Finding Gems In The Dow 30

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Includes: AAPL, IBM, UNH, VZ
by: John P. Reese

Summary

Dow 20,000 should remind us of the power of long-term investing and that returns don't come in a straight line.

If returns over the next 7-10 years are close to the 10% annual return the Dow has generated historically, we could see Dow 40K around 2025-2027.

Using our "guru"-based screens, we have identified the stocks in the Dow 30 that get the highest scores based on their fundamentals and valuations.

In late January, the Dow Jones Industrial Average hit 20,000, a milestone that was met with plenty of fanfare. Like many stock market-related headlines, however, the Dow's big day should be taken with a grain of salt. Yes, it represents a rise in the index, and that's not a bad thing, but the number itself really isn't significant.

As a matter of fact, breaking 20,000 isn't even that remarkable when you consider the trajectory of the Dow since its inception in 1896. It took over a decade to reach 100, then 66 years to reach 1,000, then another 41 years to make 15,000 (in May 2013). In fact, it hovered around 10,000 for a decade:

All things considered, rising by 5,000 in three-and-a-half years isn't that big a deal.

The Motley Fool's Daniel Kline writes, "In practical terms, 20,000 means nothing. It's just a round number, and it's easier to celebrate those than picking a random one." He says Trump's promises to ease regulation and lower business taxes were key drivers behind the Dow's push and argues, "Because Trump is something we have never seen before…we have no idea what might happen because there is no precedent."

Mohamed El-Erian, Bloomberg columnist and chief economic adviser for Allianz, is equally dispassionate about the market event. "Let's start by acknowledging," he writes, "that the DJIA is far from comprehensive when it comes to analytical content. The index covers a very narrow set of stocks and therefore is lacking in representation." He argues that evaluating the implications of the "hype about the Dow reaching 20,000 comes down to evaluating the volume of the signal, the influence on investing and business behaviors, and the implications for economic governance."

Like others, I think the importance of this milestone has a relatively short shelf-life. Eventually, the market will move on to more significant things like corporate earnings, valuations, industry developments, and related issues. That said, I think the market event presents two important takeaways for investors:

The power of long-term investing and compounding returns. Over long periods of time, the stock market is one of the best ways to generate long-term wealth. Since 1928, the Dow Jones 30 has produced an annualized return of about 10%, including dividends. By reaching 20,000, the Dow reminds us of the long-term wealth creation that can be achieved when investing in the markets over time with discipline. If the returns over the next 7-10 years are close to the 10% annual return the Dow has generated historically, we could see Dow 40,000 by around 2025-2027.

Returns don't come in a straight line. If you are just getting into the market now or you have funds to put to work, you shouldn't expect the same returns in the market over the next five years that the last five years have generated, and there will be plenty of bumps along the way. The reason that stocks produce the returns they do is because they are risky in the short term. When you get excited by events like the Dow hitting 20,000 and think you might be missing out, always remember that you have to be able to stomach short-term volatility to get the long-term gains stocks have produced.

Using my guru-based stock screening models, I found the following high-scoring picks among the Dow 30:

International Business Machines Corporation (IBM) is a technology company that operates through five segments: Global Technology Services (NYSE:GTS), Global Business Services (GBS), Software, Systems Hardware and Global Financing. The company earns a perfect score under our James O'Shaughnessy-inspired stock screening model based on its size ($168.5 billion) and cash flow-per-share of $17.11 which is well above the market average of $1.43. Trailing 12-month sales of $79.9 billion are nearly 4 times the market average (required to be 1.5 times the average).

UnitedHealth Group Incorporated (UNH) is a diversified healthcare company that earns high marks under our Martin Zweig-based investment methodology given its current price-earnings ratio of 22.13 which compares favorably with the market P/E of 18.0. In order to pass this screen, revenue growth must not be substantially lower than earnings growth (for earnings to continue to grow over time they must be supported by a comparable or better sales growth rate). With revenue growth of 13.63% and earnings growth of 8.9% (based on 3, 4 and 5 year averages), UNH passes this screen. The company also earns a perfect score under our O'Shaughnessy-based model due to its size (market capitalization of $152.7 billion) and persistence in earnings-per-share.

Verizon Communications Inc. (VZ), through its subsidiaries, provides communications, information and entertainment products and services to consumers, businesses and governmental agencies. The company is favored by our David Dreman-based screening model due to its size (market cap of $198.9 billion). Medium to large-sized companies (the largest 1500 companies) are preferred by this model because they are more in the public eye and an investor is less exposed to risk of "accounting gimmickry". VZ earns a perfect score under our O'Shaughnessy-based investment strategy due to its cash flow-per-share of $7.24, well above the market mean of $1.43, and its dividend yield of 4.73%.

Apple Inc. (AAPL), the tech behemoth, earns a perfect score under our Warren Buffett-inspired investment strategy due to its earnings predictability and ability to pay off all debt with earnings within two years. Average return-on-equity over the past ten years (31.5%) is more than double the required minimum of 15%, and free cash flow per share of $7.30 indicates that the company is generating more cash that it is consuming. Management's use of retained earnings reflects a favorable return of 20.7%. The company also gets a thumb's up from our O'Shaughnessy-based model given its trailing 12-month sales ($218.1 billion) and the number of shares outstanding (5,328), which is nearly nine times the market average (620 million).

Disclosure: I am/we are long IBM, UNH, VZ & AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.