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Quality Stocks To Play Defense With

Posted: Nov 05, 2009 11:23 AM by Todd Shriber

Tickers in this Article: MSFT, EMR, BAX

Every now and then, investors need to play a little defense and now may be one of those times. Even if risk appetite continues to swell, it never hurts to have a couple of dependable, predictable names in your portfolio. Doing so can help you avoid the meager returns offered by cash investments and many bond offerings, and position your portfolio to take advantage of a market flight to quality.

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The market rally that began in March has lifted the fortunes of plenty of stocks that, to put it delicately, were in dubious shape to begin with. The dash for profits also led to a dash for trash in some regards, but Mr. Market gets around to identifying the weakest links sooner or later and if this rally runs out of steam, you won't want to be caught holding those ugly ducklings.

Rallies like the most recent one have a way of leaving some truly good stocks behind. Or, investors just don't establish big positions in the slow movers when there are bigger profits to be had with riskier fare. With that, let's have a look at a few names that can you play offense with when it's time to be defensive.

How Long Is That Dividend Increase Streak?
Emerson Electric (NYSE: EMR) 52-Week Change: 9% Payout Ratio: 52%
Alright, we know what you're thinking. After Emerson Electric's most recent quarterly report, this may look like anything but a quality stock. The industrial conglomerate reported a 27% drop in fourth-quarter profits and doesn't expect a recovery until late 2010.

In addition, Emerson has identified numerous companies for possible acquisitions with $1.4 billion of acquisitions already in process. Emerson also said they expect to do an additional half billion in acquisitions in the fiscal year.

Despite the bad quarter, Emerson reported a record $1.21 billion in free cash flow and that's one reason why Emerson has increased its dividend every year for the last 52 years, one of the 10 longest streaks of any U.S.-listed company. And that's the mark of a quality stock. (Learn more about free cash flow in Free Cash Flow Yield: The Best Fundamental Indicator.)

Speaking Of Free Cash
Microsoft (Nasdaq: MSFT) 52-Week Change: 17% Payout Ratio: 34%
Microsoft isn't the tech high-flier it once was, but the most recent quarterly report from the world's largest software was enough to get some Wall Street analysts feeling bullish about the shares. The company beat revenue estimates by $500 million on pent-up demand for the Windows 7 operating and an Xbox price cut helped jolt the top line as well.

Windows 7 could prove to be a decent revenue driver for Microsoft for several quarters. There are 1.2 billion PCs in the world; just 20% use Vista and most of the remainder use Windows XP, which was introduced in 2001. In other words, the upgrade cycle could be lengthy and lucrative for Microsoft.

Microsoft trades at just 13 times forward earnings and with $25 billion in cash, $18 billion of it free cash flow, that's pretty cheap. That strong balance sheet combined with Microsoft's superior value makes this a quality stock.

Quality With A Laggard
Baxter International (NYSE: BAX) 52-Week Change: -12% Payout Ratio: 28%
Baxter International is the laggard of this trio and that may not be surprising given the revenue disappointment the specialty drug and medical device delivered in the third quarter. Baxter boosted its short-term investments by 43% between the second and third quarters and the company now sits on $769 million in cash, which it has said it could use for acquisitions, dividend payments and share repurchases.

According to Reuters, the five-year EPS growth rate at Baxter is above 14% and the five-year dividend growth rate is at about 10%, two signs that this is indeed a quality issue. Healthcare stocks are under some pressure due to political headwinds, but Baxter is one of the top names in the group and should be a rewarding play for prudent, long-term investors.

The Bottom Line: Quality Isn't Hard To Find
In a tumultuous market, it always pays to have a few quality names in your portfolio. Fortunately, quality is easy to find. Start by looking for companies that stash cash and return some of that bounty to shareholders and you'll be on your way to holding some quality stocks.

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By Todd Shriber

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