Citigroup Inc (C)

[Enterprising Investor]

Top 10 Stock Picks for 2017 (12/03/16)

Alphabet, Apple, Citigroup, Deutsche Telekom, Disney, Toll Brothers, and Unilever are among the best bets.

By Andrew Bary

Equity investors face a big choice for 2017. Bet on appreciated “Trump” stocks in the hopes of a stronger economy, or focus on more-defensive sectors. Since the election, economically sensitive stocks, banks, and energy producers have risen, while traditionally defensive groups like consumer stocks and electric utilities have suffered amid concerns about higher rates and inflation.

In selecting our 10 favorite stocks for 2017, we leaned toward laggards rather than chase surging stocks at often-high valuations. Our list includes many familiar companies, including Google parent Alphabet (ticker: GOOG), Apple (AAPL), Citigroup (C), Walt Disney (DIS), Merck (MRK), and Delta Air Lines (DAL).

Eight of the 10 stocks are trailing the Standard & Poor’s 500 index as the year winds down, including three European names— Deutsche Telekom (DTEGY), Novartis (NVS), and Unilever (UL). With European bourses having trailed U.S. markets in 2016, many leading European companies offer good value. And except for Alphabet, all of our picks are valued at less than 20 times estimated 2017 earnings. We use a conservative profit estimate for Alphabet that includes stock compensation.

We’d rather play an improving economy with stocks like Toll Brothers (TOL), Citigroup, and Delta, which trade for about 10 times estimated 2017 earnings, than Caterpillar (CAT), which fetches almost 30 times earnings after a 40% gain this year.

Alphabet is a prime example of the Warren Buffett maxim that it’s far better to “buy a wonderful business at a fair price than a fair business at a wonderful price.” Apple is valued like it could go out of business in a decade or so. The much-discussed challenges at ESPN obscure Disney’s strengths in movies and theme parks. Deutsche Telekom amounts to an appealing sum-of-the-parts story, given its valuable majority stake in T-Mobile US (TMUS). And Unilever has one of the most attractive growth stories among large-cap consumer stocks.

Selecting 10 Favorites each year can be humbling. Our choices from last year have trailed the S&P 500 by more than six percentage points on average, hurt by sizable losses in AMC Networks (AMCX) and CVS Health (CVS); see “2016: We’re Not Sorry to See You Go” at the bottom of this page. We’re hoping to improve on that showing in 2017.

ALPHABET IS ONE of the world’s great businesses, and it’s available at a reasonable price after declining during this year’s market rally. The nonvoting shares trade around $750, or about 23 times projected 2017 earnings of $33 a share. Our 2017 estimate includes the company’s enormous $7 billion of annual stock-based compensation. Alphabet and Wall Street prefer to focus on profits that exclude the stock comp. Using that approach, Alphabet is valued at 18 times estimated 2017 earnings of $41 a share.

Alphabet’s effective valuation is lower since it has almost $80 billion in net cash, or about $115 a share. Much of that is overseas and could be repatriated if favorable tax legislation is passed next year. Moreover, the company is absorbing about $3 billion annually in losses from its “other bets,” like self-driving cars. Chief Financial Officer Ruth Porat gets credit for instilling some financial discipline at the company, but there’s a lot more that can be done.

Despite its size, Alphabet remains an impressive growth company, with revenues and earnings per share expected to rise a robust 17% in 2017.

APPLE REMAINS DOMINANT, but it carries one of the lowest valuations among major technology companies, as investors worry about a litany of issues, including a maturing smartphone market and the lack of a big, needle-moving new product. There’s some basis for these concerns, but they appear to be well discounted in Apple’s share price, which at $110 is just 12 times estimated earnings of $9 a share in the current fiscal year ending in September 2017. The price/earnings ratio is closer to nine when factoring in the company’s $150 billion, or $28 a share, of net cash.

“The Street hates hardware companies and is far too bearish on Apple,” says David Rolfe of Wedgewood Partners, a St. Louis investment manager that counts Apple as one of its largest holdings. Rolfe argues that the iPhone 7 has outperformed low expectations and that investors underappreciate the power of the Apple ecosystem, including an installed iPhone base estimated at 500 million to 600 million. Apple gets little credit for its large and growing services business, including its App Store and Apple Pay. Services generated over $24 billion of revenues in the latest fiscal year at a high profit margin.

CITIGROUP HAS LONG been one of the cheapest of the large financial companies, and that position has solidified this year as its shares have trailed its peers. That could change in 2017 if the bank’s returns continue to increase, helped by rising interest rates.

