Selecting a Top Ten list for 2023 feels a bit different this year.
With several historical measures virtually guaranteeing recession, the prospect for stock market gains is meager at best. If a recession occurs, the S&P 500 could decline just over 30% on average from the highs and earnings may contract an average of 20%. The term “average” is a bit misleading, too. The declines could be greater or less than the average and still be considered very normal. At one point, the S&P 500 was down 24% for the year, and it looks to close 2022 down by about 19%. This could mean that the lows have been made. Tony Dwyer from Canaccord Genuity doesn’t think so. He said the data demonstrates that no historical low has ever been made before a recession had begun. To wit, it appears lower market lows await in 2023.
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The Top Ten for 2023 consist of companies – in my opinion – with fortress balance sheets, downside protection and upside opportunities. Many on the list are well off their highs and some remain out of favor.
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 three to five years.
Nevertheless, in each of the past 15 Decembers I have selected and invested personally in 10 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 Ten for 2023, listed in random order. This year’s selection represents a nice combination of growth and defensiveness.
Results have been good in some years and not as good in others. I will sell my 2022 names on Jan. 2 and buy the following names that afternoon. 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. If you are interested in any of these names, please call your financial advisor to discuss.
Here are the Top Ten for 2023, with prices as of the close on Dec. 23.
1. Amazon (AMZN)
Amazon is a top player in three areas where we see ample secular tailwinds: the cloud, digital advertising and e-commerce. Perhaps more importantly, each of these businesses has a wide economic moat. Regarding the cloud, AMZN’s Web Services business is the market leader in cloud infrastructure services. This business benefits from high customer switching costs as cloud services are typically one of the last expenses a business might cut during challenging times. Moreover, the scale of AMZN’s web services business provides many cost advantages as very few companies can compete with AMZN’s investment spend and first-mover advantage.
With regard to digital advertising, we believe AMZN should be a relative winner as its business is not as vulnerable to Apple’s App Tracking and Transparency changes as META, SNAP and other digital advertisers. In addition, AMZN has a vast amount of proprietary information and real-time data on its users that it can leverage when selling ads. AMZN’s e-commerce business, its most well-known, benefits from network effects wherein its vast catalogue of buyers and sellers attracts more buyers and sellers. More than half of the total goods sold on Amazon.com are through AMZN’s third-party marketplace, where the company collects a commission in exchange for fulfillment services. Additionally, subscription fees from Amazon Prime generate strong cash flows and the service is very sticky given the value it provides to consumers. After years residing in territory out of our price range, AMZN’s valuation has become reasonable: The current ratio of EV/EBITDA (NTM), at ~12x, compares to a historical average of over 20x. Finally, the company has an excellent balance sheet with a debt rating of AA (S&P) and negligible net debt (debt net of cash).
2. Becton Dickinson (BDX)
Becton Dickinson is a global supplier of medical devices, hospital supplies, diagnostic equipment and medication management systems to hospitals and labs. Management estimates that 90% of patients who enter an acute care setting are touched by at least one BDX product. Becton has faced a variety of company-specific headwinds in recent years that were exacerbated by the pandemic. That said, the company played a key role during the pandemic as the world’s leading manufacturer of syringes and needles and as one of the largest Covid-19 testing providers. Importantly, management has been reinvesting the proceeds from the Covid-19 windfall back into the business. Furthermore, they have divested slower growing businesses and have made several tuck-in acquisitions over the past couple years.
We expect these initiatives to improve the overall growth and margin profile as management works to return to its long-term growth algorithm (mid-single digit organic growth; low-double digit EPS growth). BDX shares currently trade at 20.7x CY23 EPS – a significant premium to the S&P 500 but more in line with its MedTech peers. The dividend yield is 1.4%.
3. Johnson & Johnson (JNJ)
Johnson & Johnson is one of the world’s largest and most diversified health-care companies with revenue divided between the Pharmaceutical, MedTech and Consumer segments. The company should continue to benefit from an aging global population and rising standards of living in the world’s emerging economies. JNJ’s Pharmaceutical segment appears well-positioned to maintain its above-market growth rate over the next few years, thanks to its diversified product portfolio and promising pipeline. In the MedTech business, we have witnessed a strong recovery following several years of market underperformance as the company has started to see benefits from ongoing pipeline investments. Recent product launches range from surgical robots, minimally invasive surgical tools and innovative contact lenses.
