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Go for the growth--and where to find it at a reasonable price
04/20/2010 8:30 am EST
Of course, what investors want to know is where is economic growth likely to produce the biggest increase in earnings. And, perhaps even more important, where hasn’t growth, actual or just hoped for, already been priced into share prices.
Not surprisingly, I think, growth has been priced into the share prices of the world’s fastest growing economies. Everyone has wanted a piece of the growth story in China or Brazil or India. Growth there isn’t cheap anymore.
Growth is much more reasonably priced for stocks of companies based in the United States, Europe, Canada, and Japan. But growth has been much slower in those economies—where there’s been any growth at all—and the growth stories in those economies come with huge second half 2010 and 2011 uncertainties.
So what’s an investor to do?
I think it’s important to pay attention to the macro economic trends, of course. For example, I don’t think investors should ever ignore the possibility that a country’s central bank will raise interest rates by 2.5 percentage points as economists are projecting for Brazil before the end of 2010. And I certainly wouldn’t ignore the forecasts that put economic growth in the euro zone economy at well below 2% in 2010.
It’s hard—although not impossible--to make money when the economic winds are blowing that hard against you.
But right now I’d recommend identifying the fastest growing sectors in the global economy and hitching your portfolio to one of those stories. That will let you search across borders to find the cheapest way to buy into a sector’s growth and also give you a chance to avoid some of the worst potential macroeconomic dangers.
In this post I’m going to suggest three global sectors—well, maybe more accurately one sector, one industry, and one niche--where growth seems especially juicy right now and where you can still find growth if not cheap, at least at a reasonable price. And I’m going to suggest five new stocks that I think are especially attractive right now for their growth prospects. I’m going to add one of them to the portfolio today.
First, here’s the macro background.
Economies from Poland east to the United States and Brazil (in other words pretty much everything except the United Kingdom and the European Union) are showing solid growth for 2010.
That isn’t to say that all growth rates are the same. China grew by 11.9% in the first quarter but U.S. growth is projected at somewhere around 3%.
Or that every economy is at the same stage of the growth cycle. Growth in developing economies such as Brazil and China is so established and so fast that governments and central banks are set to pull away the punch bowl by withdrawing economic stimulus and raising interest rates. In the United States growth is still putting down roots so government officials and central bank leaders are only talking about reducing debt and raising interest rates sometime in the future.
Or that we know how fast individual economies will be growing in the second half of 2010. Higher prices for commodities such as oil and iron ore could slow growth across the global economy. Higher interest rates in developing economies would be the equivalent of stepping not so gently on the brakes. Problems in the various national real estate sectors (ranging from housing prices that are too low in the United States to prices that are too high in China) and on bank balance sheets could still throw enough sand in the gears to slow the recovery if not to stop it entirely.
But all in all, investors in 2009 and 2010 have felt much more certain about growth in developing economies such as China than they have about growth in a developed economy such as the United States. And you can see that in the current prices of Chinese and U.S. growth stocks.
So for example, the ADR (American Depository Receipt) of China Life Insurance (LFC), the largest life insurance company in China, now trades on the New York Stock Exchange at a price to earnings ratio of 29 times earnings per share for the last 12 months. That wouldn’t be so pricey except that there seems to be a good chance—at least some Wall Street analysts are projecting this—that earnings will actually dip in 2010. MSN Money shows the ADR’s forward price to earnings ratio (that’s the ratio based on projected earnings for the year ahead) at 31. Now that would be expensive for a stock that’s now growing at all.
Other standard valuation measures also put this ADR in the expensive category. It trades at 5.3 times sales for example and at 4.5 times book value. (More about how to evaluate these numbers in a moment.)
And then there’s the risk that isn’t captured by these valuation measures. The company’s net income has been extremely volatile in recent years. For example, it climbed 95% in 2007 as the stock market rallied and China’s Life’s portfolio went along for the ride. Net income fell by 45% in 2008 as stock prices tumbled. The company tried to damp that volatility by adding debt instruments to its portfolio in 2009 but in recent months its portfolio looks to be swinging back towards the old model. China Life was one of the biggest investors in the $1.1 billion IPO (initial public offering) of Sinopharm and the $700 million IPO of construction materials producer BBMG. That’s increased the company’s leverage to stock prices again just when the government is making noises about the need to prevent asset bubbles.
Now compare growth and valuations at U.S. based Intel (INTC).
Intel trades at a price to earnings multiple of 20.4 times earnings for the last four quarters. Wall Street is projecting earnings growth for Intel of 69% in 2010. That sends the forward price to earnings ratio to a low 12.9.
Those other valuation measures? The price to sales ratio for Intel is 3.8 (compared to 5.3 at China Life) and the price to book ratio is 3.0 (compared to 4.5 for China Life). Those ratios certainly don’t make Intel a value stock. (A value investor would be looking for price to sales nearer to 1 and price to book below 1.) But these measures are reasonable compared to Intel’s own 10-year history and compared to the current market average. Intel’s average price to sales ratio is 3.4 over the last five years and the average price to book ratio for the Standard & Poor’s 500 stocks as a whole is currently 3.7.
It’s not that there’s no danger in owning Intel. Growth stocks can always disappoint. It’s just that the danger in a disappointment is greatest when a growth stock is most expensive. Given Intel’s current valuation and the earnings momentum in the first quarter financial report the company released on April 13, I’d say the shares don’t come in a serious danger zone until 2011. Wall Street analysts are projecting earnings growth of just 8% for 2011. I think they’re likely to turn out to be wrong. But the danger is still there.
