Bank of America Merrill Lynch’s Top 10 Picks for 2013, Part One: Eli Lilly & Co. (LLY), Pfizer Inc. (PFE)

Hello and welcome, readers. I’d like to issue an informal apology for the delay in writing in recent weeks. I relocated from Ohio to Florida in August 2011, and only recently discovered that living in warm weather year-round doesn’t give Florida residents any immunity to the common flu. In fact, a large portion of South Florida seems to have caught some form of illness in the past month. I’m feeling better after an extended away period and look forward to catching up on writing very soon.

Recently I had the opportunity to attend the CFA Society of South Florida’s Annual Financial Forecast event in Boca Raton, Florida. The warm January weather here in the greater Miami / Palm Beach area serves as a good draw to bring Wall Street’s best minds from New York down to South Florida. This year’s event was the 24th annual, and the CFA Society was pleased to host Mary Ann Bartels, Head of Technical and Market Analysisat Bank of America Merrill Lynch. Bartels was joined on the investment panel by two leading economists, Rich Yamarone of Bloomberg and Don Rissmiller of Strategas Research Partners.

Eli Lilly & Co. (NYSE:LLY)

Mega Cap Stocks vs. S&P 500 index

During her presentation to the CFA Society of South Florida, Bartels discussed her views on the overall market and indicated that she prefers mega caps, best represented by the S&P 100 index. Mega caps are the largest and most established publicly-traded companies, and represent 57% of the S&P 500’s market capitalization.

Why does Bartels favor mega cap stocks? She believes the largest companies in the stock market are under-owned, and are beginning to exhibit signs of leadership as evidenced by Wal-Mart (NYSE:WMT)’s breakout from a multi-year trading range. Bartels cites an internal piece of research from Bank of America which shows the “Nifty 50” vs. the “Not-So-Nifty 450.” The chart indicates that the Nifty 50, or the 50 largest companies by market capitalization, have a major catch-up trade versus the next 450 stocks in market capitalization within the S&P 500.

Bank of America Merril Lynch’s Top 10 Picks for 2013

Given that Bartels has identified her “Top 10 Picks” on an allocation and strategic basis, the purpose of this article is to evaluate the fundamental case for investment.

Do I recommend these stocks based on traditional fundamental analysis?

Let’s take a closer look on a case-by-case basis. Counting down Bank of America’s top picks for the New Year, let’s begin with numbers 10, 9 and 8.

Eli Lilly & Co. (NYSE:LLY)-#10

On January 29, Eli Lilly & Co. (NYSE:LLY) reported fourth quarter results, beating on both earnings and revenue. The $63 billion pharmaceutical giant posted a profit of $0.85 per share vs. $0.78 consensus and higher-than-expected revenue of $5.96 billion vs. $5.81 billion estimated.

Investors have expressed concern over Eli Lilly & Co. (NYSE:LLY) in recent years, as the company faces one of the most difficult “patent cliffs” among large pharmaceuticals. Many of the Eli Lilly’s drugs such as Zyprexa, Cymbalta, Gemzar, and Evista all face expiring patents in which generic competitors can produce the same drugs at a small fraction of the cost, eliminating some of Lilly’s large profit margins and revenue streams.

Nonetheless, Wall Street believes Eli Lilly’s pipeline is strong and can offset the expiring patent portfolio. The Indianapolis, IN headquartered Lilly is planning for five new regulatory filings during the 2013 calendar year.

On January 30, Citigroup raised its price target on LLY to $60 from a previous $55 following the company’s Q4 earnings report. In particular, Citigroup believes the drug ramucirumab has demonstrated strong initial data which should bode well for upcoming Phase III data points and regulatory approval. Ramucirumab is being studied for cancers of the breast, colon, liver, lung, and stomach.

Eli Lilly & Co. (NYSE:LLY) also has $1.1 billion remaining in its share repurchase program for 2013, after having repurchased $400 million of stock during the 2012 calendar year. Lilly also pays $1.96 per year in dividends, which is greater than a 3.6% yield based on recent market prices.

In other news, CEO John Lechleite told Reuters that he has no plans to spin off Eli Lilly’s animal health business Elanco. The inquiry was prompted by Pfizer (NYSE:PFE)’s decision to spin off its own animal health unit in a separate IPO. Pfizer’s Zoetis went public in late January and was the largest offering by a US firm since Facebook’s IPO last June.

I recommend that readers follow Bank of America’s advice and buy shares of Eli Lilly & Co. (NYSE:LLY). LLY’s fiscal year ends on December 31.

