(FORTUNE Magazine) – Beat the market. That, of course, is the goal of every investor, from midlevel managers trying to goose their IRA's returns to hedge fund managers trying to master the universe. In the pages that follow this story, you will read about some savvy money managers who have been up to the challenge regularly over the years. The harsh reality, however, is that the overwhelming majority of investors--both amateur and pro--fail consistently at this task. The truth is, most people would be better off socking their money into an index fund with low expenses, keeping their hands off, and letting nature take its course. But where's the fun in that?

Call us arrogant, but last year we decided we had what it takes to buck the odds--and win. We boned up on our Benjamin Graham, interviewed some of the smartest number crunchers we know, and came up with a system of overlapping screens designed to identify a portfolio full of what every investor seeks: cheap stocks with momentum.

Nearly a year later, we're pleased (okay, insufferably enthusiastic) to announce the results of this experiment: From July 19, 2002, through May 23, 2003, our diversified group of small-, mid-, and large-cap domestic and international equities (plus a handful of fixed-income investments) had a total return of 12.7%. Not only did that beat the 11.8% return of the S&P 500, but it did so with far less volatility than the index (see chart on page 58), thanks in part to our hefty 30% bond weighting. Of the 35 stocks we picked, 27 have gone up. To put our performance in perspective, consider that the average balanced fund, a category of mutual funds that, like the FORTUNE 40, puts money into both stocks and bonds, returned just 8% over the same period.

The top-performing stock by far in last year's list was Coach, which saw its shares more than double on strong sales of its trendy leather goods. Other standouts included household-products giant Clorox and pacemaker manufacturer Guidant, which each climbed 35%. Not all our picks were winners, however. Exercise-equipment maker Nautilus tumbled nearly 50%. The company blames the fall on a host of external events--war in Iraq, stiff competition, and higher advertising rates--but it didn't help that its CEO and CFO scrambled to revise their bios after questions were raised about some of their credentials. We should have studied harder.

Still, we have faith in our system overall and are confident that it can succeed again in the year ahead. It's true that despite a three-year slump in equities, stock prices as a whole have not fallen to the extremely inexpensive level that usually prefaces a new bull market (see previous story). The margin for error will be small. And that's why we believe disciplined stock-picking is paramount right now. Hence, the return of the FORTUNE 40.

On the next page is our new list of stocks and fixed-income investments. Taken together, they represent our best ideas, and we want to remain accountable. Once again this year we'll be tracking the portfolio on our website, fortune.com/fortune40, so readers can check our returns. Our methodology is the same as last year's.

We started with a universe of more than 4,000 stocks and ran them through two screens--one value, one growth. For the first screen, we returned to ValuEngine, an independent quantitative analysis firm in Stamford, Conn. ValuEngine uses a sophisticated discounted cash-flow analysis to screen for stocks selling below what it calls their "fair market value."

The model, which was created by Yale finance professor Zhiwu Chen, assigns a stock's fair value by crunching a host of numbers--a firm's trailing 12-month earnings per share, the analyst consensus of its future EPS over the next year, and the current yield of the 30-year Treasury bond, to name a few. Based on all the input, it comes up with a theoretical price at which the stock should be trading. The difference between a stock's current price and its fair value is then measured to show the extent to which the stock is undervalued (see table).

As an added check on valuation, we favored companies with price/earnings multiples that aren't substantially higher than the market's. (For our analysis we compared prices divided by operating--rather than "as reported"--earnings for the current fiscal year. Right now the S&P 500 trades for about 17 times this estimate.) In addition, we avoided stocks with a P/E-to-growth (PEG) ratio above two.

For our second screen, we once again consulted Zacks Investment Research, based in Chicago, to identify equities with earnings momentum. Zacks measures this by scrutinizing revisions to earnings estimates by Wall Street analysts. (Don't worry, the firm ignores the analysts' often meaningless target prices and ratings.)