JNJ sports a rare AAA-rated balance sheet, produces ample free cash flow and generates consistent, above-average returns on equity. These attributes support the company’s reputation as being one of the most defensive equities available. Moreover, the stock trades at just 18x estimated CY2023 EPS, which is only a small premium to the S&P 500. This reasonable multiple, the 2.5% dividend yield and our expectation that JNJ should continue to grow faster and in a more stable fashion than the overall market over the next five years, underpin our positive view of the stock at current levels.
4. Mondelez (MDLZ)
Mondelez International is a leading food and beverage manufacturer that was spun off from Kraft in 2012. The company has broad geographic reach with operations in Europe, North America, Latin America, Asia, the Middle East and Africa. Since taking the helm in 2017, CEO Dirk Van de Put has introduced a variety of strategic initiatives that have improved MDLZ’s competitive position, including: 1) investments in its brands to drive higher market share; 2) a decentralized organizational structure that allows for more efficient decision-making; and 3) investments in the supply chain, which proved to be a competitive advantage during the pandemic. Recently, the company has been able to offset inflationary pressures, thanks to its pricing power and productivity initiatives. Additionally, there is very little private-label competition in sweet snacks and chocolate (80% of total revenues), which means consumers were less likely to trade down as prices have risen.
A strong balance sheet and steady cash-flow generation allow the company to pursue tuck-in M&A as management looks to expand into higher-growth category adjacencies (e.g. cakes/pastries, premium snacks, better for you, etc.). The stock trades at 21.9x CY23E EPS – a discount to other multinational consumer packaged goods companies (e.g. PEP, KO, PG, CL). Over the long term, we would expect MDLZ to generate double-digit total returns, consisting of high-single digit EPS growth and the 2.3% dividend.
5. 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. The company has become a strategic partner in enterprise digital transformations through its cloud, app and infrastructure, as well as its artificial intelligence offerings. There is a long runway remaining for cloud growth as companies slowly deal with legacy investments that still drive value but are not cloud-based. MSFT is uniquely positioned to grow its wallet share of corporate IT budgets in this hybrid world. It is also encountering new opportunities in security, compliance and workflow, and the transition to subscription-based sales is no longer a headwind to free cash flow growth. Shares trade at 23x the CY23 EPS estimate. We think the premium valuation is justified given the above-trend growth, exposure to secular trends and strong balance sheet. Moreover, compared to software peers, the valuation is quite reasonable. The dividend yield is 1.1%.
6. Alphabet (GOOGL)
Alphabet is a holding company that owns several subsidiaries with the most visible and profitable being Google, the internet services giant. Google search is the world’s most popular search engine, and Android is the most widely used mobile phone operating software. Moreover, the company has nine products with more than a billion users: Search, Android, Chrome, Gmail, Drive, Maps, Play Store, YouTube and Photos. Search, display and video advertising account for most of the company’s revenue, with smaller, but faster growing Cloud (enterprise services) and Play Store, subscriptions and hardware accounting for the rest. We saw some softness in ad spend on concerns over economic weakness and platform privacy changes, but with advertising dollars continuing to shift to digital formats, the valuation looks compelling. Cloud migration remains a secular growth story and should allow the Google Cloud Platform to sustain its rapid growth in the coming years. The company has arguably the best balance sheet in the world with more than $100 billion in cash and investments net of debt. Shares trade at 16.9x CY 23 EPS. There are risks around government regulation, but we see that taking several years to play out.
7. Truist Financial (TFC)
Truist is the company that was formed by the recent merger of regional banks BB&T and SunTrust. The merger created the sixth-largest bank holding company in the U.S. (by assets and deposits) while also forming a banking powerhouse in the high-growth Southeastern states. We were supporters of the merger as it will yield a large amount of expense synergies and provide the resources to accelerate investments in transformative technologies. The merger should also lead to significant revenue synergies and enhanced diversification as each legacy bank cross-sells its respective products and services. We are further comforted that the integration was managed well as BB&T integrated numerous acquisitions in a disciplined and conservative manner over the past decade. Now that the integration is largely complete, we expect Truist to be able to generate industry-leading expense efficiency and returns on equity, allowing for a higher valuation multiple on a price-to-book (P/B) basis.
