The 100 Best Stocks You Can Buy 2012 Part 2

Table 4: Stocks Added for 2012.

To give a bit of a "big picture" view of our changes, Table 5 gives our annual summary of what changed by sector. Note the shift away from Consumer Staples (we probably had too many) and toward Health Care. Part of the shift to Health Care reflects the changes we envision particularly in the application of health-care technology; also, we feel that many health-care stocks have been relatively undervalued due to uncertainty arising from Federal health-care initiatives. That said, it would be a good bet that we'd trim health-care next year as events sort the best from the rest.

Table 5: a.n.a.lysis of 2012 Best Stocks Change by Sector

Yield Signs.

In mid-2010, Standard and Poors (S&P) index expert Howard Silverblatt calculated that 136 of its S&P 500 companies had raised dividends by mid-2010 and only two had reduced or suspended dividends. That compares with 157 increases for all of 2009, feathered in with seventy-eight decreases or suspensions, fifty-seven of which came from the financial sector alone. Experts expect 2011 to be a banner year for dividends, although Silverblatt himself postulates that dividends won't recover to 2008 levels until 2013.

The fact that this is so at first glance sounds like a negative, but the chief reason appears to be restrictions placed by the Fed on dividends by financial inst.i.tutions (which are slowly going away). Aside from that restriction, most agree that dividend increases will be in the double-digit range, as companies hold some 16 percent of their market value in cash, as investors clamor for greater returns, and as companies become more sensitive to that clamoring. Indeed, as reported earlier, ninety-five of our 100 Best companies paid a dividend in 20102011, and fifty-nine of the eighty-six dividend-paying stocks on both the 2011 and 2012 lists increased their dividends during that period.

Indeed, Hewlett-Packard raised their dividend 50 percent and proclaimed "double-digit" increases for years to follow; Amgen paid dividends for the first time, and Iron Mountain raised its dividends from a pittance to something substantial, from 25 cents to 76 cents per year in one fell swoop. Not only did these companies catch our eyes, but also in general, as we examined stocks for this year's edition, we saw the same thing over and overregular dividend increases throughout the past ten years and longer. It's like getting a raise every year; we like that a lot. If you buy a stock today paying, say, our average yield of 2.2 percent, and management manages to eke out a 10 percent increase every year for ten yearswe'll do the math for youthat yield would expand to 5.7 percent if the stock price stayed exactly the same. Which it probably wouldn't; we'd expect the stock price to grow as well, reflecting the company's success. So you'd get both benefitsa 5.7 percent annual return on your original investment plus whatever return the stock generated through increases in share prices. Does that sound too good to be true? Hardly, in fact, the majority of our 100 Best Stocks picks, if you look back through history, would have produced just this same sort of scenario. So we naturally circled our wagons around these stocks and others like them as a means to generate the same sort of dividend ecstasy moving forward. We think every investor should enjoy not only a decent current return, but also nice raises moving forward.

This scenario, in fact, has moved up to be one of our favored retirement planning and retirement investing scenarios. While we do expect markets overall, and our selected stocks in particular, to appreciate over time as good businesses capture more markets, become more efficient, and get better in general, stock price growth has become less dependable than in the past. The decades-long record of 1011 percent annual growth, we think, will become more difficult to match. As a result, we think the more solid play is to invest for dividends, and particularly for dividend growthand hey, if the stock price happens to grow too, so much the better.

Appendix B shows dividend yields for all 100 Best Stocks for 2012. For this year, we added a column showing the dividend paid last year, so you could see the year-to-year change. Appendix C shows all 100 Best companies, sorted by percentage yield, with the highest yielders at the top of the list. Interestingly, thirty-one of our 100 Best picks pay a yield of 3 percent or higher.

Last year, we started to define "star" categoriesgroups of stocks, essentially the "best of the best" in five categories, we chose to highlightYield Stars, Safety and Stability Stars, Growth Stars, Recovery Stars, and "Moat" Stars. This year we keep the same categories, and kick it off as we did last year with Yield Stars.