Zacks looks at four things: the extent to which analysts are revising their EPS estimates, the size of those changes, the deviation between the most accurate EPS estimates and the consensus, and the size of the most recent earnings surprise. In a nutshell, what Zacks is saying is that upward earnings revisions and surprises cause share prices to rise. It's pretty intuitive: Good news prompts investors to pour money into the stock, which of course sends the price up even higher. Ideally, the firm will continue to beat expectations and its stock price will continue on its upward path.

The ValuEngine and Zacks screens significantly winnowed our universe; the 4,000 potential names dropped to a list of about 500. We then examined each of these stocks ourselves. As a major part of our due diligence, we conducted what we call our "gut check." First we sought out stocks where cash flow and earnings are moving in the same direction; if cash flow from operations falls while net income rises, that can be--though isn't always--a sign of accounting tricks. The test eliminated a couple of stocks, such as industrial conglomerate Textron, which otherwise might have made the cut. (Textron says the sale of its auto-parts business in 2001 is largely responsible for the dropoff in cash flow.)

Next we leaned toward companies with low debt-to-capital ratios--preferably below 50%--to rule out those that might be overleveraged. IMS Health, a health-care information firm, ranked high in our screens, but its 87% debt-to-capital ratio seems anything but healthy. As a third test, we were prepared to avoid any company that had awarded a manager an obscene compensation package. That sends a signal, frankly, that management's first priority isn't the shareholders.

Finally, we tended to avoid companies that have binged on acquisitions; instead, we favored firms that have grown organically or, if they have made a large number of purchases, have grown without accumulating too much debt. That last check dinged several stocks, including insurance broker Brown & Brown.

The one major change we decided to make in this year's FORTUNE 40 is in our asset allocation. Because the outlook for equity returns is now a bit more favorable relative to bonds than it was last summer, we decided to boost the weighting of stocks in our portfolio. We're putting 75% in domestic stocks (half in large-caps, half in small-and mid-caps), up from last year's 60%, plus 10% in international equities. That means that our fixed-income allocation drops from 30% to 15%--but it is still an important stabilizing force. To make sure we play the bond market right, we consulted top fixed-income investors to find out where they are putting their money now. We then identified five bond mutual funds that we believe will bolster returns and even out any swings the equity portion may encounter. Here's a closer look at some of our picks.

Large-cap stocks

Similar to last year's, this year's list has a strong dose of health-care stocks. Fueled by growing demand from an aging population, sales and earnings at many health-care firms are climbing at a rapid clip. And health care, which faces fewer cyclical pressures than nearly any other sector, remains a defensive investment if the market goes south.

Among our favorites in this sector is Pfizer. Thanks to the recent acquisition of Pharmacia, the company is the unrivaled powerhouse of the drug industry, with this year's sales likely to approach $45 billion. Pfizer has nearly a dozen blockbusters, led by cholesterol drug Lipitor. And unlike many drugmakers, most of its top sellers aren't facing patent expirations anytime soon. Meanwhile, Pfizer's pipeline is stocked with new prospects, aided by its $7 billion annual research budget.

Chances are, if you've been sick you've probably purchased something from Johnson & Johnson. As one of the world's largest and most diversified health-care companies, J&J makes everything from drugs to medical devices to consumer products, and generates tons of cash. We picked it last year, and it has paid off handsomely, gaining 29% in the past ten months. Meanwhile, J&J's business is still going strong. Among its recent victories, the FDA approved its drug-coated stent, the only one of its type now on the market.

Our list also contains a number of big retailers. But none are bigger than Wal-Mart Stores, arguably the world's most powerful company, with $245 billion in annual sales. Its strategy is simple: Demand the lowest cost possible from suppliers and pass the savings on to customers through rock-bottom prices. It's one that the Bentonville, Ark., company is using to wreak havoc on an array of retailers, from specialty stores like Toys "R" Us to grocery chains such as Kroger. And amazingly, Wal-Mart can still grow. About half of its Supercenter stores are in just a dozen states, meaning expansion opportunities abound.

The turnaround at Gap is for real. Under the new leadership of Disney veteran Paul Pressler, the clothing chain has sensibly returned to its longtime focus on classic styles, abandoning edgier duds such as studded pink jeans. Pressler has toned down Gap's advertising, closed less profitable stores, and expanded customer research--moves that have already paid off handsomely. During the first fiscal quarter (ended April 30), the retailer bucked industry trends by posting same-store sales growth of 12%.

