October 15, 2012 B A R RON ’ S 25

cash and free cash flow to repay $800 millionover the next year. Terex’s cash generationwould likely look attractive to a buyout firm.A 20% premium is possible. Even without adeal, the stock price could gradually rise asshrinking interest payments bolster earn-ings.Charles River Laboratories Interna-

tional (CRL) provides research services todrug companies. Its shares jumped morethan 20% in January on takeover speculationand have headed higher since. They stilllook affordable at $38, or 14 times earnings.Revenue growth for the company should

pick up in coming years on a rise in drug-re-search spending and more outsourcing.Sterne Agee analyst Gregory Bolan calls thecompany a “cash flow machine” and says theshares are worth $45 and could fetch asmuch as $60 in a deal.Closeout retailer Big Lots (BIG) report-

edly turned down buyout offers from BainCapital and TPG Capital in May 2011.Shares had jumped to more than $40 from$32 in anticipation of a deal, but have sincefallen back to $30. So far this year the com-pany has spent about 14% of its currentstock-market value to repurchase shares. Abuyout in the $40s, says Anthony Chukumbaat BB&T Capital Markets, would still behighly profitable for a private-equity firm.

Target: Par PharmaceuticalBuyer: TPG CapitalTransaction Announced: 7/16/2012Buyout Value: $2.2 bil Premium: 37%

Target: Blue Coat Systems/$1.3 bilBuyers: Teachers’ Private Capital; Thoma BravoTransaction Announced: 12/9/2011Buyout Value: $1.3 bil Premium: 48%

Target: P.F. Chang’s China BistroBuyer: Centerbridge PartnersTransaction Announced: 5/1/2012Buyout Value: $1.1 bil Premium: 30%

Target: TekelecBuyers: ZelnickMedia; Comvest Group; SankatyAdvisors; GSO Capital Partners; Siris Capital

Transaction Announced: 11/7/2011Buyout Value: $778 mil Premium: 11%

Target: WCA WasteBuyer: Macquarie Infrastructure Partners IITransaction Announced: 12/21/2011Buyout Value: $533 mil Premium: 30%

*Offer Price compared to the stock price the day before theannouncement. Source: S&P Capital IQ

More on theWay?These five buyouts of mid-cap firms, done in thepast year, fetched substantial premiums. OnThursday, Carl Icahn offered to buy truck-makerOshkosh (OSK). The deal values the firm at $3billion, 21% above Wednesday’s close.

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28 B A R RON ’ S October 15, 2012

now about $133.Interviewed in the current issue, Blackstone

Advisory Partners global strategist Byron Wienalso looks for the S&P to approach 1500 by yearend. “The economy is stronger than the numbersreveal. That doesn’t mean it’s growing at 5%. Butit does mean it is probably growing better than2%,” Wien said (see page 38).Despite the run-up this year, stock-market valu-

ations don’t look excessive, especially given super-low interest rates. The Dow industrials are valuedat 13 times estimated 2012 earnings and at just un-der 12 times projected 2013 profits. The S&P 500is pricier at 14 times this year’s estimated profits.The so-called earnings yield—the inverse of

the price/earnings ratio—on the Dow is around8%, a very wide six percentage points above theyield on 10-year Treasuries. The index’s dividendyield stands at 2.5%, with plenty of room to rise,given that the payout ratio is less than 35%. IBM(IBM), ExxonMobil (XOM), Disney (DIS), Cat-erpillar (CAT), and Travelers (TRV) are justsome of the Dow components with ample abilityto boost their dividends.