Table 6 below shows the top twenty stocks on our 100 Best list by percentage yield as of mid-2011.

Table 6: Yield Stars.

REMEMBER, THERE ARE NO GUARANTEES.

While dividends and especially high yields are attractive, investors must remember that corporations are under no contractual or legal obligation to pay them! Interest payments on time deposits and bonds are much more clearly defined, and failure to pay can represent default. But with dividends, there is no such safety net. Companies can and do reduce or eliminate dividends in bad times, as most strikingly observed with BP in the wake of the Deepwater Horizon Gulf spill disaster. Dividend investors should therefore keep an eye out for changes in a company's business prospects and shouldn't put too many eggs in a single high-yielding basket. On the flip sideas investors become more conscious of returnsand as corporate management teams become more conscious of such investor consciousnesswe've seen a lot of companies trumpet their recent dividend increases rather loudly to their investors and the investing public. It's a nice sound that we hope to continue to hear.

Dancing with the Stars.

Readers have frequently asked us: "Out of your 100 Stocks, what are the best ones? What are your top ten picks?" Well, we don't actually rank our 100 Best Stocks as one through 100. Why? Because different stocks serve different interests, needs, and risk tolerances, among other things, in a stock portfolio. And we're sure that if we name a "number one," everyone will follow our lead into it and some dumb thing will happen like the Gulf oil spill or some other more subtle unforeseen change in business conditions. The art and science of stock picking simply do not lend themselves to choosing an overall number one. Smart investors should buy groups of stocks to build a portfolio much as a diner in an a la carte restaurant picks several dishes to make a meal rather than looking for the single best dish on the menu.

With that in mind, we do believe we can create some value and interest by identifying the top ten stocks by certain attributes typically of common interest to investors, especially value-oriented investors. So this year we once again offer top ten lists in four categories. We call them our "stars" list, bringing the idea forward from our "Yield Stars" list above. The four categories are Safety Stars, Growth Stars, Recovery Stars, and Moat Stars.

Safety Stars.

Safety stars are companies we think will hold up well in volatile and negative stock markets as well as recessionary economies. They have stable products and customer bases, and long traditions of being able to manage well in downturns. They are "sleep at night" stocks when the going gets tough. This list is unchanged from last year, although it wouldn't have been hard to pick a few more candidates, like Kellogg or Procter & Gamble, from the remainder of the 100 Best list.

Table 7: Safety Stars.

Growth Stars.

Looking at the other side of the coin, we picked ten stocks we feel are especially well positioned to grow, even in a negative economy and especially in a positive one. This year, because we moved Chipotle, NetApp, and Peet's to the 100 Best Aggressive Stocks You Can Buy list and book, we identified three new candidates: Apache, St. Jude Medical, and Teva Pharmaceuticals.

Table 8: Growth Stars.

Recovery Stars.

As we continue to emerge from the 20082010 recession (a.s.suming a normal course of economic recovery) we feel that certain companies will do especially well. The a.s.sessment is based both on top line revenues and their ability to cut costs during bad times. As good times return, these companies will be particularly well positioned to turn recovery into bottom line returns. Interestingly, you'll note that several stocks on this listAlexander & Baldwin, Caterpillar, and Deerealso made our "Winners" list for best performers in the 20102011 performance a.s.sessment (see Table 1).

This year we will stay on the same horses that gave us a nice ride last year: Table 9: Recovery Stars.

Moat Stars.

Finally, we get back to one of the basic tenets of value investing; the ability of a company to build a sustainable and una.s.sailable compet.i.tive advantage. Value investing aficionados call such an advantage a "moat," for it represents a barrier to entry for compet.i.tors, likely to preserve advantage for some time. The moat can come in the form of technology, the use of technology, a brand, enduring customer relationships, channel relationships, size or scale, or simply a really big head start into a business making it hard or even impossible for compet.i.tors to catch up. The appraisal of a "moat" is hardly an exact science; here we give our top ten picks based on the size and strength (width?) of the moat.

