By Kip Robbins
Let's start off with a poll. Without looking, what do you think the S&P 500 has returned YTD: A) 10% or E) don't care because you only invest in bonds? The correct answer is D because the index is up over 13% through August 27. But why do people sound like it's "doom and gloom" in the market? If the index only moves sideways the rest of the year, it would be a fairly decent year for stocks. I say ignore stocks at your peril.
For those inclined to sell some stocks, I wrote about five familiar stocks to sell a few weeks ago. As I write this they are, on average, currently underperforming the S&P 500. That sound you just heard was me cracking a smile. (I don't do it often so it makes a noise when I do.) That article drew a polarizing response - some didn't agree and some thought it was interesting and thought provoking. Now I think it would be a good idea to find five large caps that are a smart buy.
This quest presents kind of a quandary though. All eyes are scouring the big stocks - analysts, individual investors, mutual funds, etc. So if everybody's watching and scrutinizing every detail in the financial reports, it's not easy to discover which of the large caps are the best. Or is it?
A Tough Row to Hoe?
Let's use an example to bring this into perspective. IBM (NYSE:IBM) is a good illustration of a large cap stock with a market cap over $224 billion, sales over $100 billion, and over one billion shares outstanding, 50% of which are held by institutional investors. Over 20 analysts from different brokers analyze every single sneeze, twitch and hiccup of this company. You'd think with that much attention IBM's stock would perfectly reflect its true corporate value.
However, if that was true, why would the stock price range from a low of $161 to a high of nearly $210 over the last year? Did IBM's real value range by over 30%? Obviously, there's a lot of ambiguity, and stock analysis is as much about art as it is science. A lot also has to do with perceptions, which are ever changing. There's no denying the stock market is much more efficient at the top, but it's also clear that there's enough wiggle room to make a profit up there as well.
It's Easier Than It Looks
The key to profiting with large caps is twofold - you simply need to pick the right ones at the right time. In order to pick the right stocks, you need to evaluate them with proven measures that identify outperformers. You shouldn't pick stocks based on things you "think" work. You should actually know what works! The only way to invest with confidence is to test your ideas. Also, you should combine a variety of proven measures to ensure you're covering a diversified set of criteria.
A good way to do that is to combine ideas from different categories like Value and Growth or Value and Momentum. The latter is actually one of my favorite ways to pick stocks because it adds a timing element that is essential to knowing the "right time" to buy or sell. It's frustrating to buy a good stock and just have it sit there because you didn't get the timing right.
So how are you able to find measures or factors that work and which ones are most useful for timing? This is the perfect tool to answer those questions. It contains hundreds of different data items on several thousands of stocks for over ten years of history. Not only does it contain over half a billion data points, you can backtest your ideas to see what worked and what didn't over the past. How cool is that?
Since I have all this power at my fingertips, I put together a strategy that's a combination of Value and Momentum. The strategy selected ten stocks on average over time and here's how it compared to the S&P 500 via a backtest from 2002-2011.
These results show that even just picking the right ten S&P 500 stocks at the right time could yield a considerably higher return than just investing in the index. There is, however, a little more risk involved with investing in just ten stocks. The strategy's maximum drawdown is a little worse than the index's, but not terribly different considering the index has five hundred stocks versus the strategy's ten.
Here's a screen to find the smart large cap stocks to own:
First, the stock has to be a member of the S&P 500. (We want only the largest market cap companies.)
Of the S&P 500 companies, select only those with a Zacks Rank of less than or equal to 2. (Any Zacks Rank of 2 or less is expected to outperform the market.)
Add another filter by selecting only the 50 stocks with the largest Cash Flow to Price Ratio. (We want those stocks producing a high Cash Flow per unit of price.)
Next, pick the 25 stocks with the highest percentage change over the last four weeks in the current quarter's earnings estimate. (When perceptions and expectations improve, the stock price tends to increase.)
Finally, choose the 10 stocks with the lowest 1-week price change. (Research shows that the companies that had a price drop over the proceeding week tend to bounce the highest the following week.)
Here are five of the ten stocks that passed the screen this week (8/31/12):
NVIDIA Corporation (NASDAQ:NVDA)
NVIDIA, based in Santa Clara, California, provides graphics chips for use in smart-phones, personal computers, tablets and professional workstations in markets worldwide. This company is probably the best positioned chip maker in the market right now. Even though its valuation is in line with the industry average, future earnings estimates have been increasing rapidly. The company also hasn't had a negative earnings surprise in over two years.
MetroPCS Communications, Inc. (PCS)
MetroPCS, a wireless telecommunications carrier, together with its subsidiaries, provides wireless broadband mobile services in the United States. In July, this company reported earnings that completely exceeded Street estimates and the stock price soared. With increasing earnings estimates during August, coupled with good valuation measures, the stock of this company still has lots of room to rise.
XL Group Plc (NYSE:XL)
XL Group, through its subsidiaries, provides insurance and reinsurance coverage to industrial, commercial, and professional firms, as well as insurance companies and other enterprises worldwide. The valuation of this company is a little better than average, but what stands out is that the earnings estimates for the next couple of quarters, and even the next year, have been revised upward. Because earnings estimate revisions are a good precursor to stock moves, the price of this company should move up in tandem.
CF Industries Holdings, Inc. (NYSE:CF)
CF Industries, a Deerfield, Illinois-based company, manufactures and distributes nitrogen and phosphate fertilizer products, which serve agricultural and industrial customers worldwide. The stock price of this company has seen a pullback in recent weeks within its general upward trend. That indicates a good time to buy. Earnings projections have also been increasing in recent weeks. And despite a +42% YTD price change, the stock price remains a decent value relative to the S&P 500.
Northrop Grumman Corporation (NYSE:NOC)
Northrop Grumman provides products, services and solutions in aerospace, electronics, information systems and technical services worldwide. This is another stock that experienced a pullback in recent weeks indicating a good buying opportunity. When compared to the S&P 500, the stock looks great by any valuation measure. Couple the good valuation with rising earnings projections and you have a formula for a smart large cap pick.