Seven Stocks to Bet On
Hot companies often flame out, burning investors. We found ones with staying power.
(FORTUNE Magazine) – DANGER! DANGER! THE TABLES YOU JUST perused may be harmful to your portfolio.
A ranking of fastest-growing companies can tell you a lot about what's hot in business (all things energy, these days). It can also give you some pretty decent insight into what consumers are clamoring for (new homes, for instance). What it can't always do is help you pick the best stocks. The top ten from last year's 100 Fastest-Growing Companies list have seen their stock prices fall an average of 10% so far in 2005, vs. a 1% gain for the S&P 500 (as of Aug. 16). Even the earnings of last year's top ten companies have been subpar, with projected profit growth of 3% in 2005, vs. 10% for the S&P.
Call it reversion to the mean. Call it the curse of high expectations. Call it whatever you want, but there's ample evidence that a recent history of runaway results is no sure-fire path to future stock market stardom. For every Dell or Nike that turns early promise into global dominance, there are hundreds of other highfliers that end up being huge disappointments for shareholders. And that's only part of the risk. Rapidly growing companies attract a particularly trigger-happy breed of investor. One bad quarter, and all the momentum-obsessed speculators who originally flocked to the stock will bail faster than you can say 100 Fastest-Growing Companies.
Our job here is to separate the flashes in the pan and the priced-for-perfection time bombs from the companies truly poised for stock market success. We began our search by looking at valuation. Growth usually involves growing pains, and the best way for investors to mitigate the risk of an occasional stumble is to avoid paying too high a premium for premium growth. A stock with a price/earnings ratio of 70 tends to suffer bigger selloffs than one with a P/E of 15.
But you can't judge a fast-growing company by P/E alone. Many growth-oriented money managers look at P/Es in the context of earnings potential, using the PEG ratio. PEG ratios are calculated by dividing a company's P/E by its expected growth rate for the next three to five years. Thus a company with a P/E of 20 and a 10% long-term growth rate would have a PEG ratio of two. The S&P 500 currently has an average PEG of 2.8, but in our quest to avoid overpaying for growth, we spurned companies with PEGs of more than 1.5.
Next we screened for accelerating profit growth. After all, it's hard to get terribly excited about a growth stock that's already slowing down. Finally, we eliminated companies that have been publicly traded for fewer than five years. While we have nothing against new stocks, there's something to be said for companies that have weathered an extended economic rough patch under the watchful--and often vengeful--eye of Wall Street investors.
Those three screens pared the list of 100 down to 21 stocks. After consulting with a couple of dozen analysts and fund managers, we singled out seven companies we believe have the best odds of making good on their early promise.
Apache (No. 99)
For oil companies, the only thing better than selling crude for more than $60 a barrel is having more to sell. Problem is, ramping up production to meet demand has been a difficult challenge for many of the industry's major players. Not so for Apache, which posted sales of $5.8 billion in the four quarters through March 31.
Helped by improved oil production from the North Sea and unexpectedly strong gas production out of Canada and Egypt, Apache is expected to expand its total energy output by 8% this year and 9% in 2006. That, combined with fast-climbing energy prices, has translated into huge earnings gains for Apache--56% through the first half of this year.
The stock market, however, doesn't think $65 oil is sustainable--just as it didn't think $55, $45, and $35 oil prices were sustainable. That skepticism is reflected in Apache's P/E of nine, which is low even by oil-industry standards. Charles Bath, a veteran fund manager now running the Diamond Hill Large Cap fund, sees a major buying opportunity. Bath points out that the growth Apache achieved in the first half of this year was based on average selling prices of about $47 a barrel--$20 below current levels. "I can only conclude," says Bath, "that the market believes oil prices are going to decline and that earnings are thus unsustainable. Well, I think the market is wrong. I'm very positive on the outlook for oil, and Apache is one of the very best-managed [exploration and production] companies out there."
Endo Pharmaceuticals (No. 56)
Baby-boomers have been called many things. Stoic is not one of them. Their reluctance to grin and bear life's burdens has helped make boomers a fertile market for the pharmaceutical industry. Endo, home of Percocet, may be the ultimate drug-industry boomer play. "There's a greater acknowledgment now of the need to manage pain," says David Windley, a pharma analyst with Jefferies & Co.
The company's specialty is pain medicine: It offers branded and generic drugs for everything from migraines to post-surgical acute pain. Needless to say, boomers' aggressive approach to managing their own medical treatment--a stance that's changed the whole health-care culture--has been a boon to Endo's bottom line. The company is on track to earn $225 million on $845 million in revenue this year; those profits represent a 52% increase over 2004.
