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Playing with fire How investors should handle the ten biggest stocks on our list of Fastest-Growing Companies.  NEW YORK (Fortune) -- 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 percent 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 percent, 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 percent. 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). 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 (Charts) 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 (Charts). If so, congratulations: You're probably sitting on huge winnings (the stock has returned 150 percent 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 (Charts) has been a public company for only two years, it doesn't qualify for our Fastest-Growing list. Second, Apple (Charts) 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 a separate story. And now, on to the stocks. For each one, we've listed its rank on the Fastest-Growing list, along with its ticker symbol and market value. See the 10 stocks, starting with the largest, plus advice on whether or not to invest.... |
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