The best of the big caps

Jeremy Grantham and others are keying on high-quality large-caps. Here's a few that my Guru Strategies think are the best of the big boys.

By John Reese Apr 30, 2010 8:12PM

GMO's Jeremy Grantham, the longtime bear who in late 2008 and early 2009 said stocks had become cheap for the first time in more than two decades, is sounding gloomy again. In his latest quarterly letter, released last week, Grantham says he thinks U.S. stocks have blown past fair value and are now "very overpriced".

But Grantham says one particular area of the market is still offering good buys: U.S. high-quality large-caps. And he's not alone. BusinessWeek reported this week that two other fund managers with excellent long-term track records -- Thomas Perkins and Donald Yacktman -- are finding bargains in similar areas. Perkins, whose Mid Cap Value fund has beaten 94% of its peers in the past decade, says large-caps "have gotten so cheap that they should outperform for the next several years"; Yacktman, whose fund has beaten 99% of funds in its category over the past three, five, and ten years, according to Morningstar, has big positions in high-quality blue chips like Coca-Cola (KO) and Pfizer (PFE).

 

While my Guru Strategies -- each of which is based on the approach of a different investing great -- are currently finding value in a number of different areas of the market, Grantham's, Perkins', and Yacktman's comments got me wondering which large-caps these models might be highest on. And, right now, according to my models, one stock may clearly be the best of the large-cap bunch.

That one is The TJX Companies (TJX)


TJX garners approval from an impressive trio of my models -- those inspired by the approaches of Warren Buffett, Peter Lynch, and James O'Shaughnessy.


The firm, whose businesses include discount clothing chains T.J. Maxx and Marshalls, held up very well during the recession as consumers shunned high-priced items and looked for bargains. But the $19-billion-market-cap firm's solid track record goes back much farther than that -- it has upped earnings per share in each year of the past decade, one of the reasons my Buffett-based model is so high on it. This conservative approach also likes that TJX has more annual earnings ($1.19 billion) than long-term debt ($790 million), and that it has averaged a stellar 37.2% return on equity over the past decade.

 

Lynch, meanwhile, found undervalued growth stocks using the P/E/Growth ratio, and the model I base on his writings looks for yield-adjusted P/E/Gs under 1.0. At 0.81, TJX delivers. The Lynch approach also likes conservatively financed firms, and TJX, with a debt/equity ratio of about 27%, appears to fit the bill.

 

My O'Shaughnessy-based growth model is also high on TJX, thanks in part to the firm having upped EPS in each of the past five years. This model also looks for a key combination of characteristics: a high relative strength -- a sign that the market is embracing the stock -- and a low price/sales ratio -- a sign the stock hasn't gotten too pricey. With an RS of 70 and a P/S of 0.95, TJX makes the grade.

 

Another large-cap blue chip my models are high on: Indiana-based drug manufacturer Eli Lilly & Co. (LLY), which has a market cap of about $40-billion. Lilly gets strong interest from my David Dreman-based contrarian approach, which targets strong firms whose shares have been beaten down because of fear or apathy. Lilly's P/E and price/dividend ratios now both fall into the market's bottom 20%, making it a contrarian play according to this model. But while fears about the new healthcare legislation have helped drive those valuation metrics down, my Dreman-based approach sees a lot to like about Lilly, including its 47.55% return on equity, 24.16% pre-tax profit margins, and 5.6% dividend yield.

 

The model I base on the writings of hedge fund guru Joel Greenblatt also likes Lilly, thanks to the stock's strong 13.3% earnings yield and 93.7% return on capital. Those figures make Lilly the 18th-best stock in the market, according to this model.

 

Finally, a pair of big blue-chip beverage rivals are getting high marks from my models -- The Coca-Cola Company (KO) and PepsiCo (PEP).

 

Coca-Cola -- a major holding of Buffett's Berkshire Hathaway (BRK.B) -- gets approval from my Buffett-based approach, thanks in part to the fact that its EPS have declined in only one year of the past decade. The Buffett model also likes that Coca-Cola ($124 billion market cap) could pay off its $4.4 billion in debt in less than a year based on its $7.1 billion in annual earnings. And it likes the firm's 29.4% average return on equity over the past 10 years.

 

My O'Shaughnessy-based value model, meanwhile, likes Coca-Cola's size, strong cash flow ($3.65 per share vs. the market mean of $0.82), and solid 3.3% dividend yield.

 

While Buffett himself prefers Coke to Pepsi, my Buffett-based model sees room for both beverage titans. It likes Pepsi's solid earnings track record over the past decade, as well as its 32% average 10-year ROE. Pepsi has more debt than Coca-Cola -- almost $20 billion vs. $6.3 billion in annual earnings -- but not so much that my Buffett model sees a problem.

 

My O'Shaughnessy-based value model also has strong interest in Pepsi, thanks to the firm's size ($105 billion market cap), $4.89 in cash flow per share, and decent 2.8% dividend yield.

 

Disclosure: I'm long TJX, LLY, KO, PEP, and PFE.

 

John Reese is founder and CEO of Validea.com, a premium investment research site, and Validea Capital Management, a separate account advisory firm. He is author of the new investing book, "The Guru Investor: How to Beat the Market Using History's Best Investment Strategies".

 

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