×

My top 10 stock picks for 2016

Farr, Miller & Washington is a "buy-to-hold" investment manager, which means we make each investment with the intent to hold the position for a period of 3-5 years. Nevertheless, in each of the past ten Decembers I have selected and invested personally in ten of the stocks we follow with the intention of holding for just one year. These are companies that I find especially attractive in light of their valuations or their potential to benefit from economic developments. I hold an equal dollar amount in each of the positions for the following year, and then I reinvest in the new list.

The following is my Top 10 for 2016, listed in alphabetical order. Prices are as of Dec. 28 close. This year's Top 10 represent a nice combination of growth and defensiveness. Seven of the 10 S&P 500 industry sectors are represented, and their average long-term estimated growth rate (in earnings per share) is nearly double that of the overall market. Also on average, these companies are much larger than the average S&P 500 company while carrying an average dividend yield of about 2.2 percent.

Results have been good in some years and not as good in others. I will sell my 2015 names on Thursday, Dec. 31 and buy the following names that afternoon. These are not recommendations to buy or sell securities. There is risk of losing principal. Past performance is no indication of future results. If you are interested in any of these names, please call us or your financial advisor to discuss.




Chevron (CVX)

Chevron is a U.S.-based integrated oil and gas company with global operations. Chevron's production profile is 67 percent liquids (primarily oil), and oil prices are currently under $37 – a level we haven't seen since the great recession of 2009. We don't have a crystal ball, but we're guessing oil prices will be higher, not lower, three years from now. The stock is trading at 26.2 times calendar year 16 estimated EPS with a 4.7 percent dividend yield. It helps to normalize earnings of companies that operate in cyclical markets, and doing this with Chevron leads to a valuation at 17 normalized earnings or 12 times its average annual EPS for the last 15 years.

CVS Health (CVS)

A pedestrian passes a CVS store in New York.
Scott Mlyn | CNBC
A pedestrian passes a CVS store in New York.

CVS Health sold off from its high of over $113 to $92 recently as the company issued 2016 guidance that was below expectations. Only six weeks later, CVS increased its outlook for 2016, causing the stock to rally off recent lows to where it currently sits at around $98. We believe CVS offers value because of its undemanding valuation, its focus on returning capital to shareholders, and its exposure to long-term secular tailwinds, including increased health-care coverage, an aging population, and healthcare cost control.

Management recently reaffirmed its long-term target of 10-14 percent EPS growth while also increasing its dividend 21 percent to $1.70 (to a 1.7 percent yield). CVS is committed to increasing its dividend payout ratio to 35 percent by 2018, which implies a compound annual growth rate of 18 percent. Also, we expect $4 billion to $5 billion in share repurchases annually. CVS currently trades at 16.9 times calendar year 16 estimated EPS.

Donaldson (DCI)

Donaldson is a global manufacturer of filtration systems and replacement parts. The company has dominant market share in many of its end markets, which are very diverse and have attractive long-term secular growth potential. And perhaps most important, well over half of company sales are for high-margin and recurring aftermarket products and services, including replacement filters. Financial performance has been outstanding, including very impressive low-teens annual growth in EPS over the past 20+ years. Finally, the balance sheet is very strong and free cash flow generally approaches net income an annual basis. At about 17.6 times calendar year 16 estimated EPS and a 2.4 percent dividend yield, we find the shares compelling.

Goldman Sachs (GS)

Goldman Sachs has come a long way since the financial crisis. The nation's premier investment bank is now on stable ground with a much stronger financial position, including far less leverage. Higher capital and liquidity requirements, along with restrictions on proprietary trading, however, have also led to much lower returns on equity. But, we believe the company should receive more credit for its more defensive balance sheet, lower volatility, and lower chance of financial distress. In addition, much of the company's past competition has melted away leaving Goldman to gain market share (though of a smaller pie).

Finally, we think that Goldman's model is nothing if not dynamic, which means the company has the ability to adapt to any environment and earn outsized returns compared to the industry. Given these attributes, we think the stock is undervalued at 1.12 times tangible book value and 9.6 times the consensus estimate for 2016 EPS. The company also offers a 1.4 percent dividend yield, and the dividend should continue to grow.

Johnson & Johnson (JNJ)

Johnson & Johnson products
Getty Images

Shares of Johnson & Johnson remain an attractive option for defensive investors. Johnson & Johnson has grown earnings at a compound annual growth rate of 10 percent over the 10 plus years. The company is one of the world's largest and most diversified healthcare companies. Its balance sheet is rated AAA, it generates huge free cash flow and high returns on equity, and it offers investors exposure to a truly global franchise (53 percent of total sales come from international sources). Uncertainty surrounding health-care legislation and a sluggish global economy has left investors concerned about the company's future growth rate.

