Two Stocks for the Coming Correction

05/03/2010 1:00 pm EST

Focus: STOCKS

Richard Band

Editor, Profitable Investing

Richard Band, editor of Profitable Investing, says the market is ripe for a sell-off, and he recommends two dividend-paying stocks that should hold up well in a correction.

The market has picked up more ground in the past 13 months than in any similar time frame since 1933. Even the monster surge in 1982–83 that kicked off the greatest bull market of our lifetimes only boosted the [Standard & Poor’s 500 index] 68% in 14 months.

Given the power we’ve seen to date, I think the underlying “primary” up trend will probably carry through year end and well into the first quarter of 2011.

[But] I’m more cautious about the next four to six weeks, and perhaps a tad longer. While I don’t foresee a big drop, another 5%–10% dip in the indexes could be in the offing.

Morningstar just unveiled the results of an interesting survey. Morningstar—alongside its well-known mutual fund ratings—assigns star ratings (one to five) to each of 1,700 individual stocks tracked by the organization’s analysts.

In mid-April, the number of stocks earning a five-star (most undervalued) rating shrank to a wafer-thin 23—barely 1% of the sample. Bargains have all but disappeared.

When this happens, the market generally enters some kind of consolidation or retracement. As I’ve said before, I don’t expect a crash. But I think you’ll be able to buy most stocks and equity mutual funds cheaper in a few weeks.

For the moment, I suggest a more defensive tack, stressing companies that pay generous dividends.

Two that look ripe for buying now:

Merck (NYSE: MRK). In 2009, MRK absorbed rival Schering-Plough, opening the way for the combined enterprise to cut costs and concentrate its research efforts on the most promising medicines in the pipeline.

Earnings per share touched a new all-time high in 2009, and will likely progress another 20% or so over the next two years as the merger savings kick in. Surprisingly, perhaps, MRK never slashed its dividend during the Vioxx crisis and may, at last, be poised to sweeten the payout some time within the next 12 months. Current yield: 4.2%.

By 2013, based on the company’s cash-generating potential, I project a total return of 55%–75% even if the overall market goes nowhere. Buy MRK at $40 or less. (It closed above $35 Friday—Editor.)

Exelon (NYSE: EXC), the nation’s largest owner-operator of nuclear power plants, stands to benefit from increasingly stringent limits on carbon emissions in the years ahead.

At the moment, electricity demand is down, depressing wholesale power prices. (EXC earns about 70% of its profits from sales to other utilities.) Thus, I expect the company to report a modest dip in 2010 earnings.

However, a rebound is likely in 2011—and the stock is very cheap at less than 12x this year’s trough earnings. As recently as mid-2008, EXC sold for 22x net, so you’re getting a 45% discount off the peak valuation.

Current yield: 4.8%, and safe. Even at this year’s low run rate, profits cover the dividend by a comfortable 1.8x. [Buy] EXC at $46 or less. (It closed below $44 Friday—Editor.)

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