Vetting the BW 50's Investment Potential
The companies that make the BusinessWeek 50 are truly a cut above the rest when it comes to their operating performance, but how do these companies fare as investments? It's a good question. The answer: It depends.
That's because the proprietary screen we use to rank the companies in the Standard & Poor's 500-stock index by their performance—and then use to anoint the top 50 companies in that ranking as the BusinessWeek 50—rewards companies that are growing the fastest. During bull markets, growth stocks do well—and that was the case with the BusinessWeek 50 companies during the Roaring '90s when they regularly outperformed the major indexes the year after they were named to the list.
But growth stocks fare poorly during grinding markets—and particularly during recessions. That was the fate of the BusinessWeek 50 during the last recession: The 50 companies we anointed in March, 2001, on the cusp of the short economic downturn, saw their stocks plunge an average of 23.7% over the next 12 months, compared with a modest 3.7% dip for the Dow Jones industrial average and a 10.7% drop in the S&P 500.
All of which suggests that if the U.S. is indeed teetering on the edge of a brutal recession, now is not the time to blindly buy up the companies on our list. Already, some of our top honorees have suffered steep drops in their stocks—our No. 1 performer, Coach (COH) (BusinessWeek, 3/27/08), has seen its shares plunge 35% on fears its customers will cut back on purchases of $400 handbags—and there's no guarantee further declines aren't ahead. But as Wall Street pros love to say, it's a market of stocks, not a stock market, and given the operational excellence displayed by the companies in the BusinessWeek 50, this list can be a good place to start.
Sliced and Diced Two Ways
To identify the best investment plays from the BW 50, we ran the companies through two screens, all with the assistance of Standard & Poor's Compustat (like BusinessWeek, a division of The McGraw-Hill Companies (MHP)). Working under the assumption that the next couple of years could be tough for investors, we decided to construct two screens that would pull up those companies with the resources to weather both a recession and banks' potential reluctance to provide financing to anyone other than, well, companies that probably don't need the money anyway.
The first screen was designed to screen for value stocks, specifically those companies with a balance sheet strong enough to weather any coming economic storms (although since the BW 50 is at heart a growth list, you can assume that all of these companies have demonstrated strong, steady growth in recent years). And for investors willing to take on just a little more risk in search of higher returns, we also offer a second screen that is designed to mimic the philosophy of the greatest investor of the modern era, Warren Buffett.
Value Stock Screen
In our search for value stocks of companies with sound financial footing, we decided to look for companies with strong cash positions that will tide them over if the credit markets remain tight for the next year or two. But since the companies in the BW 50 vary wildly in size—IntercontinentalExchange (ICE) (No. 13) recorded $574 million in revenues last year, an amount that ExxonMobil (XOM) (No. 50), with $468 billion in sales, brings in before noon on any given day—we divided each company's cash holdings by the number of outstanding shares, producing a cash-per-share figure. Then we excluded any company whose cash-per-share holdings were below the average among the S&P 500 companies. That culled the herd to 11: Allegheny Technologies (ATI) (No. 3), Apple (AAPL) (No. 6), UnitedHealth Group (UNH) (No. 14), CME Group (CME) (No. 15), Goldman Sachs Group (GS) (No. 21), Amazon.com (AMZN) (No. 23), Nucor (NUE) (No. 25), Lehman Brothers Holdings (LEH) (No. 33), Google (GOOG) (No. 34), PNC Financial Services Group (PNC) (No. 38), ExxonMobil, and Sunoco (No. 20).
We then took another step to ensure all of these companies were producing positive free cash flow from operations (that should be a safe assumption given that these were top 50 performers among the S&P 500, but you never know). And given how tight credit markets are at present—meaning companies that need to roll over debt either won't be able to or will pay a hefty price for the privilege—we also weeded out companies that might be carrying too much debt for these uncertain times. That knocked out the three financial-services firms—Goldman, Lehman, and PNC—and left the other eight.
Sticking with the debt theme, we then eliminated any company with a debt-to-capital ratio above the average for its industry. And then there were six: Allegheny Technologies, Apple, CME Group, ExxonMobil, Google, and Nucor.
