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Farr: Top Ten Stocks for 2011

Every year for the last five years, Farr, Miller & Washington publishes our ten favorite names for the upcoming year. I own the list personally. I will sell the previous year’s portfolio on December 31st and buy the new year’s list.

Names can remain on the list for more than a year, and therefore will be rebalanced to a one-tenth weighting. There is no trading during the year. In the event that a company on the list is taken over, the cash proceeds or exchanged shares (if a stock purchase) will remain in the account for the balance of the year.

Last year’s list was defensive, and performance trailed the S&P 500. This list does not represent any offer to buy or sell securities nor does it represent any recommendation to buy or sell any of the names mentioned.

Exxon Mobil

ExxonMobil lagged for much of 2010, but the stock has begun to perform better relative to peers and the S&P 500 in the past two months. This company, like many larger, well-capitalized companies, has been largely ignored this year despite posting positive production growth the past two quarters.

XOM is well diversified between oil and natural gas. Both oil and natural gas demand will improve if the global economy continues its recovery. Longer-term, we believe that there will be upward pressure on oil and gas prices given outsized growth in emerging economies such as India and China. The company has long been known for its capital discipline and thus has generated one of the most stable track records in the energy space.

Moreover, it is one of the last companies on the planet to enjoy a AAA-rated balance sheet. The stock trades at a discount to the market (12.3x 2010 est. EPS and 11.2x 2011 est. EPS) and offers investors a 2.4 percent dividend yield. We find the current risk/reward attractive for long-term investors.

Cisco Systems

Cisco disappointed investors in the most recent quarter and has fallen 17.5 percent thus far in 2010 compared to a better than 10 percent increase in the S&P 500. The stock trades at 12.2x CY 2010 est. EPS and 11.5x CY 2011 est. EPS. If the $5.17 net cash per share is subtracted, it trades at just 9x 2010 and 8.5x 2011 consensus estimates.

The company is expected to initiate a dividend in 2011, and it has exposure to internet infrastructure and many emerging technology areas such as cloud computing. It has dominant share in almost every area of networking equipment needed to support cloud computing and bandwidth growth.

Just about half of all sales are generated internationally, and the stock should grow with an improving economy. Finally, we believe the stock is somewhat defensive if the market declines given the strong balance sheet and cheap valuation.

Johnson & Johnson

JNJ is a premier global healthcare company. Sales are diversified by product line (Pharmaceuticals, Medical Devices and Diagnostics, and Consumer Health) and by geography (about half of sales from International markets). The company’s balance sheet is one of the best in the world. JNJ has been receiving negative press due to several product recalls at its Consumer division. These recalls, including Tylenol, Motrin, Benadryl, and Rolaids, are troubling. However, JNJ has a solid record of handling recalls, and the financial impact should be manageable.

Meanwhile, the company’s Pharmaceutical division should be poised for growth now that several large patent expirations are behind it. The Medical Device and Diagnostics business should continue to gain traction as the economy improves and patient volumes begin to increase again. The current valuation (12.5x 2011 est. EPS; 3.5 percent dividend yield) appears very reasonable for long-term investors.

Monsanto

Monsanto is the global leader in the production of genetically modified seeds. The company has struggled mightily in recent years due to the collapse of its Round-Up fertilizer business and the delay of several next-generation seed products. These issues have caused the company to reduce earnings guidance multiple times, causing the stock to fall from $140 in 2008 to the current level. We believe that earnings expectations have now become more reasonable (e.g. 15 percent growth off of the current lower base) and that the stock offers long-term investors an attractive way to get exposure to gradually rising agricultural prices.

Though Monsanto is undoubtedly cyclical in nature, it has many characteristics of a biotech company. The use of genetically modified seeds is controversial in many parts of the world, but these seeds should continue to help the world produce more food without using more water and land. This issue is not going away any time soon and Monsanto is well-positioned to benefit. We find the current valuation (~23x 2011 est. EPS) attractive for long-term investors looking for high quality exposure to agricultural commodities.

CVS

CVS is now part drug store and part Pharmacy Benefit Manager (PBM). Same-store sales growth has been gradually improving at the company’s drug stores. Generic drug sales should continue to fuel growth of the drug stores and the PBM given numerous large patent expirations in 2011-2013.

The PBM business has struggled recently but appears to be showing signs of turning around. Therefore, the company appears to offer long-term investors excellent value at current levels.

The stock trades at roughly 11.8x 2011 est. EPS despite the fact that publicly traded PBMs trade at 15x-17x. We believe that long-term growth of 10 percent is a reasonable expectation for CVS and that shareholders will be rewarded with above-average returns if this turns out to be the case.