Citigroup, at $57, has risen 10% in 2017, while rivals, including JPMorgan Chase, Bank of America, and Goldman Sachs Group, are up an average of 25%. Citi has trailed the pack in the postelection rally in financials because investors want U.S.-focused companies like Bank of America. Citi gets almost half its revenues outside of the U.S.

Trading for 90% of its tangible book value, Citigroup is the only megafinancial stock still trading below tangible book. Citi fetches just 11 times projected 2017 profits. Bernstein analyst John McDonald noted recently that Citi trades at a 47% discount to peers on price/tangible book and a 25% discount based on price/earnings.

Citi’s management, led by CEO Michael Corbat, has streamlined operations and boosted returns. The bank’s low dividend yield of 1.1% should rise in 2017, and the bank is on track to buy back 5% or more of its stock in the 12 months ending in mid-2017.

DELTA AIR LINES RUNS like a disciplined industrial company, but it’s still valued like an airline. Its shares, around $49, trade for nine times both 2016 and 2017 estimated earnings. Delta has more than halved its net debt since 2009, to $6 billion, and gained an investment-grade credit rating from Moody’s. Delta pays a dividend of 1.7% and is aggressively repurchasing stock. Total capital returns to shareholders this year should total $3 billion, or 8% of its market value of $35 billion.

An industry leader in both operations and pricing, Delta has segmented its customer base through features such as a cheap, basic economy ticket that doesn’t offer passengers a preassigned seat. By cutting first-class fares, it has made them affordable to many affluent fliers. As a result, more than half of Delta’s first-class and business-class tickets are sold rather than given away as upgrades to frequent fliers.

A couple of factors have grounded the stock this year. Earnings have flattened amid a soft transatlantic market, and oil prices have rallied lately. A bullish scenario for 2017 would include a stronger economy leading to improved unit revenue. Delta management believes that its shares deserve to trade like railroads and other transportation companies, which would result in a stock price of about $100. That may be a stretch, but if Delta gets only halfway there, the stock could be up 50%.

DEUTSCHE TELEKOM HAS DECOUPLED from its most valuable asset, T-Mobile US, during 2016, as its U.S.-listed shares have fallen 13%, to $15.60, while T-Mobile’s stock has surged 40%, to $54. After these moves, Deutsche Telekom’s core European telecom business now is valued at about $9 a share, with roughly $6 attributed to its 65% stake in T-Mobile. The core business trades at a discount to European and U.S. peers, and the stock offers a dividend yield of almost 4%.

The company is the leading integrated wire-line and wireless operator in Germany. Bullish analysts like Mathieu Robilliard of Barclays and Robert Grindle of Deutsche Bank have price targets of about $20.

In T-Mobile, Deutsche Telekom controls one of the most attractive takeover targets in the telecom, media, and cable sector. Comcast is a potential buyer, and T-Mobile could take another shot at merging with Sprint if the antitrust environment thaws under a Trump administration.

MERCK’S OUTLOOK IMPROVED markedly in August with the surprise failure of a clinical trial involving a highly touted drug from Bristol-Myers Squibb. That made Merck’s rival drug, Keytruda, the leading immuno-oncology treatment in the large market for lung cancer, the main cause of U.S. cancer deaths.

After rallying about 5% since the Bristol-Myers setback, Merck still looks attractive, trading at $61, or nearly 16 times projected 2017 earnings of $3.87 a share. The stock yields 3.1%. Merck is a top pick of Bernstein drug analyst Tim Anderson, who sees Keytruda potentially generating over $8 billion in annual sales after 2020, up from about $1.5 billion in 2016. “Immuno-oncology should dominate in 2017,” he says. Merck has a broad franchise, including a strong vaccines business and a leading drug for diabetes.

One promising area for Merck is Alzheimer’s. The area has been a graveyard for drug development, highlighted by a recent failed clinical trial for an Eli Lilly drug. Merck’s leading Alzheimer’s drug to prevent the buildup of potentially disease-causing plaque in the brain works differently than Lilly’s treatment. The drug, Verubecestat, is furthest along in its class and should have Phase 3 trial results in 2017. Anderson says hopes are low for the Merck drug, effectively giving investors a “free call” option on what could be a blockbuster drug.

NOVARTIS IS A WIDELY diversified drug company that now trades for under 14 times estimated 2017 earnings of $4.97 a share. The Swiss pharmaceutical giant’s U.S.-listed shares trade around $68 and yield more than 3%. The company is another top pick of Bernstein’s Anderson, who thinks that Novartis can generate 10% compounded annual growth in earnings per share over the next five years. He notes that Novartis is valued at only a small premium to Pfizer and French drug company Sanofi, which have weaker outlooks.

