Sifting for Gold Among High-Profit Stocks

It's time to draw up a shopping list in preparation for the market's recovery. Here are 56 solid stocks that offer compelling value, relative to bonds, based on earnings yield. Topping the list: WellPoint.

THE DAY WILL COME when you will want to own stocks again. Really, truly, it will. After last week's strong showing, maybe you are already feeling a little left out. Bear-market rallies will eventually give way to a full-blown bull market. And when that time comes, you don't want to miss it. For that to happen, it is vital to prepare a blueprint to help guide your investment choices.

Jeremy Grantham, market seer and chief investment strategist of Boston money-management firm GMO, stressed the importance of being ready for the inflection point in a recent piece titled "Reinvesting When Terrified." He concluded that "you absolutely must have a battle plan for reinvestment and stick to it," all the more so when prospects appear their darkest. GMO now forecasts healthy long-term returns of 10% to 13% for equities.

There is no question that in an environment in which assets are still being repriced and balance sheets restructured, caution is wise. No one is suggesting investors should double down on the market -- but it is probably time to start averaging down.

DRAWING UP A PLAN OF ACTION and setting certain investment parameters before heading into what is arguably still a war zone should offer investors some protection against losses while positioning portfolios to capture potentially powerful returns. If you are skeptical of the ability of stocks to outperform ever again, as a case in point Grantham recalls the 105% return in the Standard & Poor's 500 for a six-month period beginning in June 1933, long before unemployment peaked and bank failures ran their course.

In a five-month period during the 1974 bear market, he points to the 148% advance in equities in the U.K. Moreover, during the Great Depression, there were six advances of 20% or more before full recovery took hold.

To help you with your blueprint, we created a screen based on the earnings yield of a stock -- the earnings per share for the most recent 12-month period, divided by the current stock price. This percentage, which is the inverse of the price/earnings ratio, provides a way to compare stocks with bonds or money-market instruments. The higher the yield relative to fixed-income securities, the better the value of the stock. Ray Dalio of Bridgewater Associates has said the key piece of advice he would offer to investors would be to consider the earnings yield of a stock before making an investment.

Understanding that the earnings outlook for a company isn't etched in stone, most of the stocks in our screen, with just a few exceptions, are expected to produce decent -- if not exceptional -- long-term earnings growth, a factor that will only enhance the rate of return compared with bonds. Last week's huge Treasury-market rally made these stocks look more attractive.

WE HAVE SCREENED FOR COMPANIES whose earnings yield is at least twice that of the 10-year Treasury's recent 2.8% level (it was trading at 2.61% on Friday). We chose that multiple to take into consideration the extra risk associated with stocks. Right now, the stock market as a whole, as measured by the S&P 500 and its earnings yield of 9%, appears to be undervalued in relation to bonds as measured by that 2.8% Treasury-yield yardstick.
Table: Better Than Bonds

We wanted to isolate those companies on the best financial footing, so we weeded out those with debt-to-total-capitalizations higher than 40% and debt-to-equity ratios greater than 60%. To underscore our emphasis on stability, only companies with market values higher than $15 billion made the final cut.

You might wonder why we didn't just screen for dividend yields -- which investors typically use when making a decision on buying a stock. Our thinking is that with companies increasingly slashing or suspending dividend payouts to conserve cash flow and bolster liquidity in these troubled times, this is fast becoming an unreliable indicator of a stock's potential investment return.

Not surprisingly in the current environment, only two financial companies made it to our final screen. They are property-casualty company Traveler s (ticker: TRV), with an earnings yield of 15% and mean long-term earnings-per-share growth estimated at 8.5%, and Warren Buffett's financial conglomerate Berkshire Hathaway (BRKA), with interests in insurance as well as manufacturing, media, consumer-discretionary and retail sectors and an earnings yield of 7.5%.

Travelers' conservative management of its investment portfolio, stable personal-lines business, manageable debt load, and strong balance sheet has helped it weather the current downturn well, and should give it an edge in a recovery.

Berkshire Hathaway is, well, Berkshire Hathaway (see Barron's, "Don't Count Out Berkshire Hathaway," March 2). Despite pressure on its investment portfolio from an ill-timed foray into the oil patch through a ConocoPhillips (COP) stake -- Conoco also makes it onto our long-term list -- and Buffett's staunch support of some beleaguered banks, plus some derivative bets that so far appear to have backfired, Berkshire ended 2008 with $24 billion in cash. And it continues to be well-positioned to take advantage of others' travails. One area Buffett now finds attractive is high-yielding investment-grade corporate bonds.

Only one utility makes our list: Duke Energy (DUK), a pure-play electric utility sporting a 9.9% earnings yield and estimated mean long-term earnings growth of about 4%. Duke has ample liquidity to support growth and see it through this economic crisis. Investors will likely be drawn to its solid balance sheet and geographic diversity, as well as its 7% dividend yield -- which in this case appears to be sustainable.

Most heavily represented on our list are companies in the health-care and information-technology sectors. Indeed, Nos. 1 and 2 on the list of 56 companies are managed-health-care companies WellPoint (WLP), with an earnings yield of 17.2%, and UnitedHealth (UNH), boasting an earnings yield of 16.8%.

After a difficult couple of years, WellPoint is on track to improve its shareholder returns. New management is in place, claims inventories are down, and reserves have been strengthened. The company is expected to generate free cash flow of $3 billion in 2009, and to repurchase up to $2 billion of its shares this year.

Topping the list of info-tech stocks is Hewlett-Packard (HP), whose earnings yield is 12.9%. Hit hard by the global downturn and frozen IT budgets, the computer-printer giant posted lower-than-expected revenue in its fiscal first quarter, and reduced its earnings outlook. But synergies from its acquisition of EDS as well as share gains should provide meaningful earnings support. When spending does tick up, Hewlett-Packard is well-positioned to benefit (see the Dec. 29, 2008 Barron's "How HP Prints Profits"). Meantime, it ended the first quarter with $11.3 billion in cash; operating cash flow was $1.1 billion. Also, the company has $7.9 billion remaining in a share-repurchase program, after buying back $1.2 billion of its shares in the prior quarter. Needham & Co. has called Hewlett-Packard "a must-own name in large-cap tech."

There are few media companies that make the grade, but one that does is News Corp . (NWS, Class B), owner of Dow Jones, which publishes Barron's. News Corp. shares have been battered by the deep advertising recession affecting the entire newspaper industry. Also, when Peter Chernin, Rupert Murdoch's longtime second-in-command, announced recently he would leave the company, concerns were raised about succession plans.

Still, the company's balance sheet is in fine shape, with a manageable debt load and cash available to cover its obligations through 2015. News Corp. is expected to generate $2.2 billion in free cash flow this year. At 8.1%, its earnings yield is about 2.9 times the yield of the 10-year Treasury. The stock could benefit if management chose to buy back shares, a signal that the worst for the media industry and economy might be over. At least one analyst has a price target of $14 on the shares, which would indicate a roughly 100% move from current levels.

Our screen, while not foolproof, is compelling for the values it has turned up among companies representing a wide range of sectors. The size and standing of the companies as well as their sound balance sheets and potential for growth should result in meaningful returns for those investors with an action plan in their pockets.

E-mail comments to mail@barrons.com