FOCUSING ON GROWTH
A friend asked me which future statistic on my Recommendation List did I consider to be more important: the 5-year growth estimate or the P/E/G? Since this list is all about growth at a reasonable price (GARP), I had to answer “the 5-year growth estimate” because only stocks with reasonable P/E/Gs (definitely less than 2.0, which I consider makes them reasonably priced) make the list—so after that, focus on growth.

This pondering lead me to make these fundamental changes to the list: 1) only companies with growth greater than, or in special cases equal to, the S&P 500 growth estimate will be included; 2) there will be no “blue” stocks (those that meet all GARP criteria), as there are always mitigating factors; and 3) mitigating factors will be considered along with statistics to determine which stocks stay on, are added to, or are removed from the list.

Linda Stewart for www.fizone.com

August 14, 2003

These 15 companies comprise my recommendation list, because they offer growth, are well-managed companies, and they are reasonably priced. There are currently no recommended energy stocks, but Kinder Morgan (above) is my favorite. The health care sector has five recommendations, more than any other sector. This is because this sector in general has not moved up with the rest of the market in the recent otherwise overall rally; these stocks still have more upside potential.

Flextronics has increased revenues in each of the last five years, even though a substantial portion of their customers are in the tough telecom industry. They are the largest contract manufacturer, providing a wide range of services to hardware companies that outsource manufacturing. Flextronics has been increasing its customer base and should continue to win new business, as equipment manufacturers prefer to deal with fewer companies.

L3 Communications – This technology company supplies sophisticated secure communication systems and specialized communication products primarily to agencies of the U.S. Government. L-3 meets all GARP criteria, and S&P expects “sales to advance 18% in 2003, primarily due to new revenue generated by acquisitions.” Organic sales growth is expected to be 8 – 10%.

First Data, which owns Western Union, is a leader in credit card and money transfer processing. First Data handles almost three times as many Visa and MasterCard transactions as its nearest competitor. Western Union has expanded its money transfer services throughout China and India, which is considered a promising region. S&P expects revenues and earnings to each grow about 15% annually for the next three years.

Cardinal Health gets most (82%) of its revenues from its pharmaceutical distribution division; but it is a diverse health care company. The company recently projected earnings growth to slow to the “mid-teens or better” in 2004 from its historically typical 20% growth rate. Still, Cardinal Health has a big competitive advantage because of its low-cost structure and its operational diversity, allowing it to increase its market share. As an innovator of new technologies, the company generates new revenue streams that are more profitable than its core business.

IDEC Pharmaceut. – This biotechnology company develops and makes immunotherapeutic and cancer-fighting products, the biggest two being Rituxan and Zevalin. Rituxan was the first monoclonal antibody approved for treatment of cancer, and it is now the standard, with sales surpassing $1 billion. Zevalin is the first approved radioactive monoclonal antibody. Recently Idec and Biogen announced a merger of equals, which has been critically received by investors. To some it appears to be more about reducing costs than increasing growth. Ultimately the combination will be the third largest biotech firm, and some analysts feel that both companies are undervalued.

Pfizer acquired Pharmacia, making it the largest drug company. It has 10 drugs with revenue over $1 billion each: Lipitor (cholestorol-lowering), Zoloft (anti-depressant), Zithromax (antibiotic), and Viagra, to name a few. Most of the blockbusters are patent-protected for seven or more years. Because of the merger, revenue for 2003 was lost, as inventories were adjusted. By 2004 this company’s products should increase revenue 6 – 7% a year for the next five years, according to Morningstar.

Teva Pharm. – Teva manufactures generic drugs, which should be beneficiaries of upcoming patent expirations, as well as the trend toward using cheaper, generic drugs. They also have a successful proprietary drug, Copaxone, an injectable treatment for multiple sclerosis, and they are one of the largest providers of active pharmaceutical ingredients. They are based in and have many of their facilities in Israel, which presents geopolitical risk, but also provides access to Israeli universities and hospitals. Second quarter profits surged, and analysts have raised the 5-year growth rate from 23% to 25%.

WellPt. Health Net – This health insurance company offers a diverse mix of managed healthcare products, including an HMO, a PPO, and other hybrid plans. They own Blue Cross and RightChoice, giving them a strong provider network in the Midwest and California. They have flexible deductible and co-pay plans, which give them a competitive advantage. S&P expects revenue to increase 17% in 2003, and earnings per share to increase 15% in 2004.

AIG – This financial services conglomerate specializes in insurance, a commodity-like industry of many competitors. AIG’s two biggest plusses are its foreign insurance businesses and its superb management. Less competition overseas has helped with AIG’s profits there, which S&P sees likely to grow in double-digits. Five years of almost 20% revenue growth has been the result of management that is innovative, creating and capturing new markets, and one that focuses on low costs and profitable underwriting.

Capital One – This credit card issuer has increased revenue 40% annually over the last five years, but Morningstar projects revenue growth of only 9 – 10% for the next few years. Their success and competitive advantage have come from their information strategy—they test products and consumer behavior, only offering products that will sell. Their current shift away from the riskier sub prime lending to focus on the prime and super prime markets has improved their credit quality. Risk is inherent in a company that extends credit, but Capital One has had a low charge-off rate, and delinquencies have declined.

