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S&P's Top Ten Stocks
08/20/2004 12:00 am EST
"Our key principle is independence," saysStephen Biggar, VP of equity research for Standard & Poor's. "Our qualitative and quantitative research is unbiased and rigorous." Here, he highlights the ten favorite stocks from S&P's exceptional universe of equity analysts.
"We think it’s a stock picker's market. I don’t think there are any bets out there we can make from a sector perspective. So we are relying on the analysts within each sector to find good opportunities. Our analysis is unbiased. Very rigorous analysis goes on behind the scenes as balance sheets, cash flow statements, income statements, are dissected. A lot of rigor goes into this, both qualitative and quantitative. We look at technical factors as well as corporate governance issues. Our analysts have an average of 14 years experience with S&P.
"In our bottoms-up approach, we use three primary methodologies for valuing stocks. Our analysts use value analysis, which is generally referred to as discounted cash flow. The analysts will come up with expectations for cash flow going forward, and we think that is the driver of stocks. We then discount that back at an appropriate rate, which includes such factors as the riskiness of the stock itself, the current level of interest rates, the risk-free rate, and the corporate capital structure— how much of the business is funded by debt versus equity or preferred stock. Second is relative valuation. These metrics are generally those that are most appropriate for that specific industry based on what typically drives a particular company to excel within its peer group. Lastly, we look at the sum of the parts. This generally works well when you have a company that is not readily comparable to many peers. In that case, we dissect the units and value them as if they were stand-alone businesses.
"At the end of the day, our overall investment theme is growth at a reasonable price, known as GARP. We like growth, but not at any price. We look for discounts based on our three methodologies in order for our analyst to have a good sense that the company is undervalued and has a greater chance of outperformance over the next 12 months. We are very selective. We cover over 1,500 companies and only 8%—or 125— of those are deemed to be worthy of our highest 5-star buy recommendation. Over the last 17 years, the average annual performance of S&P’s 5-star stock recommendations has been 16.5%, relative to the S&P 500 index, which had a return of 9.3%. A hypothetical $10,000 investment on Dec. 31 1986 when the star system was created would now be worth $142,000. That same investment in the S&P 500 would have only yielded $47,000, the Dow, $55,000 and the NASDAQ, $58,000.
"Let’s move on to our top ten portfolio. These stocks are all taken from the 5-star stocks and they represent the stocks that we believe have the best total return opportunity. A senior group chooses this portfolio and we try to balance this portfolio across economic sectors and by asset class.
"The first name on our list is Amgen (AMGN NASDAQ). This is a large cap stock with a $73 billion market cap. It is a leading biotech company that is certainly well established. It offers treatments for anemia and rheumatoid arthritis. We think the shares are undervalued based on strong earnings growth, an under appreciated pipeline which includes a lot of areas in oncology, diabetes, and inflammation, and a reasonable p/e ratio. We’re always looking for value and this stock is trading at about 23 times our 2004 estimate. And that’s for a biotech company with a significant growth rate.
"Our next company is Anheuser-Busch (BUD NYSE), with a $41 billion market cap. It’s the parent company of the world’s largest brewer. We like them for basically where they are going in the demographic sweet spots in the economy. They do have a very large market share— 50% at the moment. They have very consistent earnings expansion. This is a stable and steady grower with very sustainable cash flow growth in a wide variety of economic environments. They have earned our dividend and earnings ranking of A+, which requires a history of ten years of very consistent earnings and dividend growth.
"BJ Services (BJS NYSE) is in the oil service sector. It is a mid-cap company, with a market cap of $8 billion. It provides pressure pumping and other oilfield services. We’re seeing rising demand for pressure pumping and high capital spending by the oil and gas producers. We see especially high crude oil prices right now. The energy sector is one we are favorable on at the moment. They are very large and diversified, and they are global. We like the diversification that provides. Based on these factors, including market leadership and a higher return on equity than its peer group, we believe this company should trade at a premium price-to-earnings multiple.
"Chattem (CHTT NASDAQ) is a nationally branded health and beauty aids company, which targets niche segments. We see strong growth in topical analgesics, such as Gold Bond and Selsen Blue. There are new product introductions coming out. The company has the highest profit margins in the S&P personal care universe and yet it trades at a 25% discount to its peers, based on 15 times our fiscal 2005 estimate. This is a small-cap company with a market cap of just over half a billion.
"FMC Corp. (FMC NYSE) is a mid-cap stock with a market cap of $1.5 billion. It is a diversified product of industrial specialty and agricultural chemicals. The company is the leading manufacturer of hydrogen peroxide, which is widely used in products such as insecticides and herbicides for crop dusting and the like. The company underwent a restructuring in 2003 and it was a low point for earnings. We now see operating earnings up 65% for 2004 and for double-digit growth for 2005. We expect a cyclical recovery in this business over the next two years. The firm is generating very strong free cash flow, which is targeted toward debt reduction.
"Guitar Center (GTRC NASDAQ) is a small cap with a market cap of about $1 billion. The firm is the leading US retailer of guitars, amplifiers, and other musical instruments. When we look in our small cap and emerging growth sectors, we try to find companies that have a niche in segments or industries in which consolidation can take place. This company operates in the very fragmented music-store industry, where the top five retailers only have 26% market share. We see them growing organically from expected store openings of 16 to 18 stores this year— off a base of about 120 stores. So this is good growth. They are altering their product mix a bit, by offering lessons and a broader selection.
"Landstar Systems (LSTR NASDAQ), with a market cap of $1.5 billion, operates a family of truckload carriers. They use independent drivers and commissioned sales agents, rather than actually investing in the fixed assets themselves. They compensate the drivers with a percentage of revenues generated per load rather than at a fixed rate per mile that you would get if you owned the equipment. This generates much stronger return on equity. We also see a healthy price environment, with tight capacity in the industry right now, which should benefit sales as well. It’s a very strong cash flow generator and has a very strong balance sheet with low debt and a high current ratio, which should sustain them through a wide variety of economic environments.
"SCP Pool (POOL NASDAQ) has a market cap of a billion and a half. They are the largest independent distributor of swimming pool supplies. Here you have favorable demographics, with aging baby boomers and increased home ownership as a result of low interest rates. We see consolidation in a fragmented industry. The swimming pool business does not really have a national supplier or distributor. Return on equity has improved to 30% in 2003, up from 14% in 1997. This is based off of leverage from a higher sales base. We are assuming 20% cash flow growth going through 2008 and we derive a $52 target price on this company.
"In the technology sector, Qualcomm (QCOM NASDAQ) focuses on products and services based on CDMA, which is digital wireless technology. There is very strong demand for the chipsets that are used in phones— particularly in China, India, and South Korea. They are moving their product mix towards higher-margined license fees. They have very strong cost controls. We like this financial model, with 30% sales growth, 35% net margins, no debt, and $7 billion in cash on the balance sheet. This is a large-cap company, with almost $60 billion in market cap.
"Winnebago (WGO NYSE), with market cap of $1.2 billion, is a motor home manufacturer benefiting from leisure activities. It has very favorable demographics, as it targets the 50-year-old and older market. They are making a lot of enhancements—added creature comforts— to their vehicles. We also see higher margins and higher return on equity and assets, which we feel justifies a premium multiple compared to its peers."
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