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My top 10 stocks for 2018

  • My top 10 stocks for 2018 represent 7 of the 11 S&P 500 industry sectors.
  • Their average long-term estimated growth rate (in earnings per share) is well in excess of the overall market.
  • Of course, these are only my picks, and not an explicit recommendation to buy or sell securities.
Michael Farr
Scott Mlyn | CNBC
Michael Farr

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 twelve 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 2018, listed in alphabetical order. Prices are as of the December 19 close. This year's Top Ten represent a nice combination of growth and defensiveness. Seven of the 11 S&P 500 industry sectors are represented, and their average long-term estimated growth rate (in earnings per share) is well in excess of the overall market. On average, these companies are much larger than the average S&P 500 company while carrying an average dividend yield of about 2.1 percent.

Results have been good in some years and not as good in others. I will sell my 2017 names on Friday, December 29th and buy the following names that afternoon.

Top Ten for 2018

Prices as of Close on December 19, 2017

Bristol-Myers Squibb (BMY)

Bristol-Myers is a global biopharmaceutical company and a juggernaut in the area of immunotherapy. The company should benefit from continued growth of its primary drugs, Opdivo and Eliquis, as each have several years remaining on their respective patents. The company also has a promising pipeline of new drugs. Furthermore, an aging populating and increased spending on healthcare should act as tailwinds well into the future for the company. BMY has a strong 'A' rated balance sheet which gives the company the flexibility to make acquisitions to expand its revenue base over time.

We expect sustained double-digit earnings growth over the next 5 years, and this growth should not be particularly economically sensitive. The stock trades at 19 times the consensus for calendar year 2018 earnings per share, which represents a slight premium to the S&P 500. In addition, the stock offers a 2.6 percent dividend which should also grow over time.

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 S&P 500 by a significant percentage despite improving commodity prices. The company has historically generated strong returns on average capital employed through its relatively low exploration and development costs and superior project management. This point is often lost on investors chasing shale companies. Many that claim to be profitably drilling for oil in the US are only counting the cost to produce oil and exclude the cost of acquiring and developing the land.

The reset in commodity prices has forced companies to find ways to live within their cash flow, and ExxonMobil reached free cash flow neutrality (cash from operations covers capital expenditures, dividends, and any share repurchases) in 2017. Additionally, the company may benefit from policy changes that open more drilling areas or improve relations with Russia. The stock trades at 20 times estimated calendar year 2018 earnings per share. The stock also offers a 3.7 percent dividend yield.

FedEx (FDX)

FedEx has made great strikes in restructuring its Express unit to reflect changing customer preference away from expensive overnight air deliveries and toward more economical Ground deliveries. At the same time, the company has been investing aggressively in its Ground network, enabling it to grow that business at very rapid rates in recent years. Meanwhile, the company is in the process of integrating its largest-ever acquisition – a $4.8 billion deal to acquire TNT Express, which will vastly expand the company's presense and scale in Europe and create big opportunities for expense and revenue synergies.

Within its three major business segments – Express, Ground and Freight – the company has proven extremely adept at managing package volumes and yields to optimize profits and returns rather than focusing simply on yield, package volume or revenue maximization. This expertise, along with a vast delivery network that has taken 40 years to establish, ensures that FedEx can grow profitability even in the event that an aggressive new competitor (Amazon.com) seeks to participate in the massive growth potential of e-commerce. The stock trades at just 17 times the consensus estimate for calendar year 2018 earnings per share, which is a significant discount to both UPS and the S&P 500. The yield is 0.8 percent.

Goldman Sachs (GS)

Goldman Sachs is arguably the premier global investment bank, with consistently high revenue share in equity offerings and mergers & acquisitions, as well as a growing presence in fixed income. However, the company's trading arm, which typically accounts for an outsized 40 percent-50 percent of total company revenue, has been beset by low market volatility and heightened regulatory scrutiny following the passage of the Dodd-Frank Act in 2010. As a consequence of these pressures, the company's returns on equity have struggled to cover its cost of capital in recent years.

Looking forward, we expect the environment to improve. The Trump administration is actively working to reduce the regulatory burden on financial institutions, to include possible liberalization in the Volcker Rule (which restricts covered institutions from making proprietary investments) as well as liberalization in the capital and liquidity requirements that have resulted in depressed returns on equity.

At the same time, we believe that the recent lack of market volatility reflects a complacency that could be long in the tooth. Finally, the company is working to aggressively diversify its revenue base away from trading operations. At current levels, the stock is trading at just 1.3x book value, which would suggest that the low current ROE's will persist. As such, we think there is solid upside in the event that ROE's improve.

Medtronic (MDT)

Medtronic is a diversified global medical-technology company that operates through four segments: Cardiac and Vascular Group, Minimally Invasive Technologies Group, Restorative Therapies Group, and Diabetes Group. With sales in over 120 countries, the company has geographical scale that is hard to duplicate.

