The Best Stocks to Buy Now
Our annual portfolio of top picks has made a habit of beating the S&P 500. This year we changed the formula--and the results should be even better.
By DAVID STIRES

(FORTUNE Magazine) – Three years ago, we decided to do something radical. It was early 2002, and like everyone else in America, we had watched in horror as the value of our investment portfolios plummeted. We also felt flummoxed by the capricious behavior of a market that all too often seemed driven by herd mentality, dubious analyst ratings, and chatroom gossip. So we decided to take control of the situation and inject some logic into the investment process. We created the FORTUNE 40.

Simply put, the FORTUNE 40 was a diversified portfolio of 40 stocks and bonds. But these weren't your typical securities. Like football players at the NFL combine, each issue went through a rigorous screening process. We first ran a universe of more than 4,000 stocks through a sophisticated computer model developed by Yale finance professor Zhiwu Chen, founder of quantitative analysis firm ValuEngine, to find those selling below their "fair market values." We consulted another firm to find those with accelerating earnings growth. Finally, we kicked the tires of the 500 or so that had survived the process to uncover what every investor wants most: inexpensive stocks with momentum.

We're happy to report that our experiment has been a big success. In each of the past three years, our diversified portfolio has beaten the S&P 500.

But this year we're giving the FORTUNE 40 a serious overhaul. Our initial methodology identified stocks with strong year-ahead appeal, but not all were solid long-term holdings. We found that we were picking an entirely different batch of stocks each year, which created high turnover for those who took our advice. That's fine for traders, but not for long-term investors planning for retirement. So we've altered our methodology to uncover issues that should have upside appeal well beyond the next 12 months.

To find them, we hit the books and studied the strategies of some of the world's greatest investors and market scholars. Our thinking was simple: If we want to find the best long-term investments, we should follow the teachings of those who have the best long-term track records. So we read up on market pros, from the obvious (Warren Buffett) to the obscure (Mark Lightbown). In the end we selected five whose techniques we could replicate using professional-caliber stock screens. An important consideration was that we wanted a mix of stock-selection approaches that would allow us to construct a well-rounded portfolio with domestic and foreign stocks, small and large.

We ended up with five FORTUNE 40 miniportfolios, each inspired by the philosophy of one market expert. For growth and income stocks, we relied on research conducted by Wharton finance professor Jeremy Siegel, author of Stocks for the Long Run (for more of Siegel's views, see "Get Real About Your Future"). The bargain growth portfolio reflects the strategies of Peter Lynch, who became a legend managing Fidelity Magellan. We adapted techniques developed by Benjamin Graham, the father of value investing, to find our deep-value stocks. Our small-cap stock portfolio is based on the strategies of Chuck Royce, founder of Royce Funds and a pioneer in small-cap investing. And we created the foreign portfolio using some of the criteria of Sir John Templeton, who established the Templeton mutual funds and was one of the first U.S. investors to look abroad.

Some final notes on our methodology: Jeremy Siegel approves of the stocks we uncovered using his findings. But it's impossible to know what Ben Graham would buy today, since he's no longer alive. Through spokespeople, Peter Lynch, Chuck Royce, and John Templeton declined to comment on our selections.

After running our screens, we looked for companies whose shares appear most attractively priced in relation to their long-term prospects. We dug through SEC filings, read analyst reports, and interviewed current and former shareholders. And we favored stocks that are also owned by fund managers with proven track records. To have conviction about what we're recommending, we wanted to know that some successful pros already have some skin in the game.

On the following pages you can read more about the philosophy behind each of the five portfolios, as well as a detailed discussion of one stock in each. For all the picks--and more explanation of the screening techniques we employed--consult the tables at the bottom of each page.

Growth and Income

In his new book, The Future for Investors, Jeremy Siegel shatters the illusion that the key to building long-term wealth is finding "the next big thing" in the stock market. While hot companies in fast-growing industries make for lively water-cooler conversation, they typically generate poor returns for investors. The main reason, says Siegel, is because investors consistently overpay for their shares. Meanwhile, companies that market "tried-and-true" products such as toothpaste and ketchup actually beat the market over the long term.

With his help, we constructed a stock screen to find what he calls "corporate El Dorados"--those golden firms that consistently reward investors. We based the screen on what he found were the common characteristics--better than average earnings growth, strong brand names, and generous dividend payout--of the 20 best-performing S&P 500 stocks since 1957. That led us to a bevy of companies with strong brands in the consumer staples and pharmaceutical industries.

A good example is Abbott Labs, a diversified health-care-products company that produces everything from chemicals to nutritional formulas to diagnostic tests and drugs. Pharmaceuticals made up about 60% of its sales in 2004. Like virtually all the pharma companies, Abbott faces challenges to some product patents. But it also has a strong pipeline stuffed with some potential blockbuster drugs addressing health problems such as prostate cancer and heart failure. Trading below its five-year average P/E and offering a 2.3% dividend yield, Abbott looks well-positioned for plenty of quiet--but steady--growth.