Endo's top seller right now is the Lidoderm analgesic patch. Originally designed to treat pain resulting from shingles, the patch is widely prescribed to treat a much broader array of muscle and joint aches. Other big Endo sellers include generic versions of the powerful painkiller OxyContin, as well as DepoDura long-acting morphine intended for pre- or post-surgery.
Windley expects the stock to hit $33 over the next 12 months--21% above its recent price of $27. But given Endo's early success selling generic OxyContin, he thinks "there is a possibility that we could see some upside to earnings over the next couple of quarters, which would further catalyze the stock."
Headwaters (No. 58)
There are few commodities in shorter supply these days than oil and cement. We can all thank China for that. Now imagine a public company that offered potential solutions to both of these shortages. Sounds like an interesting investment, right? Well, that's why Headwaters is such an intriguing little stock. "They have an incredible patent portfolio," says Alan Norton, co-manager of the Hancock Small Cap Equity fund. "From what we can tell, the technology is all very solid, though there is some execution risk."
Headwaters gets its $774 million in revenue from two main businesses: a construction-materials unit that generates most of the cash flow and an energy-technology division that generates much of the excitement. The construction business sells siding, stucco, concrete, masonry blocks, and stone veneers--all benefiting from the building and remodeling boom. It also sells something called FlexCrete, a concrete alternative that substitutes fly ash (a waste byproduct of coal burning) for traditional cement.
Right now, Headwaters' energy business is heavily dependent on federal tax credits that can be earned for converting coal refuse into synthetic fuel. In the near term that's a problem, as the law authorizing the tax credits is set to expire in 2007. Longer term, however, CEO Kirk Benson has high hopes for his energy business, even if the tax credits are not renewed (and it's still possible that they will be). The dual sources of Benson's optimism: Headwaters has one technology--already generating revenue in China--that converts coal into diesel fuel. It has another that helps convert heavy oil and oil sands into high-quality synthetic crude.
Couple the abundance of coal in the U.S. and of oil sands in Canada with today's $65-a-barrel price of crude oil, and you've got near-perfect conditions for Headwaters. "The mid-30s is the tipping point where these alternative fuels and the incentives to invest in them really kick in," says Norton. So even if oil prices pull back sharply, Headwaters' technologies remain economically viable.
"The other issue," says Norton, "is what may come out of any future energy legislation. I think it's clear that this country needs to develop more internal sources of energy. We have the largest deposits of coal in the world. Given a lot of their technologies, we feel Headwaters is in a pretty strong position."
Lifecell (No. 16)
With a market cap of less than $700 million, Lifecell is the second-smallest stock among our picks--and probably the most speculative. Just two products account for a whopping 87% of the biotech company's $67 million in revenues--so much for diversification! Meanwhile, its shares trade at a pricey 52 times estimated 2005 earnings. Yet this biotechnology company's long-term potential is so intriguing that we think it is well worth the risk.
Lifecell's flagship products, AlloDerm and GraftJacket, are surgical substitutes for human skin and tendon. They're made by harvesting human skin from the cadavers of organ donors, stripping out genetic material that could lead to immune-system rejection, and then transforming the remaining organic material into a strong, infection-resistant human-tissue substitute that the recipient's body gradually adopts as its own.
Lifecell got its start 15 years ago in a University of Texas laboratory where founder Dr. Stephen Livesey was studying ways to freeze-dry biological tissues without damaging them. His work eventually led to the development of AlloDerm and GraftJacket, which are now used for burn treatment, repair of diabetic foot ulcers and complex hernias, post-mastectomy breast reconstruction, cosmetic lip augmentation, and rotator cuff surgery on damaged shoulders.
If this sounds like a rather large and disparate list of surgical applications, that's exactly the point. "There's a tremendous amount of growth potential," says Raj Denhoy, a biotech analyst at Piper Jaffray. "The markets Lifecell serves are both enormous and underpenetrated." Whereas AlloDerm is currently used in approximately 15% of complex hernia operations, for instance, analysts think that the figure could reach 30% by early 2007.
After boosting earnings 117% last year, Lifecell is on pace for a 200% gain in 2005--tops among the 100 Fastest-Growing Companies. "It's an expensive stock, but one with a very leverageable business model," says Denhoy. "The material is so beneficial that it really almost sells itself."
Meritage Homes (No. 89)
Prices are soaring, demand is outstripping supply, and the stocks are trading at a huge discount to the overall stock market. That, in a nutshell, is the state of homebuilding these days. Despite terrific earnings growth and near-ideal business conditions (low mortgage rates, low unemployment, and a dearth of housing supply in the key East and West Coast markets), all builders are bearing the cross of housing bubble fears--fears we think are exaggerated. Meritage is on track for 83% earnings growth this year--up from 42% in 2004--and yet it has a utility-like P/E of nine.