This year we dropped Boeing from the 100 Best list altogether because of continuing production problems, which to us signaled a less-than-ideal management climate, even though Boeing has one of the widest moats we can think of. We also dropped Patterson Dental from this list upon realization that there is more compet.i.tion out there than we originally perceived, all chasing what's become a more compet.i.tive dental market. We added Starbucks (yes, there's Peet's, Caribou Coffee, and dozens of other coffee players, but oh, what a brand) and Visa (who would leave home without one?) to the Moat Stars list.

Table 10: Moat Stars.

Tenets, Anyone? The Essentials of Successful Investing.

The 100 Best Stocks You Can Buy 2012 is designed to help you get started with picking stocks suitable for you. But rather than simply giving you fish (which may not be the freshest fish by the time they reach you), we feel it is also important to give you some investing groundwork to use in your own investing practice, as well as to help explain some of our guiding principles.

We do not intend to give a complete course on investing, or value investing, here. That probably wasn't the purpose you had in mind when you bought this book, and there isn't s.p.a.ce here for a complete discussion anyway. For a more complete treatment of the topic, refer to Peter's t.i.tle Value Investing for Dummies (second edition, Wiley, 2008).

At the risk of sounding "corporate," what makes sense here is to give a high-level overview of key investing "tenets" to keep top of mind and back of mind as you sift through the thousands of investment choices. By absorbing these principles, you'll gain a better understanding of the 100 Best Stocks list and take away ideas to help with your own investment choices outside the list.

Buy Like You're Buying a Business.

Already covered this one, but it's worth repeating: By buying shares of a corporation, you are really buying a share of a business. The more you can approach the decision as if you were buying the entire business yourself, the better.

Buy What You Know and Understand.

Two of the most widely followed investment "gurus" of our age, Peter Lynch and Warren Buffett, have stressed the idea of buying businesses you know about and understand. This idea naturally follows the entrepreneurial idea of buying stocks as if you were buying a business; if you didn't understand the business, would you be comfortable buying it?

Peter Lynch, former manager of the enormous Fidelity Magellan fund and author of the well-known 1989 bestseller One Up on Wall Street, gave us the original notion of buying what you know. He suggests that the best investment ideas are those you seeand can learn about and keep track ofin daily life, on the street, on the job, in the mall, in your home. A company like Starbucks makes sense to Lynch because you can readily see the value proposition and how it extends beyond coffee, and can follow customer response and business activity at least in part just by hanging around your own neighborhood edition. And we hardly need to bring up the subject of iPods, iPads, and their useand how they've turned Apple into the most valuable company in the world.

Buffett has famously stuck with businesses that are easy to understandpaint, carpet, electric utilitieswith his investments (although he deals with the fantastically complicated businesses of casualty insurance and re-insurance in his core Berkshire Hathaway business). He has famously shunned technology investments because he doesn't understand them, and more than likely, because their value and consumer preference shifts too fast for him to keep up.

Both approaches make sense, and especially in hindsight, would have kept us farther from trouble in the 20082009 crash. Many, many investors didn't understand financial firms as well as they should have; the preponderance of evidence suggests that those financial firms didn't even understand themselves!

Clearly, you won't understand everything about the businesses you invest inthere's a lot of complexity and detail even behind the cooking and serving of hamburgers at McDonalds! Further, a sizeable amount of good knowledge is confidential so you likely won't ever get your hands on it. So you need to go with what you know and realize that the devil is in the details. When you a.n.a.lyze a company, if you can say "the more you know the better," instead of "the more you know the more you don't know," you'll be better off.

Greater Trends Are Important.

Popular expressions abound about the idea of staying in touch with the big picture when you make any sort of decision. "Don't lose the forest in the trees," "keep an eye on the prize," and so forth. These phrases enjoy no finer hour than when tied in with the subject of investing.

