Best stocks for 2009 (pg. 2)

The problem is, investors are now too scared to care about any of this. When we recommended Annaly last year, the stock traded for $17 a share, had a price-earnings ratio of nine (based on projected earnings), and offered a dividend yield of 5%. (Like all REITs, Annaly pays out the bulk of its earnings as dividends.) Today, the shares sell for $13 with a forward P/E of five and a dividend yield of 16%. "They're making more money on less leverage," says Anton Schutz, portfolio manager of the Burnham Financial Services Fund. "I think Annaly is one of the best places to be in this market."

It is clear again who put the D-E-L-L in Dell. When Michael Dell returned in early 2007 to the helm of the computer maker he founded nearly 25 years ago, costs at the Round Rock, Texas, company were spiraling out of control. Worse, Dell (DELL, Fortune 500) was losing market share to rivals HP and Apple, particularly in selling computers to individuals. Nearly two years and more than 10,000 job cuts later, Dell's operating expense dropped 12% in the most recent quarter, compared with an increase of 24% a year ago.

What's more, the company has regained market share this year, according to research firm Gartner. "A year and a half ago there was a question about the integrity of Dell's business," says David Katz of Matrix Asset Advisors, which has recently been purchasing Dell shares. "All of those issues have been addressed."

Mr. Market, though, hasn't seemed to notice. That, along with the cash on its balance sheet, is what makes Dell's shares a great buy now. The company has nearly $7 billion in net cash, or about $3.60 a share. Exclude that from its recent share price of $10, and you get a price/earnings ratio of just under five, based on next year's earnings estimate of $1.31 a share. By that measure, Dell's shares are cheaper than 95% of all the companies in the S&P 500 and significantly less expensive than rivals HP and Apple, at eight and 12 on the same scale, respectively, according to Standard & Poor's. Once the quintessential growth stock, Dell has become a value play.

Some analysts worry that next year could be rough for the company. It makes 80% of its sales to corporations, which are likely to hesitate to buy huge quantities of computers as they try to keep costs low. Overall, Wall Street expects Dell's earnings per share to fall 7% next year. But Dell has been stepping up its efforts to sell to individuals by increasing the money it spends on design. Its formerly generic products can now be found in a painter's wheel of colors (some even have covers designed by African abstract artists) with features like glow-in-the-dark keyboards. And the company is selling in 20,000 retail stores, including Best Buy and Wal-Mart. "They have the cash they need to retool for a global economic slowdown," says money manager Nick Calamos of Calamos Investments. "The market is saying, 'This company is dead.' Instead, this may be one of the best buys in the market today. It's an unbelievable bargain."

Do you believe oil will remain at under $50 a barrel? We certainly don't. With oil prices collapsing by $100 a barrel in the past six months, a rebound seems inevitable. After all, even if global demand were to remain flat over the next 25 years - the International Energy Agency actually expects it to increase 45% by 2030 - the world would still have to develop new sources of oil and gas equivalent to four Saudi Arabias just to offset the declining outputs at existing oilfields. "It's hard to argue with the data," says Matthew Simmons, president of Houston energy banking firm Simmons & Co. and author of the peak-oil treatise Twilight in the Desert. "And it's ghastly, what the data says."

What's more, Africa, the Middle East, and Russia, where much of the oil is, remain politically unstable. So you can bet that when it's clear the recession in the U.S. and elsewhere is coming to an end, oil prices will snap back. The only uncertainty is when that will occur.

Shares of oil and gas companies have dropped nearly 50% in the past six months, and many of the stocks now trade with single digit price/earnings ratios. Simmons believes oil stocks in general are as undervalued as they've been in 75 years. But earnings at energy companies are on average expected to drop 16.3% in the next 12 months, according to Standard & Poor's. So the question is how to take advantage of the long-term bargains without your portfolio getting stomped in '09.

Devon Energy (DVN, Fortune 500) is one answer. The Oklahoma City-based exploration and production company does business almost exclusively in the U.S. and Canada, so it doesn't have to worry about Russia or some other nation deciding it wants a greater cut of oil profits. Devon's revenues are split between oil and natural gas, giving it an added cushion against oil price drops. To be sure, natural-gas prices are down as well. But many experts believe an Obama administration will shift the nation's energy consumption toward cleaner natural gas and away from oil and coal, which should boost demand over time. "Obama's policies are likely to strain natural-gas supplies," says Larry Nichols, chief executive of Devon. "So all else being equal, I expect higher prices next year, which is good for us."

With very little debt - just 13% of capital - the company already has a frugal operating structure. And Nichols says he plans to cut his budget "meaningfully" this year. On top of that, the company estimates that its reserves are up 10% this year, giving it more oil and gas to sell in '09. "We will sell 100% of our product next year," says Nichols. "That makes us different from hotel chains or fancy restaurants. People don't stop using oil and gas."

