What to Do with the Tech Titans

09/09/2011 8:30 am EST

Focus: STOCKS

Timothy Lutts

Publisher, Cabot Heritage Corporation

Whether it's day-to-day life or your investing life, it always pays to know the risks associated with rewards, writes Timothy Lutts of Cabot Wealth Advisory.

One of my favorite sayings, which applies to both life and the stock market, is "Trouble comes from where it's least expected."

I was reminded of this as Hurricane Irene plodded through New England ten days ago. Residents of coastal areas, thoroughly warned about the potential dangers days before, were well prepared. Damage was, for the most part, far less than feared.

And where did Irene do the most damage?

In hilly Vermont, folks had assumed that the power of the storm would have petered out by the time it hit the state, and that cleaning up would be a simple matter of clearing away broken tree limbs.

Instead, they suffered the greatest floods the state had seen since 1927!

The bottom line: despite all our digital sophistication, weather remains unpredictable, and when people say, "it's supposed to ...", you should mentally translate it as "Some talking head said there's a good chance that...but he or she might be wrong."

In the stock market, similarly, when a fear is shared by the majority of people, the collective actions of those people cause the market to adjust. So instead of joining them in their worries, it's far more profitable to watch the action of the market, and the action of individual stocks.

Speaking of stocks, I received the following from a loyal subscriber recently:

Just for fun, I would really appreciate a column on Apple (AAPL), Baidu (BIDU), Google (GOOG) and Netflix (NFLX). Their fortunes seem to be intertwined, so a fiscal group hug might be illuminating.

I have a little difficulty believing that AAPL and NFLX can continue their march upward. The power of market leaders is sometimes like viewing Niagara Falls ... breathtaking, but hard to grasp for such a limited intellect.—G.R., Racine, Wisconsin

Let's look at some numbers.

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Click to Enlarge

Apple is the elephant in the crowd, with $28.6 billion in revenues in the latest quarter, but it's dancing like a ballerina—growing revenues a simply stupendous 82% and earnings per share a fantastic 122% in the last quarter. And it has a fat profit margin—huge for a technology hardware company—thanks to its premium prices.

Baidu is the baby of the group, with just half a billion in revenues. Its growth rate is on a par with Apple (extremely good), and its after-tax profit margin is the best of the group by far.

Google's $9 billion in revenues tells you it's a full-grown company, and its relatively slow growth rate in this crowd is a red flag. Also troubling is the fact that its profit margin is shrinking slightly—it's low for a software company—and may shrink even more as the company enters the competitive smartphone market.

Netflix stands out for its low profit margin, a reminder that a lot of its revenues pass through to content owners. But its growth rate is excellent, and its small size means it can get a lot bigger faster if management makes the right choices.

But which is the best investment?

For aggressive growth investors who want to hit home runs and are quick to sell when things don't work out, I'd nix AAPL, because the company is so well loved (and therefore vulnerable to becoming less well-loved), and I'd nix GOOG for the same reason, as well as the company's slowing growth and its shrinking profit margin.

That leaves the two smaller companies, Baidu and Netflix. Being smaller, they mathematically have greater growth potential. And between those two, the hands-down choice in my opinion is Baidu, which is growing faster and has higher profit margins.

Now, there is an unquantifiable risk in the fact that the company is Chinese. We know from experience that the Chinese government from time to time will change the rules in various industries, in the spirit of protecting the Chinese people—for example by knocking down potential monopolies.

Baidu has 75% market share of Internet search in China, and just last month a government-owned broadcaster quibbled about the way the company's advertising defrauded customers.

But every investor in the stock knows all that, so you shouldn't worry about it. You should just look at the action of the stock to see if it's a problem...and the stock says it's not.

BIDU has been holding up quite well through the broad market's sufferings in recent months, and it's now just 13% off its high. Additionally, BIDU is one of the stocks in Cabot Stock of the Month Report, which I edit. Since I recommended buying 13 months ago, the stock is up 84%.

But BIDU might be too hot for you. You might be a conservative, value-oriented investor, and in that case, the other stocks are worth looking at.

Here's what Cabot Benjamin Graham Value Letter says about these four stocks:

  • Netflix isn't mentioned. It's not well established enough.
  • Baidu is listed, because it does have a great record of sales and earnings growth. But Editor Roy Ward says Baidu, currently trading around $145, is way too expensive to buy now. His Maximum Buy Price (the highest price you should pay) is $82, while his Minimum Sell Price (the lowest price you should sell at) is $174. The growth and value systems agree. BIDU is a good hold here.

  • As to Apple, Ward says it's a buy under $395 (it's very close to that now), and a sell above $838.

  • And Google? It's a buy under $562 (again, very close to today's price), and a sell above $888.

Assuming these stocks reach their Minimum Sell Prices, and those prices don't change, AAPL would bring a gain of 119% and GOOG would bring a gain of 67%. Not too shabby.

But the Minimum Sell Prices will change, and the direction of their change depends on the changing fortunes of the companies, as well as investors' perceptions of these changes...which is a way of saying your results may vary.

Also, these stocks might hit their Minimum Sell Prices in three months or three years, so patience is definitely required to follow the system.

Subscribe to Cabot Wealth Advisory here...

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