The Dow industrials are more reasonable nowthan at the 2007 peak, when the index traded for16 times the then-current 2008 earnings esti-mates. That projection turned out to be way toohigh, as did even more bullish 2009 projections atthat time, as the financial crisis and recessionsavaged earnings. Former Dow components Citi-group (C) and American International Group(AIG) are both down more than 90% since then,adjusted for reverse stock splits, while anothererstwhile Dow member, General Motors (GM),filed for bankruptcy in 2009, resulting in a near-total wipeout for shareholders.The table on this page shows the performance

of the 30 current Dow industrials since the Octo-ber 2007 market peak. At a time when many in-stitutional and retail investors favor index invest-ments over active management, the table makesa powerful case for stockpickers because of thehuge disparity in returns of the individual Dowcomponents in just five years. Home Depot (HD)and IBM lead the pack with gains (excluding divi-dends) of about 75%, while Bank of America andAlcoa are down about 80%.There has been a net change of five companies

in the Dow since 2007. Travelers, Cisco Systems(CSCO), BofA, Chevron, and UnitedHealthGroup (UNH) joined the 116-year-old averagewhile Citigroup, AIG, GM, Altria (MO), andHoneywell (HON) fell out. Kraft Foods (KRFT)joined in 2008 and left recently as it split into twocompanies.Probably the key market risk is a slowdown

in profit growth. Current S&P 500 profit esti-mates of $103 and $115 for 2012 and 2013, respec-tively, are down about 3% from early-year projec-tions. Third-quarter S&P earnings are expectedto fall 1%, the worst showing in three years, hurtby double-digit profit declines in the materialand energy sectors. Earnings warnings came last

week from normally reliable Chevron, as well asCummins (CMI), a leading maker of diesel engines.“For equities to march substantially higher,

there needs to be economic validation,” says MarkLuschini, strategist at Janney Montgomery. A morebullish Paulsen says that profit growth is unlikelyto resume at a robust rate in the next 12 months,but that the market P/E ratio may continue to ex-pand, lifting major indexes. The S&P P/E alreadyhas moved up about two multiple points.

It’s bullish that U.S. stocks have done well with-out much participation by retail investors, who con-tinue to prefer bonds despite historically low rateson Treasuries, mortgage securities, high-grade cor-porate debt, and junk bonds. The average junk-bond yield of 6% is only three percentage pointshigher than dividend yields on scores of high-qual-ity, dividend-paying stocks. Junk bonds probablycan’t go much higher, although they could go a lot

lower. If retail investors ever warm to stocks, theDow could go much higher.Even with the Dow’s advance this year, none of its

components trades for more than 20 times estimated2013 profits, and only a handful fetch more than 15times forward earnings. Six have single-digit P/Es:JPMorgan Chase (JPM), Chevron, Caterpillar,Mi-crosoft (MSFT), Cisco, and Hewlett-Packard(HPQ).The H-P P/E multiple of four isn’t a misprint.

That alone ought to attract the attention of value-ori-ented investors, plus the possibility of a corporatebreakup instigated by activist investors. Three of theother Dow tech stocks, Microsoft, Intel (INTC), andCisco, all trade at about 10 times forward earnings,and the P/E ratios of cash-rich Microsoft and Ciscoeffectively are lower than 10 when their cash isstripped away. Microsoft, at $29, and Cisco, at $18,both have about $6 a share in net cash.Some of the high-P/E Dow stocks, including

Home Depot, Verizon Communications (VZ), andProcter & Gamble (PG), don’t look as attractive.Home Depot may already discount an upturn inhousing, while Verizon’s P/E is high historically ata time when its core wire-line business remains un-der pressure. Underperforming P&G has been tar-geted by activist investor Bill Ackman. At $68, itsshares anticipate some improvement in its operat-ing results.With a bevy of reasonably priced stocks, the

Dow industrials look poised to set a new record, ifnot this year then next, and investors can get a nice2%-plus yield along the way.

Then and NowThere has been a wide disparity in the performance of the 30 current Dow components sincethe market peak in 2007, leaving opportunity for stockpickers.

