8 Dow Stocks Most Likely to Outperform

Note: Total return statistics in the second paragraph were initially misstated -- they have been corrected.

NEW YORK ( TheStreet) -- For long-term investors, navigating the stocks that comprise the Dow Jones Industrial Average has been like walking a minefield.

Had you invested $100 in each of the 10 best performing (active) Dow stocks from September 2000 to September 2010, your principal would have grown to $2,409 -- had you invested in the 10 worst, your principal would have shrunk to $579*. Had you invested across all 30 (active) Dow components, in equal weighting, your annualized return would be a meager 3.15%. But, if you had you avoided the 10 worst performing Dow stocks, your annual return would nearly double to 5.79%.

As the data shows, diversification is a useful tool -- but far more useful for investors that know which stocks to avoid entirely.

In the past we've highlighted the 10 most overpriced Dow stocks (likely to underperform in the long term), and as a corollary, the most attractively valued Dow stocks.

However, just because a stock is attractively valued does not make it a good investment. Five of the 10 Dow stocks in our attractively valued list have delivered negative returns over the last decade -- in many cases, the result of poor management and corporate governance -- not the result of poor performance by the company.

In the immortal words of Benjamin Graham:

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks."

Nevertheless, we shall attempt to select a small portfolio of Dow stocks intended to outperform the collective future performance of the 20 best-performing Dow components. To screen for candidates, all 30 Dow components were held against the following criteria.

1.) Each stock must have a liability-adjusted cash flow yield** greater than the yield of a 10-year U.S. Treasury note.

The expected rate of return of the equity should exceed the risk-free rate of a Treasury note, preferably, by a ratio of 2-1 (to compensate the owner for business-specific risks).

2.) Each stock must have a return on invested capital greater than 10% (using 10-year historical data).

Return on invested capital measures the success and failures of a company's capital expenditures -- a direct measure of managerial competence. Ten percent is a reasonable minimum figure to ensure that management is spending capital wisely.

3.) Each stock must show a positive total return (including dividends) over the past 10 years.

For an individual investor, 10 years represents a large percentage of his or her "investable lifetime." Ultimately, if the managers of a profitable company are unable to return profits to shareholders in a decade's time, something is wrong. Or, as Benjamin Graham writes in The Intelligent Investor, "poor managements produce poor market prices."

After analyzing the 30 stocks that comprise the Dow Jones Industrial Average, eight issues meet the standards of our established criteria. (It is worth noting that far greater investment opportunities exist outside of the realm of Dow components -- applying the above criteria to a greater universe of stocks will yield many positive surprises.)

*Total return does not include the impact of taxes and trading costs. Total return data only provided for securities currently listed in the Dow Jones Industrial Average. Data provided by Yahoo! Finance via BuyUpside.com.

**LACFY is defined as: 10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

8. Coca-Cola
  • Liability-Adjusted Cash Flow Yield: 3.5%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.28
  • Return on Invested Capital: 27%
  • 10-Year Total Return: 39.02%

Coca-Cola ( KO) is a goodwill giant of American culture and a proud member of the S&P 500 Dividend Aristocrats -- a select group of companies that have increased dividend payouts annually for 25 years or more. Whether or not Coca-Cola can consistently raise its dividend into the future remains to be seen, but the company did pass our dividend acid test (by a hair).

While Coca-Cola is the least attractively valued stock on our list, investors can take comfort in knowing that Warren Buffett and Bill Gates have a vested interest in the company's ongoing success.

7. DuPont
  • Liability-Adjusted Cash Flow Yield: 3.6%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.31
  • Return on Invested Capital: 11%
  • 10-Year Total Return: 50.43%

E. I. du Pont de Nemours & Co. ( DD) is the original "name brand" chemical company -- developing a well-known portfolio of materials including Nylon, Teflon, and Kevlar.

For the last decade, DuPont has delivered positive value to shareholders by offering a sizable dividend, currently yielding 3.88%. However, it should be noted that DuPont falls just short of satisfying our dividend acid test. Investors also should note that from 2005 to 2009, the company's effective tax rate averaged only 21%.

If DuPont is unable to maintain a below-average tax rate, or if the company faces an operational adversity, a dividend cut may occur, likely resulting in depressed share prices.

