The Fortune 40: How we picked them
The plan was to create a diversified, dependable portfolio of stocks for the long term, that could rise with the market but hold steady during down times.
NEW YORK (Fortune) -- Weeping. Wailing. The fetal position. Any of those would have been a fitting response to the collapse of equities -- and virtually every other asset class -- in 2008 and early 2009. For many, the S&P 500 (SPX) index's most recent crater on March 9 took on near-talismanic significance. You could almost hear the pleading: Please let that be the bottom. Please let that be the bottom. For now, the spring rally has held, with a euphoric 40% jump in the S&P from its March low to June 1.
Even with this nice leap, we're not ready to proclaim a bull market yet. Indeed, we're confident that stocks are unlikely to continue soaring at their current rate. What we can say is that although the economy may not gain its legs for a while, things somehow feel less dire than they did a short time ago.
As investors tiptoe back into the market only months after stock sages were focusing on "capitulation," the moment people finally give up on the chance of a rebound and sell, now is a good moment to consider the Fortune 40. We launched this flagship retirement portfolio in 2002 with a simple goal: We wanted to assemble a diversified, dependable portfolio of stocks for the long term - a selection that could soar when the market did but also hold steady during darker times.
In relative terms the portfolio has achieved its mission: The Fortune 40 delivered a 20.3% loss for the 12 months ended June 1. That would be a dismal number under normal circumstances. But the circumstances were anything but. The S&P lost 30.1% during the same period. Meanwhile, we don't need any qualifiers to describe our record since inception in 2002: The Fortune 40 has averaged 10% annualized returns, nearly doubling the S&P's 5.1%.
Our star stocks last year included smokeless-tobacco company UST (acquired by Altria), which returned 25.9%. Then there was National Presto, which manages to sell both ammunition and diapers, among other disparate products. It's an unlikely combination, to say the least, but one that is apparently impervious to the economy. Investors rewarded National Presto with a 17.6% gain last year.
Our worst decliners were two small-cap recommendations pummeled by the collapse of energy prices. Offshore construction and engineering concern Global Industries plummeted 55%, and natural-gas driller Grey Wolf sank 57% before being bought in December. (In the case of Grey Wolf and UST, we used the gain or loss until they were acquired in figuring the Fortune 40's annual return.)
Despite those clunkers, we believe the portfolio's track record shows the value of our approach. So we're retaining it, and as we have in the past, we're creating five mini-portfolios of eight stocks. Each of them is designed to emulate the philosophy of an investing legend: Jeremy Siegel, Peter Lynch, Benjamin Graham, Chuck Royce, and John Templeton. (Only Siegel has endorsed our use of his methodology, though he passes no judgment on the stocks we select.) We apply a series of screens patterned after each investor's strategy and then narrow each group further by combing through research reports, interrogating fund managers, and questioning stock analysts.
As all investors should, we revisit our selections annually. This year we're replacing 23 stocks, the vast majority because they didn't pass our stock screens this time. For example, National Presto was so successful that its price/earnings ratio made it too expensive for our deep-value screen. Our new group includes stalwarts such as MasterCard and BHP Billiton, along with a bunch of small stocks that may be new to you. We offer more details on our methodology in the sections that follow, along with the specifics of the screening process in the footnotes to each table. For additional information, including more on the performance of last year's portfolio, go to fortune.com/fortune40.
We built this blue-chip portfolio using the advice given by Wharton professor Jeremy Siegel in his 2005 book "The Future for Investors." Siegel's stock-picking philosophy emphasizes established companies with proven products, consistent returns, healthy long-term earnings growth, and high dividends. Perhaps they aren't the glitziest names, but "boring" can be another word for "sturdy," and that's appealing these days. This group fell 18.1% over the past year, beating the S&P by 12 percentage points.
We dropped three companies. Colgate-Palmolive and U.S. Bancorp were eliminated because their dividend yields fell below our 3.1% bar. Illinois Tool Works survived the screen (barely), but we scrapped the industrial manufacturer because its margins and return on equity have declined in recent months, while its long-term debt-to-equity ratio has more than doubled.
Several classic performers sailed through our screen. One standout is McDonald's (MCD, Fortune 500), which super-sized profits by 80% last year; analysts expect it to deliver 12% annual earnings growth for the next three to five years. Despite returning 20% to investors over the past five years vs. an industry average of -4%, McDonald's is trading at a slight discount to its peers, and at a P/E of 16, it's well below the 20 it commanded just two years ago. "It's the best price I've seen in 20 years," says Tom Marsico, manager of the USAA Aggressive Growth Fund, which owns shares of the fast-food giant. "McDonald's is entering a period where its margins will continue to improve as it grows globally."