MDT has faced a variety of headwinds in 2017, including natural disasters and IT disruptions, but we expect its new product cycle to drive top-line growth in 2018. Moreover, management has cost-saving initiatives in place that will help boost the bottom line.

The stock trades at just 16 times calendar year 2018 earnings per share, which represents a discount to both its peer group and the S&P 500. We view this stock as an attractive holding for long-term investors, especially given that we believe earnings should continue to grow in a down market. The company also offers a 2.2 percent dividend.

Microsoft (MSFT)

Microsoft is one of the largest technology companies in the world. It has successfully pivoted from a Windows PC-first world to the cloud where its focus on productivity and business processes is paying dividends.

As part of this change in focus, the company has moved from one-time licensing fees (the customer owns the software) to subscription-based sales which, for a monthly fee, allows customers to always have the latest version of the software. This transition negatively impacted revenues and cash flow over the last couple of years.

However, cash flows reached an inflection point in 2017, and the subscription base is now large enough to more than make up for the lost up-front cash generated under the one-time licensing model. We believe the company can grow free cash flow by double digits over the next few years which should support its valuation. The stock trades at 24 times the calendar year 2018 earnings per share estimate with a free cash flow yield north of 5 percent.

Ross Stores (ROST)

Ross Stores operates in the off-price channel, which has been one of the few bright spots in the retail sector over the past couple of years. As many department stores have struggled and closed stores, ROST is expanding its 1,627 store base at 6 percent per year, and management sees potential for 2,500 stores over the long-term.

Unlike most specialty retailers and department stores, ROST does not require fashion or product innovation to drive profits. Instead, access to inventory and quick turnover of merchandise drives traffic, which grows sales and allows the company to leverage operating costs. They are able to purchase inventory at a 20 percent-60 percent discount with the vast majority coming from manufacturers that have over-produced or had orders cancelled.

All of this leads to a "treasure-hunt" experience for customers that is difficult to replicate in an online setting, and this drives loyalty and repeat visits. ROST has only failed to grow earnings per share in 3 years since 1988 and their ability to grow earnings during the last 2 recessions shows that the company has historically been less susceptible to a market downturn.

ROST trades at 22 times on a calendar year 2018 basis which represents a premium to both peers and the S&P 500. Having said this, we think this stock deserves the higher valuation given its strong cash flow generation, resilient balance sheet, and ability to generate double digit earnings per share growth. The dividend is 0.8 percent.

Schlumberger (SLB)

Schlumberger is the world's premier oil services company providing the broadest range of services to companies in the oil and gas exploration and production business. We believe the company is ideally positioned to benefit from higher energy prices and increasing service intensity in the exploration and production of oil and gas.

This company has less exposure than peers to the more volatile North American market and more exposure to international markets, which tend to have longer and steadier cycles. International activity levels are near a bottom. Additionally, the company has spent the past couple of years streamlining its operations to improve efficiency.

If management's claims are correct that pricing improvements can drive 65 percent incremental margins ($0.65 of operating earnings on each $1 increase in revenue), we estimate that the company could reach its peak profit level by recovering just half of the revenue decline witnessed since oil prices reached a top in the summer of 2014. The shares trade at 29 times the consensus estimate for calendar year 2018 earnings per share with tremendous earnings recovery potential should energy prices remain stable or move higher.

Starbucks (SBUX)

Starbucks is the premier roaster, marketer and retailer of specialty coffees in the world, with over 27,339 stores in 75 countries. Following several years of very strong earnings growth, the stock has been flat over the past 2+ years due mostly to a deceleration in same-store sales growth to the low-single digits from the mid- to high-single digits it had been reporting for years. Management has attributed the deceleration to both a difficult consumer/retail backdrop as well strong customer acceptance of the company's new mobile order & pay solution, which has caused a bottleneck in filling customer orders in a timely fashion.

We think this is a high-class problem, and that this temporary setback creates an opportunity for growth-oriented investors willing to be patient. The company's recently revised long-term growth algorithm calls for 12 percent+ annual earnings per share growth driven by high single-digit revenue growth, 3-5 percent global same-store sales growth, and annual returns on invested capital of at least 25 percent.

We also anticipate that the company can continue growing its global store base by 7 percent-8 percent annually, driven by outsized growth from relatively under penetrated China. Recent sizeable investments in new platforms, products, people and technologies should help enable success in hitting these targets. The stock trades at a 24 times the consensus for calendar year 2018 earnings per share, which is a discount to similar companies. The dividend is 2.1 percent.

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 an enviable long-term track record of financial performance, with strong double-digit earnings per share 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 earnings per share growth. Based on those expectations, we continue to believe the company offers strong value for long-term investors, trading at less than 19 times estimated calendar year 2018 earnings per share – roughly in line with the overall market. In addition, the current dividend yield is an attractive 2.2 percent.

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

The reader should not assume that an investment in the securities identified was or will be profitable. These are not recommendations to buy or sell securities. There is risk of losing principal. Past performance is no indication of future results.