6. United Technologies
  • Liability-Adjusted Cash Flow Yield: 3.9%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.42
  • Return on Invested Capital: 15%
  • 10-Year Total Return: 161.01%

If you've ever used an escalator, elevator, or central air conditioner -- chances are -- you've used a United Technologies ( UTX) product.

In addition to Otis and Carrier, United Technologies' portfolio of companies includes Sikorsky and Pratt & Whitney -- two prominent suppliers of commercial and military aviation technology. Since 1978, United Technologies stock has appreciated 2.64 times more than the Dow Jones Industrial Average and has offered a stable and growing dividend along the way.

United Technologies' businesses are protected by high barriers to entry, and with a 15% return on invested capital (a notable achievement for a large equipment manufacturer), the company is poised to deliver ongoing shareholder value.

5. Boeing
  • Liability-Adjusted Cash Flow Yield: 4.3%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.57
  • Return on Invested Capital: 33%
  • 10-Year Total Return: 31.75%

Since 1978, Boeing ( BA) shares have appreciated over 300% more than the Dow Jones Industrial Average. For a large equipment manufacturer with a $47 billion market capitalization, the company's 33% return on invested capital is a tremendous achievement (this figure is the highest of any non-tech Dow stock).

Unfortunately, Boeing has very weak liquidity (the company's quick ratio is only 0.53) and is heavily indebted -- as a result, the company is more susceptible to macroeconomic risks.

4. 3M
  • Liability-Adjusted Cash Flow Yield: 4.5%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.64
  • Return on Invested Capital: 22%
  • 10-Year Total Return: 135.61%

3M ( MMM) has delivered stable returns for investors for over 30 years -- outpacing the Dow and S&P 500 since 1978. Trading near $85 per share, 3M is among the most attractively valued Dow stocks, and with a 22% return on invested capital, the third most profitable non-tech stock in the index.

The manufacturer of Post-Its and Scotch Tape is a Dividend Aristocrat, and passes our dividend acid test with a comfortable margin of safety.

3. ExxonMobil
  • Liability-Adjusted Cash Flow Yield: 5.3%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.93
  • Return on Invested Capital: 12%
  • 10-Year Total Return: 79.3%

ExxonMobil ( XOM) stock continues to trade below its March 2009 lows and has underperformed Chevron ( CVX), ConocoPhillips ( COP), and Occidental Petroleum ( OXY) over the last 12 months. Traders may have left Exxon for dead, but investors with a long-term perspective would be wise to use Exxon's prolonged undervaluation to their advantage.

ExxonMobil is the most attractively valued integrated oil major, and is two to three times more profitable than any company in its competitive set. According to Dan Dicker, TheStreet's resident oil expert, "I would put my money on Exxon's ability to see the energy future clearly. They have a history of doing that better than anyone else. In addition, ExxonMobil's return on equity is always the best in the patch and they have the kind of balance sheet that could lead to a significant stock buyback at any moment."

2. IBM
  • Liability-Adjusted Cash Flow Yield: 5.4%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 1.97
  • Return on Invested Capital: 39%
  • 10-Year Total Return: 14.11%

Oddly considered a defensive stock despite its volatility, IBM ( IBM) has shifted back into growth mode, delivering impressive year-over-year cash flow gains since 2006. IBM's current valuation gives investors a reasonably safe entry point, and the company's growing cash flows should provide investors with the confidence to buy additional shares in the event of a price decline.

IBM has increased its dividend payout by 276% since 2005, and has the wherewithal to substantially increase future payouts. In the opinion of the author, IBM could greatly enhance shareholder value by doubling its current dividend.

1. Johnson & Johnson
  • Liability-Adjusted Cash Flow Yield: 5.8%
  • 10-Year Treasury Yield: 2.74%
  • Margin of Safety Ratio: 2.12
  • Return on Invested Capital: 24%
  • 10-Year Total Return: 57.38%

Johnson and Johnson ( JNJ) has been plagued by negative short-term catalysts (that should have little impact on the company's long-term prospects):

With a 3.6% dividend yield, J&J offers one of the highest yields in the Dow (and satisfies the criteria of our dividend acid test) -- but the health care giant's margin of safety may quickly condense if it is unable to maintain below-average tax rates.

-- Written by John DeFeo in New York City


Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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