Where to Invest in 2007

Last year and 1994 had a lot in common. Both years saw a steady rise in interest rates, with inflation emerging from the crypt to spook investors, while the economy showed signs of slowing down. Twelve years ago, as a broker at UBS, Sellar told his clients that when the economy plateaus, larger firms — with lots of cash on their balance sheets and huge customer bases to keep earnings growing — are likely to outperform. And in 1995 his instincts paid off: Large-company stocks returned 37%, making them the best-performing equity class.

Bigger promises to be better again for investors in 2007 — even if another 37% bump in the Standard & Poor's 500 is only a pipe dream. To cope with a potentially murky economic outlook, large companies have advantages they didn't have 12 years ago: They're more efficient and profitable, and they have considerably less debt. The savviest of the big companies are generating more growth overseas, immunizing themselves against the swings of the U.S. economy. And best of all, even after their recent bull run, says Sellar, "large firms seem quite cheap."

To be sure, there are risks that can cloud any rosy picture. The combined effects of falling home values, high oil prices and security crises overseas put the brakes on GDP growth in the second half of 2006. If any of those factors escalates, it could hurt the economy enough to neutralize the large-cap firms' advantages. What's more, smaller, riskier stocks typically outperform in the third year of a presidential term, according to the investment research firm Ibbotson Associates, as the party in the White House pumps money into the economy to boost its prospects for the next election.

But with the U.S. facing big deficits and the Democrats taking control of Congress, such stimulus is unlikely in '07. That's one reason why Jeremy Grantham, head of the $120 billion asset-management firm GMO, has changed his mind about the prospects for high-quality blue-chip names. For years the influential quant-oriented investor has knocked the biggest U.S. stocks as overpriced, but today he, too, feels the valuations are relatively cheap — although their prices have risen, their earnings have grown far faster. The price to expected 2007 earnings ratio on the S&P is just below 16, well under the index's average of 20 since 1988.

Yet even as the Dow breached 12000 last fall, individual investors weren't buying stocks. Spooked by the markets' rough spring, they pulled money out of U.S. stock mutual funds for six straight months through October. Those moves suggest that there's plenty of money waiting on the sidelines — money that could flow back into stocks if the economy gets a second wind. That's hardly out of the question, suggests Charles Biderman, chief of TrimTabs Investment Research, which counts some of the country's biggest hedge funds as its clients. He points out that tax withholding from corporations is rising at a record pace, suggesting that the economy is better than recent reports indicate.

To find our stocks for 2007, we couldn't simply pick undervalued industries — all 10 sectors in the S&P 500 gained ground in 2006. But other macroeconomic factors tightened our focus. The current leveling off of interest rates, for example, should help financial-services companies like brokerages and insurers. With the prices of oil and other commodities stabilizing, chemical manufacturers could see their profits surge. And as a "defensive" industry that has historically been impervious to economic ups and downs, beverages look especially attractive.

Within our sectors, we sought companies that had a market value above $10 billion and were expected to increase profits by at least 8% a year over the long term. In most of the sectors, we also looked for stocks whose P/Es were less than twice their long-term growth rates. We focused on globally diversified companies that can weather domestic woes; we also picked two foreign stocks that cater to the emerging middle class in markets overseas. It all adds up to a portfolio of 12 companies that are poised to thrive in the coming year, even if the economy hits choppy waters.

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