More than a snapshot

1/5/2009


Pictures never tell the whole story.

Two-dimensional images can capture a scene, and a talented photographer can even add some depth to increase a picture’s power. Unfortunately, even the best photographers cannot do more than capture the illusion of movement in a still photo. Stock-market reviews face the same difficulties.

Anybody with a little training and access to a good database can come up with a statistical picture of the market at a certain point. The trick is to project that picture forward, to capture the movement of the market. Even for experts, such prognosticating is tricky.

In the following paragraphs, the Dow Theory Forecasts will attempt to capture the market’s image — a moving picture — for two types of investors.

PROS AND CONS
Investment
Style
Bull Case Bear Case Key Indicators
Value Many stocks look cheap, and the market’s valuation is low relative to historical norms. Stocks could stay depressed for quite a while, rendering historical values of little practical use. Quadrix Value scores, valuation ratios relative to peers and historical norms.
       
Growth Growth stocks tend to outperform after periods of broad-based market weakness. Low valuations suggest the market lacks confidence in growth targets. Quadrix Momentum and Earnings Estimates scores, expected and historical growth rates.

The debate about the relative merits of two groups of stocks — growth or value — has been raging for decades. Value stocks trade at below-average valuations based on price/earnings, price/book value, and other ratios. Growth stocks tend to trade at premium valuations because of higher expected growth rates. Our strategy is best categorized as growth at a good price, as our Quadrix system looks at a variety of statistics, including some that reflect growth and others that measure value.

While we don’t favor one kind of stock over another, we acknowledge that value has outperformed growth by a wide margin over the last 80 years. According to Morningstar, from 1928 to 2007, value stocks delivered annualized returns of 11.4%, versus a 9.2% return for growth stocks. However, growth stocks are capable of leading the market for long periods of time, and they frequently set the pace when markets recover from down periods.

The bar chart below illustrates the historical perspective, and all investment decisions made today should take that perspective into account. But history can only tell us so much.

The value picture
Buying value stocks only makes sense if you are willing to hold them until the market recognizes that they are undervalued. That often takes time.

In today’s market, with the average S&P 500 stock down 42% over the last year, value stocks abound. As the chart at right shows, both the capitalization-weighted index and the average stock in the index are trading at historically low valuations.

Looking ahead: Value investors must be prepared to exercise their patience, because Wall Street remains skeptical about corporate profits and other statistics used in valuation ratios. Stocks are cheap for a reason, and while the market as a whole seems attractively valued, not all “value” stocks are likely to do well in the years ahead. Remember that value is relative — a price/earnings ratio of nine is cheap for a defense contractor, but not for an integrated oil company. Look for companies that earn high Quadrix Value scores and trade at a discount to the average for their industry.

Two appealing value stocks are reviewed below:

Like many energy-related companies, National Oilwell Varco ($24; NOV) earned strong profits in 2008, helped by high oil prices. With oil near $40 per barrel, down from $145 in July, the coming year will likely be tougher on this maker of drilling rigs and rig equipment. However, National Oilwell should continue to profit as the world’s aging fleet of rigs requires upgrades and replacements. Most of the company’s contracts call for not only the sale of equipment, but also additional revenue from aftermarket services and parts.

Wall Street expects per-share earnings to slip 6% in 2009 but rebound to rise at an annualized rate of 12% over the next five years. Sales are expected to increase 6% in 2009 as National Oilwell taps its $11.8 billion backlog.

Contract cancellations may rise but seem unlikely to surge, as the backlog is fortified by sternly written deals with established drillers. Typically, National Oilwell doesn’t begin a step of a project until receiving an incremental payment for the work. Financial impairment from any defaults should be minimal, as portions of one project can often be cannibalized for another. National Oilwell is a Buy and a Long-Term Buy.


NII Holdings ($17; NIHD), a wireless-telephone operator in Latin America, is targeting corporate clients seeking instant communications. Fluctuations in foreign currency add risk to NII’s results, but heavy investment in infrastructure should drive strong growth. The company raised its 2009 capital budget $100 million to $850 million, primarily to fund projects in Mexico and Brazil. Cash reserves of $1.48 billion can cover the hike in spending.

Half of NII’s revenue comes from Mexico, but Brazil is gaining (31% of total sales and growth of 72% in the first nine months of 2008). Meanwhile, the company looks to broaden its customer base in Argentina and Chile.

At six times trailing earnings, NII trades at an 80% discount to its five-year average valuation. More than 69% below August 2008 highs, the stock appears undervalued. Wall Street forecasts average growth of 26% in per-share earnings over the next five years. NII Holdings is a Focus List Buy.