Bargain Growth

As manager of the Fidelity Magellan fund, Peter Lynch was famous for investing in everything from dull cyclicals to flashy IPOs--a free-form approach that helped him post 29% annualized returns from 1977 to 1990. But as he explains in One Up on Wall Street, he liked to use one particular metric to evaluate any stock: the price/earnings-to-growth, or PEG, ratio. We made the PEG ratio the centerpiece of our bargain-growth screen and went searching for what Lynch calls "stalwarts." These are blue-chip companies whose shares could gain 30% to 50% over the next couple of years if they can be purchased at the right price.

One stock we see as a stalwart is Boston Scientific. With $5.6 billion in sales, the company is the dominant player in the fast-growing coronary-stent market. Stents are tiny wire-mesh tubes used to prop arteries open after they've been cleared of blockages. Competition is intensifying as Johnson & Johnson and Medtronic enter the game. But Boston Scientific CEO Jim Tobin is expanding the company's non-stent product line by boosting spending on R&D and acquiring niche device makers. After a remarkably strong 2004, the stock has returned to a more reasonable valuation and now sells for 15 times earnings, a steep discount to the S&P 500. Yet analysts expect long-term profits to grow by 16% a year, more than twice the market's rate.

Deep Value

Famed value investor Benjamin Graham developed a number of techniques to uncover cheap and financially stable stocks. We based our screen on Graham's recommendations for the "defensive investor." As he explains in his 1949 classic The Intelligent Investor, this is someone who's looking for "safety and freedom from bother." We adhered to virtually all of Graham's many strict investing guidelines, but we did make a few exceptions. For instance, we dropped the requirement that current assets be greater than total debt, because a well-managed business should be generating enough cash to meet its obligations. We also loosened Graham's rule that stocks sell for less than 1.5 times book value.

All of the major homebuilders came up high on our Graham-inspired screen. Right now there is a growing fear in the market that the historic boom in housing prices could soon turn into a bust. For that reason, homebuilding stocks are trading at about half the average market multiple. But Bill Nygren is one of a number of value managers who believe the fears are exaggerated. Nygren, who uses Graham's techniques to select undervalued stocks, purchased shares of Pulte Homes for his highly rated Oakmark fund earlier this year. Despite "imbalances" in specific markets, Nygren believes that low interest rates and population increases will continue to drive demand for new homes. Pulte is the nation's largest homebuilder by sales, which last year totaled $11.7 billion. It's also one of the most diversified, serving all the major market segments in more than 27 states.

Small Wonders

By definition, small companies are fragile creatures. They lack the capital and management depth of larger firms, so a minor knock can send them over the edge. Investors need to pay particular attention to the financial health of small-company stocks before they buy. During his 43-year investing career, small-cap guru Chuck Royce has consistently beaten his peers by sleuthing out overlooked and undervalued companies with rock-solid financials.

With $1.3 billion in sales, Lincoln Electric is one of the world's leading makers of welding and cutting products. The 110-year-old company serves primarily industrial customers such as construction and transportation companies through a worldwide network of distributors and sales offices covering more than 160 countries. Lincoln is expanding aggressively into international markets, which currently account for about half its sales. Last year it acquired controlling stakes in three welding businesses in China and started building a new plant in Shanghai, which it expects to complete later this year.

Foreign Value

Way back in the 1950s, when many Americans had their eyes glued to movie screens at the drive-in, John Templeton was scouring the globe for investment opportunities. Templeton, who studied security analysis under Benjamin Graham, was a contrarian. In the 1960s he was one of the first U.S. money managers to invest in Japan, purchasing stocks for as low as three times earnings. He began selling when their P/E ratios approached 30. Templeton considered dozens of yardsticks when evaluating stocks, from P/E ratios to profit margins. One of his most famous buys was Japan's Yasuda Fire & Marine Insurance Co. when it was selling for 80% below the value of the firm's net liquid investments. We used the Value Line and Zacks databases to search international markets for companies selling below their book values, or for less than the assets they own.

One such company is Vodafone Group, the world's No. 2 wireless phone company behind China Mobile. Vodafone grew rapidly through acquisitions in the late '90s and early 2000s to meet its goal of creating a pan-European wireless network. It largely succeeded, becoming the No. 1 or No. 2 carrier in most European countries. And that's the problem. Many investors fear that growth opportunities are gone and the company's premium margins will plummet as incumbent carriers fight back.

But Kim Henney, an analyst at the Causeway International Value fund, argues that Vodafone still has a chance to grow profits significantly in Europe. She points out that Europeans talk on the phone for only about 80 to 200 minutes per month, a fraction of the 600 to 900 minutes that Americans gab. She expects the company to boost usage as it upgrades customers to its next-generation 3G network, which offers higher-quality service. "Voice is still a killer application," she says. Meanwhile, Vodafone is generating substantial free cash flow, virtually all of which it's paying out to shareholders through stock buybacks and dividends. We're more than comfortable with this call. âñ 

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