The Fairy Tale Continues for These Dow Stocks

This is the third in a series of commentaries on the Dow Jones Industrial Average (NYSE: ^DJIA) stocks that are in each S&P 500 section, investigating at one sector at a time. Previously, I looked at telecommunications and financial stocks. This time we will look at Home Depot (NYSE: HD), McDonald's (NYSE: MCD), and Walt Disney (NYSE: DIS). These Dow stocks are in the S&P 500 consumer discretionary sector.

Sources: S&P Capital IQ and The Motley Fool. YTD = year to date.

Note the earnings quality scores: In the past, my research has incorporated a Motley Fool Earnings Quality Score which taps into a database that ranks individual stocks. The database designates an A through F weekly, based on price, cash flow, revenue, and relative strength, among other things. Stocks with poor earnings quality tend to underpe rform, so we look for trends that might predict future outcomes.

The returns so far this year from these consumer discretionary stocks belie that the U.S. economy has been stuck in a rut. Year-to-date total average returns are 20.3%.

Home Depot
Home Depot recently reported improved earnings for its July quarter and set guidance for the year. The macro trend in homebuilding and sales of existing homes has been dismal since the end of the recession, but it appears some people are putting money into existing homes either through repairs or improvements. If that's true, then Home Depot's recent results are contrary to real U.S. economic trends. Depot reported quarterly earnings of $1.01, 17.4% ahead of last year's $0.86 a share. Year-over-year revenue was up 1.7% to $20.57 billion. Margins have been flat over the past two years. Net income for the period rose 12.4% to $1.532 billion. Depot's operating cash flow of $1.771 billion represents a 9% margin, consistent with prior quarters.

Inventory equals 53% of revenue, and inventory turns are at 74 days, down from prior quarters. While I'd like to see the inventory metrics improve, Depot doesn't carry much perishable inventory and the first rule of retailing is it's hard to sell what you don't have in stock.

As with other Dow stocks, Depot has boosted earnings through float reduction to inflate earnings. The company spent $3.85 billion to repurchase 63 million shares in the last 12 months. The forward P/E equals 19.37 based on 2013 earnings estimates of $2.94, so the stock is somewhat ahead of itself. If you believe the economy will remain weak, then this stock is a hold. Otherwise, it may be a good time to trim your position and wait for a re-entry point.

McDonald's
So far this year, McDonald's has been a Dow dog, ahead of only Hewlett-Packard for total return year to date. The company has cited economic woes in Europe as a factor affecting monthly comparable sales.

The year-over-year income statement metrics are unimpressive -- revenue was flat and gross profit, operating, net income, and earnings were all slightly lower. If we look back two years, revenue and earnings have advanced a little more than 8% annualized.

McDonald's operating cash flow for the most recent quarter was down from previous quarters (and the year-ago period), but it has maintained a healthy 26% margin for several quarters. Total debt, however, stands at 49% of total capital, up from last year. Long-term debt equals $12.72 billion and is at its highest level in 2.5 years. McDonald's spent $4.832 billion to repurchase over 68 million shares during this same period.

With Europe and Asia in economic decline, it's easy to understand why McDonald's has disappointed. Put McDonald's on hold.

Disney
Disney's stock chart looks like a fairy tale -- it's this year's third-best performer, behind Bank of America (NYSE: BAC) and Home Depot. While the company's theme park traffic may exhibit the "bad economy" thesis, escapism is alive and well, with Disney's movies and television shows likely producing much of the revenue. Revenue increased 4% year over year, and cost containment helped boost margins and earnings. Earnings per share jumped 31% over the year-ago quarter. The company's operating cash flow margin has increased slightly year over year to 20%. However, receivables and payables equal 54% and 50% of revenue, respectively. Debt, at $12.454 billion, is near its high for the past two years, and share repurchases have taken 118.3 million shares out of circulation. The trend among Dow stocks regarding share repurchases is no fairy tale.

Foolish bottom line
Foolish readers should always consider earnings quality when making an investment decisions. Companies with solid dividend payouts and highly sustainable business models will inevitably outperform. In the past, investors would have been wise to steer clear of the financial sector, for example, until many of the largest institutions sorted out their balance sheets after the subprime lending fiasco. Bank of America's comeback story has been impressive, but many investors remain skeptical even given its cheap valuation. Perhaps now is the time to take a closer look at this potentially cheap bank for your portfolio. To help, the Motley Fool has compiled a premium report that will keep you apprised of all the opportunities and risks facing Bank of America today. The report comes with a full year of updates. Interested? Click here for access.