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Jubak's Journal
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| | Jubak's Journal
5 winners for the winner-take-all market
It's not just how much dominant companies spend on research and new products that counts. Here's how to judge for yourself who'll come out on top, plus my picks.
By Jim Jubak
Winner take all. Sounds good, doesnt it? Who wouldnt want a few of those in a portfolio?
In my last column, The winner-takes-all stock market, I argued that in the slow-growth, low-inflation, harshly competitive global economy that will characterize the next decade, companies already at the top of their industries have a chance to increase their dominance. Because these companies are currently more efficient and more profitable, many will be able to put more money into even more efficient plants and developing new products than their competitors.
So how do you identify even a few of these potential winners for your portfolio?
The best indicator: R&D spending
The most reliable indicator is a companys spending on R&D -- research and development. R&D represents a companys internal projections of its future opportunities: Companies that see big future markets up for grabs tend to spend more on developing products that can capture those markets. Companies that increase their spending, especially when times are tough, have the kind of aggressiveness thats needed to win it all.
Not that R&D numbers are easy to use. Theyre unfamiliar to most investors; they arent widely or prominently reported. And they have to be put in context or theyre worse than useless. Just knowing the quantity of dollars a specific company spent on R&D or even the recent trend in R&D spending at a company can be misleading in isolation, making companies look weaker or stronger than they are.
Lets first start by developing six rules that will help us use R&D spending to find winner-take-all stocks. When were done, the rules, in turn, will lead me to a list of five stocks that are potential candidates for my portfolio.
- The perfect winner-take-all stock does exist, but its rare. The company has a dominant market share plus accelerating R&D spending that could bury competitors with a big-cap name that every investor recognizes. Johnson & Johnson (JNJ, news, msgs) has raised R&D spending in every year from 1999 through 2002 in both absolute dollar terms and as a percentage of revenue. R&D spending that was already a huge $2.6 billion in 1999 climbed to $4.1 billion in 2002. From 9.5% of revenue in 1999, R&D spending grew to 11.3% in 2002. In a period when the company saw revenue grow by 32%, rather than easing off on spending to develop new products, Johnson & Johnson pushed the pedal to the floor. Thats the aggressiveness that builds market share, even for a company that is already a dominant player in many of its business segments.
In the last three years, Johnson & Johnson is the only company out of 111 stocks that shows the kind of year-on-year increase in R&D that offers such perfection. Such perfection is rare: When I go back 10 years, I find only two companies that fit the bill then, Electronic Arts (ERTS, news, msgs) and Pfizer (PFE, news, msgs). Of course, these two stocks havent done too badly over the last 10 years, returning an annualized average of 20.4% and 22.6%, respectively. (The Standard and Poors 500 index ($INX) was up an average of 9% a year during the period and the Nasdaq Composite ($COMPX) up 10%.)
- A winner-take-all company doesnt have to be huge. Dominating a smaller niche will do just fine. Take a look at Applied Films (AFCO, news, msgs). This maker of the equipment that deposits the thin films onto glass that are at the core of flat-panel displays is hardly a household name. But the company dominates key parts of the equipment market for a product thats experiencing exploding demand. Needham Co., a Wall Street investment firm, estimates that Applied Films has a 60% market share in Taiwan, which has emerged as one of the top two production centers for flat-panel displays. In a market like this one, where constantly falling prices and constantly increasing quality of displays makes change relentless, Applied Films has shown willingness to increase R&D spending the way an investor would like to see. Revenue grew 265% from 2000 to 2003, but R&D spending jumped 771%. That spending seems to be paying off because Applied Films has recently won contracts from L.G. Philips and is in the running for an order for Samsungs new flat panel plant.
- Look for companies operating in a market where R&D counts. That includes more than the traditional technology sector these days. I certainly didnt expect a company like Donaldson (DCI, news, msgs), known for its automotive filtration business, to show up on a list of companies raising R&D spending, but it does. R&D, which has led to a slew of patents and increased proprietary content in Donaldsons newest systems, has allowed the company to raise prices, increase margins and deliver a better product to customers. Another surprise that makes the same point: GrafTech International (GTI, news, msgs), where even the business of dirty ol graphite demands R&D these days.
- Judge R&D spending against industry standards. Schlumberger (SLB, news, msgs) looks like an R&D piker when compared to a Johnson & Johnson. The oil-drilling services company with its $512 million in 2002 spending (after subtracting R&D at the soon-to-be divested SchlumbergerSEMA technology business) simply isnt impressive up against Johnson & Johnsons $4.1 billion.
