Edited by Kate Boehmet
Recently, a close friend of mine asked me about which stocks I would buy for the next 5 years. That is a pretty hard question to answer. I usually try to buy cheap stocks with low P/E ratios. I am not looking for speculative gains, but a modest capital gain of 15 percent to 20 percent is more than enough for my portfolio. Warren Buffet was once asked about the perfect holding period; he replied that the perfect amount of time to hold was "forever."
I am following Warren Buffett's steps. I consider dividends as a nifty bonus for shareholders. Historically, the stock market's annual return has been 11 percent. Therefore, any return higher than 11 percent is a success for me. Since we are talking about long periods of time, diversification is essential. In fact, diversification is the optimal investment strategy, according to the modern portfolio theory.
It might be claimed that an effective portfolio ought to include a combination of stocks and bonds, as well as ETFs and real estate investments. There are nearly limitless possibilities at all levels of risk and return. However, I think, every well-educated investor should be able to achieve a certain level of diversification by choosing a few stocks from different sectors. As I am not in favor of paying commissions to fund managers, the portfolio I am proposing consists of stocks only. Included are the stocks with strong roots in the market and the potential to grow for many years. Dividends received from these stocks can also be reinvested to achieve compounded growth in capital.
There are five stocks included in this imagined portfolio; each stock gets a 20 percent allocation of the capital. These stocks have all already shown exceptional performance during tough periods and have a lot of expansion potential. Below, you will find careful analyses that consider each company's financial, business, and industry prospects. I also estimated the fair value of these companies based on my discounted earnings plus equity model as follows:
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence. The discount rate is set at 11 percent.
There are few companies that have shown the tremendous growth exhibited by Apple. This company, with its reputation for technological innovation, has completely changed the industry landscape. Under the visionary leadership of Steve Jobs and a fully committed management team, Apple has continued to grow at an astounding rate. However, recently, Apple announced its second quarter results for 2012, with revenue figures amounting to less than expected. The Q2 2012 report showed an increase of 6 percent in gross margin. Yet, despite lower-than-expected numbers, the company still showed clear improvement. The iPhone sales - which generate the majority of Apple's revenue - showed an increase of 88 percent from last year. Meanwhile, iPad sales rose 151 percent from the same period last year. Moreover, Apple has also made advances in their efforts to gain a foothold in the direct TV market through their Apple TV.
More than half of American households possess at least one Apple product. The market shows massive potential and, through innovation, Apple can continue to grow at their phenomenal rate. For any company to grow and capture the market share, it is imperative to spend on research and development. With this in mind, Apple has increased its R&D expenditure for the quarter by 39 percent. In addition, Apple has also showed great strides in their efforts to raise capital; such measures are imperative in order to carry on healthy growth. Apple has ample cash reserves, which allows it to meet any increased product demand, as well as expand into new markets.
The Board of Directors approved a dividend of $2.5 per share from the fourth quarter of 2012, with a share buyback worth $10 billion. This stock does not only provide the opportunity for exceptional growth but also, likely promises a healthy income from dividends in the future.
At the moment, the biggest threat Apple faces is from Google in the form of the Android operating system. The iPhone is the largest contributor to Apple revenue, even though it took a hit from Android during the past year. Android has succeeded in capturing a considerable share of the phone market, but there remains little competition in other sectors. Apple is likely to sustain its current growth trend; this company will keep on increasing its margins as long as it continues its vertical integration strategies and expands into new markets. Apple TV can also represent a new area in which Apple can generate significant revenues in the future.
Fair Value Range: Based on an annualized earnings growth estimate of 19.20%, my FED+ fair value range for Apple is $960 - $1080. The stock has at least 50% upside potential to be fairly valued.
Abbott Laboratories (NYSE:ABT)
Despite the poor performance of the broad market indices in the last year, pharmaceutical companies have performed reasonably well; there has been a lot of activity in the BioPharma sector. As one such company, Abbott has a strong presence in the market and a well-established set of drugs. The company is expected to continue its strong earnings numbers and healthy growth patterns. Furthermore, the pharmaceutical market is about to experience a boom, as an aging global population instigates an increased need for various medicines and a rise in healthcare expenditures.
Recently, Abbott announced that the company would divide into two entities: the newly-formed company AbbVie will focus on research and development, while Abbott will focus on marketing and distribution. Research is the heart and soul of pharmaceutical companies. This restructuring event will help both entities to focus on their respective markets. The new entities will be able to devise better strategies to meet the needs of the market. I believe this restructuring will give both companies a competitive advantage, and turn Abbott into an even more valuable investment.
On July 30, 2012, the European Commission gave approval for Humira to be sold in Europe. Analysts expect Humira to bring in revenues in excess of $8 billion by 2016. Abbott has strong financial base, with cash reserves of $9.53 billion putting Abbott in a strong position to take advantage of an opportunity, if presented. The firm has strong gross and operating profit margins of 12.39 percent and 22.08 percent, respectively. Along with its strong future growth prospects, Abbott also has a dividend yield of 3.10 percent, and an operations cash flow that continues to increase at a gradual rate.