Fannie Mae – As a provider of liquidity for residential mortgage investing, Fannie Mae may see a considerable slow-down over the next year as refinancing diminishes. Still, Morningstar values this company at $90, assuming a housing slow-down and contracting margins. Their $90 fair value is based on 10% growth in revenues and EPS, a rate lower than that of the last five years.

Lennar – Lennar has met all of the GARP criteria since I added it to the list in February. In June it was at a new 52-week high and more than 20% higher than it was in April, and I removed it from the blue list, thinking that interest rates would go up imminently and homebuilding would decline. I still feel that will eventually happen, but now think rates will stay low for another year, and new homes will continue to be built. S&P predicts home sales will rise 20% in 2003 and 13% in 2004. This company is still a good buy, but since investors seem to think the home-building party is over, upside could be limited until employment improves, prompting more new home buying.

Autozone is the national leader in retail auto parts and has increased revenues in each of the last ten years. Contributing to the company’s growth and profitability is an innovative marketing program, such as Loan-A-Tool and free use of computer diagnostic tools, and combining commercial businesses with repair shops. The stock price is up 26% in the last six months, from 64 to 81, so upside may be stalled over the near term.

Home Depot – S&P expects 9 – 11% sales growth, expanding gross margins, and EPS growth of 12% for 2004. Revenues and long-term growth are enhanced by sales of appliances, focusing on the professional remodeling and contracting businesses, and international expansion. Same-store sales growth is hurt by Home Depot’s own aggressive expansion and by its chief competitor, Lowe’s. HD is now a mature company, no longer growing at 30% annually, but with quality brand recognition and initiatives in place to better serve its customer base, this stock should continue to be a profitable long-term investment.

Sharper Image – July same-store sales increased 11%, and internet sales increased 60%, 16% and 46% respectively year-to-date. The stock has had a tremendous run, more than doubling from its February $15 price to over $30 in July. The fundamentals are good, but investors may see the stock price level off before resuming an upward trend.

No companies were Added.

Six companies were removed from the Recommendation List, primarily because of growth concerns:

Western Digital – This mid-cap technology company makes and sells hard disk drives for a wide range of computers, servers, and networks. S&P expects revenues to grow 25% in 2003 and 12% in 2004. In 2002 revenues increased 10% from basically flat in 2001. Recently announced 4Q revenue increased 26%, but uncertainties around the recent acquisition of Read Rite have resulted in selling and a 25% decline in stock price. Consensus estimates, however, are for 5-year growth of 11%, less than that projected for the S&P 500, which is why I’ve removed it from my list.to grow 25% in 2003 and 12% in 2004. In 2002 revenues increased 10% from basically flat in 2001. They are headed in the right direction, and industry consolidation should boost market share and improve the pricing environment. This stock is well-positioned when the technology sector is revitalized.

ADP – After 41 years of double-digit earnings per share growth, ADP’s earnings were down 4% in 2003. And 2004 may not improve. In their quarterly report ADP projected earnings for 2004 between $1.50 and $1.60, down from the estimates two months ago for $1.70. With 60% of revenue coming from the payroll services division, this company will be stuck in tough times until employment picks up, which may take longer than I had thought two months ago. While that is bound to happen, and ADP will most likely return to its growth pattern, holding onto this stock until that time may prove to be “dead money”.investors as employment and interest rates pick up.

Costco – Costco recently warned that the current quarter earnings would not be as much as expected, even though sales are on target. The culprit is increased costs for employee heath care and compensation. These added costs will be ongoing, and retail profit margins are already thin. This is a great company that has increased revenue each year and has very little debt. However, I am concerned that their growth outlook will not be adequate for me to recommend them. If you own it, it’s probably a long-term keeper. Sell it, if you have a better use for the money.discount prices, making it a great long-term investment. But the company is maturing and topline sales growth is slowing. A dip below $30 would be a buying opportunity.

General Dynamics – This stock is up almost 15% since the June list, but next year’s earnings are estimated to increase only 2%. While this company has been a solid investment year after year, the price needs to come down and/or the earnings projection needs to go up before it is an attractive new investment. If you own it, keep it. While earnings estimates for next year have come down slightly, from $4.94 to $4.84, in the last two months, revenue growth has been enhanced by new contracts with the U.S. Air Force and the Defense Department, and the acquisition of Veridian, manager of top-secret government computer networks.

United Technologies – This conglomerate is a solid long-term keeper. Strong global sales of their Otis elevators and their recent acquisition of Chubb, the U.K. provider of commercial and residential security services, should add 9% to 2003 revenues, according to S&P. However, in other business segments the growth outlook for the next year or so is questionable, largely because of weak commercial airline demand for their Pratt & Whitney jet engines. I would not sell this company, but I think the weaker growth outlook and recent 8% price increase tell us to keep an eye on the stock before buying.

Kinder Morgan – Added to the list only two months ago, and still my favorite energy stock pick, I am removing Kinder Morgan because its growth outlook has come down, from 17% to 15%, but neither its debt to equity nor stock price have. Many analysts feel that our natural gas reserves are too low, but that operating costs for natural gas companies are prohibitively high, making profits difficult. This company is in good shape and among the best in its industry, but now may not be the time to buy.wealth coming entirely from the increased value of KMI and from distributions from his stake in KMP. In addition to good management, the energy infrastructure it owns provides substantial free cash flow. The stock is at a 52-week high, and the company has more debt than I like; so I would look to buy it below $50.