NEW YORK (CNN/Money) -
Stocks are sexy again. Investors may still be worried about scandals, lingering unemployment and the possibility that stock prices have sprinted ahead a little too fast.
But the trend is clear. Growth is strong, productivity gains are high, and companies are reporting positive earnings surprises for the first time in three or four years.
Stocks have responded; the Dow is up more than 30 percent since March.
And there's plenty of room for more: After a recession and a decline in the Dow of more than 20 percent, blue chips typically begin a comeback that lasts for up to six years, and they gain 100 percent or more over that period.
Clearly, this is a moment to be moving money into the market. But this time, the question of what to buy seems a little thornier than usual.
Will the stocks that shone during the 1990s boom lead the market again? Or do investors risk setting themselves up by rushing back into the stocks that were the most overvalued five years ago?
Is there any way to avoid getting sucked into the next boom or bust? Or are individual investors doomed to chase investment opportunities that seem attractive in theory but inevitably end in tears?
Fortunately there is a rational, systematic way to choose stocks that can help you build a low-risk portfolio offering above-average long-term growth potential.
If there is any way to beat the market over the long run, it consists of following the strongest, most secure stocks and trying to scoop them up when they are measurably undervalued.
Moreover, if you follow this strategy consistently and diversify properly, you'll minimize your risk as well as enhance your return.
The great surprise is that succeeding with this approach doesn't require you to spend hours researching thousands of stocks.
It turns out that for the core of your portfolio, you need to follow only 70 top-tier stocks.
There's no magic here; most principles for successful investing are just the elaboration of things you know as a matter of common sense:
- Few other investments offer total returns as high as those on stocks. While share prices can stagnate for years at a time, stocks have returned an average of 11 percent to 12 percent a year over long periods.
- Moderate growth beats hypergrowth. It's almost impossible for a company to boost profits 25 percent or more year after year. When such high fliers slow, their stocks take a beating. Companies have a better chance of maintaining moderate earnings growth of 12 percent to 16 percent.
- Giant companies with long records tend to be less volatile than smaller companies.
- Businesses with diverse product lines are more stable than companies with few products.
- Finally, firms with below-average debt can maintain their growth more easily than companies that borrow to fuel their expansion.
How do you turn these truisms into a winning portfolio strategy?
Start by building a core -- 50 percent or more of your overall portfolio -- composed of stocks from the list of 70. Augment these holdings with yield investments and inflation hedges to manage down risk.
And add a little extra zing to your returns with some smaller, more aggressive growth choices.
In this package we offer all the components you'll need -- 100 stocks in all.
For starters, we've screened publicly traded U.S. companies to find 70 suitable for your core portfolio. We also look at 10 income and inflation hedges.
Finally, "The Next Generation" spotlights 20 midcap stocks with the potential to raise your overall returns.
Charting the territory
What are the defining characteristics of a great growth stock? Size is certainly part of it, and almost all of the stocks on the core list have market capitalizations and total revenues that top $5 billion a year.
We also looked for companies with diverse product lines and dominant positions in their industries.
As for growth, we sought companies that seem capable of returning a steady 11 percent to 12 percent a year through a combination of earnings gains and yield. A few stocks on the list don't reach that level but instead offer above-average yields or inflation protection.
Putting it together
Building a portfolio is a dynamic process, not a set of decisions at a single point in time.
Diversification is always the first rule. You could put together a balanced portfolio with as few as seven stocks, at a cost of less than $40,000 (for 100 shares of each).
But ideally you should have 16 or more issues in at least eight different industries -- owning 16 oil stocks does nothing to protect against changes in the price of crude.
Sometimes you can identify a stock with genuine growth characteristics in a sluggish industry -- Alcoa is the obvious example.
But in general, you're best advised to start building your portfolio with the shares of leading companies in industries that are growing faster than the overall economy, such as technology, pharmaceuticals, financial services, media and consumer products.
Making timely picks
Even 70 stocks are too many for the average investor to own, of course. And if you did buy the entire list all at the same time, you'd simply create your own private index fund.
So while each of the stocks on the list might merit a place in your portfolio if you caught it at the right moment, you need a way to zero in on the companies that are most timely and most likely to give you that market-beating edge.
To identify them, I've focused on two factors -- current valuation and analyst support.
The best rough guide to valuation is the value ratio -- a more sophisticated variant of the peg ratio, which compares a stock's price/earnings ratio with its projected earnings growth rate.