TOP VALUE PICKS
Each of the seven stocks listed below earns a Quadrix Value score in the top one-third of our research universe and trades at a discount to both its five-year average price/earnings ratio and its industry average valuation.
Trailing P/E Ratio
Company (Price; Ticker)
Current
5-Yr.
Avg.
Industry
Avg.
Quadrix
Value
Score
Advice
Chevron
($72; CVX)
6.2
9.9
7.2
68
Buy †
General Dynamics
($55; GD)
9.0
17.4
10.2
73
Buy †
Manitowoc ($8; MTW)
2.4
23.3
9.9
99
Focus
Buy †
National Oilwell
($24; NOV)
5.1
25.9
6.4
94
Buy †
NII Holdings
($17; NIHD)
6.1
30.3
18.1
91
Focus
Buy
Questar ($32; STR)
8.5
18.0
9.4
67
LT Buy
Transocean
($46; RIG)
3.3
25.9
6.2
89
Focus
Buy †
Notes: Averages exclude P/E ratios above 75 or below 0.   Quadrix scores are percentile ranks, with 100 the best.     
† Also qualifies as a Long-Term Buy.

The growth picture
Growth stocks tend to trade based on the market’s expectation of profit or sales growth, and an increase in investor optimism regarding growth is a sign that a market rally may morph into a sustainable recovery.

We don’t expect the Dow to fall to 5,000, and the worst of the carnage is probably behind us. But we are far from confident that the economy will begin growing quickly in the first quarter of 2009. Or in the second, third, or fourth quarters, for that matter.

Looking ahead: Market rallies tend to begin during periods of widespread pessimism. If you wait until the good news is apparent before buying, you will have missed out on much of the potential gain. Shrewd growth investors try to identify prospects before their potential becomes obvious, because these stocks can move upward quickly when good news presents itself. Consider companies with high Quadrix scores in Momentum (recent growth) and Earnings Estimates (revisions to consensus estimates).

Two of our favorite growth stocks are reviewed below:

Still best known for its computer hardware, IBM ($81; IBM) has branched out beyond the volatile segment, which contributed only 7% of pretax profits in the first nine months of 2008. With forecasts of technology budgets shrinking at least 10% in 2009, IBM’s broad business mix — which includes clients worldwide in both cyclical and noncyclical industries — should provide some protection from the slumping U.S. economy.

One of IBM’s most interesting — and least cyclical — growth avenues is smart power grids. Smart grids are designed to distribute power more efficiently to avoid brownouts, better incorporate renewable energy sources, and let customers track their usage from a home display. IBM is already working on pilot projects with a stable of utility companies in the U.S. and overseas.

Consensus estimates project 2009 earnings will reach $9.03 per share, up 4%. IBM’s trailing price/earnings ratio of 9.6 is about half the 10-year average. A combination of moderate profit growth and modest margin expansion should support market-beating share gains in the year ahead. IBM is a Focus List Buy and a Long-Term Buy.


Biogen Idec’s ($47; BIIB) promising multiple sclerosis (MS) drug Tysabri has gained a lot of attention lately — adding new patients and driving a strong earnings outlook despite a connection to a potentially fatal brain infection. As Tysabri carves out its niche, Biogen relies on the steady sales of its two established offerings.

Avonex remains the market-share leader for MS therapy and was expected to see unit growth of 10% in 2008, though growth should slow going forward as newer drugs — including Tysabri — gain share. A price increase helped push U.S. sales of Avonex up 21% in the September quarter. Rituxan, already used to treat non-Hodgkin’s lymphoma and rheumatoid arthritis, may prove to be even more versatile. Researchers are looking into several new uses, including treating a form of leukemia and deterring MS relapses.

Wall Street expects 2009 per-share-profit growth of 9%, a target Biogen seems capable of exceeding. After funneling more than 30% of sales into research and development in each of the past four years, Biogen’s pipeline should support double-digit sales and profit growth over the next five years. Biogen is a Focus List Buy and a Long-Term Buy.

TOP GROWTH PICKS
Each of the seven stocks listed below earns Quadrix Momentum and Earnings
Estimates scores in the top half of our research universe and has solid long-term
growth potential.
EPS
Quadrix
Company (Price; Ticker)
Last
12
Mos.
(%)
5-Yr.
Avg.
(%)
Momen-
tum
Earns
Ests.
Advice
Biogen Idec
($47; BIIB)
53
12
92
71
Focus Buy †
Cognizant Tech.
($17; CTSH)
31
25
87
67
Buy †
Genentech ($82; DNA)
11
17
80
92
LT Buy
Harris ($36; HRS)
21
17
83
86
Focus Buy †
IBM ($81; IBM)
28
11
65
84
Focus Buy †
Laboratory Corp.
($64; LH)
14
13
53
76
Buy †
Lockheed Martin
($81; LMT)
13
12
70
79
LT Buy
Notes: Quadrix scores are percentile ranks, with 100 the best.    
† Also qualifies as a Long-Term Buy.

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