In the Second Quarter, Look for Laggards

 | Apr 02, 2013 | 9:00 AM EDT
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The first quarter was one for the record book. It ended with the S&P 500 surpassing its 2007 high-water mark, and it was the Dow's best first quarter since 1998.

Quarterly performance benefited from good corporate fundamentals and modest yet positive economic news, both here and abroad.

Already the speculation is swirling that "Sell in May and go away" will once again hit the market as it did last year. If it does, it would be the fourth year in a row that May heralded a market selloff.

We are not counting on it. While we do envision a pause, even a pullback at some point, we don't believe that March 31 will prove to be 2013's high-water mark. Unlike last year, the market is not likely to get bogged down with macro U.S. economic issues. The first quarter showed that once again, anemic economic growth and stock market gains can comfortably co-exist.

Slow but positive economic growth might in fact be a sweet spot for the market, keeping the Fed accommodative and making it likely that interest rates and inflation remain tame.

Having said that, a pause is likely, simply because annualizing the first quarter is clearly not feasible. However, rather than go away in May (or whenever a pause might take place), we suggest focusing new purchases on stocks that have strong businesses and good 2013 prospects yet did not keep pace with the strong first-quarter market.

We believe these companies are ready to play some catch-up on the upside and should be a little better insulated against a pullback, because they have not had the market's heady gains and are selling at very reasonable valuations. Three companies that fit this description are Emerson Electric (EMR), Microsoft (MSFT) and Wells Fargo (WFC). Here's why we like each of them, particularly as we enter what likely will be a slower market in the second quarter:

Emerson Electric is a leading diversified and global manufacturing company that continues to generate steady and improving revenue, margin and earnings growth from expanding opportunities in emerging markets. In particular, earnings are projected to rise 8% to 10% over the next two years. Dividends are also expected to grow from an already attractive 2.9% yield. Emerson Electric is also reasonably valued at 15.6x earnings, and we expect further stock-price games from earnings growth and modest multiple expansion.

Microsoft also lagged during the quarter, despite continuing improvements in fundamentals in areas such as enterprise software and emerging markets. Strength in these areas has offset weakness in the core Windows/Office product lines.

Earnings are expected to grow to $2.86 in 2013 and $3.19 in 2014, resulting in very attractive below-market valuation multiples of 10x 2013's and 8.9x 2014's earnings. Management continues to enhance cash payouts to shareholders with a record $0.92 per share dividend rate, or a 3.20% current yield. We expect Microsoft's board to further boost payouts in the coming years. Our bullish outlook on Microsoft would be greatly enhanced if management did a better job of implementing a more shareholder-friendly capital allocation strategy. The stock's dismal performance over the past few years might serve as a wake-up call for management to be more responsive in this regard.

Microsoft has historically traded at a premium to the S&P 500, and it is arguably the most undervalued software company today.

Wells Fargo continues to vastly outperform its major banking peers with record asset and earnings levels. Earnings are expected to continue to rise over the next three years on rising loan and fee volumes, continued cost-reduction actions and favorable share-repurchase activity.

Thanks to rising confidence, the company recently boosted its dividend to $1.20 per share, or a 3.25% yield. That's 20% higher than the January level and 36% higher than a year ago. At its current yield, Wells Fargo offers one of the highest yields in the banking group. With the stock trading for 10.1x 2013's EPS of $3.65, Wells Fargo is due for healthy gains in upcoming periods.

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