The Making of S&P's Magnificent Ten

Here's how S&P comes up with its portfolio of top-ranked stocks that its analysts believe hold the most potential for growth in the coming months

Top 10 lists are a staple of American culture. Pop music fans have the Billboard charts. TV viewers have David Letterman's nightly offering. And equity investors have Standard & Poor's Top Ten Portfolio, a list of stocks that have S&P's highest investment ranking and strong potential for price appreciation.

These 10 issues are considered to be best-positioned for capital gains over the coming 6 to 12 months by senior analysts of the S&P equity research department. But who picks the stocks, and on what basis are they chosen? And how has the portfolio performed?

With the S&P Top Ten well into its third year of existence -- and with a firmly established track record of outperforming the broader stock market -- we decided this would be a good time to provide an updated primer.

Who selects the Top Ten stocks?

The portfolio was created and is managed by the S&P equity research department's senior portfolio group. The SPG's current members are: Kenneth Shea, head of global equity research; Stephen Biggar, director of North America equity research; and Robert Gold, head of the health-care sector. These analysts cumulatively have more than 50 years of experience in security analysis.

How are the portfolio stocks selected?

At least once a week, the SPG meets to review and discuss the state of the S&P Top Ten to ensure that it truly reflects the equity research group's "best ideas." Here's a look at the criteria that the group uses in the selection process:

First, each Top Ten selection must be ranked 5 STARS (strong buy) by the S&P equity analyst that covers the stock. SPG members sift through the more than 150 top-ranked stocks within a fundamental coverage universe of over 1,800 equity issues followed by the S&P global equity research department in seven countries.

The SPG reviews key elements of these stocks, which include:

• The analyst's 12-month target price

• An assessment of risk and projected share volatility

• The company's sector and industry classification

• Market capitalization.

Embedded in this analysis is the company's ability to generate free cash flow, its financial health, quality of management, and an assessment of corporate governance.

Perhaps most important of all, though, is the SPG's view of the company's earnings growth potential relative to its valuation. One key metric that S&P analysts and the SPG observe in this regard is the stock's projected price-earnings ratio relative to the analyst's projected three- to five-year EPS growth rate, known as its PEG ratio.

In light of the S&P equity research department's so-called growth at a reasonable price, or GARP, philosophy, the lower the PEG ratio, the better.

How has the portfolio performed?

Since the S&P Top Ten's launch on Dec. 31, 2001, its performance has been very good relative to its stated benchmark, the S&P 500-stock index (including dividends). From its inception through Mar. 31, 2005, the portfolio has increased at an average annual rate of 7% (including dividends), vs. a rise of 2.6% for the S&P 500.

Below is the Top Ten list as of Apr. 26, 2005. (See also a slide show with more detailed information on the portfolio's members.) Be sure to visit BusinessWeek Online's Investing channel for updates to the portfolio's membership and performance figures.

Company Ticker
Burlington Northern BNI
International Speedway ISCA
Cooper Cos. COO
Covance CVD
Guitar Centers GTRC
Ingersoll-Rand IR
Landstar System LSTR
Lennar LEN
St. Jude Medical STJ
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