Stocks on My Short List

published 31 January 2008

You can't stop reversion to the mean. Starting in 2003, my picks of the ten best stocks for the year ahead beat Standard & Poor's 500-stock index by a wide margin -- an average of 18 percentage points each year. Alas, in 2007, the law of averages caught up with my track record, and I trailed the S&P 500 by about four points. Undeterred, I'm back.

Four caveats

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Although I usually object to any stock-investment strategy with such a short time horizon, these companies are chosen for their likely performance over the next 12 months.
While the companies vary by sector and size, they are not supposed to represent a diversified portfolio.
Beware of volatility -- I am not aiming here for safety. The 2007 list produced two stocks that gained more than 50% each and one that lost a whopping 69%.
I don't guarantee success. Follow up this advice with your own research before taking the plunge.

The Prudent Speculator is one of my favorite newsletters. John Buckingham, who took over when Al Frank died in 2002, has carried on the tradition of searching for undervalued stocks with good balance sheets. Buckingham likes Air France-KLM (symbol AKH), whose management has been boosting profits by applying operating efficiencies to formerly state-run airlines. "A little-known fact," writes Buckingham, is that "Air France has a 30% share of the Asian market and plans to expand capacity in the region 8% a year for the next three years." It's an inexpensive way to make a bet on a rising Europe and on developing markets.

Jay Weinstein, of Oak Forest Investment Management, in Bethesda, Md., has picked the best-performing stocks on my list in recent years. In 2005, his choice of Atrion, a medical-products company that specializes in intravenous fluid-delivery systems, returned 57%. In 2007, he chose Atrion again, and it returned 49% to December 10. In 2006, his pick, Astronics, returned 59%. For 2008, he's once more going with Atrion (ATRI), which he says is "still the best value for the dollar" and "a strong buy." The company is debt-free, and its price, says Weinstein, is about 15 times estimated earnings for the year ahead. Keep in mind that Weinstein's firm owns a lot of the stock, that the stock is up by a factor of about ten for the millennium, and that, with a market capitalization of just $220 million, it's highly volatile.

One way to take advantage of the stock-picking prowess of Warren Buffett is to buy shares of his company, Berkshire Hathaway, which have risen by about one-third in the past 12 months. Another is by buying what Berkshire is buying. Last year, that included a new purchase, CarMax (KMX), which sells used cars in 86 superstores. At last report, Berkshire owned about 6% of CarMax, an investment of just $300 million. I wouldn't be surprised if Buffett eventually wanted the whole thing.

Value Line Investment Survey has for years featured a portfolio of 20 stocks "primarily suitable for aggressive investors." I recently applied my own screen to the group and found that only one of the stocks had a top (1) rating for both timeliness and safety as well as a top (A++) rating for financial strength. The winner: Coca-Cola (KO), which also boasts a 2.2% dividend yield and a beta of just 0.75, indicating that the shares are about one-fourth less volatile than the market as a whole. The bad news is that Coke shares are up 66% in the past two years. The good news is that their average price is still well below the high achieved in 1998, even though the company has significantly improved.

Fidelity Contrafund may be closed to new investors, but you can still benefit from the stock picking of its stellar manager, Will Danoff. Just check out his portfolio. His top holdings are Apple and Google, both a bit pricey, but you'll also find Merck (MRK), which ranks 13th out of about 400 stocks, with Danoff adding shares during the most recent reporting period. With a decent Vioxx settlement, Merck has bounced back to the levels it reached before the controversy over the drug began. But the stock is still far below the high it hit in 2000. Not counting legal costs, Merck trades at a price-earnings ratio of 18, based on projected 2008 earnings. If history is a guide, that's a fine deal.

The list's top stock last year was nTelos, up 55%. It was the choice of Ric Prentiss, a telecom analyst at Raymond James & Associates, whose record is impressive. For 2008, Prentiss rates wireless carrier MetroPCS (PCS) a "strong buy." He writes that "the company still has tremendous growth in front of it as it gains traction in the recently launched Los Angeles market and rolls out coverage in major markets like New York and Boston." The firm, with 3.6 million subscribers, focuses on affordable, flat-rate monthly service and benefits from the rise in wireless broadband. The stock fell by half between July and December, and Prentiss likes the price. (See A Great Stock Picks List for more Raymond James recommendations.)

Little-known Villere Balanced, managed by a firm that has been running old money in New Orleans for decades, is among the best mutual funds in the U.S. The fund, with just $63 million in assets, currently holds 70% stocks and 30% bonds and cash. Manager Sandy Villere is a cautious man, but his portfolio includes smaller companies with a high-tech bent. One of the most intriguing is NIC (EGOV), which provides online services for the government, such as building state motor vehicle department Web sites that let citizens renew licenses online. It's a growth business, with earnings and revenues rising briskly. The company, based in Olathe, Kan., has no debt and a bunch of cash.

James Grant, who publishes the tough-minded and witty newsletter Grant's Interest Rate Observer, is a well-known bear, so when he recommends a stock, I pay close attention. He was lately singing the praises of companies in the growth market of cosmetic procedures, or "aesthetic medicine." He especially likes Israeli manufacturer Syneron Medical Ltd. (ELOS), which uses a technology that treats wrinkles, varicose veins, cellulite, unwanted hair growth and, maybe soon, fat. Syneron is a risky stock, but, as Grant wrote late in 2007, "much is forgiven at 12.5 times earnings, the current multiple."

Deep-water driller Transocean (RIG) is a great way to play rising energy prices. The company provides rigs and other services to oil and gas companies. The stock is one of just 31 on the Buy List of Dow Theory Forecasts newsletter, which was the source of my 2007 energy pick (ConocoPhillips, up 22%). Transocean has the highest possible rating (100) using Dow Theory's Quadrix system. Sure, the stock was up smartly in 2007, but its P/E, based on 2008 earnings estimates, is only 10 and its PEG ratio (P/E divided by expected earnings growth) is just 0.5 (anything under 1 is typically seen as a bargain). But if you think energy prices will fall in 2008,stay away.

Permit me, for the first time ever, to make my own stock selection: Walgreen (WAG), which in fiscal 2007 notched its 33rd consecutive year of record earnings and sales. Still, Walgreen took a dive in early October after a poor fourth quarter, hurt by lower reimbursements for some big generic drugs and by rising expenses. This is one of the best-run retailers in the world, with a superb balance sheet, and my expectation is that Walgreen will straighten out its problems. Clearly, management is not spooked by the relatively poor quarter. Walgreen is committing $2 billion to capital spending in 2008, opening 550 stores. It's rare that you can buy a company like Walgreen at a forward P/E of 15. That's an earnings yield of 6.7% at a time when the yield on five-year Treasury notes is 3.5%.

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James K. Glassman is a visiting fellow at the American Enterprise Institute. His most recent book is Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence.