Are These Your Next 5 Home Run Stocks?

Last month, I unveiled three stocks that my wife had picked in her Motley Fool CAPS account that have become major home runs. She picked the stocks using the classic "buy what you know" approach. In my article, I noted that while "buy what you know" can work out really well on its own -- as in her case -- it's best when combined with further exploration, including a look at valuation.

With a few nice notches on her belt now, I decided to go back to the well and see what companies my wife would want to invest in now. By combining her "buy what you know" view with some further research and valuation work on my part, I hoped to come up with a handful of really attractive picks.

What she knows
The process started with getting 10 of her favorite publicly traded companies based on where she shops, what she buys, and what she sees others buying and using.

  • Estee Lauder: The company is the parent of brands including Bobbi Brown, Aveda, Bumble and Bumble, and Clinique. For my wife, the most important brand is the apparently highly addictive MAC brand.

  • Amazon is not an online shopping destination, it's the online shopping destination. For my wife (and me!), this is a one-stop shop for everything from baby UGGs to digital camera memory cards.

  • Target (NYS: TGT) : If deals are to be found in bricks-and-mortar land, this is the first stop. Target's fashion taste means that even a picky purchaser can fill out a wardrobe on a budget.

  • Southwest (NYS: LUV) : Affectionately known as "cattle-car air," Southwest gets you to where you need to go cheaply, easily, and with a fun, cheeky attitude.

  • Nordstrom (NYS: JWN) : If Target is fashion at an affordable price, Nordstrom is the upscale pick. The duds are higher end, but the always-make-it-right service makes the prices well worth it for many shoppers.

  • Apple (NAS: AAPL) : If it's a cult, it's one of the largest and most profitable cults that I'm aware of. If you need any convincing of just how important the iPhone is, look no further than the terms that Apple was able to get out of Sprint.

  • Reynolds American: The Camel brand may not be as strong as Altria's Marlboro, but it, along with Pall Mall, Winston, Kool, Doral, and Salem are among the top 10 best-selling brands in the U.S.

  • Pfizer (NYS: PFE) : The pharma giant has done such a great job marketing its drugs that, even if you don't have a prescription, you're no doubt familiar with names like Viagra, Xanax, Lipitor, and Celebrex. And most of us at some point have taken one of Pfizer's over-the-counter items, including Advil, Robitussin, Dimetapp, and ChapStick.

  • Chevron (NYS: CVX) : This oil and gas giant is front and center for many U.S. consumers -- particularly on the West Coast -- when it's time to fill up the gas tank.

  • McDonald's (NYS: MCD) : My wife is particularly fond of McDonald's breakfast sandwiches, but diners all over the world come back to Mickey D's time and time again for consistent food and service and reasonable prices.

Narrowing the list
In my previous article, I suggested three additional steps to apply to narrow down companies "that you know" to figure out which companies you should buy.

  • Make sure they offer a product that's actually better than competitors'.

  • Make sure the company is well-managed.

  • Make sure the stock is fairly priced.

The list above passes the first bullet with flying colors.

Are there any that we can knock out due to poor management? That is, managers that appear inept, don't follow through on promises, or treat the company like their own personal piggy bank.

In short, no. Of course, while there aren't any managers that I'm convinced don't make the cut, I'm not keen on the fact that at companies like Pfizer, Chevron, Apple, and Southwest the top executives own very little company stock. While this isn't a deal breaker, I prefer a company where management has a sizable stake at risk.

But if management didn't pare our list, valuation certainly will. To determine which companies are ripe for buying, I use a modified cash-flow valuation. Admittedly, my model is relatively unkind to growth companies, but I generally don't like relying on huge growth estimates to justify a valuation (but that's just my preference).

When the dust of the valuation work settled, I was left with five stocks that are either fairly valued or undervalued. Target, Pfizer, and Chevron are three that I believe the market has put on sale. Apple and Nordstrom, meanwhile, may not be screaming bargains, but I think the current prices are very fair. As for the rest, they're still great companies -- and I happen to own McDonald's in my personal portfolio -- but I don't think the prices Mr. Market is offering right now are particularly attractive.

What now?
I will be adding the five stocks above -- Target, Pfizer, Chevron, Apple, and Nordstrom -- to my CAPS portfolio and my wife will be doing the same. That way, we can keep accountable for these picks and check back to see how well this "buy what you know -- with extra work" strategy works out.

In the meantime, you can keep a closer watch on any of the stocks above by starting a free Foolish watchlist and adding them to your list by clicking the "+" signs above.

At the time thisarticle was published The Motley Fool owns shares of Altria Group and Apple. Motley Fool newsletter services have recommended buying shares of Chevron, Southwest Airlines,, McDonald's, Pfizer, and Apple. Motley Fool newsletter services have recommended creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of McDonald's, Target, and Chevron, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.