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Markets

7 Blue Chips to Hold Forever

With little debt and lots of cash, these global powerhouses should buck the recession.

You need courage to buy stocks nowadays. The market's turbulent start in 2009, coming on the heels of 2008's awful beating, hardly leaves investors feeling warm and fuzzy. The economy is in a deep slump, and the outlook for corporate earnings over the next few quarters is somewhere between murky and miserable.

How do you invest in stocks in the midst of so much turmoil and uncertainty? We suggest you focus on the long term -- say, a minimum of seven years -- and look for high-quality, blue-chip companies that have balance sheets as invulnerable as Fort Knox and can generate wads of cash.

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Our thinking goes like this. It will take several years for consumers, the economy and the financial system to recuperate fully. Economic growth and therefore earnings growth are likely to be tepid over the next five or more years. But if you invest in well-managed, financially strong businesses that sell goods and services for which demand is consistently strong (think food and medicine, not arcane financial products), you should do well.

Businesses like these typically display certain characteristics: They carry little or no debt. They generate enough free cash flow (earnings plus depreciation and other noncash charges, minus the capital outlays needed to maintain the business) that they don't have to raise equity or sell debt -- a good thing in today's unfriendly capital markets. They have a proven history of management excellence. They have abundant opportunities for reinvesting capital (or clear policies for returning excess capital to shareholders), and their leaders boast an outstanding record of allocating capital. In addition, they are global in scope. After all, 95% of the world's population lives outside the U.S., and economic growth is likely to be greater abroad than at home.

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We suggest that you focus on companies that pay out some of their profits; in a sluggish economic environment, much of your total return will come from reinvested dividends. Judy Saryan, co-manager of Eaton Vance Dividend Builder fund, notes that over the long haul, 40% to 45% of the return on stocks has come from reinvested dividends, a share she reckons will climb to 50% over the next five to ten years.

In choosing seven great growth companies to invest in for the long haul, we didn't obsess over price. But it's hard to argue that any of our picks are overvalued. Price-earnings ratios range from 11 to 18, and all but one of the stocks have been hammered over the past year.

Finally, filter out the short-term noise when you focus on your long-term holdings. Most of the chatter from Wall Street and in media headlines -- such and such a company missed earnings by 2 cents a share this quarter and so forth -- is just that: chatter you can ignore.

Overseas tobacco giant

Philip Morris International (symbol PM) was born in March 2008, when it was spun off from Altria. PM is a U.S. company, but it books all of its sales abroad (in 160 countries), where tobacco consumption continues to grow. As an independent business, PM is the fourth-most-profitable consumer packaged-goods company in the world -- behind Procter & Gamble, NestléÉ and Unilever but ahead of Coca-Cola and PepsiCo -- and it's safe from the long arm of U.S. tobacco litigators. (You'll have to decide for yourself whether investing in a cigarette manufacturer is morally defensible.)

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Philip Morris owns seven of the top 15 cigarette brands in the world, including Marlboro, L&M and Parliament, and controls by far the largest market share of any publicly traded producer. Cigarette sales are shrinking in Western Europe but expanding in emerging nations, where brand-name smokes are an affordable luxury. To stimulate that growth, cash-rich PM recently acquired cigarette companies in Colombia and Indonesia, and increased investments in Mexico and Pakistan.

Unlike most industries these days, PM can push through price increases. "Global demand for cigarettes is extremely resilient, which is very important in today's economic environment," says Charles Norton, manager of Vice fund, which holds PM shares.

The beauty for shareholders is that Philip Morris is a fantastically profitable business. Its return on equity is a towering 55%, and the company generates immense amounts of free cash flow (capital-investment requirements are minimal for cigarette companies), most of which is returned to investors through annual share buybacks and a steadily rising flow of dividends. The company is targeting annual growth in earnings per share of 10% to 12%. At the February 6 closing price, PM shares yielded a healthy 6%.