Earnings are expected to drop 36% in 2009. But that's much better than the 53% drop expected at Anadarko Petroleum, Devon's closest competitor. And at a recent $66, the company has a P/E ratio of ten, based on next year's earnings. That's lower than the 12 P/E of Exxon Mobil, which analysts also say is well positioned to weather the energy downturn. "We believe Devon has the most attractive asset portfolio in the oil sector," says Oppenheimer analyst Fadel Gheit, who recommends Devon's shares. "Everybody's earnings are going to fall. These guys' are going to fall less."

Our second energy-related stock may pay off faster than Devon. Indeed, what stands out about Diamond Offshore (DO) is its home-run potential - Barclays Capital has a $134 price target for the shares, which are now $66 - as well as the protection shareholders get from its hefty dividend should the stock market continue to slide.

Diamond is a contract driller; it has 46 offshore rigs and drill ships, which it leases to oil companies such as Apache and Petrobras at rates of anywhere from $100,000 to $500,000 a day. While day rates for offshore rigs have been under pressure, most of Diamond's rigs are covered by long-term contracts. According to Goldman Sachs analysts, 89% of Diamond's revenues for 2009 are already locked in (the most of any offshore driller), as are 71% of 2010 revenues. And as oil prices move back up, demand for drilling - and Diamond's services - will surge.

Diamond's shares trade for a mere six times 2009 profits, but what we really like is the yield. Unlike other drillers, Diamond distributes the bulk of its earnings as dividends. The total quarterly payout (regular dividends plus special dividends that have become quite regular) now stands at $2 a share, which works out to an annualized dividend yield of 12%.

The recession has pounded the construction industry, with engineering and infrastructure stocks sinking as cash-strapped municipalities delay large public projects. But the sector should get a boost from an ambitious public works spending plan expected to be part of President-elect Obama's economic stimulus package. This bill is likely to be a direct grant rather than the more typical stimulus package that forces local governments to match federal funds, according to Bentley Offutt, of Offutt Securities. That should speed spending and allow projects to go forward even in cities and states where shrinking tax bases and bond market problems have crimped state budgets.

Fluor stands to prosper. About 45% of the engineering and construction company's business is in the U.S., and Phil Dodge, an analyst at Stanford Group, says the company will probably work on larger projects like interstate highway renovations.

Even without a stimulus package, Fluor (FLR, Fortune 500) has been flourishing. The company's revenue rose 38% to $5.7 billion in the third quarter of 2008; earnings doubled to $1.01 per share. It has robust businesses inside and outside the U.S., including oil and gas, mining, power, and global infrastructure. And Fluor generated a record $8.8 billion in new contracts for the third quarter, including a $3.4 billion project for the BP Whiting Modernization Project in the U.S. and a $1.8 billion contract to build the world's largest offshore wind farm near the coast of England. Fluor has even raised its earnings guidance for 2009, one of the few companies to do so. Despite that, the shares are trading at only ten times earnings, making it a stock that seems engineered to rise next year.

Think of Johnson & Johnson (JNJ, Fortune 500) as a comfort stock. Strength and stability seem like cardinal virtues at a time when even the bluest of blue chips - AIG, Citigroup, and Goldman Sachs, to name a few - have suffered calamitous stock declines. "In an environment where large companies are going bankrupt and seeing huge declines, J&J is safe," says Tao Levy, an analyst with Deutsche Bank Securities.

Yes, a triple-A credit rating has never looked so good (or so rare: J&J is one of only six U.S. corporations with that distinction). But it's not just a gold seal. It means J&J can borrow money at lower cost than its competition. This often-ignored strength will become more meaningful because the troubled debt markets, which are unlikely to clear in the first half of 2009, will make life more expensive for most companies.

J&J's fortress-like balance sheet, with $150 million in net cash - $14.8 billion in cash and $14.6 billion in long- and short-term debt - means it can easily complete the $10 billion share-repurchase program it began in 2007 (it has so far bought $7.4 billion in stock), increase its dividend, or swoop in for a cheap, strategic acquisition to boost earnings. In November the company announced it would acquire biosurgical-product maker Omrix Biopharmaceuticals for $438 million. (J&J bought the shares for a third less than their 52-week high.) And in December it picked up breast-implant maker Mentor Corp. at a 24% discount to its 52-week high, calling the acquisition a "cornerstone" for its move into the $4.6 billion cosmetic medicine business.

With J&J, investors gain exposure to a leading medical-device maker as well as to blockbuster drugs and top consumer product names such as Neutrogena and Listerine. The company has done well despite the current turmoil. In the third quarter, earnings per share jumped by 10.4% over the previous year, and it is growing rapidly overseas. Worldwide sales rose by 6.4% in the quarter, and nearly all of that increase was booked in Latin America and Asia.

A severe economic slowdown in 2009 will put pressure on the consumer segment, and generic drug competition will weigh on pharma. For 2009, earnings per share are expected to grow by 3%, according to research firm CapitalIQ. Pharma will be the biggest albatross as patents expire on blockbuster drugs like Topamax, a migraine and epilepsy treatment.

NEXT: The best stocks for 2009 (pg. 3)

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