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Top stock picks from top pros

They racked up some of the best fund returns of the Lost Decade by sticking with this simple strategy: Buy quality. Here's where they see opportunity now.

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Phillip Davidson
Phillip Davidson
Fund type: Bargains in large-company dividend stocks
Record: Has the best 15-year performance of funds with a similar strategy

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His picks: Lowe's and Johnson & Johnson

"Lowe's is realizing that its growth rate won't be as fast as it was in the past," says Davidson, who has been the fund manager for 16 years.

"So the company is improving its return profile internally: It is buying back stock and has started much more aggressive dividend payout strategies. In fact, Lowe's recently increased its dividend by more than 20%."

"Johnson & Johnson is a very diversified health care company -- not just pharmaceuticals -- which leaves it less exposed to patent expirations. The company has great product breadth and a high-quality balance sheet. And its 3.5% yield is very attractive."

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His strategy: Davidson, 55, aims to build a portfolio yielding two percentage points more than the S&P 500 (now paying 1.9%), before expenses. To get there he buys stocks that can reliably pay a dividend -- market leaders with low debt -- and are priced below their historical averages.

He also keeps some of the fund's assets in convertible securities, which pay interest like bonds but can be exchanged for shares if the firm's stock value rises. (It's tricky for individual investors to find pricing for these; you're best off investing through a fund.) As a result, the fund doesn't reap the full benefit of a stock rally, but it also doesn't suffer as much during downturns. In 2008, Equity Income fell 20% while the market declined 37%.

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Where he sees opportunity: "We've seen a change in the types of companies that pay healthy dividends," Davidson says. "Former growth stocks, like tech firms and some companies tied to housing, are paying out more cash to investors."

Davidson is also keeping an eye on pharmaceutical firms, many of which are offering high yields relative to their history. The industry faces big patent cliffs, which has turned off some investors (including Holland's Walker).

"But not all companies are at great risk," argues Davidson. "We look for firms that have little debt and won't go out of business if earnings suffer."

Currently, about 20% of equity income is in convertibles; one Davidson likes is Best Buy. "The stock is cyclical," he says. "With the convertible we get protection from the downside, and if the stock does better than we expect -- such as when Circuit City went out of business -- we participate in the upside."



NEXT: Lei Wang and Wendy Trevisani
Last updated January 03 2011: 4:47 PM ET
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