We also added FPL Group (FPL, Fortune 500) and Waste Management (WMI, Fortune 500), which sell recession-resistant services: electricity and trash collection. FPL, by far the largest utility in Florida, achieved 25% profit growth last year, easily surpassing its competitors' 2% average gain. Much of FPL's growth came from its alternative-energy division, which improved revenues by 32%. Going forward, stimulus tax credits for green energy should put even more wind at its back.
Waste Management is also a leader in an industry dominated by a few players, which gives it pricing power. "The demand for trash collection is quantifiable, but the ability to supply is constrained," says Todd Ahlsten, manager of the Parnassus Equity Income Fund, which owns WMI shares. Waste Management boasts a profit margin of 8%, dwarfing the industry average of 2%, yet its P/E ratio of 13 is five points lower than its peers'. Analysts think the company's earnings growth will reach 9% this year, as its recycling business is poised to benefit from rising commodity prices.
Legendary investor Peter Lynch, whose Fidelity Magellan Fund returned 2,703% during his 13-year tenure, is an enthusiast of the price/earnings to growth ratio, or PEG. Lynch hunted for stocks whose valuations belie their growth potential - the lower the PEG ratio, the better. His investing style inspired our bargain growth portfolio, which was off 24.1% last year (but outperformed most large-cap mutual funds).
Another Lynch precept is to invest only in companies with debt-to-equity ratios below 0.33. That requirement eliminated three of our 2008 holdings: 3M, McKesson, and Parker Hannifin all carry slightly too much debt. Meanwhile, two of our other stocks, Accenture (ACN) and Microsoft (MSFT, Fortune 500), managed to generate more free cash flow last quarter, proving themselves to be what Lynch calls "stalwarts," or consistent performers. They remain on our roster.
An addition we think fits that bill is scientific-equipment maker Thermo Fisher Scientific (TMO, Fortune 500). While the company's revenues suffered last quarter, it produced record free cash flow as a result of improved operating margins. Thermo Fisher sells tools for research and development, making it a likely beneficiary of stimulus dollars in both the U.S. and China. And its stock trades at a discount: a P/E of 13, well below the industry average of 17.
One high-octane stock we're adding is biotech firm Gilead Sciences (GILD, Fortune 500). The company is the dominant producer of HIV medicine and continues to innovate formulations that simplify dosages. "Gilead has a lot of the qualities that people found attractive in Pfizer and Lilly 10 years ago," says Alex Motola, manager of the Thornburg Core Growth Fund, which owns GILD shares. "It's taken their place in many portfolios." While many biotech firms are struggling to get out of the red, Gilead generated $641 million in cash from operations last quarter and attained 38% profit margins.
We also think MasterCard (MA, Fortune 500), the credit card payment processor, is undervalued given an estimated long-term growth rate of 16%. MasterCard is a "toll collector," which means it generates steady fees without being exposed to customer defaults. And the company has become more efficient, improving operating margins to a lucrative 50%. Finally, it is plastic-agnostic: Consumers may be shifting from credit to debit cards, but MasterCard makes money either way.
It's easy to find beaten-down stocks these days. But unearthing battered shares that deliver steady earnings growth, pay dividends, and have little debt - well, that's a challenge. That's what Benjamin Graham sought and what our deep-value portfolio aims for too. We look for companies whose stock prices have been punished by short-term problems but whose fundamentals are strong and could reward patient investors with reliable growth.
Last year's portfolio fell 6.7% vs. the S&P's 30.1% drop. Our laggard was forklift parts manufacturer Cascade, whose shares sank 37%. The company's parts are employed in lifts that move pulp and paper, textiles, and consumer goods, which slowed production dramatically during the recession. With little sign of a comeback among its customers, Cascade didn't generate 3% earnings growth last year and failed our screen.
In fact, all but two of last year's picks have been jettisoned. Some, like Applied Technologies, were trading at P/E ratios too high to meet our deep-value criteria. Only Carlisle Cos. (CSL), a diversified construction company that makes roofs, specialty tires, and food service equipment, and Regal-Beloit (RBC), which makes motors for heating and air-conditioning systems as well as electric-power-generation equipment, remained on the list.
One promising new pick is offshore oil- and gas-drilling company Noble (NE). It has been hammered as the recession reduced demand for oil and gas. It now trades at a P/E of 6, less than half the S&P 500's average of 15. But if oil prices rise, the demand for deepwater drilling will increase. Indeed, analysts expect nearly 13% annual earnings growth for Noble over the next five years. In the meantime, the company has a $10.6 billion backlog and lots of access to cash, and it is aggressively lowering costs. Noble has lucrative contracts with Brazil's Petrobras to build deepwater rigs, as well as contracts with Mexico's state-owned oil company Pemex.