Leader in branded foods

Nestlé (NSRGY.PK) is a bit like Philip Morris except that its products are more healthful for consumers. Every day this Swiss multinational corporation, the world's largest food and beverage maker, sells its brands to a billion customers worldwide.

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Nestlé was born in 1866 as a maker of cereals for infants. Today it owns dozens of billion-dollar brands, including Nescafé, Nestea, Carnation and Perrier among its liquid products, and Kit Kat, Dreyer's, Gerber and Purina in solid foods.

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With so many leading brands, Nestlé commands prime shelf space around the globe. Sasha Kovriga, a portfolio manager at the Osterweis fund, which holds the stock, says that the company's main appeal is the scale and quality of its global distribution system. Particularly in developing countries -- where Nestlé books one-third of its sales and its revenues continue to rise (branded coffees, chocolates and ice cream are affordable goodies) -- the ability to transport perishable foods spells the difference between success and failure.

Nestlé is a conservative company (reassuring these days) that is firmly focused on the long term. It invests $2 billion a year in research and development -- rare for a food company -- to create new products, such as healthier fare for pets and humans. The balance sheet is bulletproof, enabling Nestlé to maintain a triple-A credit rating. Earnings growth is steady, and Nestlé's shares, which trade as American depositary receipts on the pink sheets, yield 3%. Strong cash generation supports annual dividend increases and share buybacks.

Rejunvinated fast food

McDonald's transformation this decade. The fast-food giant shifted its focus from opening new restaurants to boosting sales at existing outlets. It freshened and diversified its menu by adding salads and less-fattening chicken dishes, and the company is rolling out new beverages, including premium coffees and smoothies. Meanwhile, McDonald's continues to plant more golden arches overseas, where it now generates 65% of sales.

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McDonald's (MCD) is also moving steadily from owning its eateries to franchising them. Franchisees now own more than 80% of McDonald's 14,000 U.S. restaurants. So instead of spending capital on its own outlets, McDonald's collects an annuity-like stream of rent, royalties and service fees from franchisees but keeps spending heavily on its powerful global brand.

The financial shift at McDonald's has been remarkable. Since 2003, return on equity has doubled, to 30%. Since 2002, free cash flow has quadrupled, to $3.5 billion. The company has boosted its dividend payout every year since 1976. But it wasn't until recently, when capital requirements declined and free cash flow exploded, that it became an attractive dividend-growth stock. The dividend, currently $2 a share per year, has grown at a rate of 36% a year over the past five years. At $58, the stock yields 3.4%. With its message of value and convenience, McDonald's should be a standout during this consumer slump.

The king of seeds

The fortunes of McDonald's, Nestlé and Philip Morris International are increasingly tied to the growing populations and incomes of the developing world. As middle classes grow, more people have diets rich in meat and dairy products. For example, annual per-capita consumption of meat in China has more than doubled, to 110 pounds, since 1980 (gluttonous Americans consume more than 200 pounds per head, but remember that the Chinese are 4.3 times more numerous).

That boosts demand for crops, such as corn and soybeans, that are essential ingredients of animal feed. A chicken consumes 1 to 2 pounds of feed for each pound it weighs at termination, and a pig wolfs down 2 to 3 pounds of feed grains for each pound it weighs before slaughter. The changing global diet, along with the rise of biofuels in the U.S. and Europe, explains the surging demand for corn, soybeans and other oilseeds.

Enter Monsanto (MON), the king of genetically engineered seeds. The science that goes into developing these seeds is complex (Monsanto plows 10% of sales, or about $900 million, into R&D each year), but the value proposition for farmers is simple. The seeds, which are more resistant to pests and reduce the amount of water their crops consume, raise farmers' productivity dramatically by boosting the output of crops per acre.

No wonder Monsanto's worldwide market share for seeds is steadily expanding. That's helped turn Monsanto into a growth company this decade: Profits exploded ninefold between 2005 and 2008, and the dividend continues to sprout like ears of corn in Iowa. Unlike most businesses these dark days, Monsanto is still able to increase its sales volume and prices. Agricultural yield per acre is a long-term problem on a populous planet running out of room for new farmland. That's why we think Monsanto can continue to produce annual earnings growth of 15% or more for years to come. At $84, Monsanto shares sell at 18 times estimated earnings (for the 12 months ending next November), making it the most expensive stock on this list.

