(FORTUNE Magazine) – We've got a streak going. For the second year in a row, the FORTUNE 40--a model portfolio with our best investment ideas for the year ahead--has beaten the market. From May 27, 2003, to June 18, 2004, our diversified group of small-, mid-, and large-cap domestic and international equities (plus a handful of fixed-income investments) returned 25.8%. The S&P 500, by comparison, gained 21.5% over the same period. To put our performance in perspective, the average balanced fund, a category of mutual funds that, like the FORTUNE 40, puts money into both stocks and bonds, returned just 12.5% over the same period.

Admittedly, picking winning investments last year was like shooting fish in a barrel. Pretty much anything with a ticker symbol attached to it went up, as the market recovered from a three-year slump. The consensus among market gurus, though, is that gains will be tougher from here. A big reason is that the Federal Reserve is widely expected to begin ratcheting up interest rates when it meets in late June. History shows that a series of interest rate hikes can be bad news for stocks. Indeed, during the past six Fed tightening cycles dating back to 1973, the S&P 500 fell 6%, on average, 12 months after the initial increase, according to Standard & Poor's. (For more on this topic see "How to Ride Rising Rates" on fortune.com.)

We're not intimidated, however, because we have faith in our system. We are confident that we can not only post positive returns but also beat the S&P 500 for a third year in a row. We realize that's a bold statement, but we're willing to back it up. Once again this year we'll be tracking the portfolio on our website, fortune.com/fortune40, allowing readers to 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 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 "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 determines 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 insanely higher than the market's. (Right now the S&P 500 trades for about 17 times this year's estimated earnings.) In addition, we tried to steer clear of stocks with a P/E-to-growth (PEG) ratio above two. In the few cases where we've chosen a company with a high PEG ratio, it is because we believe that the firm is in the middle of a turnaround and that analysts are underestimating its earnings potential.

For our second screen we once again consulted Zacks Investment Research, based in Chicago, to identify equities with earnings momentum. Zacks measures that 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 company 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 the 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 it isn't always--a sign of a serious problem. The test eliminated a couple of stocks, such as nursing-home chain Beverly Enterprises, where operating cash flow has fallen sharply for the past two years. (Beverly says the lower cash flow is largely the result of reductions in Medicare reimbursements.)

Next we leaned toward companies with low debt-to-capital ratios--preferably below 50%--to rule out those that might be overleveraged. That knocked a bunch of stocks out of the running, including that of AES, an electric-power company. Frankly, its 94% debt-to-capital ratio is downright shocking. (An AES spokesman says the company is "aggressively targeting debt reduction.") As a third test, we were prepared to avoid any company that had awarded a manager an obscene compensation package. That sends a signal that management's first priority isn't the shareholders.

Finally, we tended to shun companies that have binged on acquisitions. Instead, we favored firms that have grown organically or, if they have made a large number of purchases, without accumulating too much debt. That last check also dinged several stocks, including financial services company A.J. Gallagher and industrial conglomerate SPX Corp.

One major change we decided to make in this year's FORTUNE 40 is in asset allocation. Because our screens showed better values among smaller U.S. stocks, we're increasing our domestic small-and mid-cap equity weighting to 40%, up from 37.5% last year. In turn, we're reducing our domestic large-cap weighting to 35%, from 37.5%. We are raising our exposure to international stocks slightly, from 10% to 15%. Because of the challenging environment for fixed income, we are reducing our bond allocation from 15% to 10%. And rather than spread that money across five standard funds, we decided to put our entire fixed-income allotment into one conservative offering that should stand up to rising rates.

Here's a closer look at some of our picks.

