Stocks and funds you can count on
Investing with confidence means buying stocks and funds with clear strategies.
February 20, 2002: 6:56 p.m. ET
By Jeanne Lee and Laura Lallos
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NEW YORK (MONEY magazine) - Investing means taking risks; no amount of research can protect you from the occasional nasty surprise. But you can improve your odds of dodging disasters. How? Here's our approach.
To find stocks you can be confident about, we focused on companies that have straightforward business models and a secure grip on their markets. To protect against accounting hocus-pocus, we avoided companies with rapidly accelerating earnings -- and those growing solely through acquisitions -- in favor of steady growers with long histories of sales and earnings gains.
We insisted on solid balance sheets and leaned toward stocks paying above-average dividends. Finally, we considered valuation; getting in at a good price is a confidence booster because it limits your downside.
When it comes to mutual funds, confidence is mostly a matter of consistency. You want funds with stable management that sticks to a clear, simple strategy. Ones that don't chase trends, that don't make big bets on a single stock -- and of course, deliver consistently solid returns.
Below we profile five favorite stocks for today's market, followed by seven funds you can count on for steady performance -- and no nasty surprises.
Five solid stocks
ABBOTT LABORATORIES If there's one thing you can count on, it's that aging Americans will be spending more and more on medicine for years to come. But that doesn't mean all drug stocks are sure things. Among the large pharmaceutical companies, we think the two safest stocks for the long term are Johnson & Johnson and Abbott Labs.
As a diversified drug and medical device company, Abbott is subject to less volatility than many big pharma stocks. And it seems poised to deliver robust growth thanks to two factors: a new blockbuster drug patent and the reopening of a lab that was shut down by the Food and Drug Administration.
Abbott is expected to file within the next three months for approval on a new rheumatoid arthritis drug, which currently goes by the scientific name D2E7. "It will have a big advantage over the other rheumatoid arthritis drugs on the market," says Frank Sustersic, manager of the Turner Healthcare and Biotechnology Fund. "It's easily going to be a billion-dollar-plus drug for Abbott."
Abbott also has a number of early-stage drugs in its pipeline, which should come up for approval over the next few years. Through its recent acquisition of Knoll Pharmaceutical, Abbott "enriched its pharmaceutical pipeline for both early- and late-stage compounds, plus got some interesting biotech capability," says Bruce Cranna, an analyst at ABN Amro.
The resolution of manufacturing problems at its diagnostics division in Illinois should also boost Abbott's growth in coming years. In late 1999, the FDA closed the lab because of manufacturing problems. Analysts expect the FDA to permit the lab to reopen later this year. At around $57.50, or 22 times expected 2003 earnings, with a 1.5 percent yield, Abbott is reasonably priced for a diversified large-cap pharma that should be a steady low-double-digit grower for the next several years.
EQUITY OFFICE PROPERTIES The nation's largest real estate investment trust (REIT) has two confidence-boosting attributes: the high quality of its properties and the cushiness of its dividend. Equity Office Properties has 670 prime commercial properties in 38 major metro areas enjoy a high 94 percent occupancy rate.
Equity's clients are mostly FORTUNE 500 corporations that sign long-term leases, guaranteeing that revenues will flow even during an economic downturn. "Equity Office has the nameplate properties in big cities," says Bill Schaff, manager of Berger Large Cap Value Fund. "The nameplate properties are always filled."
Oh, yes, about that dividend -- by law, a REIT must pay out at least 90 percent of its taxable earnings annually to shareholders. EOP is currently yielding a hefty 6.8 percent. The stock trades at around $29.50, or a mere eight times 2003 earnings estimates. Analysts project long-term earnings growth of 10 percent a year, so it trades at a discount to its growth rate. And that's before the dividend.
PROGRESS ENERGY "Very, very conservative, with a safe dividend," is how Susan Byrne, manager of Gabelli Westwood Equity Fund, describes Progress Energy. The $9.8 billion (market cap) utility, which generates and distributes electricity in North Carolina, South Carolina and Florida, was formed in 2000 when CP&L acquired Florida Progress.
The new company serves markets with growing populations, which bodes well for continued steady earnings growth. "We think they can grow their earnings at 6 percent to 8 percent a year, which is about twice that of other conservatively run utility companies," says Byrne.
