Blue Chips That Should Lose the Blues
GE, Microsoft and Automatic Data Processing -- like many large, high quality companies -- have enjoyed steadily rising earnings, but their stocks have languished. That could be changing.
Big-company growth stocks are performing respectably in 2007: Year-to-date through May 29, the Russell 1000 Growth Index returned 8.5%. Robert Millen, co-manager of Jensen Portfolio, thinks there's more to come. As economic growth eases and credit tightens, he thinks investment will flow from lower-quality stocks to blue chips with solid balance sheets and durable expansion prospects. "We think quality-growth investing is in for a while," he says.
What does Millen mean by quality growth companies? Jensen screens first for return on equity, a measure of profitability, and considers only those outfits with a market value in excess of $1 billion and an ROE of 15% or higher for at least ten consecutive years. This screen limits the universe to 170 companies. Then the Oregon-based fund managers look for the sustainable competitive advantages that confer pricing power, and they scrutinize balance sheets. Result: a portfolio of about 25 stocks.
Consider these three well-known companies that Millen finds attractive in today's market: General Electric (symbol GE), Microsoft (MSFT) and Automatic Data Processing (ADP). He says the story for all three is similar: Earnings have risen healthily over the past five years, but the stocks have treaded water.
Millen thinks GE has reinvented itself under Jeff Immelt, successor to the great Jack Welch. Immelt has shed slower-growing businesses, such as insurance and plastics, and focused on more profitable lines, such as power-plant construction. Millen estimates that 90% of GE's revenues are generated by businesses growing at double-digit percentage rates, up from 60% just five years ago. Earnings have expanded 40% since the end of 2001, but the stock has declined. "We think GE is as undervalued as it's been in over ten years," he says.
Microsoft is much the same story. Earnings are up 30% since the end of 2001, but the stock price is down slightly (and it's well below Microsoft's 1999 record high). As with GE, Millen sees a company that generates half of its business from overseas and can grow 10% or more annually for a long time with little downside risk.
ADP, the payroll-processing king, is a bit different in that it's a domestic play, but similar in that its earnings have climbed 25% since the end of 2001 while the stock has gone nowhere. Millen notes that ADP benefits from higher interest rates: The company sits on a giant float of cash, largely tax payments headed to the IRS. He also likes ADP's towering client retention rates -- employers hate switching payroll processors -- and pricing power. A strong employment market has helped ADP to maintain a lush 19% ROE over the past decade.
GE closed at $37.73 on May 30, up 0.9%; Microsoft finished at $31.11, up 1.0%. ADP closed at $49.24, up 0.4%.