Pfizer Inc. (NYSE:PFE)- #9

On January 29, Pfizer Inc. (NYSE:PFE) released fourth quarter 2012 results, reporting better-than-expected earnings and revenue. Management provided guidance for the 2013 fiscal year of $2.20-$2.30 EPS, giving the stock a 12x forward P/E multiple. Revenue guidance stands at $56.2 billion to $58.2 billion.

Similar to Eli Lilly, Pfizer Inc. (NYSE:PFE) faces multiple patent losses between 2012 and 2015, which is the main reason the company has engaged in significant expense reduction and cost-cutting. Overactive bladder treatment Detrol and ED treatment Viagra both lost patent protection in 2012, and Celebrex will lose its protected status in 2014. A full expiration calendar is available within Pfizer’s annual report.

Despite the upcoming patent losses, Pfizer Inc. (NYSE:PFE) still generates cash flow to pay a respectable 3.5% dividend yield. On January 30, Argus raised its price target on Pfizer to $30 from a previous $28 based on the company’s strong Q4 report and upcoming pipeline. Pfizer is scheduled to launch new drugs within heart disease, immunology, and oncology in the near future.

Investors seem to be buying the Pfizer’s long-term growth story, as shares are trading at 5-year highs. I recommend that readers follow Bank of America’s advice and buy shares of Pfizer. The company’s fiscal year ends on December 31.

Wal-Mart Stores, Inc. (NYSE:WMT) – #8

During her presentation at the CFA Society, Bartels referenced Wal-Mart as a great example of leadership within the mega caps. After trading in a range between $50 and $60 for the majority of the last decade, Wal-Mart broke out in the second half of 2012 and reached an all-time high of $77.60. Bartels believes mega caps are a catch-up trade for 2013 and that Wal-Mart can see further upside.

On February 21, Wal-Mart Stores, Inc (NYSE:WMT) reported fourth quarter 2012 results before the market open. Earnings per share came in at $1.67 vs. $1.57 consensus on top of revenue of $127.92 billion, slightly lower than the $128.77 billion expected.

Management announced an 18% increase in the annual dividend to $1.88 per share. In addition to the dividend increase, Wal-Mart provided a fiscal year 2014 guidance range of $5.20-$5.40 giving the stock a 13x forward P/E multiple. Analysts are currently modeling $5.37 per share, at the upper end of management’s guidance.

Following the earnings announcement, an internal e-mail obtained by Bloomberg News indicates that February sales are off to a slow start. Jerry Murray, vice president of finance and logistics, wrote in an e-mail “In case you haven’t seen a sales report these days, February (month-to-date) sales are a total disaster. The worst start to a month I have seen in my (about) 7 years with the company.”

Although the leaked e-mail sounds like it’s straight from a competitor’s playbook, Wal-Mart confirmed on the fourth quarter earnings call that its customers were adjusting to a reduced paycheck (courtesy of higher payroll tax) and increased gas prices in the New Year. Management also lowered FY14 sales guidance to 5%-6% comparable sales growth from a previous estimate of 5%-7% same-store sales growth.

Following the quarter, analysts at Cowen and Company, J.P. Morgan, and William Blair have all expressed caution on Wal-Mart. Specifically, William Blair communicated a “sell the news” message to its clients, indicating the firm didn’t understand why Wal-Mart was trading higher and not lower following the release, given the lower-than-expected sales during Q4 and reduced outlook.

Among BAML’s Top 10 Picks for 2013, Wal-Mart is my least favorite due to the recent same-store sales weakness. Although I believe downside is limited due to the 2.6% dividend yield, the stock will need time to consolidate the recent gains.

Wal-Mart’s fiscal year ends on January 31.

Further Insights on Bank of America Merrill Lynch

If you are a believer in Bank of America’s thesis that mega caps are under-owned, Eli Lilly, Pfizer, and Wal-Mart are all candidates for outperformance over the next several years.

Furthermore, mega cap valuations are supported by strong dividend yields. The average yield for Bank of America’s Top 10 list is 3.8%, which significantly beats the 10-year U.S. Treasury bond or traditional savings account yield. Check back at johnmacris.com for Parts Two and Three of Bank of America’s Top 10 Picks for 2013 very soon.

Thanks for reading, and consider subscribing to my posts for more Fool ideas on outperforming the market. Requests for future articles may be submitted to fool@johnmacris.com.

The article Bank of America Merrill Lynch’s Top 10 Picks for 2013, Part One originally appeared on Fool.com and is written by John Macris.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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