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The Top 500 U.S. Stocks for 2013

Canadian stocks have many fine qualities but are far less numerous than their U.S. counterparts. It's only natural to look across the border for bargains to round out a diversified portfolio. That's why we extended the Top 200 methodology stateside and are pleased to present this year's MoneySense Top 500 guide to U.S. stocks.

As with Canada, we measure each stock based on its appeal as a value investment and its growth potential. Stocks with the best combination of both attributes are drafted into the U.S. All-Star team. We're happy to say last year's team fared very well indeed. Our picks shot up by an average of 21.9% since last time. Meanwhile the S&P 500, as tracked by the SPDR S&P500 ETF (SPY), climbed 16.8%. As a result, the All-Stars beat the market by 5.1 percentage points, not including dividends.

The Top 500 uses the same strategy as the Top 200 but is applied to U.S. stocks. We focus on the numbers to unearth the best prospects without being swayed by the intangibles of a particular business.

We begin with the 500 largest U.S. public companies, based on revenues in the Bloomberg database. Stocks with the best growth characteristics are awarded As, the next best Bs, and so on, down to Fs for stocks sorely in need of improvement. We also grade each stock based on its merit as a value investment. The best bargains get As while pricey glamour firms, which often tempt investors like sirens, take home Fs.

To get top marks each stock must pass some strict tests. For growth, we favour firms with good records of increasing sales and earnings per share. We also like strong returns on equity, healthy market performance over the last year, and low-to-moderate price-to-sales ratios. For value, stocks should sell at modest price-to-book-value ratios compared to peers and the market. We view high debt loads negatively and give extra points to profitable ventures that pay dividends. To get to the top of the class, a stock must past muster on all qualities but may eke by with a B if found only slightly wanting.

Ideally a stock gets a double-A rating, making it both an outstanding growth and value candidate, but that's unusual. Only four were awarded double-As this year, but 22 others scored at least one A and one B. Both groups are well worth consideration.

Keep in mind that just because a stock has good grades does not mean it's risk free. We think such stocks have all the right ingredients necessary for success, but the future is fraught with uncertainty and some will inevitably disappoint. As a group, our top stocks have sometimes trailed the overall markets. It's an important factor to be aware of. Regrettably, there are no sure things in the stock market but our goal is to tilt the odds in your favour.

The Top 500 is a wonderful place to start your search for good U.S. stocks. Our data package includes a plethora of information, making this one of the best sources for investors looking to enhance portfolios with U.S. stocks. In fact, the Top 500 stock table is so huge we had to put it online where you can pore over a variety of facts and figures.

All-Star Stocks

Before rushing to our website, we provide details on the best stocks here in the magazine. To start, the 26 stocks that earned at least one A and one B for value and growth appeal are shown in the table above, highlighting vital information on each.

We congratulate four companies with a coveted double-A this year. Stocks earning an A for their growth pedigree and an A for their value potential were HollyFrontier, Reliance Steel & Aluminum, Tesoro, and Western Digital. Two are in the oil refinery business.

HollyFrontier (HFC) of Dallas, Tex., owns five refineries and has done well over the last decade. Income investors will appreciate its strong dividend growth record, which has seen its payout per share shoot up an average of 19%over the last five years. While HollyFrontier rarely trades at a high earnings multiple, its price-to-earnings ratio of 5.3 is below average and attractive overall. It has room to move higher if its business continues to fare well.

Tesoro (TSO) of San Antonio, Tex., is the second refiner with top marks. It owns seven refineries and a network of 1,375 branded retail stations to serve customers. However, Tesoro's stock has been volatile and the firm ran into difficulties in the 2009 downturn, leading to losses. It had to eliminate its dividend, a sign of weakness and a negative. The dividend has subsequently been reinstated, but cautious investors may favour HollyFrontier.

Reliance Steel & Aluminum (RS) is the largest metals service centre company in North America. It has more than 220 locations scattered across the globe, where it provides metals processing and distribution services. It may not seem like an exciting business, but the Los Angeles-based firm sports a stellar growth record over the last decade, with sales, earnings, book value and dividends marching ahead strongly. Ten years ago it paid a quarterly dividend of $0.03 per share, while now it sends shareholders $0.25 per share every three months. The company has room for further dividend growth because it pays out less than 20% of earnings.

Western Digital (WDC) is a well known computer hard-drive maker. Information storage may not be glamorous compared to other high-tech ventures, but its results are far from dull. It has a superb record growing sales and earnings the last decade. It has started paying a dividend and with luck will follow other high-tech firms and raise it. Bargain hunters will enjoy snapping up the company for only 4.5 times earnings, putting it well into value territory. But we urge you not to stop at double-A picks. The other 22 stocks with an A and a B are all worth checking out.

Sector Diversification

To encourage more diversification, we decided to look at this year's best U.S. stocks by sector. Not only is it a good idea to spread investments around geographically, but wise investors opt to buy across multiple industry groups. It's not a surefire prophylactic against market crashes, when multiple sectors fall at the same time, but it cushions the blow in the common event of one sector catching a cold.

Problem is, sector diversification is difficult in Canada. We're overly concentrated in just three major sectors: financials, energy and materials. Those who stick only to Canadian stocks have portfolios heavily skewed to these companies. Regrettably, pickings are slim in other sectors: Canada has few health-care or technology stocks.

That's why we've refined the Top 500 this year by drawing your attention to U.S. stocks in five sectors poorly represented in Canada: communications, consumer cyclicals, consumer non-cyclicals, industrials, and technology.

We select five Top 500 stocks for each sector with good grades and display them in the accompanying table. But in this case, top grades weren't the only consideration. We wanted to ensure each of the five stocks came from different industry subgroups. It's an extra step to further enhance diversification, avoiding the problem of highlighting five stocks in one narrow field in a sector.

Household names in the sector lists include TimeWarner (TWX),CBS(CBS), Staples (SPLS), FedEx (FDX), Xerox (XRX), and Dell (DELL), all well known to most Canadians.

But lesser known companies are also worth investigating. For instance, Dillard's (DDS) operates more than 300 department stores and clearance centres in the south and midwest. While it hasn't grown sales in recent years, it has bought back boatloads of its own stock and now trades at a moderate 11.6 times expected earnings.

If your portfolio is crammed full of Canadian stocks, consider adding these specialized U.S. names to round out your holdings. They will mitigate against the risks inherent in holding highly concentrated portfolios.

Remember stock screens often have limitations. Make sure a firm's situation hasn't changed in some important way before you invest. Read regulatory filings and scan news to stay up to speed on recent developments. We hope we've set you on the path to a profitable future, but head into the markets only when ready and after you've done your homework.

First published in the December/January 2012 edition of MoneySense magazine.

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