The Dow Is Setting Its Sights on 13,000

In addition, over the last six years, the businesses of 10 of the 30 Dow components have increased in value by between 50% and 100%:

Altria(MO Quote)

American Express(AXP Quote)

Citigroup(C Quote)

Coca-Cola(KO Quote)

General Electric(GE Quote)

Johnson & Johnson(JNJ Quote)

McDonald's(MCD Quote)

Pfizer(PFE Quote)

Procter & Gamble(PG Quote)

Walt Disney(DIS Quote).

With two-thirds of the companies in the Dow profoundly undervalued, a call for the average to hit 13,000 to 15,000 in two to three years is not particularly bold. Most of the businesses in the Dow will be more valuable in two to three years. And the current stress in the economy, even an economic downturn in 2006, will be a distant memory.

Digging Into the Numbers

The financial statements of Dow Jones Industrial Average companies tell an impressive story.

When compared to the financials of Dow Average companies of a generation ago, the differences are astonishing. Back then, capital-intensive operations with low returns on assets and equity were the norm. Companies such as Anaconda Copper, International Nickel and Bethlehem Steel are long gone from the Dow Average, and they've been replaced by much higher-quality companies.

The "new" Dow Average company has dramatically improved on all operating metrics. It is much more efficient with capital, generating significantly more free cash coupled with higher yields on assets. Brains, brands and brawn are the hallmarks of today's elite, world-class Dow companies.

The intellectual assets (brains) of several Dow companies, buttressed by billions of dollars of R&D expenditures, are without peer. Many of the Dow companies are high-yielding marketing powerhouses (brands) that are able to lay off low-return manufacturing investment through outsourcing. The sheer girth of today's Dow companies (brawn) yield procurement and cost advantages that smaller companies can't match.

As I wrote earlier, by my calculations at least 21 of the 30 Dow components are undervalued by 10% or more. That said, the backdrop for the equity market is problematic. Historically, a flat yield curve always leads to an economic slowdown. Consumer confidence has dropped steeply and for three months in a row. The ingredients are in place for a difficult economy, perhaps a recession, in 2006.

Despite the obvious difficulties in the short term, a bullish stance on Dow stocks makes sense for long-term investors. Changes in interest rates and the economic cycle are largely irrelevant to the investor with a long-term time horizon. Over the next several years, we'll have many more changes in interest rates, more ups and downs in the economy, more difficulties and problems to wrestle with.