A couple of niche financial firms also stand out. Thanks in part to the noisy duck starring in its television ads, AFLAC has expanded its product mix well beyond supplemental cancer insurance, its core offering. Now it provides an array of supplemental health insurance policies designed to pay out-of-pocket expenses not covered by primary medical insurance, from home-health to accident-disability to long-term-care coverage. An aging population and rapidly escalating health-care costs in the U.S. and Japan, its two key markets, should boost demand for its products for years to come.

SLM Corp., commonly known as Sallie Mae, is the nation's leading provider of education funding. The company has a powerful demographic trend driving its shares: the children of baby-boomers, who will flood the college ranks in the next decade. And with higher tuition costs likely to fuel demand for student loans, you can expect Sallie Mae's stock price to be a big beneficiary.

The surge in technology shares in the past several months has left many of the market's best-known tech stocks trading at nosebleed levels. Yahoo, a stock that initially scored high in our ratings, is trading at 84 times this year's projected earnings. No thanks. One name we do like, however, is Microsoft. True, its peak growth years are behind it, simply because the PC market is mature. But to revitalize growth, the company is ramping up R&D in non-PC areas, from game consoles to PDAs to set-top boxes. And with $53 billion in cash and investments on its balance sheet, Microsoft has ample funds at its disposal.

Small-and mid-cap stocks

We uncovered an equally diverse group of names at the smaller end of the spectrum. Pacific Sunwear, which sells hip clothes, accessories, and footwear to teenagers and young adults, is in a tricky business: Fall behind the fashion curve, and your stores become as popular as last year's prom dress. But the company has a leg up on the competition, in large part because of its extensive customer research, which helps it stay on top of trends.

A particularly attractive sector right now is the property and casualty industry. It's notoriously cyclical, with long downturns and upturns. Right now the industry is thriving, as the long slump of the late 1990s forced many of the unprofitable insurers waging fierce price wars to exit the market. Given the more favorable supply-demand picture, insurers have the upper hand in raising rates. Our three favorites are Safeco, W.R. Berkley, and HCC Insurance. All trade for steep discounts compared with the broader market, yet sport above-average growth rates.

It's hard to run a business if you can't move merchandise. The thing that distinguishes C.H. Robinson Worldwide from other logistics providers is that it doesn't actually own any trucks, ships, trains, or planes. Instead it merely arranges to have goods shipped for its 15,000 customers using other companies' carriers. The unique business model limits the need for capital expenditures, which has kept the company debt-free. And the firm has superb growth prospects, as businesses are increasingly outsourcing their logistics needs.

At Steris, hygiene is an obsession. The company makes sterilization equipment for some 35,000 customers, primarily in the health-care industry. Its main product is a tabletop sterilization unit used for surgical and diagnostic devices. The surge in hospital construction and capital spending has helped Steris boost sales by more than 20% a year in the past five years. Expect the growth to continue, thanks to ongoing hospital construction and rising demand for sterilization equipment overseas.

America's quest for the perfect smile is good news for Patterson Dental. The Minneapolis firm distributes an array of products, from hand instruments to X-ray film, and provides services such as dental-office design and equipment installation. It's a lucrative business: Earnings and cash flow have increased roughly 20% a year over the past five years.

Picking critical suppliers of popular consumer gadgets offers backdoor entry into the tech sector. SanDisk manufactures various storage products that use flash memory, which enables a device to retain data even when power is interrupted. Its goods include memory cards used in digital cameras, PDAs, and MP3 players. The beauty of SanDisk is that it holds more than 200 patents in flash memory, allowing it to license its technology to companies such as Intel and Sony, as well as sell its actual products to manufacturers, including Canon and Eastman Kodak. Analysts expect annual earnings to surge 25% over the next three to five years as memory-intensive gadgets grow in popularity.

