(Money Magazine) -- There are plenty of reasons you might think that the rally that began in early March will slow down this year. For one thing, the stock market isn't cheap anymore -- not after enjoying a greater-than-60% climb in the past nine months.
But if recent history is any guide, making big decisions in your portfolio based on "top-down" predictions for the market and the economy is a risky proposition. Think about it: How many forecasters accurately predicted both the financial panic of 2008 and last year's stock rebound? Those who called the crisis generally missed the bounce back, while those who predicted the rally did so only after riding down the 2008 crash.
That's why I prefer to start from the bottom up -- by investigating individual companies and then seeing what patterns emerge. Fortunately, the analysts I work with at Morningstar cover almost 2,000 stocks.
After going through all those analyses, I've come up with what I think will be the big themes of 2010:
TREND 1: Big-caps bounce back
It's been a decade since they were last in favor, but the market's largest stocks are ready to take charge.
In the first phase of a bull market, smaller and junkier stocks tend to lead the way, as has been the case since this rally began in early March. But speculative frenzy eventually gives way to the fundamentals, and that should bring your focus back to high-quality blue-chip stocks this year.
I'm not alone in this thinking. GMO chairman Jeremy Grantham -- who back in 1999 famously and correctly predicted negative 10-year returns for stocks -- wrote recently that "quality stocks simply look cheap and have gotten painfully cheaper" as investors have been enticed into buying riskier assets.
He's right. Consider that a decade ago, which was the last time this group was in favor, the largest 10 stocks in the S&P 500 had an average price/earnings ratio of 59. Today, the P/E of the top 10 is closer to 15.
Aside from being just plain cheap, high-quality blue chips have other things going for them. If the economic recovery is more muted than expected, these businesses offer solid downside protection. At Morningstar we refer to these companies as "wide moat" businesses because their industry dominance can help them grow earnings in good times and bad.
By contrast, lower-quality small stocks that have priced in a strong recovery could get killed if reality falls short of high expectations.
So which blue-chip companies look attractive now?
Don't think of Exxon Mobil as just an oil giant. A more accurate way to describe this behemoth, with a $353 billion market value, is a capital-allocation machine.
Thanks to its operational efficiency and management's discipline in weighing new oil and gas projects, Exxon Mobil's returns on capital -- a measure of how effectively a firm deploys resources -- are consistently above those of its peers.
That efficiency should come in handy if commodity prices stop soaring or possibly even fall. At the same time, its immense geographic footprint should help it weather any regional economic storms.
Of course, given Exxon Mobil's maturity and modest growth prospects, don't feel as if you have to chase this stock at all costs. Morningstar believes it's worth $87 a share. Anytime it dips below $70 -- buy it. It's currently trading around $74.
There are plenty of things to like about this $172 billion health-care giant. For starters, its diverse business lines -- 40% of sales are from pharmaceuticals, 35% are from medical devices, and the rest come from consumer products -- throw off tons of cash. And that has helped J&J raise dividends for 45 years.
The firm is diversified in another way: Half its sales come from abroad, so if the dollar keeps falling, foreign revenue should see a boost.
And though the company already runs lean and mean, it announced a restructuring plan to save from $1.4 billion to $1.7 billion annually. That should send its already juicy 27% profit margins up even higher.
With a market capitalization of $16 billion, this Houston-based company is modest in size compared with Exxon Mobil and J&J. But Sysco is the largest food distributor in North America, controlling 15% of the market.
Sysco enjoys big advantages over its competition thanks to economies of scale, and those advantages only increase as the firm grows larger.
True, business has been hurt by weak household spending. In the most recent quarter, sales fell 8.1%. That's not surprising, since many of Sysco's customers are restaurants, and a night out is a pretty easy expense for cash-strapped families to cut. Yet the company's operating income fell only 1.5% in the quarter, largely because management has done such a good job cutting costs and increasing productivity.
Sysco is well-positioned for when consumers finally crawl out of their bunkers. And with a modest P/E of 13.9 and a generous dividend yield of 3.6%, you're being paid to wait.
TREND 2: Dividends count again
If the bull market begins to slow, it will pay to seek out stocks that are throwing off generous yields.
With the S&P yielding barely more than 2%, dividends probably aren't first and foremost on your mind right now. They should be.
If the market is about to enter a low-growth environment, stocks that yield 3% to 4% and that can raise their dividends year in and year out will deliver decent returns even if the market doesn't. Lest you forget, whatever gains you enjoyed in the dismal market over the past 10 years mostly came from dividends.
And if stocks don't slow down this year? Then what's the harm? Dividends are a "bird in the hand" that can lead to significant returns over long periods of time.
Income-generating stocks also happen to be cheaper than the broad market. The Dow Jones U.S. Select Dividend Index, for instance, trades at an average trailing P/E ratio of less than 15, vs. more than 20 for the S&P 500 index.
Here are four of my favorite dividend payers:
After being overvalued for some time, many utilities are back to trading at attractive levels. If you're looking for a conservative yield play, check out NSTAR. This midsize, fully regulated utility based in Boston has great fundamentals.
Thanks to its strong balance sheet, NSTAR has managed to pay its shareholders dividends for more than a century. And for 12 straight years, the company also increased those payments. The stock currently yields nearly 5%, but the firm should be able to boost its dividends by around 5% a year going forward.
