12 Magnificent Stocks for Rocky Markets

Editor's Note: This story has been updated since its original publication in the September issue of Kiplinger's Personal Finance magazine. Recent market volatility, caused mainly by fears over Europe's financial stability and a global slowdown, have drummed up public concern about a new recession. For such trying times, we continue to recommend investing in high-quality companies, such as the ones included in the story below, that have proven they can weather any economic storm.

Even in the worst of times, some stocks perform magnificently because their underlying businesses are terrific. By examining stocks that have thrived in the rocky markets of recent years, we may be able to draw broader conclusions about how to find big winners.

Using Morningstar’s online screener, I first looked for U.S.-listed companies with a market capitalization (that is, total shares times current price) of at least $1 billion that had produced annualized returns over the past five years of at least 40%. At that rate, a $10,000 investment would become $53,782.

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To be sure the gain wasn’t an utter fluke, I specified companies that increased their revenues an average of 10% annually over the past three years, had a return on equity (a measure of profitability) of at least 10%, had beaten Standard & Poor’s 500-stock index over the past 12 months, and, according to Morningstar’s analysts, were expected to increase their earnings by at least 15% annually for the next five years.

From a cast of thousands, only 12 stocks qualified when I ran my screen in late June.

Technology companies and those that relied heavily on technology dominated the list:

1) Amazon.com (symbol AMZN), the world’s largest online retailer;

2) Apple (AAPL), computers and phones;

3) Baidu (BIDU), a Beijing-based provider of Internet search services in Chinese and Japanese;

4) Netflix (NFLX), home video; and

5) Priceline.com (PCLN), online travel.

Three were in health care niches:

6) Perrigo (PRGO), generic and nonprescription drugs;

7) HMS Holdings (HMSY), cost-management services for government health programs, such as Medicaid; and

8) SXC Health Solutions (SXCI), pharmacy benefit management.

Two were retailers:

9) Deckers Outdoor (DECK), specializing in footwear, and

10) Fossil (FOSL), watches.

The final two were:

11) Green Mountain Coffee Roasters (GMCR) and

12) MasterCard (MA).

So what are the common themes among the stocks?

Nearly all of the companies are fairly new -- not brand-new but typically only a few decades old. Netflix started in 1997, Amazon in 1994, SXC in 1993, and so on (MasterCard was started in 1966 but went public only in 2006).

They reinvest their profits or hold on to them for future acquisitions, rather than hand cash back to shareholders. Only two pay a dividend, and in both cases the payouts are paltry: Perrigo yields 0.3% and MasterCard yields 0.2%.

Most depend on technology for their success. Even Fossil sells one-fourth of its watches online.

Most have excellent balance sheets. For example, Deckers, with a market capitalization of $3.7 billion, has $438 million in cash and no debt. Apple and Amazon are also debtless, with cash and short-term investments of $29 billion and $7 billion, respectively (Apple also has $36.5 billion in “long-term marketable securities”; for more on Apple’s fortress-like balance sheet and the case for its stock, see SLIDE SHOW: 6 Cash-Rich Stocks to Buy Now).

A few are household names, but most don’t spring to mind as hot stocks. Not one is among the exalted 30 in the Dow Jones industrial average.

However, the most powerful common characteristic of these firms is that they have become hugely profitable as a result of breakthrough ideas. Those ideas range from Apple’s iPod and Deckers’ UGG boots to Perrigo’s generic version of heartburn medicine Prilosec and Netflix’s brilliant concept for renting DVDs by mail (and now delivering them through the Internet). In nearly every case, an investor could have understood the concept, witnessed its early popularity and noted the lack of competition.

You Gotta Believe

To make big profits, though, you had to be a true believer -- because many of these companies were, at one point or another, given up for dead. Priceline fell so sharply that in 2003 it was forced into a reverse split to keep its shares above $1. As of August 18, the stock trades at $459, up by a factor of about 66 from its low in 2003.

From December 1999 through September 2001, Amazon shares fell from $113 to $6. They rose but then fell again by nearly two-thirds from October 2007 through November 2008, before climbing to their current price of $183.

Apple was practically a nonentity during the early part of the last decade, until founder Steve Jobs resuscitated it with bold new ways to repackage what were essentially just hard drives. Apple’s stock, just $7 (adjusted for a split) in 2003, is now at $366 -- a 52-bagger.

Because I became passionate about the concept of renting films without having to visit a dreary video store and worry about overdue movies, I urged readers in 2003 (when I was writing a column for the Washington Post) to “take a flier” on Netflix. That was just a year after Netflix’s initial public offering at $7.50 a share. The stock reached $39.80 the next year but didn’t see that level again until 2008. Then it fell by half. But it started climbing again and is now at $217.

The moral of the story: If you believe in a business, buy the stock and don’t waver. As I wrote in my article on Netflix: “Invest in an idea that strikes you as altogether wonderful. In other words, feel free . . . to fall in love with a stock.” Winning investors stuck with Amazon, Apple, Deckers and Netflix, no matter how tempestuous the love affair.

Few stocks go straight up. Pain is practically mandatory. Even Baidu, the Chinese equivalent of Google, fell by three-fourths during the bear market (since then, it’s been a 12-bagger). HMS has had an impressively steady climb since 2001, but the shares slid consistently in the late 1990s, and the stock took a decade to return to its 1997 high. Green Mountain Coffee languished for more than a decade after its 1993 IPO, then made a brilliant acquisition -- Keurig single-cup brewing systems -- in 2006. Over the past five years, Green Mountain’s earnings have grown at an astounding rate of 38% a year, and the stock has appreciated by a factor of 31.

Bad Market; Good Bargains

Although great companies generally don’t suffer the business adversities of average companies, they often suffer the same market adversities -- which is good news for investors looking for bargains. Consider Perrigo. The drug maker has increased its revenues every year since 2003 -- straight through the recession. Perrigo’s earnings have risen each year since 2005. The stock, however, was clobbered during the bear market, falling 57% from its 2008 high to its 2009 low.

Or look at Apple. Earnings per share rose from $3.93 in the fiscal year that ended in September 2007 to $5.36 in the 2008 fiscal year to $6.29 in 2009. Recession? What recession? Apple’s revenues rose by one-third in 2008 and by 12% in the year that ended in September 2009. Yet Apple’s stock fell 61% from its December 2007 peak until its January 2009 bottom. The point is that investors do not make fine distinctions in a panic. They hammer all stocks, good and bad.

Start buying now. And if you believe in a business, buy more when it’s getting pelted along with everything else (see YOUR MIND, YOUR MONEY: Control Your Fear and Profit from Crisis).

In fact, a good rule for buying stocks that rest on a powerful idea is not to worry too much about price. The current valuations for the 12 high performers are all over the lot. Apple trades at just 13 times estimated earnings for calendar 2011. But Green Mountain is at 53 times estimates, and Amazon trades at a whopping 91 times expected earnings. If profits continue to rise briskly, the current price-earnings ratio won’t mean much. You’re looking for a company that will earn $76 million today and could make $14 billion eight years later (that’s Apple’s true story). Buy these stocks because of your enthusiasm over a great idea rather than green-eyeshade analysis.

In my view, the case for buying each of the 12 stocks remains strong. Be prepared to sell if the competitive value of the innovative idea starts to fade -- if, for instance, Google starts to cut significantly into Baidu’s market share, or if Apple’s unique style and tech leadership lose ground to Microsoft or some firm that hasn’t even been created yet. Magnificence doesn’t last forever, but it can prevail for a long, long time.

James K. Glassman, executive director of the George W. Bush Institute in Dallas, is author of Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence (Crown Business). He owns none of the stocks mentioned.