The best stocks to buy now
Our picks are designed to help you weather the market's wild swings and build long-term wealth.
(FORTUNE Magazine) - The market soars! The market plunges! About a month before we began putting this Retirement Guide to bed, the market was racing ahead. With the Dow just 145 points shy of its all-time high - 11,722 - one veteran analyst told USA Today, "There is a ton of mojo in the market right now." Then talk of "market mojo" suddenly turned into cries of distress. As inflation fears spooked investors around the globe, the Dow suffered five triple-digit losses, dropping below 11,000 and leaving investors rattled. In early June one of the most popular stories on Morningstar.com was titled "How to Cope With Financial Anxiety."
We have our own way of coping with financial anxiety: the FORTUNE 40, a portfolio we designed to help you weather the inevitable market swings while building long-term wealth. Despite the recent uncertainty, we're pleased to report that the FORTUNE 40 turned in a stellar year. From June 24, 2005, to June 2, 2006, our diversified group of small, midsized, and large domestic and international equities returned 17%. The S&P 500 gained 10% over the same period.
Given the success of last year's portfolio, we used largely the same methodology to choose this year's stocks. We followed the strategies of five top investors and market scholars whose work and thinking we admire. In essence, we've created five miniportfolios, each inspired by one expert, which collectively make a well-rounded portfolio.
For growth and income stocks, we relied on research conducted by Wharton finance professor Jeremy Siegel, author of Stocks for the Long Run. The bargain growth portfolio reflects the insights 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 Charles 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. (Siegel approves of the stocks we uncovered using his findings. It's impossible to know what Graham would buy today, since he's no longer alive. Through spokespeople, Lynch, Royce, and Templeton declined to comment on our selections.)
How different is the FORTUNE 40 from a year ago? Some of our winners, like top performer Lincoln Electric - up 95% - have risen so much that they no longer meet the requirements of our screens. (Lincoln is off in part because it has grown too large to qualify for our small-cap category.) Other winners - such as Petroleo Brasileiro (Charts), Brazil's state-owned oil company, up 84% - remain on, despite their share gains, because their prospects are still so strong.
And, of course, we've dumped some losers, like our worst dog, Boston Scientific (Charts), which tumbled 25%, thanks to a disastrously expensive $27 billion takeover deal for Guidant (after an epic bidding war with Johnson & Johnson (Charts) that, frankly, we wish it had lost).
Of last year's 40 picks, 21 still make the cut this year, joined by 19 newcomers. We began our search by running stock screens based on each expert's methods. We then looked for companies whose shares appear most attractively priced in relation to their long-term prospects. We scoured SEC filings, read research reports, and interviewed Wall Street analysts and money managers. We favored stocks that are 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 serious money at stake.
On the following pages you'll read more about the philosophy behind the five portfolios, as well as a detailed discussion of one stock in each. For data on all the picks - and more explanation of the screening techniques we employed--consult the tables at the bottom of each page. And for a full accounting of how last year's FORTUNE 40 performed, see fortune.com.
Growth and Income
Here we look for what Jeremy Siegel calls "corporate El Dorados" - those titans that rack up long stretches of solid profitability. In his latest book, The Future for Investors (Random House, 2005), the Wharton finance professor shows how companies that have marketed "tried-and-true" products for decades in slow-growth or even declining industries have superior returns to firms that develop "the bold and the new."
Overall, our 2005 growth-and-income choices trailed the market last year, returning an average of 5%. The laggard was Pfizer (Charts), which tumbled 12%. Pfizer failed to make the cut on this year's screen because its profits are no longer projected to grow faster than the average company's, one of our key requirements.
But we still like the seven others and are including them again. Among them: Colgate-Palmolive (Charts), whose stock climbed 22% since we recommended it. Its four-year restructuring effort kicked off last year and has started to pay off. The consumer products giant delivered an impressive first quarter, setting revenue and earnings records. The company has grabbed market share in China, Latin America, and most of Central Europe. It also bought Tom's of Maine, a natural-products company, marking Colgate's entrance into a fast-growing segment of the market. Smart product innovation, increased ad spending, and additional cost cuts stemming from the restructuring should keep Colgate on a steady double-digit growth path for some time. The stock sells for 22 times earnings and yields 2.1%.