Even so, the stock appears attractive for long-term investors at current valuation levels (16.1 times calendar year 16 estimated EPS with a 2.9 percent dividend yield). Assuming no change to its current P/E multiple, long-term investors would only need about 7 percent annualized EPS growth to achieve a 10 percent annualized return from the stock from current levels.

Lowe’s Companies (LOW)

Lowe’s new Manhattan store.
Krystina Gustafson | CNBC
Lowe’s new Manhattan store.

The home-improvement sector, and Lowe's in particular, we feel remains one of the few attractive areas in retail. LOW offers relative immunity from online competition, and the company's economies of scale give it a competitive pricing advantage over smaller regional players. The company's strong free cash flow and commitment to returning cash to shareholders through buybacks will continue to be accretive to EPS. Margins have been improving in recent years, but they continue to trail 2007 highs by a significant amount, which gives us confidence this trend can continue. We think LOW represents good value given our expectation for mid-teens EPS growth over the intermediate term. LOW also offers at 1.5 percent dividend yield and currently trades 19.3 times calendar year16 estimated EPS.

Perrigo Company (PRGO)

Perrigo is a diversified drug company headquartered in Dublin, Ireland that stands to benefit from the growing need for low-cost health-care products. A hybrid between a drug company and a consumer products company, Perrigo produces store-brand OTC products and drugs and specialized generic Rx drugs, and holds claims to escalating royalties from Biogen's blockbuster multiple sclerosis drug Tysabri. The company is unique in the drug industry because it is not affected by the patent cliffs faced by branded pharmaceutical companies or the intense competition faced by generic drug manufacturers.

Perrigo's 3-year financial guidance calls for 5 percent-10 percent organic revenue growth to be leveraged into 10 percent-20 percent EPS growth. The current valuation (15.3 times calendar year 16 estimated EPS) appears reasonable given the expected growth rate, the less cyclical nature of PRGO's earnings stream, a strong balance sheet and solid free cash flow generation.

Qualcomm (QCOM)

Qualcomm is a leading developer, designer, and manufacturer of digital wireless telecommunication products. Nothing went right for Qualcomm in 2015. In February, China concluded its probe into the company's licensing practices, and the result seemed like a victory. We believed the agreement would lead Chinese equipment manufacturers to become licensees, shrinking the gap between estimated global device sales and total reported device sales. Progress is being made, but at a slower pace than anyone envisioned.

Also in 2015, the chipset division was caught flat-footed when leading flagship devices moved to 64-bit processors. This misstep has been corrected, and the news flow around the revamped offering for 2016 (Snapdragon 820) appears to be largely positive. The stock trades at 11.0 times calendar year 16 estimated EPS, a significant discount to other semiconductor companies. The dividend yield is 3.9 percent and the company is returning a significant amount of cash to shareholders through stock repurchases.

Sprouts Farmers Market (SFM)

Pedestrians walk outside Sprouts Farmers Market in Wheat Ridge, Colorado.
Anya Semenoff | The Denver Post | Getty Images
Pedestrians walk outside Sprouts Farmers Market in Wheat Ridge, Colorado.

Sprouts Farmers Market, whose motto is "healthy living for less," operates healthy grocery stores that offer fresh, natural, non-GMO and organic food. Sprouts sits at the ideal intersection of natural/organic, affordability and accessibility. To drive foot traffic Sprouts prices produce 20 percent to 25 percent below traditional supermarkets, and even further below Whole Foods Markets and other natural foods competitors. This price point means Sprouts is attractive to both the everyday shopper and the hardcore natural foods customer.

Sprouts' footprint is largely in the Southwest, but the company is expanding east and adding 14 percent to its total square footage every year. We believe that this rate of store growth, along with mid-single digit same-store sales growth, should translate to mid-double digit revenue and EPS growth for the foreseeable future. In addition, the company generates strong cash flow and is able to fund its store expansion internally while also returning capital to shareholders through a share buyback program. Sprouts is currently trading at 28.1 times calendar year 16 estimated EPS.

United Technologies (UTX)

United Technologies is a diversified industrial company that provides products and services to the building systems and aerospace industries worldwide. The company's aerospace segments target both commercial and government (including both defense and space) customers. The company has a fantastic long-term track record of financial performance, with strong double-digit EPS growth, outstanding cash generation, and a stock price that, until recently, had handily outperformed the market over the long term. Looking forward, there are certainly risks to the outlook, including slowing growth outside the U.S., an aging aerospace cycle, and the continued integration of a new CEO. However, trading at a significant discount to the overall market, we think patient investors will be rewarded. The stock currently trades at an undemanding 14.6 times calendar year 16 estimated EPS with a yield of 2.7 percent.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.