On top of that, she expects the company to increase the dividend payout in 2002, as CP&L did for the past 14 years. The stock trades at $44.40, or 10 times expected 2003 earnings, with a yield of 4.9 percent.
SAFEWAY In the old days, grocery stores scraped by, making razor-thin margins on heads of iceberg lettuce, but modern supercenters pamper busy shoppers with lifestyle offerings like prewashed baby salad greens and hot grab-and-go dinners.
The top three players -- Kroger, Albertson's and Safeway -- have benefited from industrywide consolidation and heightened consumer demand for convenience products. Our pick, Safeway, the third biggest by revenue, has vastly improved margins to become the most profitable of the big chains.
As much as a supermarket stock can be, Safeway has been on fire under the direction of CEO Steve Burd, boosting earnings an average of 20 percent a year for the past five years by increasing same-store sales, promoting aggressively and making moderate-size acquisitions of regional chains.
Revenue has also grown at a healthy rate, thanks to both modest acquisitions and organic growth. In the current climate, analysts don't expect Safeway to continue to burn rubber, but it should comfortably meet tempered expectations of 13 percent to 15 percent growth for the long term -- still impressive.
The stock hit a high of $61 in January 1999, dipped and returned to $62.50 in December 2000. It recently traded at $42, about 35 percent off that high, a reaction to the slowing earnings growth and fears about the entry of Wal-Mart into the grocery business. Kevin Grant, co-manager of the Oakmark Fund, thinks that at these levels the market has more than priced in the risk from Wal-Mart.
"The threat from Wal-Mart's foray into foods is being well met by management's efforts to cut costs," he says. "The mom-and-pop stores are the ones who really get hurt." At 12 times expected 2003 earnings, the stock is trading at a discount to its growth rate, affording long-term investors an excellent entry point.
WELLS FARGO "Plain vanilla bread-and-butter businesses," is how Doug Ramos, manager of Dreyfus Premier Value Fund, characterizes Wells Fargo, which has been a core holding in his portfolio for years. The fifth-largest banking company in the U.S., with assets of $307.6 billion, Wells Fargo lends money to large- and mid-size companies and underwrites consumer mortgages.
The San Francisco-based bank was hurt in 2001 by its exposure to the ailing West Coast economy, and the stock lost about 20 percent of its value. At $46, it trades at 13 times estimated 2003 earnings and yields 2.2 percent. "The substantial premium that it usually has to its peer group is basically gone, which is very unusual," says Bill Schaff of Berger. "We think that's an aberration. It's still one of the best-run banks out there."
Seven reliable funds
DODGE & COX STOCK Over the past decade, Dodge & Cox Stock has proved to be one of the safest funds around. Yet its 16.6 percent annualized 10-year return through 2001 easily whips the S&P 500's 12.9 percent. The winning strategy is classic slow and steady. The fund's managers buy durable businesses that are in the cheapest half of the S&P 500 (based on P/E ratios and other factors) and poised for a rebound.
Their strict value focus never wavers: When Lockheed Martin shot up last fall, they took profits and ventured into beaten-down techs like Hewlett-Packard. With a team of eight in charge, you needn't worry about a key manager leaving. And co-manager John Gunn says the firm will never be sold.
MERGER FUND "Arbitrage" may conjure up arcane Enron deals resulting in portfolio death spirals. But, like red wine, arbitrage in moderation can be good for you. Merger, which follows a disciplined merger-and-acquisition arbitrage strategy, has been less risky than any other U.S. stock fund in Morningstar's database over the past decade.
Managers Fred Green and Bonnie Smith never speculate on rumors. When a prospective merger is announced, Green and Smith do some digging and invest only when they are confident a deal will go through. They buy the stock of the company to be acquired, because it'll get a boost when it is bought out. They may also short the stock of the acquiring company, when the deal involves payment in stock, because the acquirer's stock typically takes a hit.
The fund is currently heavily weighted in energy stocks simply because that sector has seen the most M&A activity lately; financial services stocks have always been a significant stake.
Their goal is to methodically earn 10 percent to 12 percent a year, and the fund's 10-year 10.7 percent return shows that the strategy works. The fund fell short in 2001 but did stay in the black. Because it has virtually no correlation to the stock market as a whole, it can be a nice hedge in rough markets.
