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Merrill Lynch's 10 favourite U.S. stocks for 2012

Apple, Marathon Oil, and CBS made Merrill Lynch's list of top stocks for 2012 and may help investors beat the market next year by a wide margin.

Merrill Lynch strategist Savita Subramanian compiled the firm's favourite stock ideas for 2012, plucking one name from each of the 10 sectors of the S&P 500. Subramanian says the stock picks align with Merrill Lynch's investment themes for the year ahead.

The Merrill Lynch analysts have a 12-month price target of 1,350 for the S&P 500, 6.9 per cent higher than current levels. By comparison, the average return of the 10-stock portfolio, based on the price targets offered by analysts, is 30 per cent.

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The New York-based firm, which doesn't offer updates during the year on the list, says the stocks are chosen by Merrill Lynch's fundamental analysts. All companies carry a "buy" rating and are reviewed for favourable valuation, quality, yield and growth.

As it turns out, next year's favourites could have stood in for the firm's best picks for 2011. The group has an average return of 5.3 per cent this year. The S&P 500, a broader measure of the largest stocks in the U.S., is little changed. Of Merrill Lynch's group of favourite stocks, CBS is the best performer so far this year, up 34 per cent, while Lincoln National lags the most, with a 26 per cent drop.

The 10 stocks on Merrill Lynch's list are arranged below in order of potential upside, based on the firm's 12-month price target and the stock's price as of Dec. 5.

10. Xcel Energy

Company Profile: Xcel Energy is a supplier of electric power and natural gas service in several U.S. states, including Colorado, Kansas, Michigan, Minnesota, New Mexico, North Dakota, Oklahoma, South Dakota and Texas.

Sector Representation: Utilities

Potential Upside: 7.4 per cent based on a price target of $28

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Investment Thesis: Analyst Steve Fleishman touts Xcel for the company's yield, earnings stability and dividend growth. He also likes the stock as it is one of the highest quality, lowest risk regulated utilities in his coverage universe.

"We like XEL's strong rate-base wind program and multi-state utility model, and find the stock attractive post its equity overhang completion," Fleishman writes. "Investments in wind generation provide solid growth. Challenges will be translating these opportunities into [earnings-per-share]growth by managing cash flow and regulatory lag."

9. Altria

Company Profile: Altria is the parent company for Philip Morris USA, John Middleton, U.S. Smokeless Tobacco Company, Ste. Michele Wine Estates and Philip Morris Capital. The company's brands include Marlboro, Parliament, Virginia Slims, Stag's Leap Wine Cellars and Basic.

Sector Representation: Consumer staples

Potential Upside: 9.5 per cent based on a price target of $31 Investment Thesis: Lisa Lewandowski says that tobacco is the firm's preferred staples industry, and that Altria gets the nod because it is the highest yielding S&P 500 tobacco stock.

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"Altria is the largest U.S. cigarette producer, with about a 50 per cent market share," she writes. "While the tobacco litigation environment has improved in recent years, consumption trends continue to decline. We expect price growth, cost cutting and share repurchases to drive above category earnings growth and we expect returns to shareholders to rise. As such, we believe Altria should trade at a premium to peers."

8. Union Pacific

Company Profile: Union Pacific operates a railroad franchise that covers 23 states in the western U.S., extending as far east as Chicago and New Orleans.

Sector Representation: Industrials

Potential Upside: 12.1 per cent based on a price target of $118

Investment Thesis: Analyst Ken Hoexter says that Union Pacific comes up under the firm's screens for yield and high quality. Specifically, he highlights Union Pacific as a solid investment opportunity in a slow-growth environment.

"We continue to believe the rail group will improve service metrics and raise core rates," Hoexter writes. "Union Pacific has improved its operating ratio from the mid-80s to 70 per cent most recently, which has led to sustained upper-teens earnings growth. Ongoing benefits look to be derived as it moves to reprice the approximately 12 per cent of its business that has not re-priced since 2004."

7. Eli Lilly

Company Profile: Eli Lilly is the 10th-largest pharmaceutical company in the world. It's pharmaceutical products include Cialis, Prozac, Methadone and Cymbalta.

Sector Representation: Health care

Potential Upside: 14.3 per cent based on a price target of $43

Investment Thesis: Analyst Gregg Gilbert favors Eli Lilly in the health care space because of yield, quality and inexpensive valuation. He notes that Eli Lilly is the highest dividend yield of the S&P 500 pharma stocks.

"Eli Lilly offers a good mix of low valuation, a track record of returning cash to shareholders, and pipeline optionality, in our view," Gilbert writes. "Any positive pipeline news or reasonable business development deals could result in improved sentiment."

