If you want to get the best returns from your stocks, you simply have to pay attention to valuation. If you buy stocks when they're cheap, then you can score truly excellent returns over the long haul. But if you jump onto the hottest stocks only after they've already jumped to crazy valuations, then you'll usually end up getting burned.
I'll review the five Dow stocks that have the cheapest valuations and then take a closer look at whether those stocks are true bargains -- or have problems that put their low multiples into clearer perspective. But first, let's look at one example of how paying up even for a high-quality stock can get you in trouble.
Not always the low price for this stock
Back in late 1999, Wal-Mart
But the big problem for the stock was that it was richly priced. Trading at 58 times trailing earnings, Wal-Mart needed to perform perfectly to justify that multiple.
Since then, sales at Wal-Mart have risen 160%, and net income has tripled. The dividend is now seven times what it was in 1999. Yet in the past 12 years, the stock has gone just about nowhere. And the reason is simple: The valuation contracted to the point where now, the stock is reasonably priced compared with its earnings. But for those who bought it at its high point, Wal-Mart is a perfect example of a lost decade-plus of flat performance.
So why not start cheap?
The dangers of buying great companies at prices that are way too high led me to look instead at stocks with low valuations. That way, I don't have to worry as much about whether good financial results for a company will be good enough to keep the shares going higher.
So without further ado, let's take a look at the five stocks from the Dow Jones Industrials
5-Year Average Return
Current Dividend Yield
Source: S&P Capital IQ. As of Dec. 29.
It's no big surprise that most of these low-priced stocks have gotten beaten down. Chevron stands out because its earnings growth has outpaced even its healthy stock performance, but for the most part, these companies face threats that have investors scared. In particular:
- JPMorgan Chase is among the healthiest of the big banks. But even its relative strength can't entirely protect it from the threat of a European financial crisis that could easily spread throughout the global financial system.
- Many of my peers have chronicled Hewlett-Packard's woes, which include a revolving-door policy in the CEO position and a lot of uncertainty about the strategic direction in which HP plans to move in the future.
- Chevron has enjoyed high oil prices for a long time. But if Europe throws the global economy into recession again, investors remember very well the impact the last slowdown had on oil prices.
- Alcoa has a combination of problems to address, including both macroeconomic headwinds and product-specific threats from substitute materials.
- Most investors have seen Microsoft as a laggard in innovation, instead riding its cash-cow operating system and office software products for as much as they're worth. That perception's probably wrong, but the stock certainly still reflects it.
Get the best bargains
These stocks are undoubtedly cheap, but do they deserve to be? In my view, HP and Alcoa have fundamental internal issues they need to address before they'd make good investments. I'm more willing, though, to bet that JPMorgan Chase will dodge the financial-Armageddon bullet. And as for long-term bets, I'm comfortable that Microsoft and Chevron will be around and profitable for a long time.
Of course, if you don't like those ideas, you can always look beyond the Dow for great stocks. We have one name for you -- an exciting company with plenty of promise. You can read all about it in our brand-new free report: "The Motley Fool's Top Stock for 2012." But don't wait -- grab your copy today before it's gone.
Fool contributor Dan Caplinger loves only true bargains. You can follow him on Twitter. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of JPMorgan Chase, Wal-Mart, and Microsoft. Motley Fool newsletter services have recommended buying shares of Microsoft, Wal-Mart, and Chevron, as well as creating a diagonal call position on Wal-Mart and a bull call spread position on Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never overcharges you.