Should you dive into Dow stocks?

By Morningstar

Is it time to buy?

We get this question a lot. Some people are trying to time the market -- a strategy we frown upon. Others are simply looking for another opinion to add to their thought processes, which is laudable.

Motives aside, we think the market looks undervalued, blue-chip names especially so. For that reason, we'd be enthusiastic buyers of exchange-traded funds that invest primarily in higher-quality, large-cap stocks, such as Diamonds Trust (DIA, news, msgs), which tracks the Dow Jones Industrial Average ($INDU).

That fund was recently trading at a 19% discount to our estimate of the portfolio's aggregate fair value. Ordinarily, we'd be buyers of a portfolio like the Dow when it's trading at an 8% or greater discount to our fair-value estimate. Thus, we think Diamonds Trust is a plum deal at these levels.

But what are we seeing in the Dow that the market isn't? And is it through rose-colored glasses?

Those questions loom larger given blue-chip stocks' influence on the valuation of many ETFs.

Indeed, the Dow components pop up in a number of ETFs, reflecting the way market-cap weighting -- which most funds employ -- vaults the biggest companies into the upper rungs of many portfolios. (As of April 30, for instance, more than one in 10 ETFs owned IBM (IBM, news, msgs) shares.) And with blue chips looking inexpensive, on balance, that largely explains why we're seeing a lot of undervalued ETFs these days.

With that in mind, we thought it would be useful to peer deeper into some of the key assumptions that underpin our fair-value estimates for the 30 Dow components.

The most important of those assumptions -- our growth and profitability forecasts -- essentially dictate the timing and magnitude of the cash flows we're expecting these businesses to generate in the future. Those cash flows, in turn, form the basis for each fair-value estimate we place on a business.

If you thought we were expecting the Dow components to take off in the coming years, think again. Our growth assumptions are, on the whole, relatively sober.

5% annual sales growth

Let's start with sales growth: In aggregate, our forecasts assume the Dow components will increase revenue at a 5% compound annual growth rate, or CAGR, from 2008 to 2011. When we decompose that figure by sector, the range is surprisingly narrow, bracketed by 8% at the high end (industrials) and minus-3% at the bottom (energy).

Indeed, we're expecting most of the major economic sectors represented in the Dow to increase between 3% and 6% per year, with financials and software giant Microsoft (MSFT, news, msgs), both 7.5%, being notable exceptions. (Microsoft is the publisher of MSN Money.)

Where's the growth in industrials and financials coming from? We're expecting Boeing (BA, news, msgs), with an 11% CAGR, and Caterpillar (CAT, news, msgs), with 9%, to pace growth among the industrial names.

With respect to financials, generally speaking we're forecasting a widening of net interest margins (i.e., the profit a bank pockets when it borrows short and lends long). We also expect certain fee-based businesses to perk up. However, a big chunk of the growth is simply snap-back from a dreadful 2007 campaign.

As for individual names, we're forecasting double-digit annualized revenue growth for just two Dow components -- Citigroup (C, news, msgs), 10% annualized, and Boeing, 11% -- with a handful of others, including American Express (AXP, news, msgs), Intel (INTC, news, msgs) and Caterpillar, touching the high-single digits.

At the opposite end of the spectrum is Chevron (CVX, news, msgs), whose revenue we expect to contract slightly, reflecting our belief that oil prices will gradually trend down in 2011.

Operating income favors financials

Our operating-income growth forecasts generally track the trajectory of sales, albeit at a slightly steeper angle in some cases. (Operating income, sometimes referred to as pretax income, is a company's operating revenue less its operating costs.)

The most conspicuous example is the financial sector, where we're forecasting 16% annualized operating income growth, or roughly double our top-line growth forecast. How can this be? As write-offs gradually decline, which we expect, operating margins (operating income as a percentage of revenue) should revert to levels that more closely approximate the historical norm.

By contrast, we're forecasting a roughly 10% annualized operating income decline for Chevron and ExxonMobil (XOM, news, msgs). This is a function both of our revenue forecast (declining oil prices come 2011) and the degree of operating leverage in those businesses (scale is a blessing when sales are ramping higher, a curse when it's fading).

Our forecast of a 7% earnings-per-share growth rate for the Dow more or less tracks the growth in operating income. A similar story holds for our 5% annualized free cash-flow growth forecast (i.e., operating cash less capital expenditures; it's a reasonable proxy for the cash flows that form the basis for our fair value estimates) only slightly lags operating income growth.

Boeing may see a gain in cash flow

Cash flow can diverge from operating income for a number of reasons, not least of which is a firm's capital-intensiveness. By that standard, it's somewhat surprising that we're forecasting 16% annualized free-cash-flow growth for the Dow's industrial components, a tally that surpasses all other sectors, as industrials tend to be more, rather than less, capital-intensive. However, that's largely a function of one name -- Boeing -- where we're expecting cap-ex to gradually tail off as a percentage of revenue, goosing free-cash-flow generation in the process.

The upshot is that while we hardly expect these businesses to stand in place, our forecasts aren't predicated on lofty growth projections. In fact, we expect most of these businesses to churn out sales, profits and cash flow in the mid- to high-single-digit range.

This article was reported and written by Jeffrey Ptak for Morningstar.