SMITH BARNEY AGGRESSIVE GROWTH This may be the tamest fund to wear an "aggressive" label. That's not to say it can't outmuscle the competition: Smith Barney Aggressive Growth boasts the best return among all U.S. growth funds over the past 15 years. But manager Richard Freeman's strategy seems downright sedate amid the frenzy of fast-moving momentum funds vying to get ahead.
Freeman proves that growth investing doesn't have to mean lots of trading; less than 5 percent of this fund's portfolio turns over each year. "You don't have to trade your positions every day to get performance," he contends. "It's more important to know your companies and invest in companies whose managers own their own stock and that are in business trends rather than fads."
Freeman seeks out smaller-cap names that have staying power, such as Maxtor, an industry-dominating disk-drive manufacturer. He'll stick with his picks as they grow into large-caps -- as long as they continue to show strong earnings growth. He's owned Intel since 1985.
This temperate pace and thoughtful stock picking have moderated volatility; the fund lost only 5 percent last year vs. 20 percent for the typical growth fund. But Freeman will tolerate considerable sector risk. He added to biotech bigwigs like Amgen and Chiron when they tanked in 2001, and at one point the fund had more than 40 percent of its assets staked on health-care names.
T. ROWE PRICE SMALL CAP This sensible small-cap fund is taking success in stride. Even as assets have increased to more than $3 billion, T. Rowe Price Small Cap finished 2001 as it has nearly every year since Gregory McCrickard took charge in 1992: ranked in the top half of all small-cap blend funds.
The fund has been able to handle the extra attention because McCrickard's portfolio is extremely diversified: about 250 stocks spanning a wide variety of sectors. McCrickard favors niche-dominating companies with solid balance sheets and shareholder-oriented management.
Value picks are the core of the portfolio, and McCrickard cites SCP Pool as exemplary; the swimming pool distributor is growing at 20 percent via careful acquisitions, has little debt, sells at 10 times earnings and is led by a CEO with a great track record at similar concerns. But this isn't a strict value portfolio: The fund also buys growth stocks when prices are reasonable; software manufacturer Midway Games is a recent pick.
VANGUARD TOTAL BOND MARKET INDEX This index offering represents the bond market as a whole, so its long-term bonds are offset by safer short-term issues, and its performance never goes to extremes. Perhaps the most compelling argument for Vanguard Total Bond Market Index is its minuscule 0.22 percent expense ratio. Keeping costs low is integral to bond investing, because bond returns fall within a relatively narrow range.
VANGUARD TOTAL STOCK MARKET INDEX Sit back, relax and index the market. When the popularity of indexing surged in the mid-'90s, proponents of active management foretold doom for indexers in a bear market. After all, an index fund can't raise cash or overweight safer sectors.
Makes sense theoretically -- but this fund was in the top quartile of large-blend funds in 2001. Tracking the Wilshire 5000, it has more than a fourth of its assets in small-cap and midcap names. In the long run, Vanguard Total Stock Market Index and Vanguard 500 Index are likely to run neck and neck, but this one will outperform when small-caps lead, as they have over the past year.
WASHINGTON MUTUAL This American Funds family winner is a good old-fashioned exercise in restraint. The nine managers, who share duties here, follow strict guidelines established by a federal court decades ago for the prudent management of trust funds.
Virtually all of the purchases Washington Mutual makes are stocks that have paid a dividend for at least nine of the previous 10 years. And all investments are seasoned, profitable companies with pristine balance sheets -- such as ExxonMobil, Bank of America and Eli Lilly.
The fund isn't hidebound. Since 2000, eased restrictions have allowed the portfolio to hold as much as 5 percent in companies that don't pay dividends. But there's little chance of this portfolio flying out of control: Co-manager Jim Dunton says only 15 companies, the likes of Microsoft, meet the extra-exacting standards to which the team holds non-dividend-paying companies.
The fund hasn't had a down year in a decade. It even eked out a 1.5 percent gain in 2001, although big blue chips were hammered. Limiting losses has led to long-term outperformance: a 14.1 percent 10-year return that's tops among large value funds. 
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