Time To Buy Healthy Laggards

by: Alan Brochstein, CFA

Here we are, more than 3/4 of the way through the year, and the market has surprised most pundits, with the S&P 500 rallying over 16% in price to produce a YTD total return so far of 18.2%. You would think investors would be ecstatic, but that is far from the case, as this has been what many have described as the quietest bull market in history. Many have missed out, cautiously trying to avoid all of the oh-so-obvious headwinds.

Even those who have been bullish have likely struggled to keep pace with the popular benchmark, as smaller stocks have lagged, with performance highly concentrated in certain large stocks. While everyone is familiar with the impact of Apple's (NASDAQ:AAPL) contribution, which has added about 2% (or 1/8 of the return) as it has gained 61%, there are many more large companies that have dominated the market's return. To illustrate this point, let's look quickly at the 10 economic sectors.

In Consumer Discretionary (NYSEARCA:XLY), which is up 22.1% in price, there are five companies that started the year at $50 billion or more: Comcast (CMSCA), which is up 54%, Home Depot (NYSE:HD), which is up 50%, Amazon (NASDAQ:AMZN), which is up 49%, Disney (NYSE:DIS), which is up 41%, and McDonald's (NYSE:MCD), which is down 9%. The biggest five have averaged 37%.

In Consumer Staples (NYSEARCA:XLP), which is up 12.3% in price, there are five companies that started the year at $100 billion or more: Wal-Mart (NYSE:WMT), which is up 26%, Philip Morris Intl (NYSE:PM), which is up 19%, Coca-Cola (NYSE:KO), which is up 10%, Pepsi (NYSE:PEP), which is up 7% and Procter & Gamble (NYSE:PG), which is up 5%. The average is 13.4%, which is better than the sector return, but that's because WMT is the biggest by far.

In Energy (NYSEARCA:XLE), which is up 6.2% in price, Chevron (NYSE:CVX), which is up 10.4%, and Exxon Mobil (NYSE:XOM), which is up 9.2%, dominate the sector and have beaten the peers.

In Financials (NYSEARCA:XLF), which are up a leading 23.5% in price, the stocks that started the year at $50 billion or more include Bank of America (NYSE:BAC), which is up 68%, Citigroup (NYSE:C), which is up 32%, Wells Fargo (NYSE:WFC), which is up 30%, JP Morgan Chase (NYSE:JPM), which is up 25%, and Berkshire Hathaway (BRK.B), which is up 19%. Once again, the biggest are the best, with these five averaging about 35%.

In Healthcare (NYSEARCA:XLV), which is up 18.8% in price, the stocks greater than $75 billion at the beginning of the year include Abbott Labs (NYSE:ABT), which is up 27%, Merck (NYSE:MRK), which is up 23%, Pfizer (NYSE:PFE), which is up 18%, and Johnson & Johnson (NYSE:JNJ), which is up 6%. This is the first example of the biggest not being the best, as the average is 18.5%, roughly in line with the sector return.

In Industrials (NYSEARCA:XLI), one company stands out by far, and that's General Electric (NYSE:GE). It has increased 29% compared to the 11% return for the sector.

Information Technology (NYSEARCA:XLK) is up 20.4%, and I have already pointed out AAPL's strong performance at + 61%. The other really big companies (> $200 billion) include Google (NASDAQ:GOOG), + 19%, Microsoft (NASDAQ:MSFT), + 15%, and International Business Machines (NYSE:IBM), +15%. Averaging out these seven leads to a 27.5% average.

Materials (NYSEARCA:XLB) are up 11.1%. There aren't any stocks that started out as big as $50 billion, but the two largest stocks are the best: Monsanto (NYSE:MON), +30%, and Dupont (DD), +10%.

Telecommunications (NYSEARCA:XTL), up 22.3% in price, is dominated by two stocks: AT&T (NYSE:T), which is up 25% and Verizon (NYSE:VZ), which is up 17%. Just picking these two would slightly lag the sector return, which has been boosted by the 122% return by Sprint Nextel (NYSE:S).

Finally, Utilities (NYSEARCA:XLU), which are up just 2% in price, don't have any very large standouts. The four largest names at the beginning of the year have provided an average return of -0.4%, so the theme doesn't play out.

This quick review of all of the sectors shows how easy it would have been to beat the S&P 500 this year: Go Big. Just picking the top securities in terms of market cap at the beginning of the year was a great strategy. Maybe I could have illustrated the point more quickly by just pointing out the return of the S&P 100 (OEX), which is up 17.8% in price. Who knew it could be so easy? Not me, unfortunately! Well, maybe I did, but I forgot. Some may remember my article from early 2011, "Mega-Cheap Mega-Caps Could Fuel Mega-Gains in 2011". I guess it's not the first time I have been early!

So what now? Some may disagree, but I see the strong performance in the biggest names as a very positive force. What it tells me is that people want to buy stocks, but they have been cautious. The investment climate has been quite hazardous over the past few years, but it seems to be changing. I have shared my views on why investors should focus on Small-Caps now, but that's not a strategy that works for everyone. Today, I want to extend my thinking from a strategy I shared last week regarding buying strong relative performers. There, I suggested avoiding stocks that are down, which is something I continue to recommend until likely Thanksgiving, and buying stocks beating the market but not by too much (along with several other factors).

Today, I want to back off that requirement that the stock be beating the market. Instead, let's focus on stocks that are good ABSOLUTE performers (meaning up this year) but RELATIVE laggards (meaning trailing the S&P 500). I am going to screen just the S&P 500, but the same thinking would obviously apply to smaller companies as well. Here is what I did (using Baseline):

  • YTD Price Return : 8%-16% (lagging slightly)
  • Trailing EPS Growth: >10%
  • Trailing Sales Growth: >6%
  • PE vs. 5-year Average: < 80%

There were 106 names that fell into the price-return requirement. After the growth constraints, 40 remained. The last constraint left us with the following 10:

Now, this is an example and not recommendations. I sorted the names by PE and included some "color commentary" as well. I follow Borg Warner (NYSE:BWA) and Intuitive Surgical (NASDAQ:ISRG) closely. BWA is the more interesting to me, as it has come back nicely from the summer and has good near-term momentum. It is down 16% from the high it set earlier this year. By my calculation, the stock could return 26% over the next year assuming it can trade at 14X the current consensus. ISRG is pausing from a huge run in 2011. Assuming it can trade to 27.5 PE (and crediting for cash), it could trade to 600, which represents a return of 17%. I think that there are better buys in the Med-Tech space. I expect that some of the Industrials, which dominate the list, could be interesting too.

If you agree with me that the crowding into the very largest stocks is a positive indicator for the future stock prices, then it makes sense to look beneath these companies for opportunities. This is an interesting time of the year, with tax-loss selling beginning, performance-chasing among institutional investors likely and early positioning for 2013 getting started. The screen we ran today highlighted a broad variety of stocks that might be worth investigating for entry in the coming weeks as we go through earnings season.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: CVX and JNJ are held in one or more models managed by the author at InvestByModel.com