6. CBS Corp.

Company Profile: CBS is a media conglomerate with a focus on television broadcasting and film, publishing and Internet. CBS, Showtime Networks, CBS Studios, CNet, and CBS Radio are among the company's assets.

Sector Representation: Consumer discretionary

Potential Upside: 16.6 per cent based on a price target of $30 Investment Thesis: Analyst Jessica Reif-Cohen says that media is her preferred industry in the consumer discretionary area, and that her focus on the theme of cash deployment makes CBS her top pick in the sector.

"We believe that CBS will benefit from an improving earnings mix due to growing subscription based revenue streams, solid fundamentals across the board and support from an announced $1.5-billion share repurchase authorization," Reif-Cohen writes. "Strong ratings in a solid advertising market drove a strong 2011 upfront for CBS, format changes at radio have driven station outperformance and improving outdoor will benefit from the 2012 London Olympics."

5. Air Products & Chemical

Company Profile: Air Products supplies a portfolio of atmospheric gases, process and specialty gases, performance materials, equipment and services to a wide range of industries from food and beverage, health and personal care to energy, transportation and semiconductors.

Sector Representation: Materials

Potential Upside: 19 per cent based on a price target of $100 Investment Thesis: Analyst Kevin McCarthy says that chemicals is the preferred industry within the materials sector, and that quality, growth, and attractive valuation led him to Air Products.

"We view Air Products as a leader in industrial gases, with exposure to high-growth markets, including Asia, refinery hydrogen, and electronics," he writes. "Take-or-pay onsite gas contracts, and 3-5 year merchant gas contracts provide a cushion against downturns. We expect earnings to benefit from ongoing recovery in the global industrial economy and rising global energy prices. Additional positives include a healthy backlog of new projects, such as hydrogen for crude oil refining and oxygen for coal gasification."

4. Apple

Company Profile: Apple, the maker of consumer electronic devices like the iPhone, iPad and iMac, is one of the largest companies in the world.

Sector Representation: Information technology

Potential Upside: 30.4 per cent based on a price target of $515 Investment Thesis: Like most tech analysts, Scott Craig favors Apple because of its high quality, the secular growth opportunity, and attractive valuation.

"We remain positive on Apple's growth potential given its opportunity to gain market share in large addressable markets, especially in the PC and handset markets," Craig writes. "We find Apple's valuation compelling, particularly based on the upside potential from revenue and earnings growth in the Mac/PC and iPhone segments and from gross margins, which we think should more than outweigh the near-term slowdown in iPod units and consumer exposure."

3. CenturyLink

Company Profile: CenturyLink is the third-largest telecommunications company in the U.S. based on access lines, providing phone, high-speed Internet, and wireless services to customers in 37 states.

Sector Representation: Telecommunication services

Potential Upside: 37.7 per cent based on a price target of $50 Investment Thesis: Analyst David Barden says the CenturyLink is inexpensive with a high dividend yield, and that investors could be in store for buybacks or dividend growth in 2012.

"We view yield-based wireline stocks as the equivalent of equity bonds where the required return (yield) is a function of relative risk ([free cash flow]payout ratio)," Barden writes. "Within this framework CTL screens positively among yield stories at 8.4 per cent yield from a 48.5 per cent [the 2012 estimated]payout ratio."

2. Marathon Oil

Company Profile: Marathon Oil is an independent upstream company. The company has international operations in exploration and production, oil sands mining and integrated gas.

Sector Representation: Energy

Potential Upside: 73.6 per cent based on a price target of $50 Investment Thesis: Analyst Doug Leggate picks Marathon Oil out from his entire coverage universe because of the company's attractive valuation, high quality and yield.

"We believe the recent announcement to separate the company into two separate units that focus on exploration and production and refining, will release value from the shares and demand a higher premium to the current share price," Leggate writes.

1. Lincoln National

Company Profile: Lincoln National, with assets of $153-billion, offers annuities, life insurance, 401(k) plans, savings plans, and comprehensive financial planning and advisory services.

Sector Representation: Financials

Potential Upside: 82.3 per cent based on a price target of $38

Investment Thesis: Analyst Edward Spehar prefers insurance out of the entire financials industry, and Lincoln National stands out because of the potential for dividends and buybacks.

"The company has a 10 per cent return on equity today with some upward bias given that tangible ROE (or an indicator of potential new business returns) is closer to 13 per cent and excess subsidiary capital and free cash flow should allow for balance sheet deleveraging and increased payouts to shareholders (dividends and share buybacks) over time," Spehar writes. "All of these factors suggest that the share price should conservatively move to a 10 per cent-15 per cent discount to book value, in our view."

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