Where to invest now: 9 smart stocks

dor_investing_val.bochkov.top.jpg By Pat Dorsey, contributing columnist


(MONEY Magazine) -- Throughout the financial panic of 2008 and early 2009, when the market was acting as if Armageddon were at hand, the only question you had to ask was: "Do I think the odds of an economic catastrophe are better or worse than the odds of a rebound?"

And while buying stocks in a period of such heightened anxiety may have been emotionally difficult, intellectually it was easy, because virtually every investment was on sale.

Today, as the economy begins to heal (albeit in fits and starts), the situation has reversed. Now that investments have rebounded from their panic-stricken lows -- the S&P 500 index has gained around 20% annually for the past two years -- investing has become emotionally easier. Yet things are a lot more challenging mentally.

For one thing, there are fewer mispriced assets that would make you "tremble with greed," in the famous words of Warren Buffett.

And there are some honest-to-goodness tough calls about this recovery: When will the U.S. economy grow fast enough to create jobs? Is there another shoe or two to drop in the European fiscal crisis? Will China's economy slow or maintain its blistering pace?

That's hard to say. So even as the U.S. economy starts to get rolling again, you could argue that investing is more uncertain today than it was in the depths of the financial panic.

Still, there are several trends that I'm fairly confident about. For starters, the threat of deflation is so pernicious that the Federal Reserve will do anything in its power to combat it. Indeed, the Fed's effort to stimulate the stock and job markets through a second round of so-called quantitative easing, or QE2, is a clear sign that inflation will eventually pick up.

Fear of deflation is one reason financial stocks were among the worst performers last year. Yet from banks to credit card firms, this much-maligned sector will be fertile ground for bargain hunters in 2011, especially if the Fed can keep the recovery on track.

Finally, if growth picks up, equities will no longer be totally driven by sheer macroeconomic panic on the one hand or relief on the other. So good old-fashioned "bottom-up" stock picking -- where, instead of focusing on the economy, you pay attention to fundamentals like profit growth and valuations -- will come back into fashion.

Here are several ways you can play each of those trends, based on the research of the team of equity analysts I oversee at Morningstar.

Trend 1: The Fed Will Reinflate the Economy

Instead of betting on Armageddon, it's time to invest in companies with real pricing power.

Until recently I hadn't been worrying much about inflation. That's because unemployment remains high, wages are stagnant, and bank lending is still low by historical standards (and without access to those funds, consumers can't boost spending, which in theory would help keep a lid on prices).

Yet after listening to recent statements by the Fed, I'm convinced central bankers will reinflate this economy by any means necessary. In a truly deflationary environment (think Japan), consumers hold off on purchases because they know they'll get better deals by waiting.

For businesses, this delay has the potential to set off a vicious cycle, in which sales fall, bankruptcies rise, and asset prices head further south.

So if QE2 -- the Fed's $600 billion effort to spur risk taking by keeping interest rates low -- fails to deliver, get ready for QE3 or QE4.

Yet it's hard to reinflate the economy just enough to get job creation going, but not so much that inflation remains perfectly in check. In fact, there are precisely zero historical examples of that kind of macroeconomic fine-tuning, which means the risk of the Fed overshooting is high.

In that case, your best insurance policy is an investment that's likely to give you a reasonable inflation-adjusted return, like the following:

Health Care REIT (HCN): While many real estate investment trusts -- firms that own or operate income-producing properties -- are overpriced and beset by poor fundamentals, HCN isn't one of them.

This REIT, which manages senior living and medical office buildings, offers investors stability. HCN's balance sheet, for example, has very little debt coming due before 2012. And only around 2% of the firm's leases are set to renew before 2012, so occupancy levels will be steady.

Best of all, Health Care REIT has a couple of built-in inflation protectors. For starters, many of HCN's leases have inflation escalators written into them that automatically raise rents based on changes in the consumer price index.

Moreover, nearly all of the company's senior-living facilities and 85% of its medical office buildings are triple-net leased. That means HCN's tenants are responsible for covering the cost of taxes, insurance, and maintenance on those properties too. So if those expenses rise owing to inflation, HCN simply passes them along.

Here's one more thing that HCN passes along: dividend yields of 6%.