The cornerstone of this screen is one of Peter Lynch's favorite measures, the price/earnings-to-growth, or PEG, ratio. It's calculated by dividing a company's P/E ratio by the rate at which Wall Street expects the company to boost its earnings over the next three to five years. We used it to hunt for what Lynch calls "stalwarts," 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.
This part of the FORTUNE 40 slightly trailed the broad market last year, rising 8% on average. Our best pick was Dover (Charts), an industrial conglomerate that sells everything from truck parts to printers. Its shares climbed 38% on strong sales at all its divisions. We're not recommending it again this year, however. Recent acquisitions have driven up Dover's debt level beyond our comfort zone.
With hurricane season upon us, shareholders have abandoned stocks of many property-casualty insurers. But for long-term investors, the selloff offers an attractive buying opportunity, provided they pick the right stocks. The trick is to identify those companies that have broad earnings and revenue streams, both by product and by geography, and those that are more insulated from the competitive, cyclical nature of the insurance business. With $14 billion in sales, Chubb has carved out a number of profitable niches by insuring the precious possessions of the wealthy, from luxury automobiles to fine art. More recently Chubb has rounded out its lifestyle-related products and introduced a policy that helps customers obtain emergency medical transportation and coverage while traveling. Trading at 12 times earnings, the stock is cheap. Wall Street analysts project that earnings will grow 10% a year for the next several years.
We based this screen on what Benjamin Graham recommends for the "defensive investor" in his 1949 classic, The Intelligent Investor. Among other things, we insisted that each stock's price be no more than 15 times its average earnings per share over the past three years, and that the overall portfolio have a P/E of no higher than 13.
Led by Burlington Resources, our deep-value picks returned 22% last year. The Houston energy giant was purchased by ConocoPhillips for $35 billion, delivering a 68% gain since last year's story. Pulte Homes fared less well, falling 23%. Although the homebuilder passed our screen again this year, we're uncomfortable recommending it again. The housing slowdown has been much worse than we anticipated, and we're concerned Pulte isn't adapting quickly enough.
One value stock we like now is UST, the largest U.S. maker and distributor of smokeless tobacco, with 75% of the $3 billion market. Longtime shareholder David Dreman of Dreman Value Management points out that the company dominates the premium segment with its Copenhagen and Skoal brands, each of which generates more than $1 billion in sales. The smokeless category is the only growing segment of the tobacco industry, with sales increasing by 5% a year. The stock trades for 14 times earnings and yields 5.1%.
To find profitable and well-managed small caps (companies with market values of $250 million to $2 billion), we followed Chuck Royce's technique of requiring at least an 8% return on assets (net income divided by total assets) and positive free cash flow. We screened for stocks with low P/E and price-to-book ratios relative to the Russell 2000 index. And we considered only companies with stock prices no higher than $35 a share, because they are less likely to be covered by Wall Street analysts and less likely to be heavily owned by institutions, which creates more opportunities for individual investors to get an edge.
Continuing their strong run, small-cap stocks have risen almost 50% since the end of 2000. Our small caps turned in a solid year, delivering a 20% average gain. Lincoln Electric and Arkansas Best (up 44%) did so well that they no longer qualify as small caps, according to our screen.
A new addition is Chattem, which makes niche health-care products, including Selsun Blue shampoo and Pamprin pain reliever. CEO Zan Guerry has pursued a clever strategy of acquiring highly profitable brands abandoned by large consumer product and drug companies. This year Chattem is launching a new appetite suppressant, sunblock, and other products that should give profits a lift in 2007. Yet at 16 times earnings, the stock sells for less than half the multiple of the Russell 2000 small-cap index.
Here we followed John Templeton's advice to hunt for bargains in many markets. In countries from Japan to Mexico, we looked for stocks selling below their book values or at low P/E levels, as well as firms with accelerating earnings growth or expanding margins.
Unlike their U.S. rivals, many international pharma companies aren't suffering from a rash of patent expirations. European drugmakers AstraZeneca and Sanofi-Aventis were two of our best-performing foreign picks last year, rising 37% and 16%, respectively. We're recommending them again. And we're sticking with Vodafone Group, despite its rocky year. As the company continues to roll out its next-generation 3G service, Clyde McGregor of the Oakmark Global fund says profits should recover. Meanwhile, Vodafone generates substantial free cash flow, which it's using to fund stock buybacks and a generous 4.8% yield. We still like this call.