The 30 components of the Dow Jones Industrial Average (DJIA) have changed quite a bit over the years. Many once great companies, such as Eastman Kodak (EK) and General Motors (GM), were dropped from the index and later became bankrupt. A sizable number of companies still in the index, such as Bank of America (BAC) and Alcoa (AA), are only shadows of their former selves. For the conservative defensive investor, picking blue chip stocks that are best positioned to deliver satisfactory returns over the long run (20 years or more) is more important than ever, given the unsuitability of bonds as an alternative investment today (see 'Why Bonds are No Longer Sound Investments'). Here are some helpful criteria to distinguish the high quality stocks from the mediocre ones within the DJIA components.
1. No Earnings-Per-Share losses over the past 10 years. I consider this the most important criterion of all, because firms that are able to remain profitable over the past ten years, which should include at least one recession in a business cycle, are likely to have a durable competitive advantage to remain profitable even under challenging business conditions. No EPS deficits over the past 10 years is a solid track record; applying this as an essential criterion will eliminate the cyclical firms that go up and down with the business cycle and do not offer any real long term returns for investors. Of the 30 DJIA components, 23 companies pass this criterion. The firms eliminated are Alcoa, Bank of America, Cisco (CSCO), Hewlett-Packard (HPQ), AT&T (T), Travelers (TRV), and Verizon (VZ).
2. Debt to Equity ratio less than 1. This is an important risk control measure. Companies with long-term debt less than book value are financially sound and not over-leveraged. Companies with too much debt are at risk of not generating enough return on the debt capital during business downturns, and end up filing for bankruptcy protection from the overwhelming cost of debt. Applying this criterion to the 23 remaining Dow stocks eliminates American Express (AXP), Boeing (BA), Caterpillar (CAT), Dupont (DD), General Electric (GE), International Business Machines (IBM) and JP Morgan Chase (JPM). While I would still consider these for investment given the right price, their use of leverage is too high for the conservative investor to use as long term investments. Eliminating them leaves us with 16 Dow stocks to consider.
3. Interest coverage, or times interest earned, at least 5 times. This is another risk measure, similar to Criterion 2 above, as an additional quality check. Interest coverage is the ratio of operating income to interest expense. Because bond-holders are senior to stock-holders, stock-holders only get what is left after interests are paid. In general, interest coverage less than 2.5 is a big warning sign that a company may have difficulty meeting its interest obligations, making default likely. Because we are looking for companies to invest in for the long run, we need to set a higher threshold: at least 5 times interest coverage. Applying this criterion to the remaining 16 Dow stocks, we eliminate Merck (MRK) and Kraft (KFT), leaving us with 14 candidates. Note that companies with high debt to equity are also more likely to have low interest coverage, so most of the Dow stocks that have interest coverage below 5 are already eliminated by criterion 2.
4. Growth in earnings-per-share at least 5 percent a year over the past 10 years. Unlike the first three criteria, this criterion focuses on reward. Because we are investing for the long run, we need companies growing at a satisfactory rate so our investment can grow, after inflation. Applying this criterion to the 14 remaining Dow stocks, we eliminate Pfizer (PFE), leaving us with 13 candidates, all good stocks.
5. 5-year average return on equity greater than 20 percent. This is also a reward criterion, and helps to distinguish the best among good stocks for the long run. Return on equity measures how much profit a company generates with shareholders' money. Note that return on equity is generally higher for companies using more debt, so only the very best companies can have high return on equity and low debt to equity ratio below 1. Using this criterion on the 13 remaining candidates, we eliminate Procter and Gamble (PG), Intel (INTC), Disney (DIS) and Home Depot (HD). While these four stocks are eliminated for having ROE less than 20%, they are good stocks to buy on dips.
We now have a list of 9 Dow stocks that meet all five criteria listed above. These stocks are best positioned to offer conservative investors satisfactory returns over the long run.
|Stock||Symbol||Interest Coverage||D/E||EPS Growth||5-yr Avg ROE||Recent Price||Yield|
|Johnson & Johnson||(JNJ)||37.2||0.3||10||26.16||65.24||3.49|
Except for Microsoft, all of these stocks are dividend aristocrats with long dividend history. Microsoft is a more risky stock in the sense that it is relative new compared to the rest, and only recently started paying a dividend. That it meets all our criteria, however, means it has a good risk to reward ratio and is well-positioned to provide long-term returns. I would feel quite comfortable owning these 9 stocks for the long run.
While these 9 Dow stocks are great companies to own for the long run, some of the them may be selling at high prices right now, and the conservative investor may wish to wait for a pullback to initiate a position. See my article on '3 Large Growth Stocks to Buy; 2 to Hold', for example, on determining when to buy.
Because these stocks are selected based on the five criteria listed, they should be monitored to make sure they continue to meet all these five criteria in the future. Life is without guarantees, so if any of these 9 stocks start posting EPS losses, take on excessive debt, start to have low interest coverage, no longer grows over 10 years, or starts generating low returns on equity averaged over 5 years, it must be evaluated to see whether to continue holding, or selling and investing the proceeds into more promising stocks. On the other hand, do not dismiss the other 21 Dow stocks completely; re-evaluate them later to see if they end up meeting all five criteria in the future. The Dow stocks that meet the first 3 criteria, but fail to meet either the fourth or the fifth, might eventually meet all criteria in the future, so it is good to re-evaluate. Also, if new stocks are added to the DJIA, they should be evaluated to see if they meet these criteria.
These criteria are useful not only for Dow stocks, but also for other stocks as well. I use the Dow for illustration because all these stocks are well known and need no introduction. Motivated investors are encouraged to apply these criteria to other stocks that interest them. Here are examples of some more stocks that meet all these criteria: 10 Safe Dividend Stocks for 2012.
Use this information as a starting point for your own due diligence, before buying any stock. Be sure to read the most recent annual report (10-K) and quarterly reports (10-Q) to understand the respective businesses.