Playing with fire
How investors should handle the ten biggest stocks on our list of fast-growing companies. (Plus, our take on Apple and Google.)
(Fortune Magazine) -- Ron Baron doesn't suffer doomsayers gladly. Sitting in his sun-drenched office overlooking New York City's Central Park on an August afternoon, the 63-year-old founder of Baron Capital Group grudgingly concedes that all is not rosy in the world, given war in the Middle East, stratospheric gas prices, and the slumping housing market. But after some consideration, the fashionably tanned money manager and avid art collector brushes those concerns aside like crumbs on his Giacometti coffee table. "I invest in dreams," he says, reclining in an antique rocking chair. "These are exciting times!"
You need that kind of optimism to invest in fast-growing companies. For Baron, hot names and hot trends have been the path to tremendous profits. Others see growth investing in more skeptical terms. "Wonders can be accomplished with the right individual selections, bought at the right price," legendary value investor Benjamin Graham wrote of growth stocks in his 1949 classic, The Intelligent Investor. "But the average investor can no more expect to accomplish this than to find money growing on trees."
Readers who use Fortune's annual Fastest-Growing Companies list as a source of investment ideas are well acquainted with the twin pillars of opportunity and risk that characterize growth stocks. Hansen Natural, this year's No. 2 player, saw its shares shoot up 170% since it appeared on the list last year. But not all go-go names have been as rewarding. The selection of stocks we cited last year in "Seven to Bet On" saw earnings grow a remarkable 55%, on average, over the past four quarters. Yet because investors have such high hopes for these red-hot stocks, those gaudy numbers actually disappointed -- and our recommended group is down an average of 10%.
To help investors analyze this year's list, we decided to borrow from the teachings of one of the first and most successful growth investors, T. Rowe Price, who founded the investment firm that bears his name in 1937. He suggested finding "fertile fields for growth" and then buying the leading companies in each field. With that in mind, we decided to drill down into the prospects of the ten largest firms on this year's Fastest-Growing list (by market capitalization as of June 30). We describe what made them hot enough to compete with small players and earn a spot on our list, and we illuminate their strengths and weaknesses to help discern the outlook for their stocks.
Before we dig in, a few explanations. T. Rowe Price looked for companies increasing sales and earnings faster than inflation -- as all of our list members are. But he took an unusually patient approach in his investing, holding many of his positions for more than 30 years. The key for him was finding companies that grew from the peak of one business cycle to the peak of the next one. That meant tolerating sometimes precipitous declines in sales and earnings within a cycle -- a period that typically lasts for several years -- while awaiting the next boom. Today's world changes so quickly that such multi-decade commitments are impractical. But sticking with the very biggest firms on our Fastest-Growing list, most of which have weathered several cycles, does increase your chances for long-term profits.
This year's group, and our Big Ten names in particular, are heavily populated by energy and natural resource companies, which are not the usual high-growth fare. Growth stocks tend to trade at high multiples of earnings -- high price/earnings ratios -- even when their profits are soaring, as investors bid up stock prices in hopes of even faster growth ahead. Hansen Natural is a terrific example: Its shares, at a recent $29, trade at 27 times this year's projected earnings -- almost twice as expensive, for each dollar of earnings, as the broader Standard & Poor's 500-stock index. That's why some famous growth investors, including Peter Lynch, evaluate these kinds of stocks using price/earnings-to-growth, or PEG, ratios. (This measure is calculated by dividing a stock's P/E ratio by the rate at which analysts expect its earnings to grow over the next several years.) Ideally, Lynch preferred to buy stocks with PEG ratios of one or less.
Cyclical stocks, like energy and metals firms, call for a different approach. When times are good, they see their earnings soar, lowering their P/Es. But that doesn't necessarily make such cyclicals a bargain. Indeed, cyclicals are often most attractive when their P/Es are high, indicating that earnings are low and poised to rebound.
