High-Quality Plays for a Post-QE2 World

Includes: EXC, GD, MSFT, SNY, TOT
by: John P. Reese

June is here, and with it will come a number of things that should make just about everyone happy: warmer weather, the end of school, and the official start of summer, to name just a few.

For investors, however, June brings with it a giant question mark: the end of the liquidity jolt known as "QE2," the Federal Reserve's second round of quantitative easing. One of the results -- or, some might say, intentions -- of this huge stimulative policy was a surge in equities. And the biggest beneficiaries appears to have been smaller, speculative stocks. It seems, not surprisingly, that by deluging financial markets with cash, the Fed has encouraged risk-taking in equity markets.

An interesting byproduct of that is that the current bull run has yet to switch gears. In the typical bull, MarketWatch's Mark Hulbert recently noted, lower-quality "junk"-type stocks lead the market initially, but then give way to higher-quality stocks by the time the bull is a year old, if not earlier. We're now more than two years into this bull market, and large, quality stocks remain quite cheap compared to smaller, lower-quality plays.

Will the end of QE2 be the impetus for investors to finally give undervalued blue chips their due? Logically, it makes sense that that would happen, though so many factors play on the market at any given time that it's far from a certainty that QE2's end will mean an immediate surge in blue chips. But to me the bottom line is that plenty of blue chips remain very undervalued right now, and, whether the end of QE2 provides the spark or not, they aren't likely to stay undervalued forever. Disciplined, long-term investors would be wise to give them a good, long look.

Here are a handful of blue chips selling on the cheap that my Guru Strategies -- each of which is based on the approach of a different Wall Street great -- are particularly high on right now.

Microsoft Corporation (NASDAQ:MSFT): Sure, Microsoft isn't growing as fast as it used to. But Bill Gates' software giant ($202 billion market cap) is still putting up solid growth numbers, and, perhaps more importantly, its shares are looking quite cheap these days.

That cheapness is a big reason my John Neff-inspired model likes Microsoft. Neff, who put up one of the greatest track records of all time while managing the Windsor Fund, looked for stocks with P/Es that were 40% to 60% of the market average (a P/E that was too low could signal the stock was a dog). Microsoft shares sell for 9.5 times trailing 12-month earnings, which makes the grade. Neff also used the total return/PE ratio, which adds a stock's growth rate and yield and divides it by its P/E ratio. Microsoft's is 1.77, which more than doubles its industry average (0.67) and more than triples the market average (0.57).

The model I base on the writings of another mutual fund legend, Peter Lynch, also gives Microsoft high marks. It considers the stock a steady "stalwart" because of its high annual sales ($69 billion) and moderate 14.1% long-term earnings per share growth rate (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate). Lynch famously used the P/E/Growth ratio to find stocks with good growth and cheap shares, adjusting the "Growth" part of the equation for dividend yield in the case of big stalwarts. Yield-adjusted P/E/Gs below 1.0 are acceptable to this model; Microsoft's comes in at 0.57, a great sign.

Exelon Corporation (NYSE:EXC): Chicago-based Exelon's recent acquisition of Constellation Energy makes it the largest electricity marketer in the U.S. It is also the U.S.'s largest nuclear power producer, which may seem like reason to avoid it, given the nuclear backlash the world has seen since the tragedy in Japan. But at this point the market is already factoring in anti-nuclear sentiment, and my David Dreman-inspired model thinks Exelon's a good contrarian bet.

The Dreman approach considers Exelon ($27 billion market cap) a contrarian play because both its price/cash flow and price/dividend ratios fall into the market's bottom 20%. Sometimes, however, a stock is cheap because everyone knows it's a dog, so the Dreman-based approach also looks at a variety of financial and fundamental tests. It likes Exelon's solid 18.1% return on equity, 20.9% pre-tax profit margins, and 97.4% debt/equity ratio, which is low for a utility (the industry average is 124.8%).

My Lynch-based model also likes Exelon. It considers the firm a "stalwart" because of its high annual sales ($19.2 billion) and moderate 11.5% long-term EPS growth rate, and likes Exelon's 0.67 yield-adjusted P/E/G ratio.

Sanofi-Aventis SA (NYSE:SNY): Headquartered in Paris with operations in more than 100 countries, this big pharma firm gets approval from three of my models, including the approach I base on the writings of the late, great Benjamin Graham.

The Graham-based model looks for financially sound companies with cheap shares. It likes to see current ratios of at least 2.0 and more net current assets than long-term debt, and Sanofi fits the bill. Its current ratio is 2.3, and it has more than twice as much net current assets ($21.8 billion) as long-term debt ($9.9 billion). Its shares are also cheap, trading for a very reasonable 13.8 times trailing 12-month earnings and 1.32 times book value.

My James O'Shaughnessy-based value model also likes Sanofi. It targets large firms with strong cash flows and high dividend yields. Sanofi's size ($100 billion market cap), $4.13in cash flow per share (vs. the market mean of $1.27), and strong 4.8% yield all earn high marks.

My Lynch-based model, meanwhile, considers Sanofi a "stalwart" because of its $46 billion in annual sales and 12.9% long-term EPS growth rate, and likes Sanofi's 0.78yield-adjusted P/E/G ratio.

Total S.A. (NYSE:TOT): This France-based integrated oil and gas giant has operations in over 130 countries, and a market cap of more than $131 billion. It's a favorite of my O'Shaughnessy-based value model, thanks to its size, outstanding cash flow ($11.96 per share), and stellar dividend yield (5.6%).

Total also gets approval from my Dreman-based model, which considers it a contrarian play because its P/E, price/cash flow ratio, and price/dividend ratio all fall into the market's bottom 20%. The model thinks that because of its strong fundamentals and financials -- 19.9% return on equity, 16.1% pre-tax profit margins, and that 5.6% yield -- the stock merits more attention from Wall Street.

General Dynamics (NYSE:GD): One of the largest aerospace & defense companies in the world, this Virginia-based firm has taken in more than $32 billion in sales over the past 12 months. The $26-billion-market-cap company gets approval from the strategy I base on the writings of hedge fund guru Joel Greenblatt. In his "Little Book that Beats the Market," Greenblatt unveiled a remarkably simple approach that beat the market using just two variables: earnings yield and return on capital. With a 14.7% earnings yield and 55% return on capital, General Dynamics impresses on both fronts.

GD also gets approval from my Lynch-based model, which considers it a stalwart because of its high sales and 12.2% long-term EPS growth rate. The Lynch model likes the stock's 0.68 yield-adjusted P/E/G ratio and manageable 23.1% debt/equity ratio.

Disclosure: I am long MSFT, EXC, SNY, TOT.