Is 2014 the Year of the Blue Chips?

In this five-year bull market, McDonald's, Coca-Cola, and PepsiCo have been overshadowed by surging small-cap stocks. When the tide turns, which stocks will still stand?

Mar 16, 2014 at 12:00PM

The conventional wisdom holds that small capitalization stocks offer higher risk and higher return than large capitalization stocks. That pattern has held true in the five years since the post-recession market bottom in 2009; small capitalization stocks have crushed their larger counterparts over the last five years and they have continued to do so over the past year. Meanwhile, the Dow Jones Industrial Average (NYSEMKT:DIA) trailed the market by a significant margin.

SPY Total Return Price Chart

Total Return Price data by YCharts

The Dow's underperformance indicates that the market disfavors large-capitalization stocks like McDonald's (NYSE:MCD), Coca-Cola (NYSE:KO), and PepsiCo (NYSE:PEP), all of which significantly underperformed the S&P 500 in the last year.

SPY Total Return Price Chart

Total Return Price data by YCharts

These stocks' underperformance creates possible buying opportunities for bargain hunters. When viewed in light of the 30-year Treasury bond, which yields 3.6%, large capitalization stock yields seem especially attractive. McDonald's yields 3.3%, Coca-Cola yields 3%, and PepsiCo yields 2.8%. Although these dividend yields slightly fall short of the yield of the Treasury bond, investors who buy and hold McDonalds, Coca-Cola, and PepsiCo for 30 years will almost certainly receive mid-single-digit capital appreciation in addition to the dividends. This should pique the interest of long-term investors with cash to spare.

Owner yield
Even though these companies offer attractive dividends given the low interest rate environment, their yields appear misleadingly low. To really understand how much capital these companies return to shareholders each year, you have to include share repurchases in the calculations. You might call the dividend plus share repurchases divided by market capitalization the 'owner yield.' PepsiCo offers the highest owner yield at 5.2%, McDonald's offers a 5.1% yield, and Coca-Cola offers a 5% yield.

In essence, at current prices these stable corporate giants are on pace to return 5% of their market capitalizations to shareholders annually, and they also offer the possibility (or near-certainty) of capital gains. A buy-and-hold investor should favor this type of arrangement.

Capital gains seem satisfactory
Large cap stocks appear attractive for more than just their dividends; this beaten-down group also offers strong possibilities of outsized returns. McDonald's, Coca-Cola, and PepsiCo appear cheap based on historical price-to-earnings ratios and earnings per share gains appear likely. The combination of multiple expansion and growing earnings often leads to large returns for shareholders.

Company

5-Year Average P/E

Forward P/E

McDonald's

17.0

14.9

Coca-Cola

18.3

16.5

PepsiCo

17.2

16.1

Source: Morningstar

Moreover, if you invert the companies' price-to-earnings ratios, you get what investors sometimes call their 'earnings yields.' For instance, to find PepsiCo's earnings yield you would divide 1 by 16.1 (its price-to-earnings ratio) to get 6.2%. McDonald's offers an earnings yield of 6.7% and Coca-Cola offers an earnings yield of 6%. If each company paid out all of its earnings through dividends each year, the shareholder return would equal the earnings yield.

However, these companies do not pay out all of their earnings in dividends. PepsiCo retains about 50% of its earnings, Coca-Cola retains about 40%, and McDonald's retains a little less than 45%. For wide moat companies like these, retained earnings normally add value for shareholders over time. As Coca-Cola reinvests earnings to grow per capita consumption of its beverages, PepsiCo grows its snack business and turns around its beverage business, and McDonald's boosts its same-store sales, those reinvested earnings will turn into even more earnings in the future. Thus, each stock will probably return more than the earnings yield suggests for buy-and-hold investors.

A Foolish investor chooses safety over greed
In a raging bull market that features multiple Internet IPOs zooming to new highs and a market that never seems to go down for two days in a row, investors can find it hard to get excited about boring blue-chip stocks. However, while rocket-ship stocks tend to come down after the excitement surrounding them fades, old-economy stalwarts like McDonald's, Coca-Cola, and PepsiCo offer safety of principal and outsized returns over the long run. Buy-and-hold investors should take note.

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Ted Cooper owns shares of Coca-Cola. The Motley Fool recommends Coca-Cola, McDonald's, and PepsiCo. The Motley Fool owns shares of Coca-Cola, McDonald's, and PepsiCo and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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