When people refer to what the stock market is doing, they are more often than not speaking about the Dow Jones industrial average. This leading index of 30 high-profile stocks serves as a proxy for the overall health of both the economy and the stock market. We have long held that thinking in generalities runs the risk of causing people to paint all common stocks with the same broad brush.
When dealing with averages like the Dow, the numbers we associate with it represent an average of the whole group. It's important to remember that the individual companies or components can have materially different results, and even attributes, than what we glean from the average itself. Therefore, if the average (the index) has done poorly, people tend to associate poor performance with all equities. However, in truth, there are major differences from one company to the next.
Our research confirms that generalities regarding dividends and returns are mere prejudices. Even though it takes more effort to conduct rigorous research than statistics alone can provide, we believe the insights and the rewards are ultimately worth it. F.A.S.T. Graphs™, our powerful "tool to think with," was designed to easily facilitate a more extensive research process. Since the Dow Jones industrial average only contains 30 stocks, it's a relatively easy and straightforward process to dissect this index, which is commonly used as a proxy for the market.
The 10 Best Performers of the Dow 30 Since 1995
In this Part 1 of this 3-part series on Dissecting the Dow, we will look at the Top 10 best-performing of the 30 Dow stocks since 1995 (16-plus years) through the lens of our fundamentals-based research tool. We chose this time frame, as you will soon see, for an important reason. The year 1995 was a period where most companies in the Dow were reasonably valued, and this date was just prior to the so-called "irrational exuberance period" that ended in the spring of 2000. For a clearer perspective on returns, the performance charts compare the company's performance to the S&P 500.
Interpreting the Earnings- and Price-Correlated Graphs
The ability to look deeper into specific stock valuations beyond a mere market average, is one of many reasons that motivated us to develop our graphs. We wanted specific research, rather than relying on often misleading statistical references. Our graphs allow us to evaluate the specific sources of long-term investor returns on over 17,000 symbols.
We use three formulas for determining valuation: For companies growing earnings at 15% or better, the graphs utilize a PEG ratio (P/E equal to Earnings Growth Rate) calculation for value (marked PEG in orange ink). For companies growing earnings at 5% or less, the graphs use Ben Graham’s formula for value. These graphs (marked GDF in orange ink) are followed by the number that represents the value P/E ratio. For companies growing earnings between 5% and 15%, the graphs use a modified version of the first two (marked in orange ink GDF-EDMP) then again followed by the number representing the calculated value PE ratio.
Therefore, the orange line with white triangles represents fair value for each respective company. In other words, when the black price line touches the orange earnings justified valuation line, the stock is theoretically in value. Prices above the orange fair value line indicate overvaluation and prices below the orange fair value line indicate undervaluation.
Keep in mind that fair value does not necessarily imply high or good returns. Slow earnings growers, even when bought in value, will, all other things being equal, generate lower returns than faster-growing companies bought in value. However, and most importantly, notice how price and earnings correlate on each graph over time (i.e. the trend line movement of price follows earnings).
A Snapshot Summary of Valuation
The following table lists the 10 best performing Dow stocks in order of highest to lowest performance since calendar year 1995. For each company the table shows the annualized total return, dividend yield, current price earnings ratio, and for a first perspective on valuation, the normal P/E ratio that the market has historically applied to the company.
For a second perspective on valuation, the table is color-coded depicting each company's current valuation. When a stock is considered fairly valued, it means that its price is at or near its orange earnings justified value line, and therefore it's colored orange. When a stock is considered undervalued, it means that its price sits below the orange earnings justified value line, thereby falling into the green shaded earnings area, and it's colored green. If the stock price is above the orange earnings justified value line, it's considered overvalued, and color-coded red, implying potential danger.
The table shows that one company, International Business Machines (NYSE:IBM), is fairly valued; one company, McDonald's Corp. (NYSE:MCD), is considered overvalued (but only modestly so); and the remaining eight are considered undervalued. Consequently, the vast majority of the 10 best performing Dow Jones stocks appear to be excellent candidates for investment consideration at today's low valuations.
The Best Businesses Produced the Best Returns
As you will see, each of the following 10 best performing Dow Jones stocks produced operating earnings growth that was significantly greater than the 6.7% earnings growth of the S&P 500. And, even though 8 out of 10 of these excellent blue chip businesses are currently undervalued, they all produced double-digit returns for their shareholders since calendar year 1995. This is in stark contrast to the S&P 500's 7.2% return and significantly above the average of the Dow Jones industrial average itself, which each is a part of.
It's also important to reiterate that the year 1995 was chosen because this was the most recent year where sound valuation existed for most companies and indices. Consequently, one of the most important variables of sound investing was close to being equally applied in each example. Therefore, investment results are more fairly measured and correlate more closely to business results. This is the essence of Ben Graham's famous market metaphor, where he states: "In the short run the market is a voting machine, but in the long run it's a weighing machine."