Company/TickerPrice

10/9/2007 10/11/2012 % Change P/E2013E

DividendYield

Home Depot/HD $33.80 $59.01 74.6% 17.5 2.0%

IBM/IBM 118.30 205.76 73.9 12.3 1.7

Wal-Mart Stores/WMT 45.21 75.01 65.9 14.0 2.1

McDonald’s/MCD 57.38 92.36 61.0 15.5 3.3

Walt Disney/DIS1 35.45 50.34 42.0 14.4 1.2

Coca-Cola/KO 28.94 38.11 31.7 17.4 2.7

Travelers/TRV 53.30 69.16 29.8 10.7 2.7

Chevron/CVX 92.80 113.06 21.8 9.0 3.2

UnitedHealth Group/UNH 48.49 57.66 18.9 10.3 1.5

Verizon Comm/VZ 42.44 45.20 6.5 16.0 4.6

Johnson & Johnson/JNJ 66.25 67.97 2.6 12.4 3.6

Caterpillar/CAT 82.51 82.85 0.4 8.2 2.5

DuPont/DD 49.48 48.78 -1.4 11.2 3.5

ExxonMobil/XOM 92.67 91.17 -1.6 11.1 2.5

Pfizer/PFE 95.54 25.12 -1.6 10.8 3.5

3M/MMM 95.62 92.83 -2.9 13.4 2.5

Microsoft/MSFT2 30.10 28.95 -3.8 9.6 3.2

Procter & Gamble/PG2 71.08 68.00 -4.3 17.4 3.3

United Technologies/UTX 81.20 76.05 -6.3 12.2 2.8

American Express/AXP 62.52 58.47 -6.5 12.3 1.4

JPMorgan Chase/JPM 47.57 42.10 -11.5 8.1 2.9

AT&T/T 41.98 36.26 -13.6 14.1 4.9

Merck/MRK 25.84 45.45 -15.3 12.2 3.7

Intel/INTC 53.63 21.68 -16.1 10.1 4.2

Boeing/BA 101.45 70.83 -30.2 12.6 2.5

Cisco Systems/CSCO3 33.08 18.26 -44.8 9.4 3.1

General Electric/GE 42.02 22.51 -46.4 13.0 3.0

Hewlett-Packard/HPQ4 52.46 14.25 -72.8 3.9 3.7

Alcoa/AA 39.72 8.77 -77.9 13.0 1.4

Bank of America/BAC 52.57 9.34 -82.2 10.3 0.4

Dow Jones Ind. Average 14,164.53 13,326.40 -5.9 11.6 2.5

NO LONGER PART OF THE DOW

Altria Group/MO $21.57 $32.71 51.7% 13.7 5.4%

Honeywell Intl/HON 61.24 60.29 -1.6 12.1 2.5

General Motors/GM 5 38.20 24.66 NM 6.3 0.0

Citigroup/C6 476.20 35.52 -92.5 7.8 0.1

AIG/AIG6 1,174.64 35.68 -97.0 10.2 0.0E=Estimate NM=Not meaningful 1Sept. fiscal year; 2June fiscal year; 3July fiscal year; 4Oct. fiscal year; 5Old GMfiled for bankruptcy protection in 2009; 6Prices reflect reverse stock splits. Sources: Bloomberg; Thomson Reuters

’12’11’10’09’08’07Source: Thomson Reuters

DOW INDUSTRIALS

6000

8000

10,000

12,000

14,000

16,000

Index bottoms at6,547. QE1 starts

Lehman collapsespurs crisis

GOP takesHouse

Bernanke signalsstart of QE2

Dow hits 13,610,within 4% of peak

Europe fearsrattle stocks

Index peaksat 14,164.5

Near failureof Bear Stearns

Sizing Up the IndexThe Dow industrials are more attractively priced now than in2007. That could lead to a new high by early 2013.

Dow JonesIndustrial Average

IndexValue

CurrentP/E

ForwardP/E

Oct. 2007 14,164.53 17.7 16.1Now 13,326.40 12.6 11.6

Source: Bloomberg

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