LARGE-CAP STOCKS

As in previous years, health-care shares dominate this year's list. Soaring health costs are causing a lot of handwringing at the dinner table and in Washington. But they're also translating into huge profits for companies. Given steady demand for their goods, health-care stocks also tend to do well when the Fed hikes interest rates. Unlike most biotech firms, which aim to develop therapies to treat major illnesses, Genzyme specializes in so-called orphan drugs, those that treat just a few thousand patients with rare diseases. It's a risky strategy. But because the company often has the only product available, it can charge a bundle--as much as $170,000 a year in the case of Cerezyme, the firm's drug for the treatment of Gaucher disease, a genetic disorder that affects about 6,000 people worldwide. The consensus among Wall Street analysts is that Genzyme will increase earnings nearly 20% over the next three to five years.

Energy shares have followed the price of oil skyward, thanks mainly to the surging global economy. The market should continue to place a premium on companies that can increase their output. Anadarko Petroleum has one of the best track records for finding oil and gas efficiently. The company has increased reserves by 22% over the past three years, an improvement due partly to new discoveries, partly to acquisitions. Though big merger-related charges hurt the bottom line, CEO Bob Allison got a thumbs-up from shareholders in June when he announced plans to sell several mature oil and natural-gas properties valued at $2.5 billion. The proceeds will be used to pay down debt and buy back stock.

Most financial shares, particularly those of lenders, get whacked when the Fed jacks up rates. Higher rates means more bills go unpaid, crimping profits. The lone exception during the past six tightening cycles has been multiline insurers. Part of the reason is that investors flee to quality, diversified names for protection. With $81 billion in sales, American International Group is as diversified as they come, offering an array of property-casualty, life insurance, and retirement-savings products in the U.S. and some 130 countries. A stricter compensation plan approved by shareholders earlier this year will help clamp down on lavish executive pay. (Last year, longtime CEO Maurice "Hank" Greenberg was paid $7.5 million in salary and bonus, and awarded 750,000 stock options worth up to $66 million if AIG stock rises at a 10% rate over their term.)

Critics howled when Hewlett-Packard head Carly Fiorina purchased Compaq for $19 billion in 2002. But the onetime English teacher deserves high marks for the successful integration. She slashed costs, juiced margins, and turned HP into a tech gorilla that's second only to IBM in sales. HP still makes the vast majority of its profits from the printer business. Plus, Fiorina needs to beef up services and will have to go to war with Dell now that it has entered the highly profitable printer-supplies business. But HP shares should get a boost as corporations increase spending on tech goods. The stock sells for less than one times sales, below its peer average.

Despite their glamour, media companies historically make for lousy investments. As we noted earlier this year, America's media giants rank among the biggest destroyers of shareholder value in U.S. industry, primarily because starry-eyed executives pay too much for acquisitions. But there's no denying that media stocks are among the biggest beneficiaries during economic recoveries, in large part because of increased ad spending. Time Warner (parent of FORTUNE's publisher) has its tentacles in virtually every segment of the media landscape--films, cable, magazines, and the Internet--giving it an annuity-like revenue stream from some 50 million subscribers. Some analysts question CEO Richard Parsons's decision to hang on to the ailing America Online unit. But AOL continues to be a cash cow, buying time for him to either keep fixing the business or unload it. Meanwhile Parsons has delivered on his promise to pay down debt.

SMALL-AND MID-CAP STOCKS

If you've grilled chicken lately, you've probably noticed that poultry prices are soaring. The price of wings, for instance, has risen more than 80% in the past year, to $1.11 a pound. Chalk it up to the rebounding economy, high-protein diets, and a tight supply. It's all good news for Sanderson Farms, the sixth-largest chicken producer in the U.S. The 57-year-old company turns out some 270 million chickens each year, and profits are projected to double in 2004, to $5.60 a share.

Watson Pharmaceuticals may be classified as a generic-drug maker, but you'd never guess that from its margins. Gross profit margins run around 50%, compared with 40% for rivals. Give credit to Allen Chao, who founded the company in 1984. Instead of going after commodity-type medicines where competition is fierce, he focused on generic versions of hard-to-copy drugs. Chao is also leading a big push into branded drugs, which now make up more than half the company's sales and most of its profits.

