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Farr: My Top Ten Stocks for 2012

A last minute thank you and gift for friends. On this last trading day of 2011, I’d like to thank all of you for reading and responding to my many posts. You make what we do worthwhile. Thank you.

For many years, I have selected and invested (personally) in ten of the stocks we follow and hold them for the full year. I thought you might like to see this year’s names. Last year’s list lagged the S&P, so there are NEVER any guarantees. Investment success depends a lot on discipline, so I will continue to be diligent.

Please keep in mind that results have been good in some years and not as good in others. I will sell my 2011 names and buy the following list this afternoon. These are not recommendations to buy or sell securities. There is always a risk of losing principal. Past performance is no indication of future results. If you are interested in any of these names, please call us or your financial advisor to discuss. All prices are as of 12/29/11 closing.

Danaher (DHR - $47.48)

Danaher is a globally diversified manufacturer of professional, medical, industrial and commercial products and services. While the company is heavily dependent on acquisitions for its growth, management has a clearly-defined and proven process for the identification and integration of acquisition targets. The combination of solid organic sales growth, acquisitions, and margin expansion has enabled the company to post an annual growth rate of 17% in earnings-per-share over the past 10 years. Looking forward, our analysis of Danaher’s end markets suggests that the company should be less sensitive to a slowdown in domestic consumer spending in the future. In addition, we expect earnings growth to benefit from the recent acquisition of Beckman Coulter – the largest acquisition in the company’s history. The combination of a highly visible and defensive earnings stream and a reasonable valuation of 14.5x the consensus estimate for 2012 make Danaher attractive for 2012.

Wal-Mart (WMT - $59.99)

Shares of Wal-Mart are still trading at roughly the same level that they were ten years ago despite the company growing earnings-per-share at an annual rate of nearly 12% over that time. At current levels, the stock trades in line with the market multiple of slightly over 12x the consensus estimate for 2012. We believe the company is an above-average company and should trade at an above-average multiple. The company should continue to benefit from the US consumer's new-found frugality, which is a function of high unemployment, stagnant wages, income disparity, tight consumer credit and inadequate retirement savings. As investors begin to more fully appreciate the magnitude of our current economic challenges, we believe WMT's recent outperformance will continue. Furthermore, we believe the stock is relatively defensive. And finally, we are also attracted to the fact that about a quarter of company revenues comes from outside the US.

Goldman Sachs (GS - $91.01)

The trials and tribulations of Goldman Sachs have been well documented since the beginning of the financial crisis. And while we are not without our concerns, especially with regard to the company’s heavy dependence on proprietary trading, we also believe that the current valuation is far too compelling given the company’s status as best-in-breed investment bank. As such, we believe GS will be able to generate return on equity in the low- to mid-teens over a cycle – well below historical returns of 20%+, but still attractive. Given this level of profitability, we believe the shares are trading at an unreasonably low 77% of tangible book value. Moreover, the company has a very dynamic and flexible business model, extremely strong capital and liquidity levels, and a network of alumni that spans the political spectrum. Given these attributes, we are comfortable including GS in our top 10 for 2012.

Johnson & Johnson (JNJ - $65.88)

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). We believe the company’s balance sheet is one of the best in the world. The Consumer division appears to be getting a handle on the product recalls that threatened to tarnish the firm’s reputation in 2010. JNJ’s Pharmaceutical division should be poised to grow now that several major 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 (12.6x 2012 estimated EPS; 3.5% dividend yield) appears very reasonable for long-term investors, especially in light of the economic uncertainties currently facing the global economy.

Medtronic (MDT - $38.34)

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 45% of total company sales. Medtronicis no longer growing EPS at the 20% pace that led investors to award it a sky-high PE ratio a decade ago. Medical device companies face a myriad of challenges, including increased pricing pressure, regulatory changes, and the weak U.S. economy. Medtronic’s new CEO, former GE Healthcare executive Omar Ishrak, appears to understand these issues and has set what appears to be a very sensible course for the company. It has been our experience that the realization by management that high earnings growth is no longer consistently attainable often leads to a better run company and higher returns for shareholders over the long-run. 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 believe that Medtronic can continue to grow earnings faster than the average company, and in a more stable fashion, than the average U.S. Company. We find the shares of MDT attractive at 10x 2012 estimated EPS with a 2.5% dividend yield, a valuation level that appears to be discounting no growth into perpetuity.

