The Dow Jones Industrial Average is down around 6.2% year to date. Of the 30 stocks in the index, 14 are down at least 10% for the year. That should make it relatively easy to find undervalued Dow stocks to buy. However, the index has made gains in recent weeks, rising more than 8.4% in the past month and nearly 19% since hitting a 52-year low of 28,660.94 on Oct. 13.
On Nov. 14, Jonathan Krinsky, chief market technician at BTIG, suggested that the Dow’s outperformance relative to the S&P 500 and Nasdaq is a sign that the current stock rally is about to hit the skids. Krinsky argues that investors have been moving into defensive stocks to protect themselves from economic headwinds on the horizon.
“I don’t think we’re in a durable rebound,” he said in a phone interview with MarketWatch.”People are trying to catch upside, but in more of a defensive manner.”
The warning means investors should be extra careful in selecting undervalued Dow stocks to buy. Just because something is undervalued doesn’t mean shares can’t go lower in the short term. Of course, Krinsky’s prediction could turn out to be wrong and stocks could continue to climb a wall of worry. Therefore, consider buying the stocks below at current prices or on the next pullback in the Dow.
All three have reasonable returns on capital, along with low price-to-sales and forward price-to-earnings ratios, and should provide healthy returns for long-term investors.
Home Depot (HD)
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Home Depot (NYSE:HD) is down 21% YTD. That doesn’t make it the worst Dow performer in 2022, but it’s in the top 10. For those who are curious, Intel (NASDAQ:INTC), Salesforce (NYSE:CRM) and Nike (NYSE:NKE) are vying for the year’s worst performance.
There are a number of reasons I like Home Depot for the long term. First, the company reported better-than-expected Q3 results on Nov. 15. On the top line, revenue grew 5.6% year over year to $38.9 billion. On the bottom line, Home Depot earned $4.34 billion, up 5.1% from a year ago. And same-store sales increased by 4.3% in the quarter. Management maintained its full-year guidance for 3% same-store sales growth, an operating margin of 15.4%, and EPS growth in the mid-single-digits.
GlobalData managing director Neil Saunders liked the company’s third-quarter results, suggesting that while the home improvement giant will feel the effects of a tightening economy, it likely won’t stop it from growing.
My second reason for liking Home Depot is its financial strength. It currently has a return on assets of 22.8% and a return on invested capital of 37.4%, both very healthy numbers. As for its valuation, shares trade at 2.1 times sales, their lowest valuation since 2018.
While Home Deport is certainly not immune to the current economic woes, it should benefit from the steep jump in mortgage rates this year. With rates near a 20-year high, more people are likely to stay put and renovate their existing homes rather than buy a new one.
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Merck (NYSE:MRK) is the second best-performing stock in the Dow in 2022, up 39.5% YTD. Only Chevron is doing better, with a 58% gain. Meck’s performance is impressive when you consider the S&P 500 healthcare sector is down 4.4% YTD while the energy sector is up 63% on the year.
Of the 66 healthcare stocks in the S&P 500, MRK is the fourth-best performer in 2022, according to Finviz. So, what has it been doing well that other healthcare stocks aren’t? Acquisitions.
Acquisitions are a big part of Merck’s growth strategy as it gears up to replace the revenue that will be lost when its cancer immunotherapy Keytruda loses patent protection in 2028. In the third quarter, Keytruda accounted for nearly 42% of the company’s pharmaceutical revenue and more than a third of total revenue.
For example, a year ago, Merck paid $11.5 billion for Acceleron Pharma. That price raised some eyebrows considering Acceleron only had $92.5 million in 2020 revenue. However, the latest results for cardiovascular drugs Sotatercept, one of Acceleron’s drugs, are likely to put these concerns to bed.
On Nov. 21, Merck announced it would acquire Imago Biosciences (NASDAQ:IMGO) for $1.35 billion. Merck is paying a 107% premium to Imago’s Nov. 18 closing price. Imago develops drugs to treat bone marrow-related diseases. Its primary drug, Bomedemstat, is currently being studied as a treatment for rare blood cancers. The acquisition is expected to close in Q1 2023.
With a healthy 2.7% dividend yield, trailing 12-month free cash flow of $15.2 billion, and a free cash flow yield of 5.6%, you’re getting growth at a reasonable price with MRK stock.
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Chevron (NYSE:CVX) is up 58% YTD, making it the best-performing Dow stock of the year by a wide margin.
Energy stocks of every description are tearing it up in 2022. In fact, as of Nov. 22, it was the only S&P sector in the black for the year, up around 63%. It’s amazing what $80-a-barrel West Texas Intermediate has done for the industry’s confidence.
On Nov. 17, Chevron announced it would acquire Beyond6, a subsidiary of Mercuria Energy Trading and operator of 55 compressed natural gas stations. Chevron will take the renewable natural gas Beyond6 produces and sell it through those stations.
“B6 represents a best-in-class operator in the build-out of a renewable natural gas network, and Mercuria has been excited to help the company grow from a stand-alone business to one that can help drive growth under Chevron,” said Brian Falik, Mercuria’s chief investment officer.
Chevron announced Q3 results at the end of October. Revenue increased 49% to $66.6 billion, while net income jumped 84% to $11.2 billion. In the first nine months of the year, it generated free cash flow of $29 billion, which was more than double the same period in 2021.
Investors are concerned that OPEC+ will hike production by as much as 500,000 barrels per day at its meeting in early December. Long-term, though, Chevron remains in an excellent position to benefit from the global energy transition.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.