The best of the Dow

By Sean Silcoff

The venerable Dow Jones industrial average has had a tough 12 months amid deepening economic worries in the United States, falling by 13 per cent. But three stalwarts on the 30-stock index stand out. Not only are they among the U.S.’s best-known consumer names, but they may be some of the smartest defensive picks for investors in troubled times, having delivered top returns among their peers in the past year. What has made these stocks rise? And what lies ahead?

Johnson & Johnson (JNJ: NYSE)
Business: Consumer products, medical devices, pharmaceuticals
One-year total return: 19 per cent

J&J is one of those steady long-term performers that is easy for investors to take for granted. But when other stocks are suffering, it proves to be a relatively headache-free stock. The New Brunswick, N.J.-based giant has delivered 45 straight years of dividend increases and 24 years of earnings growth, excluding special charges. In uncertain times, the consistency of its recession-proof businesses and famous brands stands out: after all, people don’t stop having headaches (Tylenol), cutting themselves (Band-Aid) or taking their meds (J&J’s pharmaceutical company, the world’s sixth largest) just because times are tough. Its second-quarter earnings “again demonstrate the breadth of the company’s businesses and management’s ability to navigate difficult operational periods,” said J. P. Morgan analyst Michael Weinstein in a July report, in which he reiterated his “overweight” rating on the stock.

J&J sports a 2.6 per cent dividend yield, while its shares, which had lagged the market in recent years, have popped up nicely in the past 12 months, after it digested some sizable acquisitions, including Pfizer’s consumer health care business and heart device maker Conor Medsystems Inc. J&J’s pharmaceutical business represents just 41 per cent of sales, which means it hasn’t been as exposed to competition from generic drug makers as poorer performing pharma peers such as Pfizer Inc. J&J’s defensive nature isn’t the only reason for its performance, including an 8.7 per cent sales increase (to $16.5-billion U.S.) or 12.4 per cent rise in earnings per share (to $1.17) in the second quarter: a declining U.S. dollar has meant relatively stronger performance from the 56 other countries in which it operates. Its stock, trading at a forward price-to-earnings multiple of 15 times, “is not cheap, but it’s fair value, and you have a great deal of confidence in these earnings in a way you might not in other stocks,” says Gavin Graham, director of investments with BMO Asset Management. “Over time you will get index performance, plus a little bit. So overall, boring. But boring is good.”

McDonald’s Corp. (MCD: NYSE)
Business: Fast-food restaurants
One-year total return: 36 per cent

Remember that magazine cover from several years back that featured clown mascot Ronald McDonald with a sad face? Now the only Grimace you’ll see around the fast food giant’s Oak Brook, Ill., headquarters is that purple character who hangs out with Ronald. McDonald’s wrote the playbook that a struggling Starbucks is now following: after years of torrid expansion, McDonald’s hit a wall and had to retrench. In the past few years it has drastically scaled back restaurant openings and increased sales from existing locations. The company, long hobbled by weak performance of new menu items, has successfully added healthier offerings, such as salads. Consumer Reports even rated its coffee better than Starbucks. Now, the company is built to sustain the worst the economy can throw its way, UBS analyst David Palmer wrote last month. “We believe MCD remains ready for the big three risks of consumer, currency and commodity inflation,” he said.

Sales from outlets open at least one year have grown by between 3 per cent and 8 per cent over the past five years, while franchisees that haven’t kept up to the company’s rigid standards have been cut off. Earnings are increasing in the low double-digits – and ahead of estimates, which has so impressed investors that Mr. Palmer was forced to cut the stock to “neutral” from “buy” after the stock’s recent rise. “It’s been a very successful turnaround story, but the quality of the product has also improved substantially,” BMO’s Gavin Graham says. The company is trading at a reasonable if not cheap 16.4-times earnings estimates for the year, and has a 2.4 per cent dividend yield. It also has room to move prices to keep up with inflation, testing a 30 cent increase to the price of its 99 cent double cheeseburger. “The value proposition it offers is still pretty attractive,” Mr. Graham says. That makes McDonald’s – long the leader in serving the cheapest, fastest hot food in the restaurant business – a defensive pick in troubled times. After all, “if you eat out, you’ll trade down,” Mr. Graham says.

Wal-Mart Stores Inc. (WMT: NYSE)
Business: Mass merchandise retailing
One-year total return: 41 per cent

Wal-Mart is the biggest retailer in the U.S. and the world, so a decline in consumer spending is bound to hurt. Indeed, the company’s forecast of third quarter earnings between 73 cents (U.S.) and 76 cents per share is shy of analyst expectations. On the other hand, being the retailer famous for selling consumer staples at “Every Day Low Prices” is a good position to be in heading deeper into recession. Plus, the company’s notoriously efficient operations and economies of scale are a competitive advantage as rivals are squeezed by inflation. Wal-Mart has been able to keep prices relatively low without affecting margins, even rolling back prices on select grocery items. And its considerable international operations continue to do well: operating income rose 16.5 per cent in the second quarter, led by stores in China, Brazil and the U.K. In all, Wal-Mart reported a consensus-beating 17 per cent increase in second-quarter profit (to 86 cents per share) last month, on $101.6-billion in revenue, up 10.4 per cent year over year. Sales at stores open at least one year rose by between 3.7 per cent and 4.6 per cent. Wal-Mart also got a bump this year from the U.S. government’s stimulus cheques, as fancier retailers were ignored by worried consumers. Best of all, “from a share valuation perspective, Wal-Mart continues to look compelling,” Oldum Brown’s Murray Leith wrote in a report last month. “In fact, the price-earnings ratio is still near its lowest level in more than two decades” at about 17, while the stock price “more than adequately” factors in the U.S. economic situation. In other words, you can buy the stock at an every-day low price; Mr. Leith has a one-year price target of $67.50 on Wal-Mart.

Special to The Globe and Mail