Okay, so if we don’t go looking for growth in what have been the world’s fastest growing economies in the last year or so, where do we look for growth?
I think Intel’s first quarter earnings are a very useful guide. The numbers were great—the company beat Wall Street projections by 5 cents a share and raised guidance for the rest of 2010 on a forecast that gross margins would climb to 62% to 64%. (The company had been projecting a range of 58% to 64%.)
But for the clues we need, you’ll have to look beyond the “what” of the numbers to the “why.”
In Intel’s case we see a classic example of what happens to a company’s revenues and profits when customers who have been out of the market—in this case because of fear and smaller budgets as a result of the global economic slowdown—return to the market to resume their normal rate of buying to discover that while they were gone products improved so much that the whole economics of purchasing is different.
So first, Intel is the beneficiary of a return to normal buying by PC customers. Corporate customers had been out of the market really since the January 2007—even before the economic slowdown had gained full momentum—as a result of disappointment with Microsoft’s (MSFT) Vista operating system. An estimated 80% of corporate customers running Microsoft operating systems simply never upgraded to the new software—and slowed their purchases of new hardware as well. The Great Recession simply put the cherry on top of the collapse in PC growth. But the end of the recession and the introduction of Microsoft’s Windows 7 have resulted in a return to growth. PC sales climbed 5% in 2009 and soared 27%$ in the first quarter of 2010 from the first quarter of 2009, according to market researcher Gartner.
That in and of itself would be enough to produce good growth for Intel. But Intel isn’t seeing just good growth. It’s seeing great growth—and that’s a result of what happened in the server segment during the Great Recession. (A standard definition of a server is a computer, more powerful than a PC, that provides services across a network to a number of individual users.) With the economic recovery companies discovered that growing Internet traffic required them to buy new servers—and that the increased energy efficiency of new server products and their reduced heat production made replacing old servers an economic no brainer. A new server, thanks to those improvements, would turn an investment profit in two years or less.
So suddenly Intel—and other chip makers and server manufacturers—saw an explosion in server demand not just from catch up orders but from a massive wave of replacement buying created by product improvements. Since server chips carry a higher margin than PC chips, Intel saw its profit margins explode along with sales. (For more on the server market see my post of Monday, April 19 http://jubakpicks.com/2010/04/19/looking-for-tech-stocks-try-the-server-market/ .)
That’s the growth model I’m looking for right now: A solid growth base produced by catch-up buying from customers who put off purchases during the Great Recession and a rocket booster from product improvements that are spurring replacement sales or that have significantly expanded the market.
Where to start? Intel itself would be a good buy. Except that I already own it in Jubak’s Picks. Purchased on January 15, the stock was up 16% as of April 15. I recently raised my target price to $30.40 a share so it’s not too late to buy the stock in my opinion.
But you can find an additional way to grab a piece of this growth story if you head upstream to Intel’s suppliers. ASML Holding (ASML) is the world’s largest maker of lithography equipment, the machines that etch more and more circuits onto tinier and tinier chips. The company returned to profitability in the third quarter of 2009 and on April 14 reported first quarter earnings 25 cents a share. What gave the company’s report an Intel-like flavor was guidance that said the company was on track in 2010 to beat its all time record for annual sales set in 2007.
And fortunately ASML is a Dutch company. (It trades in the United States as an ADR on the NASDAQ market.) That means it hasn’t run away from us like it might have if this were a Chinese or Brazilian or Korean company. The stock trades at just 15.8 times projected 2010 earnings per share. Analysts are expecting earnings to grow this year to $2.21 from a 50 cents a share loss in 2009. In 2011 earnings growth is now projected to slow to 17.2%. I think that Wall Street estimate is low, but even so investors are paying a multiple of 15.8 for 17.2% growth in 2011.
By the way, the stock actually sold off modestly in the days after its earnings report. I’m adding this one to Jubak’s Picks today. I’ll have a more detailed post on this buy up later today.
Where else can you find this kind of Intel-like growth?
How about among truck manufacturers?
Sales of Class 8 trucks—the big rigs—fell well below the long-term replacement rate during the Great Recession. The result is that the age of the U.S. fleet is now at a two-decade high. That’s a classic replacement drives demand story. Orders have started to turn up so the industry looks like its seen bottom.
But there’s an equivalent to the Intel server story in trucks too. While customers were sitting on the sidelines truck makers and their suppliers, especially among the engine makers, were turning out new products that used less fuel and produced lower emissions. (Not a minor point when the EPA (Environmental Protection Agency) is putting in tighter emissions standards. My favorites in this industry are truck maker Paccar (PCAR), engine maker Cummins (CMI), and emissions filtration company Donaldson (DCI). I’ll be adding one of these to Jubak’s Picks later this week.
My last suggestion for where to look for growth is actually more a niche than an industry. Stanley Works acquired Black & Decker in March to form Stanley Black & Decker (SWK). The merger gives the combined company a huge share of the market for construction and do-it-yourself tools just as the construction sector is starting to crawl off the bottom. (Industrial tools make up the second biggest business unit at the combined company. That’s not a bad business to be in when manufacturing is in turnaround.) Standard & Poor’s projects that organic sales growth (that’s sales growth that isn’t a result of the acquisition) will climb 5% in 2010 and 16% in 2011. The company is scheduled to report earnings on April 27. I’ll take another look at Stanley Black & Decker after that report.
Full disclosure: I own shares of Microsoft in my personal portfolio.
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