We already covered the notion that technologies and consumer tastes change, and with them so do businessesat least the good ones. Add to this the idea of change brought on by demographic trends (the aging of the population, for instance) and changes in law and policy (toward "green," for instance) and you end up with a wide a.s.sortment of "forest" influences that can affect your stock picks.

Sector a.n.a.lysis is employed by many investors as a starting point. Where sector a.n.a.lysis does make sense is in capturing and correctly a.s.sessing the larger trends in that sector or industry. The sector thus becomes the arena in which to appraise those trends, often by reading sector a.n.a.lyses published in the media or in trade publications in that sector. One can, and should, learn about the construction industry or health care industry before investing in a company in that industry.

Once the sector trends are understood, a selection of a company, or companies, in that sector can make more sense. A good example is offered by PC makers Hewlett-Packard (a 100 Best Stocks choice) and Dell Computer (not a choice here, although, for different reasons, Dell appears on the 100 Best Aggressive Stocks list). Dell was the darling of the sector for years, achieving high margins and return on equity, market share growth, and popular marketplace preference for years. The direct sales model seemed unbeatable as a way to reduce costs and avoid obsolescence, and the just-in-time supply chain model, using accounts payable as a primary financing mechanism, all seemed strategically right.

But change was in the air for the PC industry. Lower prices, greater standardization, and the migration to laptops all pointed to HP's retail-centric model. No longer was it necessary, or even advantageous, for customers to order direct from Dell. With more standardized computing applications and inexpensive technology, there was less need to customize computers. With laptops, displays, size, and the look and feel are more important than simple "speeds and feeds" and people wanted to see what they were buying. Finally, as costs came down, a PC, laptop or otherwise, was simply something to pick up at a local store. We predict PCs will soon sell in Walgreens, and if you don't believe that, consider that VCRs and DVD players also followed that thought-to-be-impossible path.

So HP ended up in the right place with their emphasis on the retail channel (Dell struggles as a latecomer) and further, was strategically correct in their emphasis on printers and high margin consumables that go with them, and in their emphasis on international markets. Dell has fallen by the wayside on countshence their 80 percent price drop from 2000 and 70 percent drop from their 2005 price peaks, respectively.

The ground continues to shift under both companies, really, as HP now faces the threat of tablets and smartphones (will their Palm acquisition helps them keep up with these changes?) and Dell reinvents itself as an enterprise and corporate supplier. And of course, the looming "cloud" may turn out to be either an opportunity or a threat; it remains too soon to tell. The upshot is that you must understand a company's marketplace position today, and be able to project it forward a few years as well.

So again the lesson, or "tenet," is to understand the greater trends in the economy, in the market, in the sector, and in the industry. If you buy a business, you want to know about the industry, right? Who the compet.i.tors are and how they compete, what the market and customer needs and customer tastes are, and how companies do business in that market. Right? You want to understand the future of that industry and market, right? It's no different when you buy shares.

One more thing to add: Most of the time we try to buy what we think to be the best company in the sectorbest based on past, current, and expected future performance. But sometimes it makes sense, from an opportunity viewpoint, to "play the Avis game," that is, to buy a more nimble, more aggressive, less arrogant, or complacent number two compet.i.tor. Such a company is leaner, meaner, hungrier, and likely sells for a more reasonable price. Sometimes we'll buy both if we feel the industry or sector is large enough to support two strong compet.i.tors, and if there are large enough or strong enough niches available so they won't become cutthroat compet.i.tors.

For example, Peter owns Starbucks (a 100 Best stock) and Caribou Coffee, a much smaller compet.i.tor located largely in the upper Midwest. There are two reasons for this choice. One, he felt that the Caribou brand cachet would work well in Minnesota and similar places. Second, and more importantly, he liked Caribou's franchising model as a contrast to Starbucks' company owned model (which now may be starting to change with the announcement of franchising for their own subsidiary Seattle's Best). Caribou just might do well capturing business with ambitious franchisees doing the work and understanding local markets best.

