Related Articles
3 stock sectors with precious pricing power
8 ways to earn 8%
Related Resources
Whats going on in the market?
How does your stock rate?
Who are the biggest shareholders?
Check out the top 10 lists
Jubak's Journal
Recent articles:
• The pro forma problem won't go away, 1/30/2003
• Find a turnaround with a shot at success, 1/28/2003
• 8 ways to play a shaky market, 1/24/2003
More...
| | Jubak's Journal
My 15% earnings test for finding stock gems
The next three to five years will be volatile and tough, making careful stock selection a must. The winners will be those companies in leadership positions who can grow earnings 15% or more a year. Here are four.
By Jim Jubak
Im not rooting for the stock market to go down. I own enough stock in my personal portfolio that any drop costs me money.
And Im way past the days when I thought that every drop was a buying opportunity. That worked when the bull ran wild, but the bear has thoroughly mauled that strategy.
But I still watch any drop that takes stocks to the lower end of the current trading range with intense interest. These moves are my best opportunity to build the kind of long-term core for my portfolio that I now believe will work best for the next three to 10 years.
I build my core beginning with this assumption: Were headed for an extended period of only modest economic growth and intense competitive pressures that add up to downward pressure on corporate profit margins. If thats the case, then the stocks I want to own at the core of my portfolio include companies that:- Are taking market share from competitors.
- Have management that knows how to wring the most profit out of each dollar in sales.
- Have enough growth opportunities to profitably invest those earnings.
Companies like these have histories that demonstrate an ability to boost earnings 10% to 15% a year in both booms and recessions. And they appear able to grow earnings at comparable rates despite a potentially lackluster economy for the next five years.
Theres just one problem with stocks like these: They arent exactly stock market secrets, so they tend to be expensive. Which is why I find the current market volatility so interesting. Drops like last weeks represent a chance to get in at lower than normal prices.
In this column, Im going to lay out why I think that these kinds of stocks should form the core of an investors portfolio now, and then Ill offer the names of four stocks that fit this profile.
Its not your average bear
Let me start by stating that were not in a run-of-the-mill bear market.
The typical bear market is built on a collapse in consumer demand. As consumers stop spending (why they do this isnt entirely understood by economists), the economy slides into recession, and corporate profits drop as companies see sales decline. In the typical scenario, a slowdown or an outright stop in business investment follows. With consumers buying less, theres no reason for companies to expand production, and theres no money to invest in improving production.
That sets the stage for the typical recovery. At some point (again, economists dont know much about why or when), consumers decide that they feel OK about spending, and they unleash a buying surge to catch up on all the purchases they postponed. Releasing this pent-up demand leads to a surge in corporate profits. That, in turn, leads to an upswing in spending on capital equipment as businesses rush to catch up with demand and then spend their extra profits on improving their businesses in the hope of increasing profits even more.
But as anyone who has read the headlines during the current slowdown knows, that isnt whats happening now.
We dont have a recession led by a collapse in consumer demand; weve seen consumer spending remain strong. Business spending, on the other hand, has plunged. Misled by their own projections of how fast demand would grow, and previously encouraged to add capacity by the availability of cheap capital, businesses have now had to cut back.
Too much capacity left
The recovery from such a capital-spending-led economic slowdown is likely to be much, much slower than the recovery from a more typical consumer-spending-led recession. Because consumer spending didnt collapse, the economy cant count on a surge as consumers catch up on deferred purchases. And yet, because the slump has been relatively mild, the downturn itself hasnt removed much excess capacity from the economy. WorldCom Group (WCOEQ, news, msgs), for example, isnt going out of business. Instead, its reorganizing, and all its long distance and Internet capacity remains on the market. Once the company emerges from bankruptcy with a new and reduced cost structure, consumers will be able to buy all that capacity from WorldCom at lower prices. And that will pressure other telecommunications service providers to cut prices. In such a situation, its hard to see why any company would start to increase its capital equipment budget much above the level required merely to replace aging or uncompetitive equipment.
