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10 best stocks for 2012: How we picked them

December 8, 2011, 3:00 PM UTC

Based on current valuations, it looks like a great time to invest in companies with solid fundamentals. But we still recommend erring on the side of caution.

How do you pick stocks in a market defined by unpredictability? With caution and a heavy dose of humility.

Consider the fate of our Best Stocks for 2011. A year ago, we identified 10 reasonably priced growth companies (average price/earnings ratio: 12) that we believed were poised for big profit growth and even bigger stock gains. Well, we were half right. Since then, our stocks reported average annualized earnings growth of 53%, compared with an average 17% for stocks in the S&P 500 index (SPX). Unfortunately, the market was unimpressed, and the picks returned an average of -2.1%, vs. a 7.8% gain for the S&P in the 12 months ended Nov. 30. It’s enough to make us want to march down to Zuccotti Park and pitch a tent.

We still believe in almost all of these stocks. Lennar (LEN), for example, remains a great way to bet on the coming housing rebound. And the huge earnings growth notched by our chemicals and commodities picks — Agrium (AGU), Dow (DOW), Mosaic (MOS), and Royal Dutch Shell — can’t be ignored by the market forever. As for the most disastrous pick, Entropic (down 44%) (ENTR), it has sunk so low that its bargain price offers a benefit: The maker of chipsets for home-entertainment networks is now a takeover candidate. Despite these miserable results, it should be noted, we’ve still beaten the S&P 500 in four of the past six years.

This year there’s no shortage of fundamentally attractive stocks to choose from — only a shortage of investors willing to own them. Still reeling from the 2008 collapse, worried about job security, and fearful of the European debt crisis, investors have little appetite for risk. That makes stock picking a minefield today. “There’s a significant disconnect in the market between macroeconomic concerns and micro company performance,” says Bob Turner, manager of the Turner Large Growth Fund.

Corporate profits are actually quite healthy: S&P earnings growth for 2011 is expected to clock in at 15%. But since 2009, mutual fund investors have pulled $109 billion from equity funds, and lately the selling has been almost indiscriminate. And whether they’ve been falling or rising, stocks and other assets are moving in lockstep to a degree not seen in decades. In October, for example, the share prices of S&P 500 companies were more aligned with one another than at any point in the past 30 years, according to data from Birinyi Associates.

The 10 best stocks for 2012

In a different climate, we’d recommend a lot of underpriced highfliers, much as we did last year. But we’re not convinced investor sentiment is going to turn anytime soon. Even bullish pros see short-term risk inside longer-term opportunity. “Based on valuations, I’d say this is an unbelievably good time to invest,” says Mitch Rubin, a former Baron Funds portfolio manager who is now chief investment officer of Riverpark Funds. “But can I envision a scenario where over six months the market loses another 15% to 20%? Yes — absolutely.”

That’s why we’ve erred on the side of caution in selecting our top stocks for 2012. You’ll find no next-big-thing technology stocks or contrarian takes on troubled businesses. Instead, we’re emphasizing the most tangible of stock market rewards — dividends — and have tried to mitigate risk by seeking stocks with P/E ratios that are not just low but so unjustifiably low that the odds seemed stacked against their underperforming the S&P 500.

Our portfolio has an average dividend yield of 3% (vs. 2.1% for the S&P 500) and an average P/E of 9.9, vs. 11.6 for the S&P (based on projected 2012 earnings). Half of our picks have a PEG ratio (P/E divided by projected long-term earnings growth rate) below 0.6 — extremely attractive given that a PEG below 1.0 is considered cheap.

Playing it safe doesn’t mean our selections lack potential, nor is betting on dividend stocks purely a defensive move. It’s a strategic one too. Since 1979, dividend payers have out-returned the broader market 11.6% to 11.1% annually, according to T. Rowe Price. Investors seem to be recognizing that, as the lone stock-fund category experiencing major inflows this year has been equity income. According to Lipper, investors have shifted a net $25.8 billion into equity income funds through mid-November, vs. $31.6 billion in outflows from other equity fund categories. Meanwhile, the yield on the 10-year U.S. Treasury bond has been halved since April 2010, and the 2.1% dividend yield of the S&P 500 actually exceeds the 2% interest rate on 10-year Treasuries as of Nov. 22 — only the second time that has happened since the 1950s.

The upshot is that the money now flowing into dividend funds could be the tip of the iceberg as retiring baby boomers and others scramble to replace the yield they once earned from bonds. Just look at the shifting investor base of Intel (INTC), one of our 2012 picks. While still a staple holding of technology funds, two of Intel’s largest mutual fund holders today are now bond funds. This makes sense when you consider that Intel’s stock now yields more — 3.6%, vs. 3.1% — than its 10-year bonds. That’s the sort of dividend to give investors patience, which they’ll need, until good times return.

More Fortune Investor’s Guide 2012

10 best stocks for 2012

Expert roundtable

Ramit Sethi: The new finance guru on the block

Where to put your money now

Investing after the Arab Spring

Jeff Cardon plays it small and plays it safe

The best and worst of Wall Street 2011

Being a boring investor … and loving it

Can Wall Street thrive again?

This article is from the December 26, 2011 issue of Fortune.