Here's a new way to consider value for stocks in the S&P 500

By Philip van Doorn

A look back at quality highlights companies that have made a lot of money for investors and are expected to grow earnings rapidly through 2025

Investing and trading are not the same thing. A lot of financial-media coverage of the stock market is geared toward the short-term concerns of traders trying to buy or sell at the best prices. But long-term investors who select individual stocks need to think about the quality of the companies they hold.

A long-term investing approach can take many years to pay off. The SPDR S&P 500 ETF Trust SPY, for example, returned 26.2% in 2023, with dividends reinvested. But that followed an 18.2% decline in 2022. Through Friday, the fund had returned 4.8% since the end of 2021. But over the past 10 years, SPY has returned 215%, for a compound annual return of 12.3%, according to FactSet.

So the index has an excellent long-term record for patient investors. But what about individual stocks? Last week, Mark Phillips at Ned Davis Research published a list of 31 "wonderful European companies at a fair price," based on the firm's analysis of 10 years of returns on assets and other factors.

That list was all based on historical data, so we narrowed it further to 10 stocks by looking at expected increases in earnings per share through 2025.

Why not apply NDR's approach to the S&P 500 SPX?

S&P 500 stock screen for long-term quality and reasonable current prices

To apply NDR's methodology for its screen of European stocks to the U.S. market, we began with the S&P 500 and looked back at 10 years of returns on assets, as calculated by FactSet. Here's how the screen narrowed down the list:

468 companies in the S&P 500 had 10 years of earnings history available through their most recent reported fiscal quarters.262 companies had 10-year average ROA of at least 5%. FactSet calculates current ROA by looking at the most recent four quarters of net income, adjusting to remove earnings or losses from discontinued operations, and dividing that sum by total assets. We're in the middle of earnings season, so for a company that most recently reported earnings as of Sept. 30, the most recent ROA is for four quarters through that date. The previous year would be through Sept. 30, 2022, and so on. So the average ROAs are for each company's 10 most recent reported four-quarter periods. For comparison, the S&P 500 had an estimated 2023 ROA of 3.99%, based on weighted aggregate estimates among analysts polled by FactSet, with a 10-year average ROA of 3.48%.216 companies also had ROAs above zero for all 10 four-quarter periods.123 companies also had two-year average ROA above their 10-year average ROA.

The last part of the historical screen was to look at companies' earnings yields over the past three 12-month periods. A company's earnings yield is its trailing earnings per share divided by its current share price. For the S&P 500, the weighted trailing earnings yield as of Friday's close was 4.13%.

This is the part of the screen that was meant to isolate companies trading "at a fair price," according to Phillips, who wrote that "since better quality companies tend to have higher valuations than lower quality companies, rather than simply screening on the raw earnings yield, we divided the earnings yield by the median market earnings yield and compared it with the three-year average."

For each of the remaining 123 companies, we calculated relative earnings yields for each of the past three 12-month periods by dividing the earnings yields by the median earnings yields among S&P 500 companies. It turned out that 55 companies in the S&P 500 had most recent relative earnings yields above their three-year averages.

The final cut - looking ahead

To pare the list further, we looked at consensus earnings estimates for calendar years through 2025 among analysts polled by FactSet. Here are the 20 companies that passed the historical screens above and also show the highest expected compound annual growth rates for earnings per share through 2025:

   Company                               Ticker   2-year avg. ROA  10-year avg. ROA  Earnings yield, past 12 reported months  Two-year estimated EPS CAGR through 2025  10-year total return 
   Nvidia Corp.                           NVDA             27.30%            21.21%                                    1.87%                                     43.8%                15672% 
   Chipotle Mexican Grill Inc.            CMG              13.96%            10.98%                                    2.30%                                     20.8%                  342% 
   Booking Holdings Inc.                  BKNG             16.49%            13.15%                                    4.66%                                     19.3%                  207% 
   Monolithic Power Systems Inc.          MPWR             21.97%            14.06%                                    2.00%                                     15.4%                 1916% 
   MSCI Inc. Class A                      MSCI             18.52%            12.60%                                    2.34%                                     13.5%                 1286% 
   Idexx Laboratories Inc.                IDXX             27.69%            22.23%                                    2.24%                                     13.5%                  822% 
   Visa Inc. Class A                       V               18.34%            14.76%                                    3.54%                                     13.3%                  400% 
   Waste Management Inc.                   WM               7.57%             6.26%                                    3.71%                                     12.7%                  433% 
   Martin Marietta Materials Inc.         MLM               6.60%             5.76%                                    4.20%                                     12.7%                  411% 
   Rollins Inc.                           ROL              17.38%            17.28%                                    2.23%                                     12.4%                  484% 
   Arista Networks Inc.                   ANET             22.52%            16.73%                                    3.27%                                     12.2%                   N/A 
   Marriott International Inc. Class A    MAR              10.18%             7.08%                                    4.80%                                     11.9%                  410% 
   UnitedHealth Group Inc.                UNH               8.59%             7.68%                                    4.53%                                     11.7%                  709% 
   Trane Technologies PLC                  TT              10.03%             6.95%                                    4.18%                                     11.6%                  516% 
   Zoetis Inc. Class A                    ZTS              15.76%            12.06%                                    2.83%                                     11.6%                  539% 
   ResMed Inc.                            RMD              15.54%            13.21%                                    4.16%                                     11.4%                  335% 
   Fortinet Inc.                          FTNT             15.55%             8.05%                                    2.47%                                     11.2%                 1318% 
   Aon PLC Class A                        AON               8.67%             5.21%                                    4.06%                                     11.0%                  309% 
   Edwards Lifesciences Corp.              EW              16.63%            15.87%                                    3.38%                                     10.9%                  551% 
   Bio-Techne Corp.                       TECH             11.15%             8.96%                                    2.24%                                     10.5%                  220% 
                                                                                                                                                                             Source: FactSet 

If you are selecting individual stocks rather than taking a lower-risk broad approach with index funds or actively managed funds, it is important to form your own opinion about a company's ability to remain competitive providing goods or services over the long term. One way to begin your research is by clicking on the tickers.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

When describing his screen for European companies, Phillips wrote that companies that passed the screen tended to outperform that equity market as a whole. The same holds true for this screen of the S&P 500. Among the 20 companies in the table, 20 had 10-year total returns exceeding the index's 10-year return of 218% return through Friday.

Nvidia Corp. (NVDA) tops the list with the highest expected EPS CAGR through 2025. But it is also the most expensive stock on the list by the screening criteria, because it has the lowest earnings yield. Rapid growth commands a premium, and Nvidia has also been a consistent ROA performer.

Don't miss: Why Microsoft's stock is a better investment than Apple's

-Philip van Doorn

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01-27-24 0616ET

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