A little froth could be good for blue chips
As money flees overpriced investments, it should flow to big growth stocks that are still undervalued.
NEW YORK (MONEY Magazine) - Soaring prices make gold, oil and other commodities markets look like bubbles waiting to burst. And recent big gains in small stocks recall the boom that occurred right before the last bear market.
So should you be worried that another 2000-style meltdown is just around the corner?
Hardly. It's true that some analysts see signs that the bull market is past its prime, but I believe the far likelier scenario is that today's froth will soon turn into solid gains for blue chip growth stocks.
In a fundamentally sound market, a growing appetite for risk is healthy. After a recession, volatile investments normally rebound the fastest. Then, if all keeps going well, the advance broadens out to less speculative areas.
It looks to me as though that's where we are now. The price of oil notwithstanding, the economic outlook hasn't changed in three years. In 2005 the U.S. economy grew a strong 3.5 percent after inflation, and this year should be nearly as good. Unemployment is a rock-bottom 4.7 percent.
Yes, rising commodity prices are a worry, but Federal Reserve chairman Ben Bernanke seems to think that inflation is under control. And most Fed watchers believe that Bernanke will be cautious about pushing short-term rates much above 5 percent. If the two-year rise in interest rates is nearly over, the next 12 months should see a new phase of this bull market.
That's good news for blue-chip stocks, especially those that have above-average earnings growth. They haven't come close to fully recovering from the most recent bear market. That means big-cap growth stocks are not just sound long term investments, they're the most likely to benefit from a flight to quality.
To find growth at a fair price, analysts divide a stock's price/earnings ratio by its projected earnings growth rate, which yields the so-called PEG ratio. Only trouble is, that ratio ignores dividends. I prefer to compare a stock's P/E with its projected return based on both expected growth and dividends. Stocks are ranked that way in the Sivy 70 table this month.
Where the returns are
By that measure, the cheapest choices include major banks, such as Citigroup (Research) and J.P. Morgan Chase (Research), which I recommended in the May issue. But since big growth stocks as a group have trailed the rest of the market, you can afford to look at those that have higher P/E ratios if they offer superior earnings growth rates in the mid-teens. Here are three that offer a good balance between valuation and return potential.
Drugstore chain CVS (Research) is 22 percent cheaper than its chief rival, Walgreen. There are some legitimate reasons for this: Walgreen has no long-term debt and a slightly higher projected growth rate. But CVS is so much cheaper that it looks like the more compelling buy.
Moreover, the business of drug retailing itself is quite attractive. Sales are benefiting from the aging of baby boomers. The new expanded Medicare benefit is also helping business. And although the shift toward cheaper generics may reduce store revenue, generics can actually be more profitable for the store.
As small and mid-size companies continue to prosper, so will Staples (Research), the leading retail chain for office supplies. Staples' earnings were up 20 percent in 2005, partly because the company has been gaining ground from its rivals and partly because its direct-delivery business is such a great success.
The chief engine of the chain's long-term growth is the addition of new stores. With about 1,780 outlets, Staples plans to open 100 a year in North America, as well as additional ones overseas. That should sustain annual earnings gains of as much as 15 percent a year.
The semiconductor industry may be slack, but Texas Instruments (Research) is doing great. For the first quarter, net income was up 42 percent on a 23 percent revenue increase. Those results beat consensus estimates, and a couple of analysts revised their projections upward.
TI is benefiting especially from chips for cell phones. Sales are booming for both high-end phones and for the cheaper models popular in China and India.
Longer term, the company also stands to profit from chips used in the latest big-screen televisions. By focusing on the best parts of the chip market, TI should be able to keep outpacing the industry as a whole.
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