Opportunities in big oil

ExxonMobil (XOM) seems to emerge stronger from each wicked commodity cycle. The global footprint of this energy colossus and its integration of production and refining operations help to smooth out the volatility. But the real key is a culture of disciplined capital allocation, says Kurt Wulff, an independent energy consultant in Needham, Mass.

Exxon avoids high-risk projects that are sensitive to oil-price volatility, says Wulff, and instead focuses on projects that are low-cost and profitable. That's how it routinely squeezes out more profit per barrel than its big integrated competitors and achieves the industry's highest returns on capital.

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You won't get rich overnight holding Exxon, but the stock has rewarded shareholders handsomely for many decades. Over the past 15 years, for instance, it returned an annualized 14%, twice the gain of Standard & Poor's 500-stock index. Exxon, one of a handful of industrial companies in the U.S. with triple-A debt ratings, has a huge net cash position -- $30 billion after subtracting outstanding debt -- and generates immense amounts of free cash every year. So the company should have little trouble raising dividends (it's done so for 26 consecutive years) while feverishly repurchasing stock (the share count has shrunk 20% over the past five years). Founder John D. Rockefeller Sr. would be proud.

Middle East drug wonder

Diversified health-care outfits, such as Johnson & Johnson and Abbott Laboratories, have richly rewarded loyal shareholders over the past 50 years. After all, people visit the doctor and take their medicine in any economy. With long records of boosting their dividends, J&J and Abbott are likely to remain sound investments.

Still, the branded-drug business carries risks. Pipelines of new products in the laboratories are hard to find and to value. More important, governments from the U.S. to Germany to Japan and China are trying to suppress the runaway costs of health care. But those chronic budgetary pressures are a tonic for makers of generic drugs, which is why we like Israel-based Teva Pharmaceutical Industries (TEVA).

Teva, which generates nearly all of its sales outside Israel, is by far the world's largest maker of generic drugs and is gaining worldwide market share. Wendy Trevisani, co-manager of Thornburg International Value, says that Teva, which just completed its acquisition of Barr Laboratories (for $9 billion, including assumption of Barr's debt), is often first to market with generics when branded drugs come off patent. This bestows a highly lucrative six-month window of exclusive sales before rivals can enter the fray.

With its global reach, Teva has become a one-stop shop for generics. It is strong in the lab, which Trevisani says will become even more important as the first generation of hard-to-copy biotech drugs comes off patent. Overall, she says, medicines with annual sales of nearly $100 billion will lose patent protection over the next five years.

Analysts, on average, project that Teva will generate earnings gains of 15.5% annually over the next five years. At $42, the stock trades at 15 times estimated 2009 profits, which seems a modest price to pay for that kind of growth.

Tech transformation

You'll notice that our list of stocks is light on technology. There's a reason for that. When you consider the short life span of high-tech products, the fierce competition and the cyclical nature of many of the businesses, it's difficult to project the future cash flows of technology companies. But IBM (IBM) is an exception.

Like McDonald's, Big Blue has quietly transformed itself this decade into a more-profitable business that generates excess cash flow. IBM has done this by shedding its commodity-like personal-computer and disk-drive businesses and migrating more deeply into businesses with higher profit margins and recurring revenues, such as information-technology services and software (which account for 75% of revenues today).

The result has been a jump in profitability; IBM's operating profit margin has climbed from 17% in 2003 to 21% today. Free cash flow has surged, allowing Big Blue to triple its dividend over the past five years and to buy back shares aggressively. Even in 2009, IBM, which books about 60% of sales overseas, should eke out a small gain in earnings. Eaton Vance's Saryan says IBM's brand power, global leadership in IT services, financial strength, consistency and commitment to dividend increases earned it a spot as one of very few technology stocks in her Dividend Builder portfolio.