Published: December 11, 2009

Exactly 250 U.S. companies are valued at more than $10 billion, but only 18 of them -- the top 7.2% -- have no long-term debt on their balance sheets.

It's an impressive statistic, but perhaps more notable to investors is that all but one of these companies have beaten the S&P 500 for the year.

Even more amazingly, eleven of the 18 have more than doubled the benchmark average, and seven of them have actually seen returns in excess of 67%, which equates to more than three times the performance of the S&P.

The question is twofold: Are all of these companies already fairly valued, and to what degree are these outsize returns sustainable?

Before examining those questions, I'm scratching a few companies from the list: Gap and Bed Bath are retailers that have no long-term debt but that nevertheless borrow plenty of money in the short term. And short term debt is the key to Annaly's business model. This Real Estate Investment Trust borrows at a low short-term rate and uses the money to buy higher-yielding long-term mortgage-backed securities. It's a great business model -- Annaly pockets the spread between the two rates -- and the REIT is an income investor's favorite because of its high yield, but its heavy leverage means it doesn’t belong on a listing of debt-free companies. (My colleague, Carla Pasternak, holds Annaly in one of the two high-income portfolios of her successful High-Yield Investing newsletter advisory. All 20 of her open picks are up -- paying out safe dividend yields of up to 12.5%.)

It's a principal of mathematics that all outcomes can be plotted within a certain distance from the average. The outcomes -- a stock's return, in this case -- that either sharply lag or exceed the mean ultimately will fall back in line with long-term averages. So the answer to our second question -- whether an average company can generate extraordinary results over an extended period -- is no. But these are not average companies. Average companies aren't this large. Average companies have debt. There is no reason to suspect that these companies can't keeping generating substantial returns and continue to beat the market. It's unreasonable to expect an average stock to consistently thump the broader market by a factor of three. With that in mind, here's a good rule: Let someone else buy average stocks.

To determine which companies have the best shot at delivering superior long-term results to investors, the key is not to look at the income statement or the stock price but instead to study the balance sheet. Companies whose management consistently delivers a strong return on equity will generate superior long-term results. I calculated the compound annual growth rate for the companies on the list. Seven of the fifteen posted a compounded return on equity of 15% or more.

To consider the complete answer to whether these stocks can maintain their winning streaks, we can compare their current valuation to their average and determine a reasonable earnings multiple. Once we arrive at that, we multiply the price-earnings ratio (PE) by the earnings estimate for the upcoming year.

In other words, if a company typically trades for an average 20 times earnings and its estimated earnings per share for the upcoming 12 months is $4, then it's reasonable to conclude the stock will be worth $80 at the end of 2010. If the stock is trading at $60, then the potential upside is $20 a share, or +33%.

The following chart shows that calculation for the seven stocks on our list, using an appropriate earnings multiple based on current and historical valuation:

The chart suggests that Celgene, Apple and Qualcomm have substantial upside. Google and Cognizant and Stryker look poised to beat the market, and Intuitive Surgical, even though its outlook seems bleak compared to these peers, still offers potential upside substantially greater than the roughly 10%-11% historical return offered by the S&P 500.

Large, debt-free companies are the most nimble players in any industry -- fearsome competitors with wide moats around their business. Each of these stocks is a suitable long-term hold for a growth-oriented portfolio.

-- Andy Obermueller
Chief Investment Strategist
Government-Driven Investing