Finally, the earnings accretion from the integration should act as an engine for earnings growth even if the operating backdrop remains difficult (subdued economic growth, rising credit costs). At less than 8x our current expectation for CY23 EPS and a generous 4.9% dividend yield, we believe the stock is attractively priced, especially given that earnings growth should handily outpace the peer group.
8. FedEx (FDX)
While FedEx benefited from a surge in e-commerce package volume following Covid’s arrival, the company has also endured a series of (mostly unforeseeable) headwinds over the past couple of few years. Unfortunately, these challenges coincided with heavy investment outlays at the company, to include a buildout of its ground network, the modernization of its airplane fleet, and the integration of TNT Express Now, given the ongoing normalization in e-commerce, new CEO Raj Subramaniam’s primary charge is to rationalize the company’s expense bases, raise margins and close the performance gap to competitor UPS. This may prove to be no small feat, and the selection of FDX for inclusion in a top ten list with an investment horizon of just one year is not without risk. However, the opportunities for improvement are many, and we think that given the trough valuation in the stock, the harvesting of just some of the low-hanging fruit could get the stock going in the right direction again. We are further encouraged that the company maintains significant pricing power as it uses its network capacity to cherry-pick the most profitable delivery services. Finally, as industrial production, global trade and labor availability gradually begin to improve, the company should be able to post solid revenue growth, margin expansion and very strong earnings leverage. In the meantime, we think the company’s discounted valuation (11.3x CY23E EPS) relative to both the S&P 500 and its major competitor, UPS, provides downside protection. The yield is 2.6%.
9. CVS Health (CVS)
CVS Health provides health plans and services through its health insurance offerings, pharmacy benefit manager (PBM), and retail pharmacies. The vertically integrated model provides CVS with diversification across the health-care supply chain, thus making it a more defensive company. For the consumer, CVS seeks to improve health care outcomes by integrating medical, lab, and pharmacy data. Over time, this should lead to medical cost savings as the company uses this data to promote better medical management/adherence, improved engagement, and the utilization of lower-cost health-care settings such as CVS’s MinuteClinics and HealthHubs. CVS has enormous scale with about 85% of the U.S. population living within 10 miles of one of its stores. This bodes well in the evolving health-care landscape where trusted brands and a nationwide footprint are essential keys to success.
CVS’s businesses are stable and generate strong cash flow, which has enabled the company to reduce its leverage to the long-term target of 3x net debt-to-EBTIDA. With this newfound balance sheet flexibility, management is looking to expand its offerings into primary care and in-home health through a combination of internal investments and M&A. The stock currently trades at just 11x estimated CY23 EPS and offers investors a 2.4% dividend yield. Management remains committed to its goal of high single-digit EPS growth in 2023, followed by sustained double-digit growth in 2024 and beyond. We believe the risk/reward tradeoff is attractive for long-term focused investors.
10. Raytheon Technologies (RTX)
Raytheon Technologies was formed through the combination of Raytheon Company and the legacy United Technologies aerospace and defense (A&D) businesses. The merger created a powerhouse in the A&D industry, but management’s near-term sales and profit targets for the combined entities have been pushed out as a result of the Covid-19 crisis. The crisis took an enormous toll on the commercial aerospace industry as steep production cuts at Boeing and Airbus were combined with a massive drop in airline passenger miles. Fortunately, the defense side of the new company, which contributed 65% of total company pro forma sales in 2020, picked up the slack during the throes of Covid. The defense side should continue to provide downside protection and steady cash flow as result of geopolitical uncertainty, allowing the company to continue investing in R&D during economic downturns. As conditions continue to improve on the commercial side, the company should start to benefit from aircraft production increases as well as greater aircraft utilization. Furthermore, the growing installed base of the company’s groundbreaking geared-turbofan (GTF) engine, combined with a rebound in aircraft utilization, will contribute to a growing stream of high-margin and high-visibility aftermarket revenue.
Finally, we also expect the company will ultimately reap huge cost and revenue synergies from the ongoing integration of both Rockwell Collins and the Raytheon Company. The synergies will help the company return an expected $20 billion in capital to shareholders in the four years following the Raytheon merger. The stock offers strong value at just 19.5x CY23E EPS – a moderate premium to the market but a well-deserved one. The dividend yield is also attractive at 2.2%.
— Michael K. Farr is a CNBC contributor and president and CEO of Farr, Miller & Washington.