MORE PICKS FOR 2012

Microsoft (MSFT - $26.02)

Despite putting up solid results in recent quarters, the stock has slightly underperformed the overall market in 2011. Microsoft continues to grow earnings and the earnings multiple the market assigns the stock continues to shrink. The stock is discounting an unrealistically negative scenario. That said, as a growth manager, we view the upcoming year is a make or break year for this stock. A new upgrade cycle should start with the release of Windows 8 in the fall of 2012. This version is designed to run on traditional PC’s, tablets, and phones. There is demand from corporate customers for a tablet that runs productivity software (think MS Office) and if Microsoft can deliver a winning product, we just might have a catalyst to cause the market to award the stock something closer to a market multiple. The company holds over $5 per share of cash (net of debt) on the balance sheet. The stock is discounting zero or negative growth in perpetuity (9x CY 2012 est. EPS; 3% 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 Windows 8 reviews well, especially on tablets.

NetApp (NTAP - $36.31)

NetApp is a leading provider of computer storage and data management solutions. Demand for storage capacity is being driven by the 60% plus annual growth in digital content. Another driver of demand is the centralization of computing power in data centers (“cloud” computing) where networked storage devices are required to reap the cost and efficiency benefits of server virtualization. NetApp has an impressive record of growth and has consistently gained market share. Over 70% of the Company’s revenues are derived from the fastest growing storage segment where the company has increased its market share from 12% to nearly 20% over the past three years. The company has a solid balance sheet with about $9 per share of net cash. The stock trades at 13.8x calendar year 2012 earnings estimates. The company had some missteps in 2011 on a combination of product transition, deal slippage, and macro weakness. The disruption to hard drive production from flooding in Thailand will be temporary and while that will hurt margins a bit these next few quarters, margins should return to more normal levels as we move through 2012. We believe the company can sustain share gains and drive long-term growth of 10-15% making this an opportunity to acquire a growth company at a reasonable price.

Rockwell Collins (COL - $55.35)

Rockwell Collins designs, produces and supports communications and aviation electronics for commercial and military customers worldwide. Historically, the company’s sales have been split equally between products and services sold to government entities and those sold to commercial customers. Financial performance at the company held up relatively well throughout the commercial aerospace downturn due to outstanding results at the company’s Government Systems division. Now, however, the opposite is the case as the defense budget is in the crosshairs for cuts. Nevertheless, we prefer the balance to a pure-play commercial or government contractor. COL’s end-market diversification has enabled the company to profitably withstand many different cycles and post 13% annual growth in EPS over the past 10 years. At 11.8x the consensus estimate for 2012, an outstanding balance sheet and cash flow, and a 1.7% dividend yield, we find the shares attractive.

Schlumberger (SLB - $67.41)

Schlumberger is the world’s premier oil service company providing the broadest range of services to companies in the oil and gas exploration and production business. We believe the company is ideally positioned to benefit from higher energy prices and increasing service intensity in the exploration and production of oil and gas.This companyhas less exposure than peers to the more volatile North American market, where pressure pumping appears to be near peak margins, and more exposure to international markets which tend to have longer and steadier cycles. We believe a new international up-cycle is emerging and spending on services is expected to increase double digits in 2012 driven by offshore, especially deepwater, activity. The stock has pulled back during the recent economic uncertainty as investors fear slower global growth will bring oil prices down to levels that will affect exploration and production budgets. At 14x the consensus estimate for 2012 earnings per share, we believe the stock is attractively valued given its growth prospects.

Staples (SPLS - $13.93)

Staples stock was a disappointment in 2011 as job growth remained weak and investors increasingly questioned the sustainability of the office supply “superstore” business model. While we agree that consolidation is needed in this sector, we believe that Staples is by far the best managed of the three major competitors. The company has consistently generated superior sales growth and margins while also generating large amounts of cash flow. Moreover, the company has implemented a number of internal initiatives that should contribute to solid earnings growth in 2012 and beyond. As for its financial health, the company has a great balance sheet with outstanding free cash flow. At less than 10x the consensus estimate for 2012 EPS, a free cash flow yield of about 10%, and a 2.8% dividend yield, the stock appears attractive.

Disclaimer

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.