S&P 500 10 Sectors
In the previous Part 1 of this two-part series, we looked at the first five of 10 companies in the various sectors of the S&P 500. In Part 2, we present the final five of 10 examples. As a reminder, the sectors were listed and picked at random and are not offered in any specific order. Our goal is to present one company from each of the 10 sectors that make up the S&P 500. Also, once again, note that even though the S&P 500 is a weighted index, this more concentrated group of only 10 companies is presented equally weighted.
For those of you that missed Part 1, the criteria we used to make each selection are repeated below:
In order to compile this list of above-average achievers in both capital appreciation and current dividend yield, each company had to meet certain criteria. First of all, each selection had to have historical earnings-per-share growth in excess of the S&P 500 index. Next, each selection had to have a current dividend yield that was higher than the 2.2% current yield for the S&P 500.
Since valuation is very important, each company had to have a current P/E ratio that was no more than 120% of the modern 17.5 historical normal S&P 500 P/E ratio. Also, because controlling risk was a major consideration, only companies with a market cap greater than $5 billion were included.
Sector Six: Energy
Figure 8A and 8B look at Chevron Corp. (CVX). This is the world's fourth-largest energy company on proven reserves of both oil and natural gas. Chevron Corp. currently trades at under 11 times earnings and offers a dividend yield of 3.9%.
Figure 8A CVX 11yr EPS Growth Correlated to Price
Figure 8B calculates the performance associated with Figure 8A. Clearly this leading integrated oil and gas producer has rewarded its shareholders quite well since calendar 2000 in contrast to the losses received from passive investors in the S&P 500.
Figure 8B CVX 11yr Dividend and Price Performance
Sector Seven: Healthcare
Figures 9A and 9B look at Johnson & Johnson (JNJ). The recent weakness in the stock market and a recent recall and marketing faux pas has caused Johnson & Johnson's stock price to trade at one of its lowest valuations in over 20 years. Notwithstanding these issues, Johnson & Johnson recently raised their dividend by 10.2%.
Figure 9A JNJ 11yr EPS Growth Correlated to Price
Figure 9B calculates the performance associated with Figure 9A. With share price starting out above JNJ’s earnings justified value and currently trading below its earnings justified level has masked the full measure of JNJ’s consistent operating performance. However, this quality company was still able to generate a positive rate of return coupled with a solid and growing dividend income stream.
Figure 9B JNJ 11yr Dividend and Price Performance
Sector Eight: Telecommunications
Figures 10A and 10B look at CenturyLink Inc. (CTL), formerly known as CenturyTel Inc. This rural focused telecom carrier is the fourth largest telephone company in the United States. Although historical earnings growth over 13% has been significantly above average, future growth is only expected to average a much more subdued rate of 3%.
Cognizant of this fact, CenturyLink has increased their payout ratio dramatically since calendar year 2008. Therefore, although they offer the highest current yield of the companies in this article, CenturyLink is also expected to have the lowest future rate of earnings growth.
Figure 10A CTL 11yr EPS Growth Correlated to Price
Figure 10B calculates the performance associated with Figure 10A. An abnormally high beginning valuation and the subsequently current low valuation based on reduced growth expectations, has caused this once fast grower to underperform the S&P 500. We found this to be the most difficult industry to find a suitable selection in. Legacy telecom companies have questionable future fundamentals, and the more modern wireless companies do not meet our dividend requirements.
Figure 10B CTL 11yr Dividend and Price Performance
Sector Nine: Utilities
Figures 11A and 11B look at NextEra Energy, Inc. (FPL-OLD), formally known as Florida Power & Light. The new name describes a strategy that many electric utilities are utilizing in order to diversify away from their regulated businesses.
In order to grow going forward, utilities need to find growth opportunities that are not controlled by regulation. Since calendar year 2000, NextEra Energy, Inc. has grown earnings at a compounded rate over 7%; current estimates expect earnings growth over the next five years to be slightly above 6%.
Figure 11A FPL 11yr EPS Growth Correlated to Price
Figure 11B calculates the performance associated with Figure 11A. Since NextEra Energy, Inc. was undervalued at both the beginning and the end of this time period, shareholder returns correlate very closely to operating earnings growth. Additionally, their dividend has increased at a rate that is consistent with earnings growth. When valuations are aligned, shareholder returns will logically be a reflection of the companies compounded annual growth rate in earnings per share.
Figure 11B FPL 11yr Dividend and Price Performance
Sector 10: Information Technology
Figure 12A and 12B look at Automatic Data Processing (ADP), the 10th and final company in our series. Automatic Data Processing is the nation’s largest payroll and tax filing processor. From Figure 11A it is very clear that Automatic Data Processing was excessively overvalued in calendar year 2000.