It has long been, and remains, our contention that the only fair way to evaluate the merits of common stock investing is when you measure them when fair value is evident at the beginning of the period. Otherwise, valuation bias can distort not only the results, but also the reviewer's attitude and perspective towards the virtues of investing in common stocks.
As an aside, we believe all the nonsense about the lost decade is mostly attributed to ridiculous overvaluation and not the common stock asset class itself. Our motto is: "Measuring performance without simultaneously measuring valuation is a job half done."
Pictures of the Dow Top 10 Performers Since 1995
As you review these Top 10 performing DJIA stocks, there are several important characteristics that we would like to draw your attention to. First of all, you should notice that each of these companies produced operating results that were higher than the 6.7% average of the S&P 500. Since they were all reasonably valued in 1995, it is also logical that they were the best performers of the 30 DJIA constituents. Although a few of these companies will show occasional bouts of cyclicality, you should also notice that the majority of these Top 10 holdings produced reasonably steady and consistent earnings growth.
It's also interesting to point out that although each of these Top 10 companies pays a dividend, the actual rate of dividend varies greatly. Moreover, the lowest dividend paying companies in this group sit at the top of the list in terms of best performance. IBM is number one with the second lowest dividend yield of the Top 10, and Cisco sits at number three with the lowest dividend yield of the Top 10. On the other hand, when reviewing the performance results, the benefits of dividends are clearly evident. Also, you should notice that the longevity with which the company has paid a dividend is a major factor.
The earnings and price relationship on each of these companies is also very revealing and offers valuable investing insights. By reviewing these earnings and price correlated graphics one-by-one, a sense of the importance of operating results (earnings growth) crystallizes in the mind. Furthermore, the undeniable reality that the market will misprice a stock from time to time is evident, and so is the reality that the stock price will inevitably move back to fair value. As Warren Buffett once so eloquently put it: "The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable."
This study, and the two that will follow in subsequent articles, is offered as a historical review based on fundamentals starting out fairly valued. Consequently, the most important investing insights of evaluating stocks based on business results will be vividly revealed. A very brief commentary will be offered on each selection for clarification.
International Business Machines Corp.
Since 1995 IBM was the best performer of the 30 Dow Jones industrial stocks. As you can see, this was a time when IBM generated a very consistent record of earnings growth of 15% per annum. The long-term correlation between earnings (the orange line) and stock prices (the black line) is remarkably strong. On the rare occasions where price deviated from earnings, it soon returned to its justified level.
Although IBM paid a modest dividend, the dividend increase each year closely correlated to this blue-chip company’s earnings growth. But since stock price started out in value and ended in value, shareholder capital appreciation (closing annualized ROR) perfectly synchronizes with the company's earnings growth rate of 15% per annum.
United Technologies Corp. (NYSE:UTX)
Number two on the list, United Technologies Corp., shows a very closely correlated earnings and price relationship. When price fell dramatically more than earnings did during the great recession of 2008, it rapidly returned to its true worth.
Similar to IBM, United Technologies offered its shareholders an annually increasing dividend. However, a higher initial yield led to a larger level of cumulative total cash dividends paid. This compensated shareholders for the slightly lower earnings growth rate of 14.1%. But once again we find an example of earnings growth rate and shareholder capital appreciation being almost perfectly aligned.
Cisco Systems Inc. (NASDAQ:CSCO)
Number three on our Top 10 list is Cisco Systems Inc., and although it has one of the highest earnings growth rates of the entire group at 19.2%, a significantly discounted current valuation and only a recent institution of a dividend policy dropped it down to number three on our list.
Even with a current P/E ratio significantly below its earnings growth rate, Cisco Systems Inc. was still able to generate over 14% in capital appreciation for its shareholders. Since it only paid a dividend for one year, its contribution to total return was minimal.
Microsoft Corp (NASDAQ:MSFT)
Number four on our list is Microsoft, which represents an example of a growth stock morphing into a dividend growth stock. Microsoft grew earnings at 20% per annum, however, there was a modest amount of cyclicality along the way starting with the recession of 2001. Microsoft’s stock price became extremely disconnected from its earnings justified level (overvalued) during the irrational exuberant period starting in 1995 and ending in the spring of 2000. This extreme overvaluation led to very poor price performance for many years even though earnings remained solid.
From 1995 to 2002 Microsoft was a pure growth stock. In calendar year 2003 they paid their first dividend, and in calendar year 2005 they paid a special one-time $3 dividend (the spike in the blue shaded area). However, excluding the special dividend, Microsoft has raised its dividend every year since starting one. Even though the stock appears to be undervalued today, shareholders have earned a total annualized rate of return of 14% per annum with dividends contributing greatly to the total.
