We expect that finding good stocks will only get more and more challenging as markets come to accept that (1) the post-recession rebound in growth is over, (2) commodity prices and inflation limit the Federal Reserve’s ability to keep interest rates artificially low for much longer and (3) the valuations on many stocks look quite full in the current environment.

So where does one look for good stocks? First, you should start in a defensive sector like health care or consumer staples. No matter the economic environment, people still need medical attention and they still need to eat and drink. Not surprisingly, our research on the best and worst sectors confirms that the health care and consumer staples sectors are the only attractive-rated sectors.

In choosing between health care and consumer staples, one has to consider the impact of the sharp and sustained rise in commodity prices. Though most experts agree that commodity prices will fall back to more normal levels in the second half of this year, much of the damage to 2011 profits is already in the pipeline for consumer staples companies. On the other hand, the health care sector is not as sensitive to the rise in commodity prices and it tends to enjoy more pricing power, which means increases in costs get passed onto the consumer and profit margins are unscathed. With that background, the health care sector appears to be the safest place to invest these days.

For research on the best and worst health care ETFs, click here.

Within the health care sector, we have a few favorite stocks. One of them is Eli Lilly & Company (LLY). As one of April’s Most Attractive Stocks, LLY get our Very Attractive rating because it offers investors excellent risk/reward for two key reasons.

First, our model shows Eli Lilly’s profits are strong and rising as the company’s 2010 economic earnings rose over 10% to $3,740 million and reached an all-time high – at least since 1998. Economic earnings have grown every year since 2004 – that is profit growth for each of the past 6 years, including 2008 and 2009! There are few businesses in the market that can match that achievement. In addition, the fact that LLY grew its profits during the last recession gives me confidence that it could handle touch economic times better than most stocks.

Second, LLY’s market valuation is remarkably low. The current stock price of ~$35.62 implies the company’s profits will decline permanently by nearly 55%. In other words, market expectations as reflected in the stock price are for the company to experience a permanent 54% decline in profits. That is a big drop, especially for a company that grew its profits during the last recession.

Much of the valuation’s discount to the current level of cash flows comes from the fact that LLY has some major drugs going off patent, including #1 selling Zyprexa, which makes up over 20% of LLY revenue. However, for every dollar lost from patent-expiring products, the company has $6.64 dollars coming from new products (those launched within the last five years), which compares well to an industry average of only 77 cents.

In other words, despite patent expiration for some of its major products, LLY has a relatively young product portfolio that can help offset those losses. The takeaway is that expectations for a 54% drop in profits are much too low.

When I juxtapose market expectations to LLY’s historical profitability and the defensive nature of its business, I am left with the inescapable conclusion that LLY is a great stock to buy.

The risk/reward of this stock is quite compelling. Downside risk is low as the valuation already implies a permanent 54% decline in profits. How much worse can the valuation get? Upside reward potential is strong as the stock has to go over $77/share to trade at a value that implies the company’s profits will experience a 0% decline, still a no-growth scenario. Limited downside risk compared to over 100% upside return potential, if the stock trades at a no-growth valuation, looks pretty good.

To summarize, LLY’s stock presents an excellent buying opportunity at current levels because it meaningfully underestimates the future cash flow potential of the company.

For details on what causes the dif­fer­ence between eco­nomic ver­sus account­ing prof­its during the last five fiscal years, see Appen­dix 3 on page 10 of our report on LLY. See Appen­dix 4 to learn how LLY increased net operating profit after tax (NOPAT) and its NOPAT mar­gin from 22.9% to 23.3%. LLY’s ROIC (detailed in Appendix 7) rose from 19.1% to 19.9%. LLY’s invested cap­i­tal grew more slowly than revenues; so invested cap­i­tal turns rose from 0.83x to 0.85x during the last reported fiscal year.

Note: Stock pick of the week is updated every Tuesday.

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