In 2007's economy, big growth companies have the best chance of posting solid earnings increases. It just so happens they're also the most undervalued stocks on the market.
(MONEY Magazine) -- See the forecast
Even though the economy is sputtering, stocks are cruising. Counterintuitive, perhaps, but there are good reasons it's happening--and together they point you to the best investments for 2007.
First, what's going on today looks a lot more like the beginning of a soft patch than the start of a grueling recession. The really scary scenario--sharply rising oil prices and inflation combined with rapidly slowing demand--is a nightmare only the most bearish forecasters see. The more likely path for the economy is three or four quarters of subpar growth, followed by a pickup. Second, earnings have held up surprisingly well, rising 12% for the S&P 500 in the third quarter, the 18th quarter in a row that increases have been in the double digits.
All that is encouraging, but with the Dow Jones industrial average bouncing around near-record highs, it's fair to ask if the good news isn't already priced into the market, as the pros like to say. The answer is no because there remains one group of seriously undervalued stocks, and they're the very companies that have the best chance to keep their earnings growing rapidly even in a slow economy.
Blue-chip growth companies--well-known giants in consumer products and technology that can consistently post earnings-growth rates in the low double digits--have returned only three-quarters as much as the S&P 500 this year and even less of the Dow's gains. And they're still at least 20% below their normal valuations, as measured by their price-to-earnings ratios.
Growth stocks are particularly sensitive to inflation and interest rates. And as long as those were rising, investors preferred the kinds of stocks found in the Dow--defensive stocks with significant dividend yields, and stocks that do really well in boom times, like those in energy and heavy industry. But now growth shares have the best prospects, since it looks as though inflation is abating and interest rates will be stable, if not falling. In a period of calm, stocks that post steady growth will catch investors' eyes.
Even now, many big growth companies are generating more cash than they need--and they can't find compelling places to reinvest it when economic opportunities seem limited. So they've been buying back stock. Such repurchases can turn an 8% increase in net income into an earnings-per-share gain of 12%, which should give prices a boost.
SINGLE BEST IDEA For fund investors, the Vanguard Growth Index (ticker: VIGRX) fund tracks a broadly diversified portfolio of big growth stocks. So does the iShares S&P 500 Growth Index (IVW) ETF. Buy the former if you invest a little each month. The ETF, which trades like a stock, is cheaper if you buy in large dollar amounts infrequently. On the other hand, if you prefer to invest with a manager who picks stocks, the T. Rowe Price Blue-Chip Growth (TRBCX) fund, a MONEY 65 entry, is attractive.
For stock investors, here's a look at three choices that seem especially timely.
The conservative pick is General Electric (GE). Since he became CEO in 2001, Jeff Immelt has been trying to get GE's growth back to its historical 15% level. Last quarter, four of GE's businesses turned in double-digit growth, and one, financial services, was up modestly. The sole remaining problem is NBC Universal, which suffered a 10% earnings decline. GE has pledged to cut costs there over the next year or so. Companywide, earnings per share were up 14%, with several points coming from GE's ongoing stock buybacks.
With oil prices coming down, you might think that the energy sector offers few opportunities. One exception, though, is Schlumberger (SLB), the largest, most technologically advanced oil services company. Long-term demand for oil will keep growing, and that means continuing exploration worldwide, additional drilling in fields with known reserves and the use of sophisticated techniques to stretch the life of old fields that are nearly played out. Schlumberger excels in these areas, and the stock trades well below the premium that its growth rate usually commands.
Texas Instruments (TXN), the leading maker of semiconductors for cell phones and other consumer electronics, can enjoy periods of exceptionally high earnings growth. In fact, earnings per share were up a whopping 25% last quarter. That pace will slow for a while, however. Orders have dipped, the company acknowledges, and chip inventories have risen. Because of this, TI's shares are trading at less than 17 times projected earnings for 2007. That's a bargain. Buy this stock now and you could lock in terrific long-term growth while the chips are down.