Nevertheless, Meritage's appeal goes beyond valuation. (Indeed, the stock's P/E is on a par with those of most of the other publicly traded builders). What it has going for it are size and location. Meritage is a small company ($2.2 billion in sales, vs. $11.7 billion for industry leader D.R. Horton) in an industry in which consumers pay little heed to brand--how many times have you heard someone say, "I just traded in my Pulte for a Toll"? As a result, Meritage should have an easier time maintaining its outsized growth rate. In a tight real estate market, it also doesn't have to acquire the huge parcels of land that a D.R. Horton or a Pulte needs in order to grow. "I think Meritage has a lot of ability to grab market share," says Stephen East, a homebuilder analyst with Susquehanna Financial Group. "It's probably my favorite stock in the [sector]."
Meritage's other advantage is geography. Given its size, the company isn't nearly as regionally diversified as some of the bigger players. Bubble-mongers might consider that a drawback, but not A.G. Edwards analyst Greg Geiber. He estimates that in coming years, 53% of net new growth in housing stock will come in just four states: Arizona, California, Florida, and Texas. "Those four states," Geiber observes, "accounted for 96% of Meritage's revenues in the most recent quarter."
Penn National Gaming (No. 92)
Penn National is a gambling company, but don't buy its stock expecting a jackpot return. With sales of $1.1 billion, Penn is a well-run regional casino and racetrack operator that trades at an inexplicable discount to some of its slower-growth peers. That's the opportunity for investors.
Penn has been expanding its casinos and racetrack-based "racinos" in Illinois, Maine, and Pennsylvania, and analysts are optimistic about the eventual payoff. Merrill Lynch analyst David Anders expects earnings to climb 51% this year and another 35% next year.
Historically, one negative had been Penn's lack of regional diversification, but its pending acquisition of Argosy Gaming should remedy that problem. The acquisition will add casinos in three states where Penn doesn't operate--Indiana, Iowa, and Missouri--and make it the nation's third-largest gaming company, behind MGM Mirage and Harrah's Entertainment.
In light of the Argosy deal, Penn's current valuation doesn't make much sense. It's trading at 24 times this year's estimated earnings but only 17 times projected 2006 earnings; Station Casinos, a company with less impressive growth rates than Penn, is trading at 24 times next year's earnings. Anders, who likes to value companies based on year-ahead earnings, thinks that gap is unjustified. "I think it should trade at least at 20 times," he asserts. A P/E of 20 would translate to a stock price of $44, about 20% above where it was trading in mid-August.
Sonic Solutions (No. 14)
Does your teenager like using his computer to burn homemade CDs? Well, odds are he's using Sonic software to do the burning. Do you sate your home-entertainment cravings with mail-order movies? Those movies were probably put onto DVDs with Sonic software too.
Indeed, while Sonic may not have created the digital media craze, it's certainly fueling it--and benefiting from it as well. Sonic saw sales rise 59%, to $91 million, in the four quarters through March 31; earnings rose 59% in 2004, and the company figures to post a 65% profit gain in 2005.
The future looks even brighter for Sonic, our smallest pick, with a market cap under $500 million. Burning home videos or downloaded movies onto DVDs may not be commonplace today, but it's only a matter of time until it is, analysts say. "We're going to continue to see more and more consumer applications of CD and DVD burning, and DVD is still in its early stages," says Robert Crosby, co-manager of the Munder Micro-Cap Equity fund, which recently owned 286,000 Sonic shares. Sonic now has deals with Dell and Hewlett-Packard to distribute its DVD-player and CD/DVD-burner software on new PCs and laptops, and consumers will have the opportunity to upgrade their software directly through Sonic.
Despite Sonic's rapid earnings growth, its stock has been anything but hot. Shares are flat for the year, a byproduct of lingering doubts about Sonic's recent acquisitions and some skepticism about its ability to meet its ambitious earnings goals for the year. We think the concerns are overblown, especially with Sonic trading at 27 times estimated 2005 earnings and 16 times next year's earnings. Says Crosby: "For a company with these kinds of operating margins [24%] and a 50%-plus growth rate, the valuation is just very low."
Speed Thrills Fast-growing companies are inherently risky, but our seven picks have low PEG ratios, which means you're not overpaying for growth.
Data as of Aug. 16. Prices are rounded. P/Es based on estimated 2005 earnings. Earnings growth projected for five years. PEG ratio is P/E ratio divided by earnings growth rate.
FORTUNE TABLE / SOURCE: BASELINE