Whether you're buying growth stocks or cyclicals, it's crucial to recognize the assumptions you are making with each stock and to build in some margin of safety. Some of our Big Ten names, for instance, may already be in your portfolio -- a major oil company like, say, ConocoPhillips. If so, congratulations: You're probably sitting on huge winnings (the stock has returned 150% over the past three years). But it may also make sense to take some of those winnings off the table -- to safeguard some of those profits -- in case this cyclical business is at its peak. Similar arguments could be made for investors in Genentech (Charts), another of our big names. We'll try to address the outlook for buyers and existing shareholders in the sections that follow.
One final note: Our Big Ten list would probably have been a Big 12 were it not for a couple of anomalies: First, because Google has been a public company for only two years, it doesn't qualify for our Fastest-Growing list. Second, Apple would have ranked near the very top of the list. But ensnared in the burgeoning options-backdating scandal, the company has said that its reported earnings for the past three years should not be relied upon. Since Apple and Google meet the general qualifications and spirit of our list, we've decided to assess them in the sidebar on page 152. And now, on to the stocks, starting with the largest. (For each one, we've listed its rank on the Fastest-Growing list, along with its ticker symbol and current market value.)
Rank 75 Ticker COP Market value $108 billion
WHY IT'S HOT: High oil prices. ConocoPhillips is the nation's second-largest refiner and third-largest American oil company overall (behind ExxonMobil and Chevron).
CHALLENGES AND OPPORTUNITIES: and opportunities Almost 80% of Conoco's oil and gas reserves are in mature regions in North America and Europe, so CEO Jim Mulva needs to push into more resource-rich regions, such as Russia and the Middle East. This year Mulva is spending $18 billion to finance new drilling projects, upgrade investment-starved refineries, and make acquisitions, including increasing Conoco's stake in Russian oil producer Lukoil. But this can be risky--witness the charge Conoco had to take when Venezuela unexpectedly slapped higher taxes on foreign oil companies. And growing by acquisition is getting pricey. Critics say Mulva overpaid when he bought energy giant Burlington Resources last year for $35 billion, a deal that added $19 billion in debt.
STOCK OUTLOOK: With a price/earnings ratio of six (based on the previous 12 months' earnings), the stock sells at a significant discount to its peers. The gap stems in part from Mulva's willingness to embrace risky exploration projects. But so far Mulva's bets have paid off, making Conoco shares look awfully attractive.
Rank 79 Ticker DNA Market value $84 billion
WHY IT'S HOT: Think of Genentech as the cancer company: Its success rests largely on four blockbuster drugs that combat various forms of the disease. Top treatments include Avastin for colorectal, lung, and breast cancers; Herceptin for "Her-2" breast cancer; Rituxan, for non-Hodgkin's lymphoma; and Tarceva for lung and pancreatic cancer. Notes Citigroup analyst Elise Wang, for instance: "No other biotech or pharmaceutical company has ever been in a position to be launching four $1 billion--plus products simultaneously."
CHALLENGES AND OPPORTUNITIES: Genentech turns 30 this year. With its $84 billion market capitalization, it is larger than rival Amgen, as well as such old-line drugmakers as Wyeth, Schering-Plough, and Eli Lilly. Therein lies Genentech's real test: to run among the giants without contracting the malaise plaguing Big Pharma. Can Genentech continue to foster a free-flowing creative spirit among its scientists while becoming more like Big Pharma in areas like sales and marketing?
In late June the FDA approved the company's newest drug, Lucentis, a treatment for age-related macular degeneration. Although investors were underwhelmed, the drug could top Pfizer's already established Macugen in the market. Clinical tests suggest Lucentis is more effective at restoring vision and reversing the disease. The next two years are critical for Genentech, as the company will need to prove that its R&D boom wasn't a fluke. Researchers plan to test existing drugs for additional uses, while moving three new drugs (for cancer, arthritis, and diabetes) into Phase II, or human, testing by the end of this year.
