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My top 10 stocks for 2017

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 eleven 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 2017, listed in alphabetical order. This year's Top Ten represent a nice combination of growth and defensiveness. Six of the 11 S&P 500 industry sectors are represented, and their average long-term estimated growth rate (in EPS) is well in excess 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 2.0 percent.

Results have been good in some years and not as good in others. I will sell my 2016 names on Friday, December 30th 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.


Abbott Laboratories (ABT)

Abbott Laboratories is a diversified, global healthcare company focused on nutritionals, medical products, established pharmaceuticals, and diagnostics. Abbott is a unique asset because of its significant emerging-market exposure and the significant "direct-to-consumer" revenue that it generates. Abbott's stock price has recently under-performed the broader market and its healthcare peers due to concerns about nutritional sales in China, the company's exposure to emerging markets in general, and the company's proposed acquisition of St. Jude. Though emerging markets are currently out-of-favor, we believe that this exposure will prove to be profitable for clients over the long run. The St. Jude acquisition is expected to be very accretive to 2018 earnings per share (EPS). And though Abbott will need to substantially increase its debt load in order to fund this transaction, coverage ratios should be reasonable, and St. Jude and Abbott have both run businesses that have held up well during tough economic times. The aforementioned concerns have left Abbott's stock trading at a discount to the overall market (e.g. 16 times estimated CY17 EPS) while offering investors a 2.7 percent dividend yield. This multiple looks especially attractive vs. the 20 times plus multiples being awarded to consumer staple stocks, a sector that is also considered defensive in nature by investors.

Alphabet (GOOG)

Alphabet is a holding company best known for owning Google. Google generates revenue primarily through selling advertising through Google Search, Google Maps, and YouTube, with a growing contribution from sales of apps and content (Google Play), hardware, and cloud services. The stock has under-performed in 2016 as it consolidated big gains from the second half of 2015. Despite 16 percent earnings growth this year, the stock is up just 4 percent. Meanwhile, the company continues to tweak its algorithms, ad loads, and placements to generate more clicks and higher revenues. The balance sheet is flush with net cash and investments totaling some $85 billion. Sixty percent of that cash is overseas, so any tax reform that lowers the rate on repatriation would benefit the company and shareholders. The company does have some regulatory issues in Europe, but it could be years before that gets resolved. We expect earnings growth in the low-to-mid teens over the next few years as the company benefits from the ongoing movement of advertising dollars from traditional formats to digital, ramps up cloud software and infrastructure services to corporations, and capitalizes on its investments in artificial intelligence and machine learning. The stock trades at 19.3 times estimated CY17 EPS.

Becton Dickinson (BDX)

Becton Dickinson is a global supplier of medical devices, hospital supplies, diagnostic equipment, and medication management systems to hospitals and labs. Consumable products comprise 85 percent of revenue with the other 15 percent coming from equipment. The company should continue to benefit from the following long-term secular trends: 1) Aging populations spending more on healthcare in developed nations; 2) Rising wealth in emerging economies leading to higher healthcare spending and a greater focus on safety; and 3) Movement in the U.S. health care market away from products and towards "solutions." Becton Dickinson has a strong track record of growing sales and earnings faster, and in a more stable fashion, than the overall market. The company's earnings did not drop during the 2008/2009 financial crisis, and we believe that the company's long-term growth algorithm (e.g. 5 percent revenue growth and 10 percent EPS growth) is reasonable and attractive in the current slow-growth environment. Questions about the future of the Affordable Care Act could weigh on the shares near-term, but the long-term secular trends cited above should ultimately outweigh these near-term concerns. The risk/reward appears positive with the stock trading at 17.2x estimated CY17 EPS. The dividend yield is 1.7 percent.

CVS (CVS)

CVS is comprised of over 9,600 retail pharmacies, more than 1,100 walk-in medical clinics, a pharmacy benefits manager (PBM) with over 80 million plan members, a senior pharmacy care business serving over one million patients per year, and an expanding specialty pharmacy business. CVS drove industry-leading performance by combining its retail pharmacy business with Caremark's PBM. However, the stock has been weak in recent months as the competition appears to have caught up a bit. Specifically, the company recently announced that rival PBMs were steering business away from CVS pharmacies. This caused the company to reduce its expectations for prescriptions filled in 2017, which reduces revenue but hits profits more severely due to the significant fixed costs incurred by running a retail pharmacy. Longer term, we believe that CVS is well-positioned to take advantage of higher U.S. drug demand (generic, branded and specialty), and its PBM business should continue to play an important role in keeping drug costs from rising too rapidly. The stock currently trades at 13.5 times estimated CY17 EPS and offers investors a 2.5 percent dividend yield. The current valuation appears quite attractive for long-term focused investors.