Western Digital is one of the largest independent makers of hard-disk drives, which store volumes of data. Drives for desktop PCs account for the bulk of Western Digital's sales. But the big growth opportunity is in developing products for cable and satellite set-top boxes as well as for videogame consoles. The company won a major victory last year when it was selected by TiVo to provide the hard drives for its second-generation digital video recorders.

International

Having successfully restructured its operations during the past several years, Dutch banking giant ABN Amro is now better positioned to begin growing again. The company is focusing much of its effort on Europe, where the introduction of the euro and the convergence of financial markets has driven up demand for big banks that can offer a smorgasbord of financial services. The stock sells for just 11 times this year's projected earnings.

Formed by the 1997 merger of beverage giant Guinness and food and spirits company Grand Metropolitan, Diageo is the world's largest seller of alcoholic drinks. The British-based company owns some of the strongest brands in the world, including Johnnie Walker Scotch, Tanqueray gin, and Smirnoff vodka. It recently sold its Pillsbury and Burger King divisions so it can better concentrate on its premium alcoholic drinks, its fastest-growing and most profitable segment.

Ever since its founding in 1989, Danish drug maker Novo-Nordisk has focused on diabetes care, and today it is one of the world's leading producers of insulin. Unlike many drug categories, the insulin market is not as threatened by generic competition, primarily because the cost of building an insulin plant is prohibitive. And while diabetes care still accounts for 70% of sales, Novo has thriving hemophilia and hormone-replacement units. With some 20 new products in the pipeline, the company is expected to increase earnings 15% a year for the next several years.

Unlike most of its rivals, Total, the French oil giant formerly known as TotalFinaElf, has been able to boost production at an impressive rate. It posted a 10% rise in combined oil and gas production last year and has prospects for 5% average annual production increases to as far out as 2008. One of Total's key advantages over Western peers is its ability to tap into the volatile Middle East, since the French are closer to many Arab states, including Iran and Libya. The company is also the top producer in Africa, which holds many large but mostly untapped reserves.

Three years into a major restructuring plan, Netherlands-based Unilever is delivering on its promises. The maker of Hellmann's mayonnaise, Skippy peanut butter, and Dove soap announced in early 2000 that it would reduce the number of brands it sells to 400 from 1,600. In addition, the company consolidated its manufacturing facilities and reengineered its supply chain to improve margins. Unilever is now well on its way to delivering 5% to 6% sales and low-double-digit earnings growth for the next couple of years.

Fixed income

With bond prices on a tear and yields down to their lowest level in nearly 50 years, investors need to be creative--and careful--in figuring out a strategy for the fixed-income portion of their portfolio. One area we continue to favor is short-term corporates. The Vanguard Short-Term Bond Index fund tracks the Lehman Brothers one-to five-year government/corporate index and thus sticks to a mix of government and investment-grade issues. But the portfolio tends to hold a higher percentage of corporate bonds and fewer Treasuries than the index in an effort to pick up some additional yield and return.

Convertible bonds offer the best of both worlds: downside protection from their bondlike characteristics and the upside potential of their underlying stocks. At Calamos Growth & Income, managers John and Nick Calamos specialize in convertibles. They tend to buy securities issued by solid and growing companies but will occasionally buy lower-quality convertibles to boost returns. The fund's 14% annualized gain over the past ten years is tops in its category.

If low yields in the U.S. have you down, one good solution is to venture abroad, where bond opportunities are often brighter. Pimco Foreign Bond invests in both government-and corporate-issued international bonds and avoids big regional or duration bets. Moreover, because of the skill with which manager Sudi Mariappa hedges his foreign-currency exposure, the fund is less than half as volatile as its peers.

We're sticking with our two intermediate bond picks from last year. Dodge & Cox Income consistently ranks near the top of the charts by favoring government and high-quality corporates. Its expenses are among the lowest in its category, which is a huge help in this low-yield environment. And Fremont Bond allows you to tap into the wizardry of Bill Gross, Pimco's star bond manager. Regardless of market conditions, he consistently outpaces the pack by making sometimes aggressive sector and rate bets. Lately he's been buying Treasury Inflation Protected Securities (TIPS), as well as emerging markets and German government bonds. If history is any guide, those will be great moves.