STOCK OUTLOOK: Take a deep breath. Genentech sports a high-octane P/E of 61 (based on this year's earnings), yet its earnings growth is likely to slow from its current breakneck annual pace of roughly 50% this year to a more moderate 33% in 2007 and 25% by 2008. That means "Genentech shares are headed for a period of stagnation while the early-stage pipeline matures," contends Lehman Brothers biotech analyst Craig Parker. Still, the company has enormous long-term growth potential, making Genentech a stock to watch and buy if it becomes a little cheaper over the next year or so--as long as any dip in price is not caused by a fundamental change in its prospects.
Rank 19 Ticker YHOO Market value $40 billion
WHY IT'S HOT: Yahoo has been riding the boom in online advertising.
CHALLENGES AND OPPORTUNITIES: Yahoo seems to be in a cooling phase. Its stock has dropped from $43 to $29 since early January. Part of the problem is that expectations coming into the year were so high. Many observers -- FORTUNE among them -- believed Yahoo was on the verge of transforming the online advertising biz. But then Yahoo's much-ballyhooed new search-advertising system, a.k.a. Project Panama, which is supposed to help advertisers better target consumers, was beset by delays. It's now expected to debut in the fourth quarter. Another concern is the gap between page-view growth and revenue growth. "Essentially, while traffic growth was very strong, it did not translate into comparable revenue growth," notes Paul Keung, an analyst with CIBC World Markets.
A successful launch of the new search system could make Yahoo more competitive with Google. That said, Yahoo is less reliant on search than Google. As Yahoo CEO Terry Semel told Fortune in August, "Over the past four quarters Yahoo was the only major Internet company that experienced people spending significantly more time on its site doing more things." More time spent on Yahoo's website means more page views, which mean more opportunities for Yahoo to sell banner ads.
STOCK OUTLOOK: The consensus among analysts is that Yahoo will average earnings growth of 27% over the next five years, so it's hard to see why the stock deserves a premium P/E of 53. While Panama may be a smash, the brief history of the web is filled with fizzled innovations that were originally billed as game changers. We'd wait to see how the new search system performs before buying Yahoo shares.
Rank 16 Ticker VLO Market value $37 billion
WHY IT'S HOT: Recognizing the yawning gap between the cost of building a new refinery and how the market was pricing existing ones, Valero founder Bill Greehey went on a buying spree in the late 1990s, building Valero into the nation's largest independent refiner. It proved to be a brilliant strategy. No new refineries have been constructed in the U.S. for 30 years, and the existing facilities are operating at or near full capacity.
CHALLENGES AND OPPORTUNITIES: With gasoline prices around $3 a gallon and interest rates rising, cash-strapped consumers may finally cut back on their driving. Yet while Valero can't produce much more gasoline than it's now making, it's in a good position to make more money on each gallon sold. That's because Valero specializes in refining "heavy sour" crude at a time when heavy oil trades at a discount to the easier-to-refine "light sweet" variety.
STOCK OUTLOOK: At its recent $60, Valero stock trades at a P/E of only seven (vs. nine and 12 for rivals Sunoco and Frontier Oil). One reason for that discount is that investors think Valero could do a better job controlling costs. Chi Chow, an analyst with oil and gas investment firm Petrie Parkman & Co., thinks incoming CEO Bill Klesse will prove more shareholder-friendly than Greehey by keeping down costs better, selling underperforming assets, and undertaking more share buybacks. Were the market to reward Valero with a P/E of just nine, that would translate to a stock price of $82 (a 37% gain) based on projected 2006 earnings.
Rank 56 Ticker GILD Market value $29 billion
WHY IT'S HOT: Gilead's success in the HIV market has rocketed the company into the No. 3 spot among biotechs. Gilead has launched five drugs in six years, including Atripla, a revolutionary combination pill that allows HIV patients to take three treatments at once.
CHALLENGES AND OPPORTUNITIES: HIV is a very narrow market, and it accounts for 70% of Gilead's $2 billion in sales. The company also receives royalties on Roche's sales of Tamiflu, which is being stockpiled as a treatment for bird flu. Much of those profits could evaporate if the threat of that disease fades.