The problems with how this cycle is playing out are exacerbated by changes in longer-term economic trends, including:
Interest rates are nearly ready to reverse direction. Rates have moved downward with remarkable consistency from the double-digit rates of the high-inflation 1980s. Even if rates dont rise much because of an increasing federal deficit and a weaker dollar, companies will still face an end to ever-cheaper money. Heavily indebted companies wont be able to count on refinancing at lower rates. Stocks and bonds wont get the pushes theyve had from declining rates. Consumer spending wont get a boost from lower mortgage rates.
Stress on prices and profits will continue. Thanks to a global expansion of capacity (think China on the manufacturing end and India on the service end), prices and profit margins are likely to continue to stagnate or drop even as competitive pressures increase.
So what kind of company would you like to own shares in during this kind of economy and this kind of market?- A company taking market share in its industry. If general economic growth will be very modest, the rising tide wont be strong enough to lift all boats. Companies that take share will be able to grow at rates above the trends for their industries and have the chance to distance themselves from competitors.
- A company thats more efficient than the competition. If the general direction for profit margins is down, the only way to buck the trend is to constantly deliver greater efficiencies than competitors. Greater efficiencies also produce higher profits that can be reinvested to improve efficiency even more. Beware companies with falling margins in their core businesses.
- Companies with clear growth opportunities in good-margin areas. In some industries, its hard to see any growth opportunities at all: Anybody see big new market opportunities in front of U.S. airlines? How about long distance service providers? Other companies, especially among the big-cap stars of the last bull market, face the problem that identifiable new business opportunities carry lower margins than their existing businesses. Thats a challenge confronting EMC Corp. (EMC, news, msgs) and Cisco Systems (CSCO, news, msgs). Its easier for a small or mid-size company to find significant new markets than for a big-cap behemoth to do so.
- Companies with the demonstrated ability to grow earnings by 10% to 15% a year pretty much every year. This is a double check on the accuracy of your assessment of a companys future potential, and a reality check on overly optimistic projections of future growth from the company or from Wall Street analysts.
4 stocks that make the cut
Can I find companies that deliver these five characteristics? Sure.
Are there very many? No.
But here are four suggestions that I think make the cut.
Cintas (CTAS, news, msgs), the nations leading uniform supplier. The companys core uniform rental business has grown by just 6% annually over the last three years (Hey, theres a recession on, you know), but Cintas has been able to gain share in its fragmented market and to hold margins steady. Sales growth has averaged 17% over the last five years and earnings per share have risen 14% on average. Market capitalization is $7 billion.
First Data (FDC, news, msgs), the financial-transactions giant. First Data, which owns Western Union and is the biggest credit-card processor, has a bigger market capitalization than Id like at $26.5 billion, but Ill stretch here because the companys market opportunity is so large. The company already processes 40% of all credit card transactions in the United States, and its volume is three times greater than that of its closest competitor. Earnings per share have grown 30% annually on average over the last 5 years; sales have risen 9% on average.
Stryker (SYK, news, msgs), a big manufacturer of surgical products and now the world leader in joint-replacement devices. The aging of the worlds population gives the company plenty of room for growth. If you exclude results from 1998 when Stryker took a big charge for its acquisition of Howmedica, the company has produced average earnings growth of 20% a year for the last 20 years. Looking at the shorter term, earnings have climbed an annual 34% over the last five years on 26% annual sales growth. Market capitalization is about $12 billion.
Sysco (SYY, news, msgs), the leading food-service distribution company. Margins are razor thin in the food business, which is why Syscos ability to raise gross margins to 19.8% in 2002 from 18.4% in 1998 is so remarkable. While Sysco is the biggest player in food-service distribution, the sector is still remarkably fragmented. That assures the company of lots of room for growth either internally or by acquiring small competitors. Sales have grown by 10% annually on average over the last five years. (The 7.2% sales growth recorded in 2002 counts as a huge slip given Syscos record.) Earnings per share have climbed by an average of 19% during the last five years. Market capitalization is $18 billion.