Magellan Midstream Partners LP (MMP): Magellan is a master limited partnership, a type of income-producing company usually involved in energy or other commodity-related fields that receive certain tax advantages. Because it operates one of the nation's biggest pipelines for refined petroleum products such as gasoline and heating oil, it can benefit from inflation in a couple of ways.

First, in a reflated economy, demand for fuel is likely to climb. That could boost the volume of refined products that Magellan ships through its pipelines and the fees it collects. But Magellan's revenue could grow even if volumes don't rise. That's because the company's regulated pipeline business collects tariffs that can increase with changes in the producer price index for finished goods, plus 1.3%.

One warning, though: Since you could lose some tax advantages by holding shares of a master limited partnership in an IRA, invest in MMP in your taxable account.

Abbott Laboratories: (ABT, Fortune 500) In addition to businesses with contractual inflation protection, look for firms that can pass along price increases to their customers without hurting sales. They are generally companies with strong brands or unique products that customers are willing to pay up for.

Abbott qualifies on both counts. This $74 billion health care conglomerate -- think of it as a smaller Johnson & Johnson -- makes and sells a wide array of pharmaceuticals and medical devices.

While Abbott's drug pipeline isn't as strong as some of its competitors', the firm's pharmaceutical division enjoyed 23% growth in the third quarter, thanks in part to the strength of brand-name drugs like Humira, used to treat autoimmune disorders such as rheumatoid arthritis.

Meanwhile, about 40% of Abbott's revenue comes from nonpharmaceutical businesses, such as medical devices, vascular stents, and its line of popular nutritional products like the baby formula Similac.

Abbott shares trade at a price/earnings ratio of around 10, based on projected profits this year. And the stock pays a healthy dividend of 3.7%.

Trend 2: Financials Join the Party

After lagging the broad market in the early stages of the recovery, this sector is ripe for the picking.

Bank stocks have historically been one of the first groups to rally once the economy starts to heal. They were the best-performing sector coming out of the 1990-91 recession. And financials were the second-best-performing group emerging from the 2001 downturn.

Since this recession officially ended in June 2009, though, bank stocks have been among the market's worst sectors. That's not surprising. Between the mess surrounding subprime loans, "robo-signed" foreclosures, and tightening lending standards, banks have been the public's favorite whipping boy recently.

Yet well-capitalized banks with good lending practices are excellent values now. And if the Fed prevents another downturn, several areas of this sector should stand to benefit.

Wells Fargo: (WFC, Fortune 500) At a time when banks are struggling to boost sales -- as consumers are paying down debt, not taking on more -- Wells has one huge advantage: its ability to cross-sell products to existing customers.

The average Wells customer has 6.1 relationships with the bank, ranging from checking accounts to credit cards to mortgages. By comparison, Wachovia -- before it was acquired by Wells in 2009 -- averaged 4.6 products per client.

Meanwhile, Wells has demonstrated a tremendous amount of lending discipline, which resulted in lower loan losses than most of its peers during the mortgage meltdown. Fewer losses meant Wells had the capital available to buy Wachovia at a rock-bottom price when it imploded amid the financial crisis.

Analysts here at Morningstar think the combined bank has tremendous unrecognized earnings power. Yet the stock trades at just 10 times its projected 2011 profits.

Bank of New York Mellon: (BK, Fortune 500) If the Fed is successful in promoting risk taking in stocks, this $35 billion bank stands to be a big beneficiary. BNY Mellon is a leading financial custodial services provider -- overseeing assets of investment-management firms around the world and providing back-office functions for them.

Since those are fee-based services, a rise in the market value of the assets BNY Mellon oversees should boost revenue. Indeed, as market values lifted over the past year, fees the bank generated from asset servicing jumped to $832 million in the third quarter, up from $600 million a year earlier.

Despite this potential, the stock trades at a cheap P/E of 10.9, based on projected 2011 profits.

Visa: (V, Fortune 500) Too frightened to invest in banks? There are other opportunities in financials -- like Visa, which operates the eponymous credit card network. Visa does not lend out any money. Instead, it acts as a middleman between merchants that accept the Visa card for purchases and banks that issue the cards to consumers. Think of it as a toll bridge for consumer spending -- and a phenomenally profitable one at that, as the firm enjoys operating margins of around 60%.

