielding featured stocks, Ford (F) and GM (GM) have not performed as well still negative for the year. If we can get any economic rebound in the second half of the year, we may see a reversal in fortunes of these four stocks.
As mentioned, energy has been the surprise sector so far in 2016. We highlighted three energy stocks Conoco (COP) yielding 6.2%, Chevron (CVX) yielding 4.7%, and Exxon (XOM) yielding 3.7%. Each made statements they would do whatever it takes to maintain their dividends. It didn't take Conoco but about a month or two to change their mind slashing their dividend. Conoco has paid the price with a negative return year to date and a modest current dividend yield of 2.3%. After their dividend cut, fortunes change for the broad sector as oil has rebound dramatically. On the other hand, the bigger brethren, have maintained their dividends. Chevron was able to produce a 15% year to date return while Exxon has produced a 20% return not including the dividends. Going forward, the oil stocks may have to consolidate their gains, but it's a good sign that oil has rebounded.
My favorite segment of the dividend paying stocks remains not the high yielding ones, but the stocks yielding 2% to 3% with above average capital appreciation potential. Boeing (BA) remains one of my favorite stocks in this category. The stock has gone nowhere for some time down 7% year to date, however the fundamentals continue to improve long term. Short term the company has had to shift plane production and investors remain concerned about a slowdown even though the company has a 5-year backlog in orders. Thanks to improving profit margins, Boeing's cash flow has improved from $6 billion to $9 billion and should continue to grow to possibly $12 billion in the coming years. Boeing has made a commitment of returning 100% of their cash flow to shareholders and a with a market cap of only $83 billion, Boeings is attractively priced at 13.5 times earnings with a dividend yield of 3.3%. Once investors gain more confidence in Boeing's fundamentals and start looking toward 2018 earnings, Boeing's stock should have 25% to 50% upside. A similar Industrial with good upside is United Tech (UTX) trading for 14.5 times earnings and a 2.5% dividend yield. An out of favor Industrial, Caterpillar (CAT) has long term potential. The stock is up over 10% yield to date, but down 30% in the last two years as investors wait for the fundamentals to improve. Currently the stock trade 21 times reduced earnings, hopefully trough earnings, but sports a hefty 4% dividend yield. Good income stocks for investors with a long term focus.
Besides the Industrials, one of the cheapest sectors, and the worst performing sector year to date, is the financials. The financials do like a rising interest rate environment, and with interest rates moving toward zero worldwide, it is getting tougher for the banks to make money, but yet they are making money and lots of it. The two big banks, Wells Fargo (WFC) and JPMorgan (JPM) are negative for the year, but both yield over 3%, trade for 10 times earnings and trade below book value. Both passed the recent government stress tests which means they'll be able to hike their dividends and buy back more stock in the future and continue to improve earnings per share. Warren Buffett agrees with my valuation assessment. He recently approached the government to request permission to hike his holding in Wells Fargo to more than 10% of the outstanding shares. Investment banks, Morgan Stanley (MS) and Goldman Sachs (GS) also passed their recent stress tests. Both stocks yield around 2%, trade for less than book value and less than 10 times earnings. If both stocks could trade for just 11 times earnings, then both stocks would appreciate 25% or more. Good risk reward going forward.
The healthcare and biotechs are a study in contrasts. Gilead and Amgen have gone nowhere to start 2016, but Pfizer, Merck, and Bristol Myers are all outperforming the major averages. Pfizer and Merck are up 10% year to date and still sport dividend yields over 3%. In the biotech space, Amgen (AMGN) has long term appeal trading for 12 times earnings and yielding 2.5%. Celgene (CELG) provides no dividend, but has recently been written up in Barron's as one of the best growth prospects in the biotech sector. Currently the stock trades for 13 times earnings yet sales and earnings are expected to grow 18% or more in the next year. If the PE can expand to 18 or 20, the stock has 25% to 40% upside without incorporating any further earnings revisions to the upside.
My home run stock, Wynn Resort (WYNN) is living up to its billing. The stock is up 33% after running up as much as 52%. Wynn is not conservative and the stock is very volatile, but provides attractive valuation for the long term. Basically, Wynn is a $9.3 billion company that just spent $4 billion on a new casino in Macau, China to open on August 22nd. Wynn is a play on the rebound in China and the Chinese middle class which is expected to double in the next 5 years. Once the new casino opens and the Chinese economy rebounds, Wynn's earnings should easily double which means the stock could easily double or even triple from current levels in the coming years.
That's it for now. Hopefully, the second half of the year will produce better economic growth around the world. The surprise rebound in oil may be an indication of that. However, if the Brexit vote and the UK leaving the EU causes further deterioration in growth across the pond we may remain in this muddled stagnated economy with modest capital returns for the stock markets.