Gilead is testing Viread, currently used as an HIV treatment, to see whether it can help healthy people avoid contracting the disease. But the company needs to expand beyond that one market. With $2.5 billion in cash and marketable securities on the books, CEO John Martin has money to spend on acquisitions. Most recently he paid $365 million in August for privately held Corus Pharma, which is developing an inhaled antibiotic used to treat lung infections in patients with cystic fibrosis. Analysts speculate a bigger deal may be near -- perhaps one that takes Gilead into the highly lucrative cancer market.
STOCK OUTLOOK: Biotech is one of the few areas of the market where a P/E of 30 is considered cheap. But Gilead's relatively low multiple reflects the concern that investors have for the company's thin pipeline. Gilead's HIV franchise is indeed potent. But until Martin comes up with another growth driver, the stock is no bargain.
Rank 27 Ticker PD Market value $18 billion
WHY IT'S HOT: It's all about supply and demand. In our 2006 Investor's Guide we forecasted higher copper prices and picked Phelps Dodge, the world's second-largest copper producer, as a top investment. Well, copper prices are up 70% this year, while Phelps shares boast a 23% total return. Global economic growth, particularly in China and India, has spurred demand for commodities, and as industrial metals go, copper is fairly indispensable: It's used mainly for electrical wiring, and there's no good substitute.
CHALLENGES AND OPPORTUNITIES: Of late, the ups and downs in Phelps stock have been driven less by the copper business and more by the market's reaction to Phelps's attempted acquisition of Canadian mining companies Inco and Falconbridge. Analysts and investors weren't wild about the complicated deal, and Phelps stock rallied when Falconbridge was ultimately acquired by another suitor. (Prudential mining analyst John Tumazos thinks Phelps would rally again if the Inco deal also falls through.) Offsetting declining copper demand from U.S. residential construction has been increased demand from commercial construction as well as solid demand growth from Europe and China.
STOCK OUTLOOK: Tumazos has a $100 price target for Phelps (now $89), based on an ultra-conservative $1.25-a-pound copper price estimate for 2007. Tumazos says that if copper stays around $3.60, "price targets in the $150 to $200 range are possible."
Rank 53 Ticker EOG Market value $16 billion
WHY IT'S HOT: As an independent producer of natural gas, EOG Resources (formerly Enron Oil & Gas, which split from parent Enron unscathed in 1999) has one of the most attractive niches in the energy business: supplying natural gas to the thirsty American market. And as a low-cost operator, EOG boasts some of the highest margins in the industry.
CHALLENGES AND OPPORTUNITIES: EOG doesn't have any refining or retail operations. This approach has its advantages, but it leaves the company vulnerable to unexpected commodity price swings. Although natural gas prices remain high, they have dropped by half over the past year. And since CEO Mark Papa shuns acquisitions, EOG is left to bolster reserves by drilling alone. The big opportunity is in shale. Like its peers, EOG is using new exploration techniques such as horizontal drilling to extract natural gas from nontraditional areas, including the notoriously hard-to-penetrate shale. Papa recently scored big at Barnett Shale, a prodigious patch near Fort Worth, where EOG is one of the industry's largest leaseholders, with more than 500,000 acres. He's now applying the new techniques at several other large shale-based plays in North America that could significantly increase reserves.
STOCK OUTLOOK: If Papa can make good on his vow to increase annual production 7% to 11% for the next few years, holding EOG shares should be a gas.
Rank 21 Ticker CELG Market value $15 billion
WHY IT'S HOT: Celgene, a barely profitable biotech with $540 million in sales, recently won FDA approval for Revlimid to treat two blood diseases, including multiple myeloma, the second-most-common blood cancer in the U.S. (It afflicts 50,000 people.)
