Jubak's Journal Recent articles: • When will oil run out of gas?, 7/8/2005 • 5 buy-on-the-dip opportunities, 7/6/2005 • 5 stocks playing catch-up with oil, 6/30/2005 More... | Jubak's Journal 6 stocks for a second-half growth rally Growth investors have been losing badly to value investors for some time, but many feel the tide is about to turn. I'm not convinced just yet -- but here are 6 stocks to watch just in case. By Jim Jubak It's been value over growth for so long now that it's a wonder that more growth stock investors haven't thrown in the towel. For 2005, through the end of the June quarter, value stocks were up 1.7% and growth stocks were down 1.9%. That's not just a case of isolated outperformance, either. Value stocks, according to index manager Frank Russell Co., show a one-year return of 14.1% -- vs. 9% for growth stocks. The last two years? It's 18.1% average annual for value stocks vs. 10% for growth stocks. Three years? It's 11.2% for value stocks and 7.56% for growth stocks. But growth-stock investors are a hardy group, and they now see signs that the year's second half will belong to them. Growth rally? Let's wait and see I'm not totally convinced. At least not yet. But with growth stocks priced at the lowest valuation premium to value stocks in 15 years, according to State Street Global Markets, it's worth weighing the arguments for a growth stock rally. In this column, I'll even give you a list of growth stocks to research so you'll be ready to move if and when you're convinced. Growth and value are relative and subjective terms. But the trend in the stock market over the last few years has been real -- and profitable, if you've been on the right side.
Growth stocks such as Microsoft Value stocks such as Exxon Mobil After lagging so badly, growth investors are inclined to clutch at any straw of evidence of a comeback for their investing style. This is why the recently concluded June quarter has given them hope: The Russell 3000 Growth Index ($RAG.X) returned 2.6%, beating the 2% return on the Russell 3000 Value Index ($RAV.X). Related news and commentary on MSN Money One quarter of outperformance isn't enough to convince me that the trend has turned. Value has lost to growth before in the last 18 months, but that didn't stop the value style from outperforming growth in four of the last six quarters. But the case for a growth rally isn't built on the June quarter alone. The case for a growth rally For one thing, there's recent economic evidence indicating that growth may have started to rebound from a slowdown in March and April. Factory orders, for example, rose in May (by 2.9%) for the third straight month. The Institute for Supply Management reported that its manufacturing-activity index rebounded to 53.8 in June from 51.4 in May, the first increase since November 2004. The ISM service activity index rebounded to 62.2 in June, reversing a decline from 63.1 in March (any reading above 50 indicates expansion). Business investment climbed 8% in the second quarter, according to J.P. Morgan Chase, after growing by just 4% in the first quarter of 2005. Then there's the valuation evidence. The stock market began the year's second half almost exactly where it was at the beginning of the year, with the Standard & Poor's 500 ($INX) at 1,202 on Jan. 3 and at 1,191on June 30. In those six months, however, trailing 12-month operating earnings on S&P 500 stocks climbed to $71.05 from $67.68, a 5% increase. With the index stuck near the same price at the beginning and end of the period, the earnings increase has been enough to drive the price-to-earnings ratio down to 16.8 from 17.6. With the yield on the benchmark 10-year Treasury note actually lower than it was six months ago, stocks are cheaper relatively and reasonably priced historically, at least at current interest rates. But since growth stocks increase earnings faster than the average stock, the drop in the P/E ratios for this group is even more pronounced. Microsoft's shares, for example, have climbed just 2% in three years while the company's earnings climbed 49%. That's not great growth for a company with Microsoft's record, but it has been enough to bring the stock's P/E ratio down to 24.3 from 42.9 in June 2002. If stocks as a whole are reasonably priced or even cheap now, selected growth stocks are even cheaper. Growth-stock advocates go on to argue that because we're getting near to the end of interest-rate increases from the Federal Reserve, because there's rising confidence that high energy prices won't tank the economy (since high energy prices haven't already tanked the economy), and because technology earnings always pick up in the second half of the year (and the technology sector is the growth-stock leader), growth stocks will have stronger winds at their back in the second half than the first. Still skeptical, but ready to move I don't find these arguments terribly convincing. It's at least as likely that the Federal Reserve will keep raising rates through the end of the year as that it'll stop with an August hike. I'm not sure what the economy's reaction to $50-a-barrel oil tells us about the economy's response to $65-a-barrel oil. And the second half of 2004 put the same seasonal trends behind growth stocks as we expect this year, and the style still managed to trail value in the year's fourth quarter 9.7% to 10.6%. But I do find the valuation story interesting because prices for some growth stocks have tumbled enough that they're priced like value stocks -- but with the potential earnings gains of a growth stock. So, I've built a screen to look for growth stocks that are trading at low valuations when you consider their projected earnings-growth rates. To get the growth part of my screen, I've looked for companies projected to grow current quarter and current year earnings by 15% or better and projected to show accelerating growth (20% or better) next year. To make sure that these are growth stocks, I set the beta at 1 or above and looked for a P/E ratio above the S&P 500 average of 16.8. To get at the low valuation part of my agenda, I looked for a PEG ratio (forward P/E divided by next year's earnings growth rate) of 1.2 or less. And to make sure that I wasn't taking on more risk than I could handle, I capped the current P/E ratio at 34, twice the average for the S&P 500. (And, finally, to assure liquidity, I required a market capitalization of $500 million or more.) The screen pulled up 91 matches. Growth stocks to watch Some, Coach After due diligence, I came up with four names from this screen that I'd put in a growth-stock watch list as I wait to see how the next couple of months develop: They are:
Two near-misses for the watch list After I've built a screen like this, I like to poke around with the parameters and see which stocks miss by just a hair. (You can use the comparison tool in our stock screener to do this. Just plug in the symbols that you want to check against the screen criteria.) They often deserve to make a watch list like this, even though they don't quite make the screen. In this case, I'd add two stocks to my watch list: Hutchinson Technology That makes six growth stocks to watch for a second-half growth rally. Do your due diligence on these now, so you'll be ready to move if the market is indeed finally swinging to growth from value. Changes to Jubak's Picks Buy Komag Komag During the March quarter, the company announced plans to increase quarterly production to 26 million units from 24 million. Gains in efficiency enabled the company to expand production to that level from a capacity of 25 million, but Komag likely ran at full capacity in the June period. That's great news for a company with high fixed costs like Komag since, according to the company's midquarter update, it'll push profit margins to 15% from the 13%-15% range it previously expected. The company has also announced plans to increase capital spending by $70 million to push capacity to 30 million units by the end of the first quarter of 2006. I'm adding the stock to Jubak's Picks with a target price of $36 a share by December. I'd set a stop loss on these shares at $24.25. New developments on past columns 3 ways to capture the September effect Good news and bad news for two of the gold stocks in Jubak's Picks. First, the good news: Indonesia has dropped criminal charges against five Newmont Mining Second, the bad news: Shares of Placer Dome Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Microsoft, Newmont Mining, and Placer Dome Gold. He does not own short positions in any stock mentioned in this column. | |||||||||||||||||
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