The Dow Is Setting Its Sights on 13,000

Call me a raging bull. Anyone who has followed my writing on RealMoney since December 2000 knows that I never predict specific levels in the market indices. Until now, that is.

I won't give you an exact date, but I will say this: On the basis of my quantitative valuation work, I wouldn't be surprised if the Dow Jones Industrial Average trades in the 13,000-15,000 range over the next two to three years.

Any observer of the market can recite a litany of reasons to be cautious on equities. Leading the list is our hyperactive Federal Reserve Board. Rather than letting the markets be markets -- fulfilling their function of flushing out inefficiencies and imbalances -- the Federal Reserve has adopted a strategy of micromanaging the economy. Only a couple of years ago, the Federal Reserve pushed interest rates to 45-year lows amid angst over the lack of growth and the potential for a deflationary spiral.

Now the Fed is on an unprecedented hike-a-meeting pace in an effort to fight another phantom, inflation. Equity investors should be concerned. Look at 100 years of interest rate history and there is no exception to this rule: Flat-to-inverted yield curves always presage economic weakness, usually a recession. At the current pace of increase, the curve will invert (when short rates exceed long rates) in a couple of months.

In addition to high interest rates and a potentially weaker economy in 2006, there is plenty more to worry about: high energy prices, falling consumer confidence and a costly and seemingly unending war in Iraq. But the key is, by my calculations, that these worries are already discounted in stock prices, and then some.

Raging Undervaluations

In the face of a negative economic backdrop, I'm bullish on the Dow for just one reason: There is a wide gulf between price and value. Of the 30 components of the Dow, 20 have compelling valuations. Later in this column, I'll rate the top 10 buys in the Dow and list the 10 other undervalued components.

Investors get tripped up when they focus solely on nominal stock prices. For example, some might say that Dow component Intel ( INTC ) is materially higher at the current quote of $23.50 when compared with its multiyear low of $13 per share in 2002.

It's true that the nominal stock price is much higher. But the underlying asset, the ongoing business at Intel, is demonstrably more valuable today than when it traded at $13 per share in 2002. Since then, sales are up 75%, net assets are 42% higher, and earnings are up threefold. If Intel trades at or about $22 per share in 2006, it will be bumping up against its 10-year lows relative to the underlying business value.

Another Dow component, Wal-Mart ( WMT) currently trades at eight-year lows relative to its business value. For more than 20 years, Wal-Mart has performed like clockwork, more than doubling earnings, net assets and sales every six years. To equate the nominal current quote of $45 per share with a $45-per-share quote of six years ago (the trading range was $41 to $69 six years ago) is nonsense. Wal-Mart's business value has more than doubled in value during that time frame. It was overvalued in 1999. Now it's undervalued.

My valuation calculations indicate a current value of $61 per share for Wal-Mart. I expect that its business value will grow to $69 per share in 2006.

The Dow first traded at the current level of about 10,200 some six years ago. Then it was distinctly overvalued. Now it's undervalued. Business values of nine of the 30 Dow components have doubled in value over the last six years. In addition to Intel and Wal-Mart, business values doubled at:

  • 3M ( MMM)
  • AIG ( AIG)
  • Caterpillar ( CAT)
  • Exxon Mobil ( XOM)
  • Home Depot ( HD)
  • Microsoft ( MSFT)
  • United Technologies ( UTX).

    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)
  • American Express ( AXP)
  • Citigroup ( C)
  • Coca-Cola ( KO)
  • General Electric ( GE)
  • Johnson & Johnson ( JNJ)
  • McDonald's ( MCD)
  • Pfizer ( PFE)
  • Procter & Gamble ( PG)
  • Walt Disney ( DIS).

    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.

    Several Dow stocks can be purchased today at a hefty discount and, importantly, these assets will be worth even more over the next few years. I expect this basket of four Dow stocks will return 50%-75% to the investor over the next three to four years:

    Wal-Mart ( WMT): This one is easy, as the business value doubles like clockwork every six years. There is very little operational variance in this model and no serious competitor with the girth to challenge its procurement, purchasing and distribution advantage. Investors are making a mistake if they overlook the growth opportunities extant for this model. Even if I ratchet down growth expectations a bit, I still calculate a $75-$80 value in three to four years, or 67% above the current $45 quote.

    Microsoft ( MSFT): This stock traded as high as $60 a share in 1999 in the midst of the tech bubble, when the business was worth $18 a share. Since 1999 the business has grown in value to $29 a share. Using modest growth estimates, the value will grow to $40 or more a share in three to four years. That's 60% above the current quote of $25 a share. There's a chance that $40 a share may prove conservative, especially if the company uses its ample cash position and free cash flow to aggressively shrink the share base.

    Boeing ( BA): Investors have several levers working for them that will unlock value in Boeing stock over the next few years. Commercial aerospace demand will be robust for many years to come, particularly in Asia, where Boeing has a strong foothold. Airbus lacks the capital to develop a serious alternative to Boeing's 787, which is set to be rolled out in 2008. New CEO James McNerney took an already efficient profit machine in 3M ( MMM) and made it even more efficient. Boeing should produce big earnings gains over the next three to four years as McNerney works with Boeing's significant operating margin leverage. Expect at least $110 a share over the next three to four years, or about 70% higher than the current quote of $65 a share.

    Home Depot ( HD): This is another one of the elite companies in the current Dow with operating metrics that retailers of a generation ago, e.g., Woolworth, couldn't touch. Expect at least $62 a share in three to four years, or 55% above the current quote of $40 a share.

    In addition to the four mentioned above, other exceptional values in the current Dow Average include Intel ( INTC), American International Group ( AIG), General Electric ( GE), Citigroup ( C), and out-of-favor pharmaceutical companies Pfizer ( PFE) and Merck ( MRK).

    There are at least 11 more Dow stocks that are undervalued relative to their prospects for the next business cycle: Altria Group ( MO), Hewlett-Packard ( HPQ), American Express ( AXP), 3M ( MMM), Coca-Cola ( KO), McDonalds ( MCD), JP Morgan ( JPM), Disney ( DIS), Johnson & Johnson ( JNJ), IBM ( IBM) and Procter & Gamble ( PG).

    Top Ten Turnarounds for 2006

    In mid-November I'll begin my series Top Ten Turnarounds for 2006 for RealMoney. In a difficult market environment, terrific turnaround opportunities abound. I've done two previous lists, for 2001 and for 2002. I hope you will consider the Top 10 Turnarounds list as a source of stock ideas. If you simply bought and held the list for 2001, you would be up 102% vs. an S&P 500 decline of 13%. If you simply bought and held the list for 2002, you would be up 48% vs. an S&P 500 increase of 2%. Interestingly, nine out of 10 stock ideas on each list have outperformed the S&P 500.

    At time of publication, Alsin and/or ACM was long Wal-Mart, Microsoft and Boeing, although holdings can change at any time.

    Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.

    More from Opinion

    Red Hat CFO Tells TheStreet: Tech Trends Are Still in Our Favor

    Red Hat CFO Tells TheStreet: Tech Trends Are Still in Our Favor

    Throwback Thursday: Intel Edition

    Throwback Thursday: Intel Edition

    Intel's Next CEO Should Try Harder to Protect Its Flanks Against AMD and Others

    Intel's Next CEO Should Try Harder to Protect Its Flanks Against AMD and Others

    3 Warren Buffett Stock Picks That Could Be Perfect for Your Retirement Portfolio

    3 Warren Buffett Stock Picks That Could Be Perfect for Your Retirement Portfolio

    Wednesday Wrap-Up: GE and Facebook

    Wednesday Wrap-Up: GE and Facebook