Put apples against apples, however, and Schlumberger looks much better. The company spent more than twice as much on R&D as Halliburton (HAL, news, msgs), the No. 2 R&D spender in its industry in 2002, with $233 million. And Halliburton produced more revenue than Schlumberger in 02.
The same goes for judging R&D as a percentage of revenue. Johnson & Johnsons climb to 11.3% of revenue spent on R&D looks huge, but not compared with a tech company such as Altera (ALTR, news, msgs), where R&D spending hit 26% of sales in 2002. Again thats apples and oranges. But recognizing how exceptional 26% R&D spending is helps an investor understand the extraordinary commitment to R&D at a market leader such as Avid Technology (AVID, news, msgs). Avid has kept R&D spending near 20% of revenue year in and year out recently.
- Give more weight to how much a company spends when the going gets tough. Avid Technologys dedication to R&D is particularly impressive because swings between profit and loss havent changed the companys R&D budget.
But for a real dedication to R&D in tough times, look at Sun Microsystems (SUNW, news, msgs). Suns revenue plunged from $18.3 billion in 2001 to $11.4 billion in 2003. But R&D spending as a percentage of revenue rose from 11.5% in 2001 to 14.4% in 2002 to 15.8% in 2003. Now, absolute R&D spending during that same period fell from $2.1 billion in 2001 to $1.8 billion in 2002 and 2003. But any technology company that can cut R&D spending by just 14% while revenue falls by 38% is clearly committed to R&D.
An investor who wants a true picture of a companys R&D spending, especially for a technology company that went through the boom and bust of 2000/2001, should take out the effects of the boom year when everybody had cash to spend on everything. Thus, its very important that EMCs (EMC, news, msgs) 2002 R&D spending of $780 million (14.2% of revenue) equaled the $780 million (8.8% of revenue) the company spent on R&D in 2000. Critics will point out the company spent $929 million on R&D in 2001. That, however, was at a time when the company thought the technology boom would last forever.
- An important caveat: Not all increases in R&D spending are good signs. Increasing R&D spending can be a sign that a company is in the competitive fight of its life. Sun Microsystems CEO Scott McNealy has ignored Wall Street analysts who have called on him to cut R&D because he knows that, if Sun doesnt keep spending, the company is toast.
Similarly, Alteras increase in R&D in both absolute and percentage terms from 2000 to 2002 (from $179 million to $182 million) despite an almost 50% drop in revenue is a sign of the companys dogfight with Xilinx (XLNX, news, msgs).
Xilinxs R&D spending has jumped from $124 million to $205 million. And it has gone from trailing Altera in R&D by roughly $50 million in 2000 to leading by about $22 million in 2002.
The battle at Sun is by no means over: The company may pull off its high-risk bet, but this is a company in a battle for survival rather than a market leader strengthening its position. The battle between Altera and Xilinx also is by no means over. Although Altera is being outspent, the company is currently more profitable than Xilinx with a gross margin of 67.8% to Xilinxs 60.8%.
My five candidates to buy
From the companies Ive mentioned here, Id put these as potential candidates to buy:
- Johnson & Johnson
- Applied Films
- Donaldson
- Schlumberger
- Avid Technology
As always, please remember that what Ive provided is by no means complete due diligence on any of these stocks; I havent once mentioned such issues as valuation. Youll need to complete that work before you can decide if of these are a buy for your own portfolio in the currently very unsettled stock market.
You can judge, however, my opinion on three of these at least by noting that Johnson & Johnson and Schlumberger are members of my long-term 50 Best Stocks in the World, and Donaldson is a current Jubaks Pick.
New developments on past columns
5 stocks to retire on -- and count on
Oh, well whats a little 40% error? Turns out that Royal Dutch/Shell Group, the oil company owned by Shell Trading & Transport (SC, news, msgs) and Royal Dutch Petroleum (RD, news, msgs) overstated proven reserves in its leading oil field in Oman by some 2 billion barrels or 40%. Company documents show that oil production in this companys leading oil field in Oman went into decline in 1997. And, while new horizontal drilling techniques were able to increase production, they did not increase the long-term potential reserves of the field as the company claimed in 2000. In fact, the techniques actually increased production costs. This isnt a big deal for Royal Dutch/Shell, at least not in comparison to the companys write-down of its entire global reserves by 20% in early 2004. But it does show that the flow of bad news that is keeping the stock down isnt over.
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: Donaldson, Pfizer, Schlumberger, and Shell Transport & Trading. He does not own short positions in any stock mentioned in this column.
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