Finally, to make sure we weren't chasing stocks with rich valuations, we ran a fourth analysis intended to pull up companies that were undervalued. Instead of simply measuring each company by its price-earnings ratio, or p-e, we divided enterprise value (the stock market value plus total debt, net of cash and liquid investments) by revenue.
Why did we go to all this work? Because comparing enterprise values allows you to better compare companies with different capital structures—utilities like Exelon (EXC) (No. 22) that carry hefty debt against software firms such as Autodesk (ADSK) (No. 28) that don't. Here, we excluded companies with enterprise-to-revenue ratios above 3.5, which is around the median for the BW 50. That left just three survivors: Allegheny Technologies, ExxonMobil, and Nucor. If there's one issue that could give investors pause, it's that these three firms' fortunes are tied to commodities—specialty metals, oil, and steel, respectively—and their profits could be hurt if prices in those markets fall.
The value approach admittedly may be too narrow for some investors. For that group, we ran a second screen that speaks to the management performances of the BW 50 companies. And if you're going to pursue growth companies, why not follow the approach used by Warren Buffett, who has a track record of buying well-run companies with cheap valuations. As avid market followers are aware, Buffett has never revealed the screens his own investment team uses, if any. To get a sense of the yardsticks he uses, you have to follow his public comments and the letters he writes to investors in his publicly traded investment fund, Berkshire Hathaway (BRKA).
One of the best analyses of his style is in Buffettology: The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor, by Mary Buffett, a former daughter-in-law, and David Clark, a portfolio manager who is acquainted with the Buffett family. The philosophies discussed in the book were, in turn, used by researchers at the nonprofit American Association of Individual Investors to build a "Buffettology" screen, from which our own screen was adapted. (Indeed, investors who like the discipline of stock screening would be well-advised to join the AAII; among the many benefits and services it provides are more than a dozen stock screens that are constantly updated.)
The Buffett Screen
Since one of the first things Buffett looks for are not Wall Street highfliers, but companies with a long history of steady, predictable growth, he'll bypass an upstart growing at 40% for an established company that delivers a predictable 15% return each year. Hence, we first screened for companies that increased earnings at least 15% in each of the past five years. That quickly reduced our group to seven stocks: Coach, C.H. Robinson Worldwide (CHRW) (No. 12), CME Group, Starbucks (SBUX) (No. 16), Cognizant Technology Solutions (CTSH) (No. 19), Goldman Sachs, and T. Rowe Price Group (TROW) (No. 29).
Over the years, Buffett has shown a penchant for buying blue chip companies such as Coca-Cola (KO) and Gillette with strong brand recognition, which not only helps insulate them from the threat of commoditization by generics and cheap imports, but gives them the power to raise prices. Since ascribing a value to brands is a subjective exercise, we then looked for companies with operating margins and net profit margins above their industry averages—a good sign of pricing power. That reduced the ranks to four: Coach, CME Group, Cognizant, and T. Rowe Price.
One of Buffett's biggest bugaboos is debt. Buffett has long preached against companies that try to juice their earnings through the use of leverage, once saying, "It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant." To eliminate companies with heavy debt loads, we looked for companies with total liabilities-to-assets ratios below the average within their industries. The result? All four passed and advanced to the next round.
Winnowing the Field
We then ran three final screens, including one that assessed the companies by their return on assets, something Buffett puts a lot of stock in (literally). Why? A higher return on equity, or ROE, means that a company's surplus cash can be reinvested to improve operations without management having to raise extra funds through a secondary stock offering or by taking on more debt. To make sure we pulled up companies that were making the best use of capital, we further narrowed this list to include only those with an average ROE above 14%, which Buffett has deemed desirable.
Next, to make sure the companies that passed the cut here were still on the upswing, we looked for companies with accelerating growth—specifically, with three-year growth rates higher than their seven-year growth rates. Finally, since Buffett is the ultimate disciplined investor—he can wait years until a company he likes falls to the price he's willing to pay—we borrowed a page from the AAII's Buffettology screen and looked for companies with high earnings yields, one of the Oracle of Omaha's favored measures. To measure the earnings yield, earnings-per-share are divided by the share price. We eliminated any company with an earnings yield lower than the S&P average.
Only one company survived this rigorous screen: T. Rowe Price, the asset management giant based in Baltimore whose shares are down a little less than 25% from their recent high. That's just the kind of entry point Buffett would love.
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