A stock with a 24 P/E and a 16 percent growth rate would have a peg of 1.5 (24/16).
The value ratio simply replaces the growth rate with projected total return, so that stocks are not penalized for getting a significant part of their return from dividends.
Essentially, you divide the P/E by the return potential based on the sum of earnings growth and dividends.
Thus, a stock with a 24 P/E, a 14 percent growth rate and a 2 percent yield would have the same 1.5 value ratio [24/(14+2)] as a stock that got all of its return from 16 percent earnings growth.
The lower the valuation ratio, the cheaper the stock.
I also consider analyst recommendations. It isn't essential for a stock to get top ratings from every analyst who follows it. In fact, if the consensus for a stock is too positive, that can be a bad sign -- there's no one left to provide new buying and help push up the stock price.
As a rule, the most encouraging ratings are positive enough to indicate that current good results are expected to continue, but not so wildly positive that they seem unrealistic or vulnerable to grave disappointment.
Here's a look at five fast-growing sectors and the stocks in each that are worth buying now. I'll also touch briefly on income investments and inflation hedges you might want to make your portfolio resilient in any market setbacks.
Glamorous tech stocks often receive high valuations, but many such companies look expensive today because their earnings were deeply depressed during the bear market. Aggressive investors may want to bet on a rebound for battered companies such as Cisco Systems and Oracle. But conservative, long-term investors should focus instead on businesses that have preserved impregnable franchises.
Topping that list is Microsoft (MSFT: Research, Estimates), which remains the 800-pound gorilla in PC software. The company has managed to maintain a near monopoly in many of its businesses, and as a result, the stock held up better than many other tech issues during the recent bear market.
In addition, Microsoft has been able to build a staggering $50 billion cash hoard (available for bigger dividends or for acquisitions). Microsoft paid its first dividend in 2003 and plans to double that small payout for 2004. Even so, the company will have plenty of cash left to fund expansion. Annual earnings growth should average more than 10 percent over the next five years.
Other tech stocks with powerful franchises include Applied Materials (AMAT: Research, Estimates), the leading -- and highly cyclical -- producer of chipmaking equipment and other capital equipment for the semiconductor industry. The company's deeply depressed earnings are expected to enjoy a sustained upswing as the economy improves, gaining 20 percent annually over the next five years.
A less volatile alternative is Intel (INTC: Research, Estimates), still the dominant producer of microprocessors. In an industry where research-and-development costs run into the billions, Intel has the deep pockets. The share price has doubled so far this year and may consolidate at some point. But in a long bull market, the stock still has plenty of headroom for further big gains.
Thanks to the aging of the baby boomers, pharmaceutical producers will enjoy strong demand for another decade or longer. Moreover, drugs are often the cheapest way to treat chronic illnesses.
Having acquired Pharmacia in 2003, Pfizer (PFE: Research, Estimates) is now the world's greatest drug powerhouse. Despite short-term charge-offs resulting from the merger, the company will have ample room for post-merger cost cutting. Pfizer also has massive resources to support existing hot drugs, such as Viagra, cholesterol-lowering Lipitor and antidepressant Zoloft, and to develop an impressive pipeline of new products.
Earnings growth this year and next should bring Pfizer's P/E well under 20, a reasonable level for a company that dominates its markets and offers 13 percent to 14 percent annual earnings growth as well as a yield of almost 2 percent.
Among less recognized companies, Abbott Laboratories (ABT: Research, Estimates) offers a broad range of health-care products, including diagnostics and items for hospitals, and is enjoying increasing success in its pharmaceutical division. Top-performing products include cholesterol-lowering TriCor, Flomax for treating prostate problems and the new rheumatoid arthritis treatment Humira. Earnings growth is projected to be 12 percent annually, and the stock yields 2.3 percent.
Low inflation and the Federal Reserve's commitment to holding down interest rates create a highly favorable environment for financial services.
Washington Mutual (WM: Research, Estimates) is a Pacific Northwest lender offering diversified services to individuals and small to mid-size businesses. Historically, a significant share of the company's business has come from mortgages and commercial real estate loans. Over the past few years, WaMu has opened hundreds of branches across the country.
This expansion has been a major success and can continue for many years. The company earns a stunning 19 percent return on equity and offers a 12 percent projected compound annual earnings growth. The stock also yields a hefty 3.7 percent, thanks to 33 consecutive quarters of dividend increases. Yet the shares trade at a bargain P/E below 10.