Microsoft

Despite putting up solid results in recent quarters, the stock has underperformed the overall market in 2010. MSFT is no longer the dynamic growth company that it was in the 1990s. However, the company’s business continues to be a veritable monopoly. Growth is likely to come from new products and a corporate PC upgrade cycle.

The company has over $40 billion in cash on its balance sheet. The stock appears to be discounting no growth into perpetuity at the current valuation level (10.9x CY 2011 est. EPS; 2.3 percent dividend yield).

We find these growth prospects to be too pessimistic and believe that these shares offer investors a nice combination of downside protection and upside potential if the economy continues to improve.

Staples

Staples' stock has underperformed the retail rally as company sales remain weak due to the tepid recovery in employment. But while sales could remain weak for a while longer as we wait for employment to gain traction, the company has implemented a number of internal initiatives that should provide strong earnings growth in 2011 and beyond.

Most notably, the company continues to integrate its Corporate Express acquisition, which dramatically increased the size of the company in 2007. Ongoing revenue and expense synergies related to the merger should continue to positively affect margins over the next couple of years.

Secondly, the company continues to grow its higher-margin services businesses, which include EasyTech and Copy & Print centers. And finally, reduced interest expense and share buybacks (resulting from strong cash flow) should help EPS growth into the future. As for its financial health, the company has a great balance sheet with outstanding free cash flow. At 14.5x the midpoint of company guidance for next year, the stock appears attractive.

JP Morgan

We are not overly optimistic about the outlook for banks over the next couple of years. We believe that as more data points surface, the evidence will become clear that banks are having a hard time growing their revenues. However, some exposure to bank stocks may be justified given the seemingly attractive valuations.

Our preference would be to stick with the large, money center banks that offer a number of attributes that the smaller regionals do not. Larger banks, in general, are more diversified, have better pricing power, more opportunities to cut costs and cross-sell, and the ability to reallocate capital to higher ROE businesses. Moreover, the large money center banks with capital markets businesses stand to benefit from an increase in M&A activity and equity underwriting, which may already be underway.

And finally and perhaps most importantly, we believe the government's actions have reinforced the notion of "too big to fail", providing investors a modicum of insurance that they won't lose all their money. Having said all that, JP Morgan deserves a spot in the top ten for 2011.

CEO and industry guru Jamie Dimon showed his prowess throughout the financial crisis, avoiding many of the pitfalls that befell countless other banks.

Lowe's

An unlikely choice for an investment manager that is worried about further home price declines, LOW's has a number of attributes that could nevertheless lead to solid stock performance in the year to come. First, the company is generating huge amounts of free cash flow now that it has dramatically slowed store growth in response to slowing demand. The balance sheet is in great and only a small portion of the company's debt needs to be refinanced in the foreseeable future.

Also, residential investment as a percentage of GDP was the lowest it has been in over 60 years in 2009, providing strong upside when demand eventually returns. Perhaps most importantly, though, is that LOW operates in a very attractive industry which is dominated by two companies (LOW and Home Depot). These companies consistently take market share from the small "mom-and-pop" stores, pricing is generally rational, and the industry is relatively insulated from competition from the large discount retailers. We believe all these attributes will offset the continued overhang of lower home prices in 2011. At 15.5x 2011 est. EPS, we find value in the shares.

Medtronic

Medtronic is a leader in a diverse group of attractive industry segments, including cardiac rhythm management, vascular, cardiac surgery, spinal, gastrointestinal, urology, diabetes, neurological, and ear, nose and throat. Foreign sales currently account for roughly 40 percent of total company sales.

The stock performed poorly in 2010 due to concerns that the weakening economy and the recently passed healthcare law will continue to weigh on results. Both of these concerns are valid. The new health care law will likely lead to increased pricing pressure throughout the healthcare supply chain. An excise tax on device sales will also pressure margins. High levels of unemployment could continue to pressure procedure volume.

However, we believe that these concerns have provided long-term focused investors with a unique opportunity. Despite all of these issues, MDT is expected to grow its earnings by about 5 percent in its current fiscal year. Longer term, we believe that MDT is capable of getting back to growing its earnings at 10 percent per year. The company’s new product pipeline appears solid, its financial strength remains excellent, it has a great global footprint, and its business remains less economically sensitive than the average company.

We find the shares of MDT attractive at 10.4x 2011 est. EPS, a valuation level that appears to be discounting no growth into perpetuity.

Good bye, 2010 and thank you to all of our wonderful clients and supporters for another wonderful year. Thank you to all of our weekly subscribers and CNBC viewers; your kindness and many emails throughout the year meant a great deal. I wish you and your families great health, much happiness, and fabulous prosperity in 2011! Happy New Year!

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.