By David Sterman
Virtually every blue-chip company has been focusing on a key issue for the past two years: Costs. Trimming expenses wherever possible was an absolute necessity during the scariest phases of the economic downturn. Those cuts, in turn, powered a remarkable expansion in profit margins and enabled many companies to record stunningly large profits.
Those days have passed and most large companies are expected to post slowing profit growth in 2011 and 2012. But a few companies aren't done just yet. Thanks to a combination of more expense reductions, solid top-line gains and/or improving gross-margin spreads, it's not hard to find companies that may boost profits by a combined 40% -- or more -- in the next two years. In fact, I've found five stocks in the Dow Jones Industrial Average that are shaping up to be earnings powerhouses for the next two years.
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The risk -- and opportunity -- in bank stocks
It's no coincidence that a pair of bank stocks made my list of the Dow's top five profit growers. (Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) would have also made the cut if they were members of the Dow.) The entire banking sector is still wheezing back to life, so the next few years could represent a return to traditional banking profit margins. Notably, analysts' forecasts anticipate subdued lending activity in 2011 and 2012 and, more than likely, bank profits will be meaningfully higher again in 2013 and beyond, if the economy is truly healthy (and the housing market gets out of the sickbed).
Therefore, the opportunity to buy shares of banks like Bank of America (NYSE:BAC) and JP Morgan (NYSE:JPM), while they trade for less than 10 times 2012 profits, looks quite appealing. Trouble is, some investors are convinced that we haven't seen the end of the mortgage crisis. They also fear banks may be subject to a great deal of litigation in 2011. So buying these bank stocks carries the risk that yet more funds will need to be set aside to cover liabilities. But it's important to stay focused on the long-term. Shares could well take a hit from these passing events, but the long-term outlook wouldn't be tarnished.
As a possible catalyst for the group, the end of the government's Troubled Asset Relief Program (TARP) restrictions is leading to talk of a reinstatement of dividends. When that happens, many large banks could offer up 3-4% dividend yields. And if you look at the current share prices in the context of what dividends may look like in 2013 or 2014, you may be looking at yields that are twice as high.
A fully-valued stock
Caterpillar's (NYSE:CAT) profit growth is expected to moderate in 2011 and take off again in 2012. That view anticipates a robust mining sector, a still-hot Chinese economy and a rebound in major U.S. construction projects. But are those factors really likely to play out? Recent economic data out of China, coupled with the steady surge in oil prices (which had been underway long before the Middle East erupted), could start to blunt global economic momentum.
Of all the stocks in the table above, I have the least confidence in earnings forecasts for Caterpillar. Moreover, shares already trade for around 12 times 2012 profits; historically speaking, that multiple is usually closer to eight or nine in the context of peak earnings. Even if Caterpillar sharply boosts profits again in 2013, and if you assume that 2013 is the peak, then shares are still fully valued.
The clear winner
There's one name in this group -- Alcoa (NYSE:AA) -- that continues to be underestimated by many investors. Shares of the aluminum giant have shed about 3% since I wrote about it again in late January.
As I noted then, profits are expected to grow strongly in 2011 and 2012, according to consensus forecasts, but I think they'll keep surging in 2013 and 2014. That's not because I think the global economy will be very hot by then. Instead, I think the industry dynamics will keep shifting in Alcoa's favor. The company is the most energy-efficient player in an energy-intensive industry, which could be a key advantage if energy prices remain high. Moreover, China has been throttling back output for a host of reasons, most notably around energy and environmental concerns. That should help Alcoa avoid the vicious pricing dynamics that hit in 2008 and 2009.
In addition to my bullish view on Alcoa, which I see rising up into the low- to mid-$20s by the time the cycle has played out, I can't help but notice the appeal of bank stocks. They have emerged from the crisis in strong shape, sport reasonable multiples and could be looking at a half-decade of sustained profit growth. The mortgage crisis-related risks are real, but perhaps casting too large a pall on this group.