As an alternative for more conservative investors, Citigroup (C: Research, Estimates) ranks as the largest and best-diversified financial services stock -- despite recent troubles. The successor to 70-year-old CEO Sandy Weill is his longtime associate Charles Prince, 53, whose job will now be to wring maximum profit from the house that Weill built.
Entertainment remains one of the most important U.S. exports. And the key to the business is strong franchises. At the moment, the leading company with the fewest distracting problems is Viacom (VIA.B: Research, Estimates). The diversified entertainment company operates MTV, VH1, Nickelodeon, Paramount Pictures and Blockbuster Video.
The company has strong cash flow, and earnings are projected to grow at a 15 percent compound annual rate over the next five years. Chairman Sumner Redstone controls much of the class-A voting stock; individual investors should buy the class-B nonvoting stock, which trades far more actively.
Tribune (TRB: Research, Estimates) is a nearly pure play on a recovery in local advertising. It gets more than 70 percent of its revenue from newspaper publishing, chiefly the Chicago Tribune, L.A. Times and Newsday. Most of the rest comes from broadcasting -- mostly WB and Fox affiliates and local radio stations. A cyclical recovery in local advertising could propel Tribune's earnings up 12 percent annually over the next five years.
Consumer spending accounts for two-thirds of the economy. One of the pillars of the group is Procter & Gamble (PG: Research, Estimates), which controls a stable of world-class brands, from Tide and Crest to Pampers and Miss Clairol. Growth of those brands provided 13 percent sales gains and 20 percent earnings increases in the most recent quarter. Based on recent earnings, the stock's 25 multiple looks high, but the P/E should drop below 22 based on the expected earnings gain for 2004.
Among companies with more focused businesses, Home Depot (HD: Research, Estimates) looks particularly attractive. Do-it-yourselfers are having a field day thanks to low mortgage rates and a booming housing market. Now at their lowest P/E in more than a decade, Home Depot shares look like a bargain.
Investments that pay regular income act as ballast, reducing overall volatility and increasing the odds that your portfolio will post a positive return in a down market. However, since interest rates are about as low as they can go and are likely to rise as the recovery proceeds, long-term Treasury bonds look risky right now.
Choices less vulnerable to a moderate rise in interest rates include intermediate-term bonds, corporate issues and preferred shares.
The best income choices, however, are those that offer significant growth potential as well as yields above 3 percent.
A few stocks on our list have yields that make the grade, including Bank of America (4.2 percent), DuPont (3.5 percent), J.P. Morgan Chase (3.7 percent) and Washington Mutual (3.7 percent).
But stocks that don't have the return potential required to be on the list may be worthwhile choices to balance more aggressive stocks in your portfolio.
Five other tempting yield picks are drug giant Bristol-Myers Squibb (4.4 percent), California Water (4.1 percent), food processor Conagra (4.2 percent), Virginia electric company Dominion Resources (4.2 percent) and Georgia electric utility Southern Company (4.6 percent).
The greatest risk to stocks -- one that investors have forgotten almost entirely -- is the chance of a resurgence of inflation. Fortunately inflation is likely to remain low for the foreseeable future. That benign inflation outlook is, in fact, the strongest argument that the boom of the 1990s doesn't have to be followed by a decade of underperformance.
To protect yourself against an outbreak of inflation, you can include in your portfolio shares of oil and gas companies, other raw-material producers and real estate investment trusts.
Stocks in those groups that meet the criteria for our list include Alcoa, Conoco-Phillips and ExxonMobil.
Other inflation hedges with strong business franchises are real estate investment trust Boston Properties (BXP: Research, Estimates), copper producer Phelps Dodge (PD: Research, Estimates), Florida land developer St. Joe (JOE: Research, Estimates), oil and gas producer Unocal (UCL: Research, Estimates) and D.C.'s Washington REIT (WRE: Research, Estimates).
As you put together your portfolio, don't rush to fill all the slots at once. Some fundamentally appealing investments will be better buys at some point in the next year or two.
The top REITs, for instance, have had big run-ups over the past three years and may be a bit ahead of themselves. Also, don't try to protect your holdings against every possible eventuality -- it can't be done.
Ratchet down your general level of risk and defend yourself against the dangers you can anticipate, even if they aren't looming on the horizon at the moment, and you'll be able to enjoy your superior long-term profits and still sleep well at night.