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Top 10 for 2010

Michael Farr | Wednesday, January 20th, 2010

For the past 7 years we have published our Top Ten Stocks for the coming year.  The results have been very gratifying, but we need to be mindful that concentrated positions also concentrate risk.  Some institutional accounts have expressed interest in more concentrated portfolios like this.  I buy this list personally for one of my personal accounts on the first trading day of the year and sell it completely on the last trading day of the year.  All prices have been updated since this report.

Our outlook for 2010 is modestly positive.  We would be delighted with 10% returns.  The main question for 2010 and perhaps 2011 is the questionable sustainability of the current rebounds both for stock prices and economic data.  Stunning amounts of government money averted disaster in the financial system and have served to stem mounting losses in jobs, housing, and credit.  The economic contraction has been artificially forestalled and somewhat reinflated.  Will the latest government hot air be replaced by the warm trade winds of real economic growth or will the contraction resume as accomodations are removed?   Everyone has an opinion, but NO ONE KNOWS.

Our 2010 list, therfore is defensive and has exposure to international and emerging markets.  Most names have lagged during the market rebound, and all have excellent balance sheets.  Few of our names are “well-loved” by the Street.  Long time reader will note that this year’s list does not include a financial stock and that we have added an energy company.
PepsiCo (PEP – $60.52)
PepsiCo is a leading global snack and beverage company operating in four major business segments: Frito-Lay North America, PepsiCo Beverages North America, Quaker Foods, and PepsiCo International.  The company manufactures, markets and sells a variety of salty, convenient, sweet and grain-based snacks, carbonated and non-carbonated beverages and foods.  The company has leading market share in many of its product categories, and its presence in all major emerging economies positions the company for continued growth well into the future.  While the stock has appreciated over 38% since the market lows in March, it now trades at a discount to the market at 14.5x the consensus estimate for 2010.  Historically, PEP has traded at an average of over 20x EPS and a considerable premium (25+%) to the market.  Combining the attractive valuation with a rock-solid balance sheet and a 3% dividend yield, we find uncommon value in shares at these levels.  Furthermore, the stock’s defensive characteristics should be highly valued in this uncertain economic environment.
CVS Caremark Corp. (CVS – $32.07)
Shares of CVS sold off sharply following the company’s most recent conference call, on which management lowered financial guidance for the company’s Pharmacy Benefits Manager (PBM) segment.  The problem at the PBM stems from the fact that management deviated too far from its core offerings as a PBM and spent too much time trying to sell new services, such as the ability to fill 90-day scripts at either retail or via mail order.  This issue is confined to the PBM segment, as the fundamentals at the core retail business have been quite good in recent quarters.  Having said that, management has acted swiftly to address the PBM problems, most recently by hiring a new president of PBM operations.  Our analysis suggests that even if the original rationale for combining a PBM with a drug retailer is completely disproved, the company still trades at a very attractive multiple of 12x our conservative estimate for 2010.  This valuation is even more appealing if we value the company on a sum-of-the-parts basis.  If we assume a market multiple of 15x on our estimate for core retail EPS of $1.78 in 2010, we would effectively be getting the PBM for an about 6x our 2010 EPS estimate for that segment – well below the multiples commanded by similar PBM’s.

Wal Mart (WMT – $53.43)
After holding up much better than the market on the way down, Wal Mart did not participate in a signficant way during this year’s massive rally off the March lows. However, we believe the company is ideally positioned for a protracted period of increased consumer frugality, higher consumer savings rates, and relatively stable energy prices. Recent data confirm this assertion as Wal-Mart’s domestic stores consistently posted superior same-store sales results throughout the recession. The largely positive sales results, which stood in stark contrast to other retailers which had been posting sizable sales declines, were the result of a “trade-down” effect to more affordable substitutes, Wal-Mart’s high percentage of staples offerings, and sharp declines in gasoline prices during the worst of the economic crisis. Going forward, the stock offers attractive value at just 13.5x the consensus estimate for 2010, which is a meaningful discount to the overall market at 15.0x. The combination of attractive valuation, reasonable growth prospects, relative earnings stability, and balance sheet strength position WMT for out-performance in a volatile economic environment.

United Technologies (UTX – $69.33)
Shares of United Technologies have rallied over 85% from the March low, but are still trading at a reasonable market multiple of 15x the consensus estimate for 2010.  While we still have lingering concerns about the company’s exposure to commercial aerospace, and US housing and commercial construction, we also believe the company’s outstanding track record is likely to continue over the longer term given its strong global presense, particulary within emerging economies.  The company recently provided guidance for EPS growth guidance of 7-13% in 2010 based largely on significant restructuring initiatives taken throughout the downturn.  These proactive initiatives reflect management’s prowess in navigating difficult environments and ultimately coming out stronger as conditions improve.  The company also consistently generates free cash flow in excess of net earnings, enjoys significant revenue contribution from more recurring and stable aftermarket business, and sports a dividend yield of 2.2%.   Reflecting our belief that investors will increasingly ascribe more value to quality blue chip names with strong management, we find solid value in shares of UTX at today’s level.
Dell (DELL – $14.24)

Dell’s business model, once envied by every other IT hardware manufacturer, has come under enormous pressure in recent years.  Demand has shifted dramatically away from corporate buyers willing to buy Dell computers in bulk over the Internet to finicky consumer buyers more inclined to purchase a computer from a physical retail location.  Dell has done a terrible job of reacting to this trend and financial results have suffered as a result.  So why do we like Dell at current levels?  The answer is simple.  We believe that the market is giving Dell virtually no credit for growing its business over the next 5 to 10 years.  DELL currently trades at 11x 2010E EPS, or 9x 2010E EPS excluding the cash on the company’s balance sheet.  This valuation tells us that the market is discounting some growth in 2010 and then virtually no growth into perpetuity.  This assessment by the market appears far too conservative to us.  There are numerous ways to reach a forecast of 10%+ growth for DELL over the long-run, including: 1) an improving global economy, 2) a shift in industry demand from the consumer to the enterprise, 3) an enterprise IT upgrade cycle, and 4) continued cost-cutting which would boost Dell’s currently depressed margins.  As such, we find the current risk/reward proposition appealing for long-term investors.