CHALLENGES AND OPPORTUNITIES: CEO Sol Barer needs to get his hot new drug Revlimid off to a strong launch -- and then crank out some new products, stat. The problem is that the drug has a dubious past. Revlimid is derived from thalidomide, a therapeutic that is known to have caused thousands of birth defects in the 1950s. Any safety or regulatory setbacks could be devastating for shareholders. Assuming that Revlimid remains safe, Barer can use the profits it generates to fund R&D and make acquisitions. Analysts are projecting the drug will generate a staggering $2.5 billion in sales within a few years. And even that estimate could prove low, because Barer is testing the drug on other diseases, from non-Hodgkin's lymphoma to lymphocytic leukemia. Celgene also has promising candidates for treating asthma, psoriasis, and other diseases, although they're deeper in the pipeline.
STOCK OUTLOOK: Shares have tripled in the past two years and now sell for a whopping 120 times this year's estimated earnings, making Celgene one of the most expensive stocks on the market. Certainly some of the excitement over Revlimid is warranted, but at its current multiple, Celgene makes even Google -- trading at 42 times estimated 2006 earnings -- look cheap.
Rank 81 Ticker CME Market value $15 billion
WHY IT'S HOT: A quick look at the Chicago Mercantile Exchange's stock chart tells you all you need to know about the state of high finance these days. The boom in options and futures trading has pushed the price of Merc shares from $42 when it went public in late 2002 all the way up to $437 today.
CHALLENGES AND OPPORTUNITIES: The Merc's earnings growth has been tied to rising trading volumes, and those volumes are impossible to predict, because they hinge on market conditions. For example, reduced volatility in foreign exchange or interest rates could dry up trading business from hedge funds and other big investors.
The most exciting growth opportunity for the Merc is a joint venture with Reuters announced in May. The two companies intend to create a centralized foreign exchange marketplace for over-the-counter currency transactions. The Merc already trades currency futures, but futures represent a relatively small share of currency trading, which at $2 trillion a day is the largest financial market in the world. Most currency transactions are cash trades -- not futures -- and the cash business has traditionally been decentralized among the big banks. But with more and more hedge funds getting into the foreign exchange market, Reuters and Merc think there's demand for a centralized trading post.
STOCK OUTLOOK: The Merc's highflying share price makes us wonder whether there's a cheaper way to get exposure to the booming market for futures, options, and other financial esoterica. Goldman Sachs, for example, has transformed itself from a traditional investment bank devoting most of its resources to underwriting securities and advising on mergers into arguably the most sophisticated trading machine on Wall Street. Goldman's earnings growth over the past four quarters exceeds the Merc's -- 88% to 31% -- and yet Goldman's P/E is nine, compared with 48 for Chicago.
Rank 10 Ticker NUE Market value $15 billion
WHY IT'S HOT: The steel industry is in the midst of a historic boom, and Nucor is now the largest steel producer in the U.S., with $12.7 billion in sales. President Bush's onerous tariff on imported steel helps too.
CHALLENGES AND OPPORTUNITIES: CEO Dan DiMicco needs to prepare for the inevitable downturn in this notoriously cyclical industry by reducing debt and building cash reserves. That will allow him to scoop up assets from struggling competitors if a slump hits. With the world's ten largest steel companies accounting for only a quarter of the output, the industry is enormously fragmented, which means acquisition candidates abound. One big advantage for DiMicco is that Nucor has the girth to dictate pricing, allowing him to pass on higher raw-material and energy costs to customers. And in an industry known for belching smokestacks, he's introducing a bit of high-tech gadgetry. At one plant in Indiana, DiMicco is using a patented system that cuts the number of steps required to make certain steel products. If his team can apply that to more grades of steel, it could cut Nucor's costs dramatically -- and even reshape the industry.
STOCK OUTLOOK: Shares have more than doubled in the past year. But they still trade for just 11 times the past 12 months' earnings, which puts them near the low end of their historical range. Investors are clearly concerned about whether the steel boom can continue, which means the stock is attractive if the boom goes on longer than expected. The flip side: Even Nucor's seemingly modest valuation may prove lofty in a sharp downturn.