Five Good Stocks to Buy in 2012

Over the last two years, it's been difficult to tell where the stock market is heading. Investors are hoping the momentum that started late last year will carry over into 2012. Consistent with the approach taken in the past, we'll use the techniques of value investing described elsewhere in this publication to identify five good stocks to buy in 2012.

Volatility of the Stock Market Continues

The Dow Jones Industrial Average was up 5.5%, while the S&P 500 finished nearly even on the year (up 0.04 points).  As was the case in 2010, the stock market was volatile for much of 2011.  Finishing the year at 1,257.64, the S&P 500 Index hit a high of 1,363.61 on April 29th and a low of 1,099.23 on October 3rd.

When the Dow hit a 2011 high of 12,810.54 on April 29th, surging past 13,000 seemed a certainty.  But the inability to deal with growing debt in America, followed by the downgrade of the U.S. credit rating, would push the DJIA down 2,000 points in five weeks.  The debt crisis in Europe would keep the stock market bouncing for the remainder of the year.

With all of the volatility the market has experienced over the last two years, consistently picking stocks that provide above-average returns has been a challenge.

Picking Stocks

As we've done before, we're going to start by discussing the performance of our stock picks from last year:  Five Good Stocks to Buy in 2011.  Next, we'll briefly run through the process of finding stocks that represent a good value.  Then we'll finish up with a list of stocks for 2012, including the rationale for choosing each of the stocks picked.

2011 Stock Picks

In 2011, the S&P 500 Index finished the year with a 0.0% gain, while the Dow Jones Industrial Average was up 5.5%.  Overall, three out of the five stocks picked last year outperformed both the S&P 500 and the Dow as demonstrated in the table below:

The average of the portfolio was 15.2%, which outpaced even the DJIA by nearly 10%.  The standouts included TJX Companies, an off-price retailer of apparel and home furnishings, along with the food retailer, McDonald's.  The worst performer, 3M Company, appears to have been a victim of the global economy and European debt crisis.  But the company remains financially strong and well-managed.  This positions 3M well for a comeback year in 2012.

Good Stocks to Buy

The process used for selecting good stocks to buy is based on a systematic approach to researching and selecting stocks.  This multi-step approach is based on value investing; something embraced by Benjamin Graham, an economist and premier investor.

Excellent Stocks

The first filter applied when selecting stocks to buy is choosing excellent stocks.  This eliminates 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.

Intrinsic Value

There is always a choice to invest money in relatively safe, risk-free securities such as government bonds.  When buying stock in a company, it's important to be adequately compensated for the additional risk.  That means investing 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

The above stock screening resulted in roughly 65 candidate companies.  The five good stocks to buy in 2012 were selected because of their strong financial performance and widespread brand recognition.

Five Good Stocks to Buy in 2012

Rationale for Stock Picks

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

• Excellent Stock:  These stocks have strong brand recognition, and none sell commodity-type products.
• 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 2012

In case you're not familiar with some of the stocks picked in 2012, here is a brief description of the company and its business operations:

• Union Pacific Corporation:  principal operating company is Union Pacific Railroad, which links 23 states in the western two-thirds of the United States of America. Union Pacific Railroad Company serves many United States population centers, and provides them with freight transportation.
• McDonald's Corporation:  a food service retailer that franchises and operates McDonald's restaurants worldwide, offering food items, soft drinks, coffee, and other beverages.
• Intuit Inc.:  a provider of business and financial solutions for businesses, consumers, accounting professionals and financial institutions. Products and services include QuickBooks, Quicken, and TurboTax.
• Mattel, Inc.:  designs, manufactures, and markets a variety of toy products. Brand examples include Barbie, Polly Pocket, Little Mommy, Disney Classics, Hot Wheels, Matchbox and Bitty Baby.
• Chevron Corporation:  manages its investments and provides administrative, financial, management and technology support to subsidiaries that engage in petroleum, chemical, and mining operations in addition to power generation, and energy services.

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 2012.  It serves as a demonstration of the thought process behind a sound stock-picking technique.

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