True, slack consumer spending is a bit of a headwind for Visa. But an improving economy should help the firm's outlook. And even if spending doesn't pick up much, one key long-term trend remains intact: Consumers are moving away from cash and check usage and toward electronic forms of payment. That should power Visa's growth over the long haul, regardless of how strong the economy is.

Now, Visa shares have taken a big hit recently the stock is down around 20% since its spring peak -- because of pending regulatory changes that will hurt the profitability of its debit card business.

But those concerns have already been priced into the stock. So you can now buy a ridiculously profitable firm with virtually no credit risk at a P/E ratio of less than 14.

Trend 3: Macro Fears Take a Back Seat

So it's time to focus on company-specific issues, like earnings growth, market share, and P/E ratios.

There are two basic ways to approach the market: The first is to key in on macroeconomic trends and invest accordingly. Bad subprime loans? Short the housing sector! China's stockpiling copper? Buy commodities. Great Depression II? Dive into bonds.

This "top-down" school of investing took center stage ever since the global financial panic erupted in 2007. But I think that will change this year.

For one thing, the worst of the fears that gripped the markets recently are behind us. And while there may yet be other macro concerns that pop up, there aren't obvious big-picture calls that you can be certain of right now. At this stage of the recovery, the other school of investing, the "bottom-up" approach, should come back.

NVR: (NVR) If you paid attention to only macro trends -- like the continuing decline of home prices -- you'd probably avoid this homebuilder. But if you focus on the company itself, you'll notice that NVR isn't your typical homebuilder.

For starters, this Reston, Va., firm typically acquires land via option agreements with developers. This lets NVR walk away from deals -- forfeiting only a deposit -- if conditions in a market sour. This unique business model resulted in something rare: NVR suffered just one money-losing quarter throughout the entire housing crash.

Avoiding such losses has left NVR with more than $1 billion of cash on its extremely clean balance sheet. And the firm recently started using that cash to buy back its shares aggressively.

This is the first re-purchase activity for NVR after a hiatus of more than two years, and it indicates that company execs think the shares are finally a good value. Morningstar analysts concur. At a price of $668 a share, we think the stock is more than 20% undervalued.

Landstar System: (LSTR) With annual sales of $2.4 billion, this transportation firm may be small. But within its industry, Landstar's scale is enviable. That's why we refer to Landstar as a wide-moat firm, meaning competitors will have a hard time muscling in on this company's market share.

Landstar is a logistics company that hooks up shippers that need to move goods with truckers who are ready to drive. Sounds pedestrian, but the firm's competitive advantage comes from its massive network of 1,300 agents, 27,000 broker-carriers, and 8,000 truck owner-operators.

The company also travels light. Its only physical assets are computer equipment and trailers, which helps keep costs down. That has helped Landstar generate returns on equity (a gauge of profitability) of more than 40% on average over the past decade, despite two recessions and little use of leverage. An ROE of 20% or more is considered efficient.

Granted, with a P/E of around 17, Landstar shares don't necessarily look cheap. But we believe that wide moats and good growth prospects are worth paying up for. We think the shares are trading around 25% below their true value.

Advanced Micro Devices: (AMD, Fortune 500) Unlike Landstar, Advanced Micro Devices enjoys no economic moat. In fact, this semiconductor maker has been beaten down by bigger rival Intel in the market for chips that power PCs and servers.

But once in a while AMD punches back. That happened between 2003 and 2006, when AMD's Opteron processor helped the company gain market share. This year could mark the start of another such period.

AMD is set to launch a set of microprocessors for the server market based on a new design that allows more processing power to be packed on a single chip. Intel will also be introducing a new chip, but we at Morningstar think AMD's design will appeal more to IT administrators at large corporate data centers, since they'll be able to run more machines on a single server processor.

At the moment, AMD's share of the market for server chips is next to nothing, so even a modest gain would have a huge impact on the bottom line. For instance, if AMD captures 10 percentage points of market share, that would generate an added $1 billion in revenue, roughly doubling its earnings.

Yet the market is pricing AMD as if the chip will be dead on arrival. At around $8 a share, AMD stock is trading at nearly a 50% discount to its true value. By comparison, Intel is almost exactly at fair value.

Now, if macroeconomic fear ruled this market, Intel might still seem more appealing because of its sheer size. But a bottom-up analysis says AMD is the way to go.  To top of page

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