Five Good Stocks to Buy in 2011

Over the last two years, it's been difficult to tell if the stock market is really on the rise.  In 2011, it will be interesting to see if the bull market that started back in July is sustainable.  Consistent with the approach we took last year, we're going to demonstrate the techniques of value investing described elsewhere in this publication.  We'll use that process to identify five good stocks to buy in 2011.

Buying Stocks in a Volatile Market

The Dow Jones Industrial Average was up 11.0%, while the S&P 500 finished the year with a 12.8% gain.  As was the case back in 2009, the stock market had investors guessing for much of 2010.  Over the first four months of the year, we saw a steady increase in the S&P 500.  That rally was followed by a declining market, which seemed to bottom out in July 2010.  From that point forward, the market started to climb.

As the saying goes, past performance is not necessarily indicative of future results.  With the broader market measures up nearly 13% on the year, many investors may look at 2011 as the year the market broke the hold of the Great Recession.

Picking Stocks

As we did in previous years, we're first going to discuss the performance of the picks from last year:  Five Good Stocks to Buy in 2010.  Next, we'll briefly run through the process of finding stocks that represent a good value.  Finally, we'll provide a list of stocks for 2011, including the rationale for choosing each of the stocks picked.

2010 Stock Picks

In 2010, the S&P 500 Index was up nearly 13% for the year, while the Dow Jones Industrial Average was up 11%.  Overall, two out of the five stocks picked last year outperformed the S&P 500 and the Dow as demonstrated in the table below:

The average of the portfolio was a disappointing 4% return, which is 7% lower than the performance of the DJIA.  In April, Lockheed Martin lowered its earnings outlook for 2010.  In addition, the possibility of defense budget cuts weighed heavy on the stock throughout the year.  Exelon was the biggest loser for the year.   Inexpensive shale gas continued to lower the market price of producing electricity, and decreased the profitability outlook for Exelon's large fleet of nuclear generating plants.

Good Stocks to Buy

The process for selecting good stocks to buy is based on a systematic approach to researching and selecting stocks.  This five step approach, which is based on value investing, includes evaluating each stock for the following attributes:

Excellent Stocks

The first filter we apply when selecting stocks to buy is choosing excellent stocks.  We're going to eliminate from consideration companies that sell commodity-type products.  We want to find companies that can command a price premium in the marketplace because they have either strong brand recognition and / or loyal customers.  Unfortunately, this is something we ignored when picking stocks last year.

Intrinsic Value

We have a choice of investing money in relatively safe, risk-free securities such as government bonds.  If we're buying stock in a company, we want to be sure that we're being adequately compensated for the additional risk.  That means we want to invest in companies with high intrinsic value.

Return on Equity

A stock's return on equity is defined as the total return to shareholders divided by stockholder's equity.  In practice, it is calculated by taking a company's net income and dividing it by stockholder's equity.  Return on equity is arguably one of the most important measures of a company's profitability.  There should be a strong relationship between a stock's market price, its actual return in the past, and its expected profitability in the future.

Earnings per Share

Another very important measure of a company's financial strength is earnings per share.  This measure tells us how much money a company earned in a given time period, stated in terms of each share of common stock issued.  Industry analysts often project earnings per share into the future.  This projection is based on guidance they receive from the company they're analyzing.  The future earnings of a company are the key to deriving an estimate of a stock's future price.

Five Good Stocks to Buy

We're taking a more conservative approach to the stocks we're saying are good to buy in 2011.  The above stock screening resulted in roughly 70 candidate companies.  We identified the five good stocks to buy in 2011 by selecting defensive stocks, with widespread brand recognition.

Five Good Stocks to Buy in 2011

Rationale for Stock Picks

All of the above stocks satisfied the requirements of the process, and show strength in the following four areas:

• Excellent Stocks - These stocks have strong brand recognition, and none sell commodity-type products.
• Defensive Stocks - These companies sell products that are considered essential or non-luxury items, which should perform well even if the economy continues to struggle in 2011.
• Earnings Per Share - The consensus among market analysts is that these companies are all expected to demonstrate strong earnings per share growth over the next five years.
• Financial Stability - Finally, all of these companies demonstrate they have a strong balance sheet when looking at interest coverage and debt-to-equity ratios.

Stocks Picked in 2011

In case you're not familiar with some of the stocks picked in 2011, here is a brief description of the company and its business operations:

• The TJX Companies, Inc. - an off-price retailer of apparel and home furnishings.  The company operates T.J. Maxx, Marshalls and A.J. Wright chains in the United States, the Winners chain in Canada, and the T.K. Maxx chain in Europe.
• McDonald's Corporation - a food service retailer that franchises and operates McDonald's restaurants worldwide, offering food items, soft drinks, coffee, and other beverages.
• Johnson & Johnson - engages in the research, development, manufacture, and sale of health care products, pharmaceuticals, medical devices and diagnostic equipment.
• Kellogg Company - manufactures and markets ready-to-eat cereal and convenience foods.  Products include cookies, crackers, pastries, cereal bars, fruit snacks, frozen waffles, and vegetarian foods.
• 3M Company - operates as a diversified technology company in six segments of the market: Industrial and Transportation, Healthcare, Consumer and Office Supplies, Safety and Protection Services, Display and Graphics, and Communications.

Stock Pick Disclaimer

There are many ways to go about picking stocks, and we've mentioned several other methods in publications such as Dogs of the Dow and Dow Diamonds.  The purpose of this publication goes well beyond distributing a list of stocks to buy in 2011.  It serves as a demonstration of the thought process behind a sound stock-picking technique.

About the Author - Five Good Stocks to Buy in 2011

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