Emulex makes the goods that allow corporate servers and storage networks to communicate. With market share approaching 50%, it is the dominant provider of so-called host bus adapters, which it sells to tech giants including IBM, Hewlett-Packard, and EMC. It's an enormously profitable niche--gross margins run above 60%. Both small and large companies will increasingly need Emulex's goods, given the growing use of data-intensive applications such as e-commerce software and multimedia applications.

You've probably never heard of Ball Corp., but chances are you use its products all the time. Founded in 1880, Ball is one of the world's oldest and largest makers of metal food and beverage cans, selling its goods to the likes of Kraft Foods, Anheuser-Busch, and Pepsi. Glamorous? Hardly. But CEO David Hoover runs a highly productive outfit: Ball churns out more than 2,200 beverage cans each minute. Recent acquisitions have pushed its debt-to-capital ratio up to 66%, which is higher than we like. But Hoover has made retiring debt one of his top priorities in the years ahead and plans to pay off at least $200 million this year. What's more, Ball is precisely the kind of stock you want to own when rates are rising. People may put off buying a new home as interest rates go up. But they'll still buy beer.

INTERNATIONAL

AstraZeneca focuses on high-margin medicines for major illnesses such as cancer and heart disease. Unlike most of its peers, the British company develops the bulk of its drugs internally, allowing it to keep all the profits. Acid-reflux remedy Nexium is the biggest seller, raking in $3.3 billion a year. But the pipeline is well stocked with a number of potential new drugs, including thrombosis medication Exanta and diabetes therapy Galida.

Allianz is rebounding from its troubled 2001 acquisition of Dresdner Bank. The merger, which created Europe's largest one-stop shop for financial services, sent the stock tumbling, as the firm was forced to write off large investment and loan losses. But new CEO Michael Diekmann is aggressively cutting costs and reducing equity market exposure. His turnaround efforts are bearing fruit: Allianz returned to profitability last year.

FIXED INCOME

With the Federal Reserve about to embark on what many believe will be a series of interest rate hikes, bonds are about as attractive as a wool sweater on a hot summer day. That's because bond prices fall when interest rates rise. How much a bond or bond fund falls in a rising rate environment depends on its duration, which gauges the bond's (or fund's) sensitivity to interest rate fluctuations by taking into account both its maturity and the amount of its payment. A bond fund with a ten-year duration could expect, for example, to drop about 10% if interest rates rise by only one percentage point. A portfolio with a five-year duration would drop 5%.

For a low-risk way to earn a decent yield, you can't beat a stable-value fund. The beauty of these funds is that they offer a fixed share price like a money-market fund and the higher yield of an intermediate bond fund. Stable-value funds invest in a mix of investment-grade securities such as mortgage-backed securities, insurance products, and corporate bonds. Unlike bond funds, however, stable-value funds do not fluctuate in principal with changes in interest rates. That's because banks and insurers provide insurance contracts to the fund for a small fee to stabilize their net asset values and accumulated earnings.

In 1994, the last time the Fed really jacked up interest rates, the average stable-value fund held in a defined-contribution plan rose 6%, according to Hueler Cos. The average intermediate bond fund, by contrast, fell 4%, according to Morningstar.

Accounting rules dictate that stable-value funds can be offered only through tax-deferred accounts. Most 401(k) plans offer them, and that's a better place to own them than in an IRA. In defined-contribution plans, yields average 4.3%, while expense ratios run just 0.41%. Yields in retail funds, by comparison, average 2.9% and charge over 1%.

For our purposes, we'll use a retail mutual fund, PBHG IRA Capital Preservation. The fund is subadvised by a five-member team at Dwight Asset Management, which has been running stable-value portfolios for 30 years. (Because Dwight is completely separate from PBHG, it's not tied up in the fund scandal that hit PBHG.) The managers limit themselves to issues rated AAA, so there's very little credit risk, and they spread their assets across a variety of securities. The fund currently yields 3.2% and charges a 1% expense ratio. Since its August 1999 inception, it has returned 5.2% annually.

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