10 Stocks for a Really Rainy Day

Here's a fun question: What 10 stocks would you buy if the market dropped 30% over the next week?

Don't have a clue? Well, start thinking. (No, I'm not predicting that the market will get cut by a third over the next week.) Having a watchlist of stocks you'd love to buy at lower prices is a big part of being a successful investor--a lesson that I learned later in my investing career than I would have liked.

If you continually research companies, increase the size of your "mental database" of stocks, and constantly watch the ones that are not yet attractively priced, you'll be ready to pounce when Mr. Market gives you the opportunity. Great companies don't go on sale very often, and when they do, the market's probably getting whacked badly--which means the drumbeat of negative headlines and fear in the market can make it hard to think rationally and look for great long-term investments. By "preclearing" a list of companies and putting them on your watchlist, you can make it easier to pull the trigger when everything on your quote screen is red. Your thought process becomes, "Do these companies still have strong businesses, and have they fallen enough to have become bargains?" rather than "My whole portfolio's down! What do I do?"

My watchlist is pretty long, but, like everyone, I have my favorites. Here are 10 of them, spread across different areas of the market. I already own some of these companies, and I'd gladly increase my stake if the market were to tank precipitously. As for the ones I don't own--well, let’s just say that I'll likely have some orders in if they ever drop to a 5-star price!

10 to Watch
 Maxim Integrated Products . Many parts of the chip industry are either fiercely competitive (communications), horribly cyclical (memory), or consume vast amounts of capital (foundries). Analog chips are an entirely different story--product cycles tend to be long, prices tend to be stable, margins are very high, and capital spending is relatively low. Maxim is my favorite among the analog players. With 30% of sales converted to free cash flow and returns on capital of around 50%, the firm is enormously profitable, and Maxim's broad product line and analog focus should keep profits strong for some time to come.

 Chicago Mercantile Exchange (CME). This is one of the three stocks on this list that I already own, but I'd happily increase my stake if the stock dropped back to 5-star territory. (It was there just a few weeks ago, in fact.) Although relatively young as a public company, the Merc has one of the most beautiful business models I've ever come across, pumping out a return on equity just under 30% and converting nearly half its revenue to free cash flow. This incredible level of profitability is likely to persist because the Merc's deep pool of liquidity would be very tough for a competitor to replicate--a similar competitive advantage to  eBay's (EBAY)--and because futures contracts are nonfungible. In other words, you can't buy a futures contract on one exchange and close out your position elsewhere as you can with equities. Finally, growth prospects are excellent, partially because volatility is a fact of life for financial markets (futures volume tends to increase with volatility), and partially because the Merc can launch new futures products for almost no cost--whereas an exchange like the NYSE or Nasdaq has to compete for a finite number of equity listings, or hope for a robust IPO market.

 Expeditors International (EXPD). I've written about this firm quite a bit, but it's still hands-down one of my favorites. Expeditors is basically a travel agent for cargo: It buys space in bulk from airlines and oceangoing shippers and resells that capacity to firms that need to transport goods. In the big picture, I think of this company as earning a royalty on the growth of global trade. Although the volume of global trade has grown about 6% annually over the past three decades, Expeditors has managed to post 25% compounded growth over the past decade by taking market share in a very fragmented industry, and it has lots of market share left to go, I think. Moreover, the firm has one of the most shareholder-oriented management teams that I've ever run across--I'd put them in a very small group of managers about whom I never worry. (Note: The shares may get whacked if the Chinese yuan is revalued, because investors will fret about a dramatic slowdown in trade between the U.S. and China, and Expeditors does a lot of business in that trade lane. If the shares do get whacked, I'd view it as a buying opportunity rather than something to worry about.)

 Strayer Education (STRA). I came across this for-profit education firm when a colleague dropped the letter to shareholders from a recent annual report on my desk with a note that said "You gotta read this." It was simply one of the best letters I've ever read--candid and straightforward--which piqued my interest, since I was familiar with rival  Apollo Group  and the fantastic economics of for-profit education firms. Returns on capital are fantastic, and the growth prospects for degree-oriented adult education are quite high. Strayer's shares have a Morningstar rating of 5 stars right now, but they'd be an even better buy if the market took a tumble and dragged Strayer along with it.

 Electronic Arts (ERTS). I've been (wrongly) skeptical of the video-game industry for a while, viewing it as a cyclical niche market. While many industry players are still tied to the timing of new consoles, EA's scale mutes this dynamic--and moreover, the firm's cyclical peaks have each been dramatically higher than the last, which is variability I can certainly live with. Gaming is becoming increasingly mainstream, now generating more revenue than the movie industry, and EA's enormous scale gives it crucial advantages as games become more complex to develop. Having exclusive rights to a number of popular sports franchises--the PGA, NFL, NCAA football, and NASCAR--adds to the company’s appeal.

 Brown & Brown (BRO). If I told you this insurance broker was a roll-up in an industry that's been under regulatory scrutiny, you wouldn't be interested. But if I told you that it's generated 37% returns on capital for the past decade, executives and directors own 21% of the stock, and that the issues that the regulators are fussing about would likely affect the firm's intrinsic value by less than 10%, you might sit up and take notice. This company is the class act in a very profitable industry, and, as our analyst pithily puts it, "the 10-K reads like poetry." I'd love to own this one at lower prices.

 Biomet  and  Zimmer (ZMH). The growth drivers behind the orthopedic device market are very robust--baby boomers are staying active longer, which is increasing demand for artificial hips, knees, and the like, while new surgical techniques are making joint replacement a much less traumatic procedure for many patients. Market shares tend to change slowly in this industry, since surgeons tend to stick with a particular company's products once they're familiar with them, and the result is very high returns on invested capital. I've included both companies because while I've long been a fan of the smaller Biomet's quiet niche strategy and model management team (CEO and founder Dane Miller gets paid only about $600,000 per year and has never taken a stock option), some changes in the way hospitals are negotiating prices may give the advantage to larger firms like Zimmer in the future. In any case, both stocks are well worth placing on your watchlist.

 Ultra Petroleum  and  EnCana (ECA): In my opinion, one of the more attractive long-term themes within the energy sector is North American natural gas. Gas consumption is increasing relative to other energy sources, and gas is in many ways a stranded resource--it's quite costly to transport overseas, which means that domestic producers that can ship via pipeline can have a large advantage over foreign competitors. Ultra is a smaller firm with a lower finding and development costs than any other firm we cover, which means that it pays less than its competitors to add new natural-gas reserves--a big advantage in a commodity business. Ultra's pretty risky, though, so another company worth watching in this area would be EnCana, a very large Canadian firm that's one of the largest natural gas producers in North America. Both of these stocks would only be attractive at substantially lower prices, of course.