Abbott has a small Beta of .39 and an attractive EPS of $3.08, though the P/E ratio for Abbott is a little high at 20.86. Forward P/E is 12.06. Furthermore, Abbott has been steadily increasing dividends for 40 consecutive years. This long tradition of increasing dividends shows the strength of their growth trends and the confidence that management has in this firm. I believe that Abbott has strong growth prospects and could be added to any investor's portfolio with a piece of mind.
Fair Value Range: Based on an annualized earnings growth estimate of 8.9%, my FED+ fair value range for Abbott is $60 - $75. The stock is currently fairly valued, but it is a buy after market correction.
Chevron Corporation (NYSE:CVX)
Chevron operates in the production, exploration, manufacturing, and transportation of energy products worldwide. Chevron is also diversifying into energy-related chemical manufactures and nano-science research, as well as leading geothermal energy production.
This giant has a market cap of $213 billion and net income of over $27 billion for the last year. Demand for energy is constantly increasing. Recent manufacturing stats released by China and an expected increase in the production will further augment this revenue growth. Like most giants in other industries, huge jumps in sales cannot be expected year after year. Chevron is a leader in its industry and will carry on growing at a slow, but steady, pace.
Chevron has an attractive EPS of $13.62. The P/E ratio also stands at an attractive 7.92, while the forward P/E estimate is 8.81. The P/S ratio sits at a positive 0.84. This company also shows a nifty dividend yield of 3.30 percent. Meanwhile, trailing twelve-month dividends were $3.60 per share. Chevron has a sustainable payout ratio of 26 percent.
This company's biggest threat is the highly volatile price of oil and gas, which will certainly affect their revenues and balance sheet. Chevron always tries to look after its employees as well as the environment, which gives it stability through a motivated workforce and a sustainable business model. This company is also diversifying into other fields, while maintaining expert status in its primary sector. Most notable of these efforts is Chevron's move into geothermal energy. Overall, Chevron is clearly an attractive prospect.
Chevron is certainly an appealing investment. This is more than evidenced by the company's many accounts, dividends, low P/E ratio, splendid balance sheet, and the diversification of its business model. Chevron's management is working extremely hard to establish it as the industry leader.
Fair Value Range: Based on an annualized earnings growth estimate of 11.80%, my FED+ fair value range for Chevron is $200 - $265. The stock has at least 75% upside potential to be fairly valued.
General Electric Company (NYSE:GE)
A world famous conglomerate, GE, believes in being the best. General Electric consists of four sectors: Energy, Technology Infrastructure, Capital Finance and Consumer and Industrial. Being a conglomerate, GE is able to function in a number of different markets, including transmission, generation and distribution of electricity, railway locomotives, aircraft jet engines, and aviation services. This company also offers an array of financial services through GE Capital. General Electric has presence in over 100 countries.
In many markets, existence of General Electric stands as a significant barrier to entry by new companies; it is incredibly difficult at the moment for new companies to compete with GE. This company, through its innovation and research, works hard to keep these barriers high. Namely, it is focused on industrial processes, while simultaneously extricating itself from the capital division. GE capital has been the company's Achilles Heel since the financial upheaval of 2008. At the moment, the capital division contributes the highest proportion of company debt.
General Electric continues to make strides in the energy sector. In fact, these movements could make GE a leader in power infrastructure. Yet, despite such improvements, GE has failed thus far to regain the market value it had prior to the financial collapse. Back in September 2007, the stock was trading at $41.40. Currently GE is showing slow revenue growth, but it ought to improve as the economic situation starts to get better.
General Electric is certainly not currently performing up to its potential. For this reason, at the moment, the stock is available at a considerable discount. GE business is likely to improve over the next two years, and the stock will start to soar.
Fair Value Range: Based on an annualized earnings growth estimate of 12.50%, my FED+ fair value range for General Electric is $24 - $35. The stock has at least 15% upside potential to be fairly valued.
Bank of America (NYSE:BAC)
Bank of America has been performing wonderfully over the past year; most notably, after passing the Federal Reserve's stress test. Bank of America is following a new expense reduction policy and has successfully managed to clean up the balance sheet while increasing profitability. This two-phase project is intended to restructure and simplify the business in an effort to increase profits and revenue. Bank of America announced in May this year that it was going to cut two thousand jobs belonging to high-earning employees across various departments. The company is valued low compared to its peers; the forward price-to-earnings ratio for the bank stands at 8.71, compared to its industry average of 10.88. However, Bank of America has a fairly high debt-to-equity ratio of 2.71, which is higher than the industry average.
The bank has been trying to increase its capital base, and their efforts are now starting to bear fruit. Bank of America got excellent news from the Federal Reserve recently, confirming that it had made noteworthy progress with regards to strengthening their capital. Then, instead of increasing dividends or repurchasing shares, the bank opted to further reinforce this capital base. Consequently, Bank of America is not currently paying out high dividends. At the moment, it is paying out a dividend of $0.04, yielding 0.4 percent. However, as management tries to get Bank of American back on track, investors have reason to be hopeful about the future. The baking giant is going through significant reorganization, and divesting itself from non-core assets. I believe Bank of America is ready to turn around and start its return to former glory.
Fair Value Range: Based on an annualized earnings growth estimate of 11.40%, my FED+ fair value range for Bank of America is $14 - $32. The stock has at least 80% upside potential to be fairly valued.
Disclosure: I am long AAPL.