Nokia (NOK – $12.70)
Nokia is the world’s largest producer of cell phones (37% global market share).  The stock has been weak of late due to the tough global economic environment and because the company has lost several points of market share in recent quarters.  We believe that this recent weakness represents an attractive investment opportunity for long-term investors.  Nokia currently trades at 12x 2010E EPS and offers investors a 4.0% dividend.  2010E earnings, though higher than 2009 earnings, are still expected to be roughly half of what Nokia managed to earn in 2008.  The market appears to be assigning almost no chance that Nokia stabilizes its market share and improves its margins from the currently depressed levels.  We’ve watched Nokia stumble and then regain its footing multiple times over the past 10 years.  Meanwhile, we take comfort in the company’s solid balance sheet, great cash flow, solid returns on capital, top 5 global brand recognition, huge global scale advantage, and excellent presence in the emerging markets.  As such, we find the current risk/reward proposition attractive for long-term investors.

Exxon Mobil (XOM – $68.36)
Exxon Mobil outperformed the market during the decline, but has failed to participate in the rally off the March lows as investors have jettisoned this name for lower quality and higher beta energy companies.  Since March 9th, ExxonMobil is up just 7% versus a 48% rise for the energy sector and 64% for the S&P 500.  Investors remain concerned about the company’s sheer size, which naturally inhibits its ability to grow both reserves and production.  On the other hand, ExxonMobil is the industry’s most efficient operator and remains well positioned to out perform many of its energy peers over a full-market cycle since its vast resources allow it to acquire and develop oil and gas reserves in times of weakness.  Its recent acquisition of XTO Energy may not pay immediate dividends, but it has the potential to help the company grow production and become the global leader at developing unconventional natural gas reserves.  The stock trades at just 11.7 times the 2010 consensus estimates, has the best balance sheet in the industry, and is trading at 3.3x book (low end of the historical 2.8x – 4.2x range).  Given the attractive valuation and other investment attributes, we find the current risk/reward proposition attractive for long-term investors.

Medtronic (MDT – $44.10)
The company is a leader in a diverse group of high growth industry segments, including cardiac rhythm management, vascular, cardiac surgery, spinal, gastrointestinal, urology, diabetes, neurological, and ear, nose and throat.  Foreign sales currently account for nearly 40% of total company sales.  Medtronic’s end markets should continue to grow significantly faster and in a more stable manner than the overall U.S. economy due to attractive demographic trends. Specifically, we believe that MDT has a reasonable chance of increasing EPS at a low- to mid-teens annualized pace over the next five years.  Recent stabilization in the company’s core ICD markets, numerous new product offerings in 2010, and the longer-term benefits from Medtronic’s recent acquisitions in certain high-growth medical technology markets, give us confidence that the company is turning a corner.  Health care legislation should provide the company with new customers, although the proposed tax on the medical device industry is an offset.  We find the shares, valued at roughly 13x 2010E EPS, attractive for long-term investors.

Patterson Companies (PDCO – $27.85)
Patterson operates three business units: Dental Supply (70% of sales), Veterinary Supply (18% of sales), and Rehabilitative Supply (12% of sales).  Patterson and Henry Schein continue to enjoy significant scale benefits vs. smaller competitors in the Dental business.  U.S. demographics remain favorable for solid long-term dental industry growth.  The Vet and Rehab businesses were created through bolt-on acquisitions.  These industries share many characteristics with the Dental business (e.g. solid long-term secular growth trends, not particularly economically sensitive, etc.) but differ from the Dental business in that these markets remain extremely fragmented.  Consolidation opportunities in these fragmented areas should allow Patterson to boost its growth rate significantly over time.  PDCO currently trades at roughly a market multiple (~15x) on 2010E EPS.  We believe that PDCO offers long-term investors a unique combination of downside protection (earnings didn’t actually fall during this economic downturn) and high-quality, above-average long-term growth at a reasonable valuation.

Johnson & Johnson (JNJ – $64.65)
We believe that Johnson & Johnson is an excellent choice for uncertain economic times.  Johnson & Johnson is one of the world’s largest and most diversified healthcare companies. The company sells Pharmaceuticals, Medical Devices & Diagnostics, and Consumer products. Johnson & Johnson sports a AAA balance sheet, generates huge free cash flow, and has churned out 12%+ annualized earnings per share growth over the past 10 years.  The S&P 500 has rallied over 60% since the March 2009 low.  Many high quality, low beta stocks have under performed over this period as investors have flocked to severely depressed, lower quality stocks.  As a result, it is our view that many high quality companies are now trading at very reasonable valuations in relationship to both the overall market and their lower quality peers.  Johnson & Johnson is a perfect example of this trend.  JNJ is up 36% off of its March 2009 low and currently trades at 13x 2010E EPS with a 3.0% dividend yield.  Improved certainty on the healthcare legislation front should calm investor fears for the entire healthcare sector.  We continue to like JNJ for long-term investors.

* The securities identified and described do not represent all of the securities purchased, sold, or recommended for client accounts.  The viewer should not assume that an investment in the securities identified was or will be profitable.

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