Caterpillar Inc. (NYSE:CAT)
Number five on our list, Caterpillar Inc., gives us our first true glimpse of a cyclical stock. Nevertheless, in spite of a record of cyclical earnings performance, total earnings growth still averaged just less than 11% per annum. The real interesting takeaway here is how stock price closely tracks and correlates with the cyclical earnings growth.
Notwithstanding cyclical earnings growth, Caterpillar has increased their dividend every year since 1995. Shareholder capital appreciation of 11.5% closely correlates to its earnings growth and dividends bring the total annualized rate of return to over 12% per annum.
McDonalds Corp. comes in at sixth place on our Top 10 list, and similar to Microsoft, has morphed from more of a growth stock into a dividend growth and income stock in recent years. Although the company remained very profitable through the recession of 2001, earnings did flatten for a few years before they began accelerating again.
Although McDonald's started out with a very modest yield in 1995, their dividend growth expanded with earnings and really kicked in after their payout ratio more than doubled in calendar year 2002. Consequently, McDonald's growth yield (yield on cost) expanded significantly since 1995.
Intel Corp (NASDAQ:INTC)
Intel, the seventh best performer on our list, represents another example of a company that could loosely be classified as a cyclical growth stock that has morphed into a growth and income stock. Earnings growth since calendar year 1995 has averaged 11.7% per year, but the road has been bumpy along the way. Also, notice how disconnected stock price became during the irrational exuberant period before reverting to the mean.
Even though Intel has paid a dividend since 1995, you will notice from the historical chart above that the blue shaded area is virtually invisible due to a low single digit payout ratio. However, in calendar year 2001, Intel dramatically increased its payout ratio turning Intel into a legitimate growth and income holding. Total shareholder returns including dividends (dividends are assumed paid and spent, not reinvested) have averaged over 11% per annum.
Exxon Mobil Corp (NYSE:XOM)
Exxon Mobil Corp comes in at number eight on the Top 10 list, displaying a high earnings growth rate of 13.5% with occasionally bouts of cyclicality along the way. This may partially explain why the correlation between price and earnings of major energy producers is not as pure as some of the other examples we looked at. The exposure to commodity prices would be another reason.
The original yield on cost of 4.8% in calendar year 1995 was one of the highest of this group. Therefore, shareholders have enjoyed a very attractive stream of dividend income over this time frame. Low current valuation has caused shareholder capital appreciation to be less than earnings growth. However, its generous dividend stream has pushed total shareholder returns to over 11% per annum.
Chevron Corp (NYSE:CVX)
Number nine on our list, Chevron Corp has produced an earnings record that is very similar in perspective with Exxon, as they both relate to oil prices. Although Chevron’s 14.9% earnings growth rate is actually higher than the record Exxon achieved, the market is currently valuing it at a steeper discounted PE ratio below 8.
Chevron’s record of dividend payments and capital appreciation is understandably similar to what Exxon produced for its shareholders. Even with today’s unjustifiably low price-earnings ratio, in our opinion, Chevron has still been able to generate double-digit returns for its shareholders since 1995.
Johnson & Johnson (NYSE:JNJ)
Our final Top 10 DJIA constituent is Johnson & Johnson. Although this blue chip started out reasonably valued in 1995, the market had generally overvalued their shares relative to earnings until the great recession of 2008. However, Johnson & Johnson is currently valued at its lowest valuation since 1995. This company, with its AAA credit rating (currently higher than the US government) offers a current dividend yield higher than even a 30-year Treasury bond.
This recession-resistant blue chip has raised its dividend every year. This impeccable dividend record contributed greatly to shareholders earning a double-digit rate of return over this time period.
This article covering the Top 10 best performing Dow 30 stocks is actually the second in a four-part series focusing on current stock market valuation. (The first article dealt with the S&P 500.) An underlying theme of this series of articles on valuation deals with the reality that it's really a market of stocks, not a stock market. Obviously, it's not practical to try and show every one of the 500 companies in the S&P 500. On the other hand, since there are only 30 stocks in the DJIA, this task becomes feasible.
A second important theme of this series of articles is to illustrate that there are many extremely high-quality companies that are trading at very attractive valuations today. We are hopeful that by looking at each of the 30 Dow Jones stocks individually, the reader will be given a much clearer perspective of the potential benefits of investing in high-quality stocks, especially when valuation is sound. However, we also hope to clearly illustrate how important it is to be selective and to not paint all stocks with the same broad brush.
This article looked at the best of the Dow Jones. So far 8 out of 10 of the best DJIA stocks look undervalued, one looks fairly valued and only one, MCD, looks slightly overvalued. Our next article will cover the second best 10 stocks of the DJIA. The top stocks on that list will look a great deal like many of the stocks in this group. However, towards the end of this second group of 10 you will begin to see stark evidence of companies with very different operating records than we have seen thus far. When this occurs, the realities of how and where shareholder returns come from will become much clearer.
Disclosure: I am long UTX, CSCO, MSFT, MCD, INTC, JNJ at the time of writing.
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.