ExxonMobil (XOM)

ExxonMobil is an integrated oil company. Its business starts with the exploration and production of crude oil and natural gas and then moves to the production of petroleum products, and finally to the transportation and sale of crude oil, natural gas and petroleum products. The stock performance has lagged the broader energy sector, which is not unusual in the early stages of a commodity price recovery. Oil prices are up 50 percent from the lows of January 2016. The company has historically generated strong returns on average capital employed through its relatively low finding and development costs. The reset in commodity prices has forced companies to find ways to live within their cash flow, and ExxonMobil appears well on its way to achieving free cash flow neutrality (cash from operations covers capital expenditures, dividends, and any share repurchases). ). Additionally, the company may benefit from policy changes that open more drilling areas or improve relations with Russia. If the U.S. rolls back sanctions on Russia, the company stands to regain access to huge reserves of oil. The stock trades at 21.4 times estimated CY17 EPS. On cash earnings, the stock is trading at 7.6 times our estimates for 2017 EBITDA per share. The stock also offers a 3.3 percent dividend yield.

Johnson & Johnson (JNJ)

Johnson & Johnson is one of the world's largest and most diversified healthcare companies with revenue divided among the pharmaceutical, medical device and consumer divisions. The company should continue to benefit from an aging global population and rising standards of living in the world's emerging economies. Johnson & Johnson has a long history of growing its businesses organically while simultaneously adding value by adeptly managing its portfolio of over 250 operating companies. The company enjoys a AAA-rated balance sheet, produces a lot of free cash flow, and generates above-average returns on equity. Healthcare stocks have been among the worst performers in 2016 due to concerns about intervention in drug pricing and the future of the Affordable Care Act. These concerns have left Johnson and Johnson trading at 16.2x estimated CY17 EPS, which represents a discount to the broader market averages. This reasonable multiple, the 2.8 percent dividend yield, and our expectation that JNJ should continue to grow faster, and in a more stable fashion than the overall market over the next five years, underpin our positive view of the stock at current levels.

Lowe's (LOW)

The home improvement sector has been one of the few attractive areas within retail for the past few years, and we think the strong relative performance can continue for a few more years as residential investment remains depressed compared to long-term historical averages. LOW's effectively operates in a duopoly with competitor Home Depot, while the remaining industry competitors are too small to achieve the economies of scale that the two industry bellwethers enjoy. In addition, LOW offers relative immunity from online competition from the likes of Amazon.com. These characteristics are hard to find within the retail sector. With regard to financial performance, earnings growth has been very strong over the past several years as solid sales growth has combined with margin expansion to produce high-teens EPS growth since 2009. Based on continued positive sales and margin trends, we believe the company can continue to put up double-digit EPS growth for several more years. As such, we think LOW represents good value. The stock currently trades at an attractive multiple of 15.9 times estimated CY17 EPS, and the dividend yield is 1.9 percent.

Microsoft (MSFT)

Microsoft, best known for its Windows operating system, is a productivity software powerhouse that has made the move to the cloud and more of a subscription-based revenue model. This transition has occurred over the past couple of years and has resulted in flat cash flow from operating activities. Satya Nadella has done a superb job of changing the culture within the company to focus on making the best productivity software no matter the operating system on which it runs. Azure is Microsoft's open, flexible, enterprise-grade cloud computing platform that has emerged as a strong number two to leading Amazon. Office and server tools continue to appeal to commercial enterprises. We see 2017 as the inflection year in which subscription revenue is large enough to consistently offset the loss of one-time (transactional) software sales. This ongoing transformation should drive acceleration in revenue growth and margin expansion, leading to increased profitability and cash flow. The bulk of the big investments have already been made, and the company is nearing its big, slow turn to the cloud. Shareholder-friendly capital allocation should continue with a 2.5 percent dividend yield and 1 percent-2 percent of shares being repurchased each year. The stock is trading at 20.7 times estimated CY17 EPS.

Sprouts Farmers Market (SFM)

Shares of Sprouts Farmers Market have suffered in recent months due largely to intensified competition and food price deflation. The company, 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 its produce offering 20 percent-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 from its relatively young store base, should translate to mid-teens 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 20.5 times estimated CY17 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 rock-solid balance sheet. However, recent performance has been held back by development costs for the company's ground-breaking new geared turbofan (GTF) jet engine as well as increasing competition and pricing pressure in Europe and China for Otis elevators (both equipment and service). We think the company is taking the appropriate action to improve performance in these two areas. Once through the current investment phase, we think the company can ultimately return to sustainable double-digit EPS growth. Based on those expectations, we continue to believe the company offers strong value for long-term investors, trading at 16.9 times estimated CY17 EPS - a significant discount to the overall market. In addition, the current dividend yield is an attractive 2.4 percent.



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