Novartis is down 21% this year, making it one of the worst performers in Big Pharma, amid shortfalls at its Alcon eye-care business and a slower-than-expected launch of its new heart-failure drug Entresto. Anderson isn’t fazed by the issue, projecting that Entresto will become a blockbuster with about $3 billion in annual sales by 2020, up from about $200 million this year.

Novartis gets 25% of its sales from high-growth emerging markets, among the best of its peers, and it’s less dependent on U.S. pricing increases for higher earnings. It has a large generics business, including one of the best biosimilar operations. Anderson calls the Alcon and Entresto problems “fixable” and says Novartis has an underappreciated drug pipeline. He carries a Buy rating and $89 price target on the U.S. shares.

TOLL BROTHERS AND OTHER home builders haven’t participated in the recent rally in economically sensitive stocks, as investors worry about a peak in the housing cycle and higher interest rates—even though single-family home construction is restrained by historical standards and modest interest-rate increases usually haven’t done much to depress housing.

Toll Brothers, the leading maker of luxury homes, looks inexpensively priced at about $29, or less than 10 times projected earnings of $3.12 a share in the year ending in October 2017. (Toll will report fiscal-2016 results on Dec. 6.) Earnings are expected to be up 20% in the current year. Toll trades for just 1.2 times its most recent book value and at its projected year-end 2017 book of $29. Toll repurchased 7% of its shares in the first three quarters of the recent fiscal year.

With its luxury focus, Toll is the most differentiated of the major home builders. Its average home price of $860,000 is double that of its major rivals, which tend to focus on first-time buyers in Sunbelt markets.

Of concern is Toll’s New York–focused condo business, which generated almost 20% of its earnings this year. The New York luxury condo market has been soft, but Toll insists that its projects are doing OK. Those fears give investors a chance to buy one of the country’s best home builders at around liquidation value.

UNILEVER’S U.S.-LISTED SHARES look appealing after a 20% drop from a September high, driven by mildly disappointing third-quarter results, a stronger dollar, and the rotation into cyclical stocks. The third-largest consumer-products company in the world behind Procter & Gamble and Nestlé, Unilever isn’t as well known to U.S. investors but probably has a better outlook than P&G, thanks to its exposure to high-growth emerging markets, where it gets about 60% of its revenues. Its brands include Dove, Hellmann’s mayonnaise, Lipton Tea, and Ben and Jerry’s ice cream.

Unilever isn’t cheap at $39, or 18 times projected 2017 earnings, but it trades at a discount to its peers. The shares yield 3.6%. An Anglo-Dutch company like Royal Dutch Shell, Unilever has two U.S.-listed shares, tickered UN and UL. We prefer UL, which is based on the United Kingdom shares and has no withholding tax on the dividends.

Under CEO Paul Polman, the company has kept a tight rein on costs and emphasized higher-growth household products like soap and laundry detergent over food. “We believe that Unilever can deliver strong and consistent operating performance,” wrote Bernstein analyst Andrew Wood in a recent client note. He sees nearly 5% sales growth and a 9% gain in earnings per share in 2017. His price target is about 30% above the current share price.

WALT DISNEY IS A CONSUMER and media powerhouse with one of the world’s best brands. The shares, down 6% this year, to $99, don’t reflect its strengths in movies, theme parks, consumer products, and cable television.

Investors worry about the impact of cord-cutting and higher sports-programming costs on Disney’s ESPN, but both of those issues look manageable, and ESPN is far from everything at Disney, accounting for an estimated 35% of total earnings. “What distinguishes Disney is the quality of its content and the way consumers associate that content with Disney,” says Anthony DiClemente, an equity analyst at Nomura/Instinet who carries a Buy rating at a $110 price target on the shares. Disney faces a well-advertised profit lull in its current fiscal year ending in September 2017, when earnings per share may grow just 4% after an 11% rise in fiscal 2016. This fiscal year, it will be lapping the huge profits it had in its studio division last year, when it had four films that each grossed over $1 billion at the box office.

DiClemente sees a resumption of double-digit profit growth in fiscal 2018, as the studio churns out four Marvel movies, three animated features from Disney and Pixar, and two Star Wars films. Disney shares now trade for a reasonable 15 times that 2018 estimate. There’s also the possibility of a dramatic corporate event like a purchase of Netflix, or a scenario tossed out recently by media mogul John Malone, who said Disney could be sold to Apple after spinning off or selling ESPN. Farfetched? Probably. Impossible? No.

http://www.barrons.com/articles/top-10-stock-picks-for-2017-1480748688?mod=BOL_hp_highlight_2