In a private speech to the Financial Planning Association, legendary Vanguard founder and former CEO John Bogle made an absolutely critical observation about where the best stock returns come from -- and how to find the next great stock to buy.
He told the assembled guests that only three things drive investor returns:
Changes in valuation
Historically, stocks have returned 9.6% per year on average -- 5%, 4.5%, and 0.1% from dividends, earnings growth, and valuation changes, respectively. Naturally, the best stocks produce the highest combined return.
So which diversified chemicals stocks will earn investors the best returns today? Obviously, no one knows for sure. You should always take future estimates with a grain of salt, particularly when analyst forecasts are involved. In fact, studies show that analysts' long-term earnings-per-share estimates tend to be overly optimistic by roughly 40%, so I've reduced their estimates accordingly.
But investing is all about making predictions based on imperfect knowledge of the future. So long as we're aware of the need to think critically about a company's prospects and to build a margin of safety into our stock purchases, analyst estimates can be a helpful tool for generating ideas. By running the numbers, we can round up the stocks that represent their implied best buys today. Here are our assumptions:
Dividend Yield (current)
5-Year Growth Rate (reduced by 40%)
Price-to-Earnings Ratio (in 2016)
Olin (NYS: OLN)
Solutia (NYS: SOA)
Cabot (NYS: CBT)
Ashland (NYS: ASH)
PPG (NYS: PPG)
DuPont (NYS: DD)
LSB Industries (NYS: LXU)
Data from Capital IQ, a division of Standard & Poor's. Includes stocks on major U.S. exchanges capitalized at more than $200 million, with positive earnings and at least one analyst issuing long-term earnings estimates.
And here are their implied five-year annualized returns for shareholders. I've ordered the three return components by their reliability -- first dividends, then earnings growth, then valuation.
Earnings Growth Return
Implied Cumulative Annual Return
Source: Author's calculations.
*Assumes dividend growth at rate of earnings growth.
The raw numbers tell us that these are the seven most promising names in diversified chemicals. Of course, analysts' growth assumptions for any individual company could prove overly optimistic or pessimistic, as could their future valuations, so the implied cumulative returns are hypothetical. That said, this list helps you focus on this sector's highest potential returners -- and provides an excellent starting point of names for further research.
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.
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