Niche and Get Rich.

In understanding sectors, industries, and markets, it's important to consider success opportunities for niche players. A "niche" is a small captive market segment, usually too small for the biggest compet.i.tors to profitably consider, but still lucrative for a smaller, more nimble player. Niche players can define and play smaller markets based on product, location or geography, distribution channels, or other differentiators like language. Caribou is an example, capturing the franchising niche. Or McCormick & Co. (a 100 Best stock) capturing the spice niche in a larger food and beverage industry. Or Pall Corporation, another 100 Best stock, capturing the market for filtration systems in a variety of manufacturing industries.

For more on niche marketing, see Niche and Get RichPractical Ways to Turn Your Ideas Into a Business (Entrepreneur Press, 2003), a book Peter wrote with his former wife Jennifer back in 2003. It is aimed at small business, but (not by design) offers useful material for investing, too.

Stick to the Real Stuff.

If you're familiar with accounting or the accounting profession, contrary to public perception, accounting for business a.s.sets and activity is not always a precise science. In fact, there can be quite a bit of art involved in accounting, especially for business a.s.sets and business income.

Why? Because, while the purchase price for most "physical" a.s.sets is known, the value of those a.s.sets over time is a subjective calculation. And there are many a.s.sets, like intellectual property, that elude precise evaluation altogether. How much is a patent worth? How much is an acquired business worth? Just like a stock you buy, you know what you paid for it, but how much is it really worth in terms of future returns to the acquiring company? It's a subjective number.

Likewise, reported net income can be fairly subjective, too. How much depreciation expense was taken against a.s.sets, and thus against income? How much "expense" was taken to write down intangible a.s.sets like patents and other intellectual property? How much "restructuring" expense was incurred? The rules give the accountants and corporate management quite a bit of flexibility to "manage" reported earnings, and a.s.set values as well: What you see may not always be what you get.

The bottom line is this: While a.s.sets and income have at least some subjectivity in their valuation, debts are quite real, and so is cash. Debts must be paid sooner or later; there is no subjectivity or "art" to their valuation. Likewise, cash is cash, the stuff in the proverbial drawer, and is a take-it-or-leave-it, like-it-or-not fact of life or death for a business.

Thus, as value investors, we look at a.s.sets and income as important measures of business activity, but know that there's some subjectivity in those measures. At the same time, we look at debts, cash, and cash flow in and out of the business as absolute; neither cash nor debt lie. So we hang our valuation hats on cash and debt where we can.

Now, in particular, cash isn't an absolute measure of business success, either, for there are timing issues. Suppose you are running an airline, and decide this is the year to buy an airplane. A huge cash outflow, possibly matched by a cash inflow from borrowing. Are this year's cash flow statements fully representative of the firm's success or failure? No, because the airplane will be used over a number of years, and the cost of the airplane must be divvied up among those years and matched to airfares collected and other costs to truly understand performance. That's where conventional income accounting comes init helps to do that.

All that said, sharp value investors learn to look for companies that, over time, produce capital, in contrast to companies that consume it. As judged by the statement of cash flows, a company that produces more cash from operations than it consumes in investing activities (capital equipment purchases mainly) and in financing activities (repaying debt, dividends, etc.) is producing capital. When a company must always go to the capital markets to make up for a deficit in operating or investing cash flow, that's a sign of trouble, which is incidentally borne out by the other absolute measuredebt. If debt is high and increasing and especially if it is increasing faster than the business is growinglook out. Or at least, look for a story, like company XYZ is going through a known, understood, and rational expansion that needs to be funded. Going to the capital markets to fund operational cash deficits is an especially bad thing to do.

Thus, as an investor, you should always pay attention to a.s.sets and income, but even closer attention to cash and debt. This tenet was used in identifying the 100 Best Stocks.