Meanwhile, the company enjoys competitive advantages. For starters, a high percentage of its customers are colleges, hospitals, and research centers. Energy demand from these types of businesses is steadier than from industrial users.
Moreover, the regulatory environment in Massachusetts has allowed NSTAR to expand consistently. The company recently built a new underground transmission line that added $220 million to its rate base, which should boost the utility's earnings for years to come.
Another utility -- with a bit more upside than NSTAR, but a little more risk -- is Exelon. This Chicago-based company operates electric utilities in Illinois and Pennsylvania, where the regulatory environment isn't as friendly as in Massachusetts.
But that business accounts for only a third of the company's operating profits. The remaining two-thirds is generated from Exelon's unregulated "merchant" operation, which sells power to other utilities.
The stock yields about 4.3%, compared with the industry average of 3.6%. But dividends could see a boost if Exelon's depressed shares get a lift, which could happen if electricity prices surge.
High-yielding stocks sometimes suffer when market interest rates rise -- which they eventually will as the economy accelerates. That's because in a rising rate environment, bond yields begin to look more attractive than stock dividends.
But Paychex, the nation's largest provider of payroll-processing services for small businesses, would actually benefit from higher rates.
Why? Paychex holds "float" -- in other words, it collects payroll taxes from small businesses, and then holds on to the cash for a brief period before remitting the levies to the IRS. It also holds on to customer deposits and uncashed employee paychecks, all of which add up to a decent amount of money sitting on Paychex's balance sheet.
While it holds this cash, the company earns interest on it, and that's pure profit profit that's likely to grow as rates climb.
And while you wait for interest rates to rise and employment trends to improve, this large-cap stock yields a healthy 4%.
Realty Income (O)
Yield-seeking investors have traditionally looked at real estate investment trusts to boost income. Though -- don't think many REITs are terribly attractive today, Realty Income is an exception.
This conservatively managed REIT with a strong balance sheet owns more than 2,300 retail properties in 49 states. Its tenants range from restaurants to retailers to convenience stores.
Granted, the consumer economy isn't roaring. But Realty Income structures its leases so that tenants bear most of the risk -- renters, for instance, are usually responsible for property taxes, insurance, and maintenance costs. Many of its lease agreements also tie rents to inflation, which should result in greater cash flow over time.
On top of that, the company's strict underwriting discipline has produced great results. With a 7% yield and a modest, but sustainable, dividend growth rate of around 3% to 4%, Realty Income should be at the top of your yield-seeking list.
TREND 3: Health care recovers
It's a counterintuitive idea: With health-care reform still uncertain, now's the time to bet on this sector.
As a value-minded investor, you know it often pays to look at yesterday's laggards to find tomorrow's leaders. Well, health care was one of the worst-performing parts of the market in 2009.
But 2010 will be brighter for several reasons. For starters, with a P/E of around 12, these stocks are cheap -- trading significantly below the valuations of the broad market.
Also, regulatory uncertainty will almost certainly diminish this year no matter what happens to health-care reform. If a bill is passed, companies and investors will know the rules of the game, which should cause valuations to rebound. If no bill is passed, the same thing applies.
Outside of the hospital industry (which is a disaster), returns on capital are actually quite high throughout the sector, as is cash flow. And the long-term prospects for health-care demand are solid. Whatever happens to reform, insurance coverage is likely to expand, and that should increase the volume of treatment.
In addition to the aforementioned Johnson & Johnson, here are three other winners in waiting:
In recent years Big Pharma has been plagued by slow growth. But this Swiss pharmaceutical giant is bucking the trend, thanks to a number of recent blockbuster launches.
They include Aclasta, used to treat osteoporosis; Lucentis, an ophthalmology drug; and two hypertension drugs, Exforge and Tekturna. Those new products helped Novartis's pharmaceutical sales climb 11% in the most recent quarter. And because these drugs are at the start of their marketing cycles, the company is well-positioned for years to come.
Novartis has several other things going for it. With a P/E of less than 12, its shares are cheap. It pays out an attractive 3.2% dividend yield. And about two-thirds of its sales come from overseas, so it's not a bad hedge against a weak dollar.
This $19 billion manufacturer of scientific equipment is essentially a one-stop shop for health-sciences researchers.
Its diversity of products -- it sells everything from basic consumables like lab chemicals to big-ticket items like mass spectrometers -- certainly helped during the recent recession. Steady sales of consumables, for instance, helped make up for weaker demand for high-end equipment.
At the same time, Thermo Fisher's size should help it move into new markets like China and India, which are expected to drive future growth.
Shares of beaten-down health insurance companies like WellPoint are very cheap. And the sheer size of this Indianapolis-based company -- it is the largest U.S. health insurer (based on membership), and runs 14 Blue Cross and Blue Shield plans across the country -- gives it bargaining power with hospitals when it comes to negotiating costs.
True, managed-care organizations are all affected by the regulatory environment. And even if the worst-case scenario for WellPoint -- a public insurance option that would compete with private insurers -- doesn't come to pass this year, future reform efforts in Washington could still hurt the company's prospects. (This might be one area where regulatory uncertainty may not completely lift this year.)
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