However, until only recently, it is clear that the stock market has generally capitalized this extremely high quality company at a premium level. The current dividend yield is in line with a ten-year T-bond and about a third higher than the average company in the S&P 500.
Figure 12A ADP 11yr EPS Growth Correlated to Price
Figure 12B calculates the performance associated with Figure 12A. Due to excessive overvaluation in calendar 2000, above-average earnings growth was not able to overcome the high valuation. Consequently, Automatic Data Processing produced a loss for its shareholders. However, current consensus estimates for five-year future growth are in excess of 12% which augurs very well for future shareholder returns.
This assumes that the market will assess a high valuation for this blue-chip company in the future as it has in the past. Also, the Information Technology Sector has long been thought of as a growth sector rather than a dividend income play. But as the industry matures, that is changing, as there are currently several other companies in this sector with dividend yield greater than 3%.
Figure 12B ADP 11yr Dividend and Price Performance
There are several principles and lessons that we are hopeful this article illuminates. One of the great advantages of our EDMP, Inc. F.A.S.T. Graphs™ is the ability to receive an instant perspective of how well a company has been historically managed. When valuations are in line with earnings justified levels, then performance tends to mirror and or correlate very closely to the rate of change of earnings growth.
Prospective investors can have a reasonably accurate estimation of the rate of return a company is capable of generating based on its historical earnings growth record. On the other hand, investing is about looking forward instead of looking into the rearview mirror. Therefore, forecasting future earnings is the key to successful future results.
Valuation Based On Growth Rate
Another valuable feature of our EDMP, Inc. F.A.S.T. Graphs™ is assisting investors in making a prudent decision on knowing when to buy. Generally speaking, risk and rate of return tend to be closely related, i.e., the greater the risk the higher the return potential should be; the lower the risk the lower the return potential should be.
Therefore, our EDMP, Inc. F.A.S.T. Graphs™ offers three iterations of the earnings justified valuation level based on rates of growth and risk. Typically, faster growers tend to command higher valuations (PE ratios) and are therefore usually considered riskier. Our research has identified three key ranges of growth that define value based on earnings growth rates.
Companies growing at 15% a year or better will calculate a PEG ratio (Price Equal to Growth rate) orange line with white triangles, earnings justified valuation line. Of the ten companies in this series only HCBK and CVX graphs are listed as a PEG ratio multiple.
Companies growing at 5% or less will calculate an orange line with white triangles earnings justified value line, utilizing Ben Graham's classic formula for valuing a company. These slow growers will be marked with an orange GDF followed by a number which equals the fair value PE ratio. None of the examples in this article were GDF companies.
Finally, in the middle are companies growing between 10% and 15% per annum. These companies are typically more mature and pay a dividend. The orange line with white triangles (earnings justified valuation line), in these examples represents an EDMP modified version of the previous two graph types. These graphs will be marked with an orange GDF-EDMP followed by a number representing the fair valuation for this group of companies. The majority of the examples in this article are GDF-EDMP graph types.
Risk vs. Reward
Once again, as a general rule the faster the growth, the higher the risk. Therefore, the risk an investor is willing to assume will be a key factor in which of the three groups he or she should choose from. The most important points to understand here are that when taking lower risk one must also be willing to accept a lower rate of return.
Also, the rate of return one should intelligently expect from an investment in any company will correlate to the rate of change of earnings growth the company is capable of achieving. History clearly establishes this fact, and therefore, we see the evidence as undeniable and conclusive, assuming of course, that valuations are in line with earnings justified levels when purchases are made.
The Key: Forecasting the Future
Additionally, the lesson that making investment judgments based purely on current metrics can often prove misleading. In the ten examples cited above, future returns based solely on current yield does not necessarily imply good returns in the future. The quality of the company and the consistency and dynamic of its operating history can be very enlightening and important information to know.
Even though EDMP, Inc. F.A.S.T. Graphs™ provide a vital fundamental perspective of a company and its business, they are no substitute for comprehensive and thorough research. Companies and industries are subject to change and no chart or graph is capable of telling the future. Only hard work and diligence are capable of assisting in that task.
These ten selections, one from each sector of the S&P 500, have outperformed the S&P 500 historically. If an investor expects to outperform a benchmark index like the S&P 500 in the future, it's imperative that rational thought and behavior be applied to the task.
Common sense would dictate that above-average companies like the ten covered here that have produced above-average results, are a good place to begin looking for above-average future returns. The idea behind this article was to provide an example of how this task could be accomplished in a sound and prudent manner.
A well thought-out and executed buy-and-hold strategy is still an effective and viable approach as evidenced by the ten companies reviewed above. However, there are two keys to success. First, an achievable forecast for above-average future earnings growth is essential, and second, the stock must be trading at or below its earning justified level when purchased.
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.
Disclosure: Long: CVX, JNJ, FPL, ADP at the time of writing.