The Dow's 5 Most Loved Stocks

You might say that short-sellers are still relishing their victory in August that knocked the Dow Jones Industrial Average (^DJI 0.40%) down 4.4%. Over the past 12 session, short-sellers have again been in charge, pushing the iconic blue-chip index lower three-quarters of the time.

Yet for all of the negativity that's surrounded the Dow, it's within a few percentage points of reclaiming another new all-time record closing high. In other words, no matter how hard the short-sellers keep kicking and pointing to the ongoing government shutdown and the upcoming debt-ceiling debates, the Dow continues to hold up very well, all things considered.

The main reason the Dow continues to outperform bonds and inflation has to do with a slow but steadily improving economy. I know I've harped on this before, but sometimes the same points need to be rehashed to understand why we're heading higher. First, even though we didn't get any new information on September's unemployment data this week, we do know that as of the latest report from August the unemployment rate was nearly at a six-year low. We also know that the housing industry is on more solid footing and that historically low lending rates are encouraging consumer and business level refinancing, as well as business expansion. These are all reasons for optimists to be encouraged by the market and the Dow especially.

That's why today, as we do every month, I'm going to suggest we take a deeper dive into the Dow's five most loved stocks – essentially the five companies within the Dow that the short-sellers most avoid. Why? Because these companies offer insight as to what to look for in a steady business so we can apply that knowledge to future stock research and hopefully locate similar businesses.

Here are the Dow's five most loved stocks:

Source: S&P Capital IQ.

Source: Walmart, Flickr.

Wal-Mart
Why are short-sellers avoiding Wal-Mart?

• Wal-Mart is so nice, we'll talk about it twice! Short-sellers tend to keep a safe distance from Wal-Mart since it's a retail industry disruptor. By that I mean it's so large, has such incredible cash flow, and can out-stock practically any other retailer in any category, that it can undercut local stores' pricing to gain a loyalty advantage over its smaller competitors. The brand name of Wal-Mart alone is synonymous in this country with being a place for cost-conscious shoppers. As long as slow growth persists in the U.S. economy, Wal-Mart is going to be a very relevant name and short-sellers are likely going to avoid it.

Do investors have a reason to worry?

• To regurgitate a bit of what I wrote last week, yes and no. Wal-Mart has incredible pricing power, unrivaled selection, and has generated a whopping $60 billion in free cash flow over just the past five years. If that weren't enough, Wal-Mart is a low-beta stock, which usually takes it off the radar for short-sellers looking for a quick buck. However, Wal-Mart could also struggle with the government shutdown as many of its core customers are tied to government paychecks. The shutdown would certainly be a situation worth monitoring as it could put quite a dent in Wal-Mart's bottom line in the interim.

United Technologies
Why are short-sellers avoiding United Technologies?

• Sometimes it's as simple as the most recent earnings report driving growth despite other uncertainties. In this case, United Technologies, a technology products and service provider to the aerospace and defense industries, reported sales growth of 16% in the second quarter and upped the lower end of its full-year EPS forecast which now calls for growth of 12%-15%. Clearly, United Technologies is putting higher quality products than its peers in front of the right customers and shareholders are seeing success in the bottom line results. That is proving to be a pretty successful formula for keeping short-sellers at bay.

Do investors have a reason to worry?

• To emulate what I said about Wal-Mart, yes and no for United Technologies. The earnings growth in recent months would speak for itself and determine that most investor fears are overblown and too short-minded. Then again, it's hard to overlook a government shutdown for a company that needs government defense auditors to come in and approve projects. Without those approvals United Technologies is having to furlough thousands of its aerospace division employees which isn't good news. Until we have better clarity when it comes to government spending, it might just be best to avoid the stock altogether.

General Electric
Why are short-sellers avoiding General Electric?

• Unlike the previous two companies that dominate their specific sectors, GE tends to keep short-sellers at bay by channeling a bit of Berkshire Hathaway and diversifying its product line across multiple sectors. GE has a financial arm, along with energy, transportation, and health care businesses, among other things. Being this diversified helps GE survive downswings a bit easier, since many of its businesses are geared toward necessity items. In other words, people always need electricity and health care regardless of how the economy is doing, which puts GE's product portfolio in great shape to prosper through good and bad economic times.

Do investors have a reason to worry?

• For the first time among the three stocks here I'm going to say, "No!" The big worry with GE had been the loan quality of its financial arm, but that is so far improved it's not even comparable to the credit crisis period anymore. In addition, GE is going to monetize its credit card issuing consumer lending business in the coming months via a spinoff which should add better transparency to the company's bottom line and free GE from some of the fears associated with another banking and credit sector meltdown. I think that with a growing dividend and top-notch diversification, GE has a clean bill of health over the long run once again.

Procter & Gamble
Why are short-sellers avoiding Procter & Gamble?

A.G. Lafley. Source: Procter & Gamble, Wikimedia Commons.

• The "love" for Procter & Gamble embodies exactly why I chose the company for my Basic Needs Portfolio -- it provides consumer goods products that offer inelastic demand and pricing. To make that a bit easier to understand, P&G makes consumer products like laundry detergent and toothpaste which people need to buy and use regardless of how well or poor the economy is doing. What that means for P&G is little incentive to ever lower prices and pretty consistent cash flow. For shareholders that means a growing dividend which is a good way to keep short-sellers away.

Do investors have a reason to worry?

• P&G has the largest advertising budget of any other company, but the end result of its recent advertising efforts, especially with regard to detergents, haven't returned excellent results. However, with Bob McDonald stepping down as CEO and A.G. Lafley, the former CEO from 2000-2009 who took P&G from good to great, coming back to run the company earlier this year, my hope is once again renewed that P&G is going to find itself back on the path to mid-single-digit growth with the help of emerging markets. With a remarkable streak that's seen its dividend rise for 56 straight years, I would probably recommend short-sellers not bet against P&G.

Microsoft
Why are short-sellers avoiding Microsoft?

• Just to be different from all of the rest, Microsoft tends to keep short-sellers away because of its incredible cash-generating capabilities. This isn't to say the preceding four companies don't generate copious amount of free cash (because they do), but Microsoft has generated $100.6 billion in free cash flow over just the past four years and has practically $60 billion in net cash sitting in the bank right now. With that kind of clout, Microsoft's downside is really limited by its cash value and its dominant position in operating systems via Windows.

Do investors have a reason to worry?

• Obviously, Microsoft's cash is one reason Microsoft shareholders are sleeping well at night. As a legacy behemoth, Windows is going to be a difficult operating system to unseat even over the next decade. However, shareholders also have to be a bit concerned about Microsoft's lack of successful innovations over the past couple of years, as well as the coming departure of CEO Steve Ballmer. Some investors will be thrilled to see him go, but the changing of the guard is always a time of uncertainty for shareholders -- and uncertainty is what short-sellers feed on, so keep that in mind over the next couple of months.