We also included stocks that can hold up if the economy continues to struggle: Becton Dickinson (BDX, Fortune 500) and Bristol-Myers Squibb (BMY, Fortune 500). Medical supplies maker Becton Dickinson trades at a P/E of 14, below the industry average of 27. The company makes things like syringes, needles, and catheters, as well as flu diagnostic products. Analysts say it could boost its earnings by 12% over the next five years. "They have the best global health-care-products franchise in the world," says Bill Webb, deputy chief investment officer at Gluskin Sheff, which owns shares of Becton Dickinson. "It's largely protected from slowing economic conditions, and they focus on dominating specific high-margin, high-return product markets."
Investors have been nervous about Bristol-Myers because its blockbuster blood thinner Plavix, which it produces with Sanofi-Aventis, will soon lose patent protection. But patents on Bristol-Myers's popular antidepressant Abilify and cancer treatment Erbitux don't expire until 2014 and 2017, respectively. And the company has a promising pipeline that focuses on higher-margin oncology and diabetes treatments. Several of those late-stage drugs are being co-developed with other pharma companies, which lowers Bristol's costs.
Between the company's $2.3 billion in net cash and the equity it retained in the baby-formula division Mead Johnson, which it spun off in an IPO, Bristol-Myers has the resources to make acquisitions - such as a biotech - to provide growth. It recently beat analysts' earnings expectations because it was able to slash costs. The company has "superior growth prospects," according to a report by Deutsche Bank analyst Barbara Ryan, and earnings could increase by more than 8% in 2009 and 12% in 2010. Meanwhile, it sells at a P/E of 8, vs. 13 for the pharma sector, and it pays a handsome 6.2% dividend yield.
Our collection of diminutive-company stocks dropped 27.2% over the past year, in line with the 28.4% decline in the Russell 2000 (RUT) index. Since March 9, the Russell 2000 is up 53%, outpacing the S&P 500's 40% rise. That's not a fluke: The stocks of corporate munchkins tend to sprint ahead after market lows. A recent report from Wasatch Funds shows that small-caps have outperformed large-caps after every recession since 1953, with average returns of 34% to large-caps' 18%. And the category still has room to run, says Lori Calvasina, small- and mid-cap strategist at Citigroup.
With that in mind, we set about finding the standouts. First, we revised our range for small-caps to companies between $200 million and $1 billion, following Standard & Poor's lead. Then we ran a screen modeled after the approach of small-cap investing sage Chuck Royce (for more, see "The Ultimate Mutual Fund Portfolio"). We focused on candidates with positive free cash flow and at least an 8% return on assets, paying special attention to companies with little or no long-term debt.
Our ROA requirement knocked out all but two of last year's bunch, with another eliminated for exceeding the market-cap limit. That left Tessera (TSRA). This intellectual-property powerhouse licenses technology that lets chipmakers reduce the size of their chips. That in turn allows electronics manufacturers to shrink gadgets such as cellphones, while Tessera collects royalties. Shares were pounded last year as investors worried that several patent disputes threatened the company's profits. But Tessera scored a big win last month against wireless giants including Motorola and Qualcomm. Motorola has already signed a licensing agreement and others are expected to follow, all of which will generate new payments for Tessera.
The stock, meanwhile, has rebounded and now hovers near its 52-week high at a P/E ratio of 21. But analysts say there's still room to grow: The recent legal victory bodes well for another upcoming patent fight, and Tessera's optics business - it makes autofocus and zoom technology for cellphone cameras and the like - is gaining traction. "The emerging optics business is something that's been undervalued, especially if it has the ability to execute on its ambition to get to $100 million in revenues in 2011," says Raj Seth at Cowen & Co.
Newcomers include biotech Neogen (NEOG), which sells an array of products focused on food safety from farm to factory, including test kits that help foodmakers detect allergens, toxins, and bacteria like E. coli. This business should benefit from increased regulation and growing consumer concern about the food supply. Neogen's customers already include 19 of the world's top 20 food companies, such as ConAgra and Hershey. The company, which boasts zero debt, posted its 64th consecutive profitable quarter in March. "This is one of the few companies that has grown through this entire [economic] mess, and we think it gets easier for them to grow from here," says Steven Crowley of Craig-Hallum Capital Group, who expects revenues to grow 10% and earnings to increase by 13% over the next year.
Shares of weight-loss company NutriSystem (NTRI) have withered, but the stock price is poised to bulk up once people start spending again. NutriSystem has been reducing costs, reaching new customers by selling plans through Costco, and adding options like a program for diabetics. Revenues from returning clients now make up a quarter of sales, a boost for the bottom line since reactivations are more profitable than new accounts. "The stock is on a launching pad. It's not ready to take off, but I'm not worried about it going down," says Mitch Pinheiro, an analyst with Janney Montgomery Scott. "If the consumer does loosen the purse strings, this stock could perform very well." And with no debt and $74 million in cash, NutriSystem is paying shareholders to wait for better times with a 4.7% dividend yield.