These stocks and the companys stories arent exactly secret, and they hardly ever get cheap. Sysco is probably the cheapest of the bunch (thats why it has made it into Jubaks Picks), but even that stock trades at a price-to-earnings ratio of 26. When I added it to the Picks at $30.50, I calculated a target price of $36 for December 2002. Given market conditions, that turned out to be optimistic. Id now put the target at $33 for June 2003. Thats roughly a 10% return from my original purchase price in less than a year -- but a much better 18% potential return from the recent price of around $28. The pullback in the market has, in this case, given investors who want to build a core position in Sysco a decent entry point below $30.
First Data is moving into range. I get a target price for those shares of $39 in a year, and the shares recently traded at about $35. Thats a potential gain of 11% in a year by my calculations. Not enough to tempt me in the current volatile market for financial shares.
I cant say that Stryker is even in striking range. For that stock, I get a target price in a year of $64, but the shares recently traded around $62.
As for Cintas, my target is $38, but the stock currently trades at about $42.
So I watch and wait and see what the stock markets volatility might bring me. And meanwhile, I explore other kinds of market opportunities -- such as the income from preferred stocks, the subject of my next column.
New developments on past columns
Much maligned target prices offer superior payback
Using Wall Streets scoring system, Apache (APA, news, msgs) reported earnings of $1.30 a share, two cents above analyst consensus. (Wall Street decided not to count the 6 cents-per-share charge the company took for the impairment of assets in Poland.) Revenue for the quarter climbed to $730 million from $537 million in the fourth quarter of 2001. The company pulled off the difficult trick of cutting back on drilling for part of the year in response to higher costs but still increasing proved reserves by 4%. For the year, Apache replaced 138% of production. The cutback in drilling enabled the company to reduce debt to 34% of total capitalization, from 37% at the end of 2001. Still, the big event for Apache was the Jan. 13 purchase of $1.3 billion of oil-and-gas assets from BP (BP, news, msgs). The major part of the purchase consists of BPs Forties field, one of the oldest and largest of the North Sea oil and gas fields. Apache has a long history of buying established properties and squeezing extra oil from them, and this deal is not expected to dilute current shareholders. As of Jan. 31, I'm raising my target price on Apache to $65 a share by March 2003. (Full disclosure: I own shares of Apache.)
5 stocks poised to lead the market back
On Jan. 27, Sysco (SYY, news, msgs) announced fiscal second-quarter earnings of 28 cents a share, matching Wall Street expectations. Earnings growth came to just a tad shy of 18% from the same quarter in 2001 in an extremely tough environment. Deflation, which cuts into Syscos revenue, ran at almost 1% in the quarter, but Sysco still managed to grow sales at 13.6% for the period. (Internal sales, which subtract the effect of acquisitions, grew by 7.6%.) Sysco was actually able to increase operating margins by 6 basis points in the quarter (100 basis points equal one percentage point) by knocking 20 basis points out of sales, general and administrative (SG&A) costs. Nothing here to indicate that Syscos ability to deliver reliable 15% annual earnings growth is in question. The company is the clear market leader in a fragmented industry, which gives Sysco the clout to continue to grab share from weaker competitors (or to acquire the best of them), and plenty of room to grow. The food-distribution business is one with high fixed costs, which makes for high returns for anyone who can spread those fixed costs over a larger base. The demographic trends favor growth in the industry as a whole, as the average American now eats out 4.2 times a week. That total has increased steadily over the last decade. To reflect the weak overall stock market, Im cutting my target price for Sysco to $33 a share by June but with the recent pullback in the stock to below $30, that target still presents an attractive potential return. (Full disclosure: I own shares of Sysco.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Sysco. He does not own short positions in any stock mentioned in this column.
|