The latest economic bust has shown that the world's economies are truly interconnected (so much for "decoupling"). But that doesn't mean they will all recover at the same pace. Smart investors have been balancing their portfolios with non-U.S. companies for years to cash in on opportunities abroad. Our assortment of foreign stocks is modeled after the strategy of John Templeton, who was among the first major American investors to look beyond national borders. Like Templeton, we seek companies that are selling at a discount to their global peers and that should deliver earnings growth and expanding profit margins. In general, we aim to reduce share-price volatility by focusing on large companies based in stable, well-established markets like Western Europe, though their business lines in developing countries provide additional growth potential.
Last year our foreign value portfolio sagged 25.6%, which is better than the 33% plunge in the MSCI EAFE index (the global equivalent of the S&P). Our top performer, French pharmaceuticals maker Sanofi-Aventis, lost 5%. Large pharma companies tend to weather downturns well because consumers buy medicine even in a recession. Meanwhile, shares of Philips Electronics (PHG) dropped 44% as consumers and hospitals reined in spending.
With the global economy still struggling but pockets of growth popping up, this year's foreign portfolio plays both defense and offense. Diageo (DEO), Total (TOT), and Unilever (UL) return and should keep the portfolio stable amid global volatility. Generic-pharmaceuticals maker Teva (TEVA) replaces Big Pharma plays Sanofi and Novartis. Novartis has warned that it faces headwinds in Europe and emerging markets. Sanofi's blockbuster blood-clot treatment Plavix will soon lose its patent shield, as noted, and at a P/E of 15, Sanofi's shares are much pricier than those of Bristol-Myers (a P/E of 8), its partner in Plavix.
Generic drugmakers, however, don't risk toppling over a "patent cliff" the way Big Pharma companies do. Analysts say Teva is the best of the generics. It stands to profit as more employers encourage the use of generic drugs to lower health-care costs. Analysts see 17% earnings expansion over the next five years.
It's that gaudy growth rate that justifies what may, at first blush, seem like an inflated price. Teva shares trade for 41 times its earnings over the past 12 months. But if you look ahead, the value is clear: The shares sell for 11 times projected earnings for the next 12 months, compared with 17 for its peers.
In addition to recession-resistant stocks, we've selected some poised to benefit from a recovery. Economists and fund managers see potential in Asia and South America, which could propel demand for materials like steel and cement as well as commodities such as copper and iron ore. Keith Walter, a senior portfolio manager at Artio Global Management, says growth in countries such as China, India, and Brazil will be driven by "more infrastructure spending and more consumption as living standards rise."
Beneficiaries could include BHP Billiton (BHP), which mines aluminum, copper, coal, iron ore, and precious metals like gold and silver. The Australian giant's proximity to Asia makes it a natural partner for countries like China and South Korea (China accounted for about 20% of sales in 2008). It has a strong balance sheet with little debt and offers a dividend yield of 2.8%.
We also chose Brazil's state oil company Petrobras (PBR). In a recent report Barclays analyst Paul Cheng concluded that the company was among "the best positioned to benefit from any oil price recovery over the next several years." This is in part because there have been massive oil discoveries off the coast of Brazil. The Tupi field, for example, was the largest discovery in the world in the past 20 years. Petrobras has begun well tests and should start its pilot drilling program in 2010. This deepwater site is expected to produce 1 million barrels of oil a day, which would place Brazil among the world's largest oil-producing states. The company's exceeded expectations in its most recent quarter, and analysts predict that it will grow 20% per year over the next five years.
The Canadian fertilizer maker Potash of Saskatchewan (POT) rounds out our growth picks. The stock trades at a P/E of 11, which is about the same as its rival Mosaic and much lower than the S&P's average of 15. It produces about a quarter of the world's potash. Analysts at Canaccord Adams project a return to high grain prices, which should create strong demand for fertilizer. Indeed, many farmers eschewed potash use in 2009 to save money. It's possible to do that for a year, says Walter of Artio Global, but after that, fields will suffer. That means demand will rise next year, he says: "They must order the full dressing of fertilizer or risk having their crop yields go down." Because of the downturn and current drop in orders, the company will probably ship only 5.5 million to 6 million tons of potash in 2009, J.P. Morgan analyst Jeffrey Zekauskas wrote in a recent note. More typically, the company ships 8 million to 9 million tons. Should Potash shipments revert to that level, that could translate to $3 of earnings per share, according to Zekauskas. That would add $30 to the stock price - just the sort of return that makes a portfolio healthy and green. 
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