Five stocks for a stormy market
Wall Street is worried about oil, interest rates, and a slowdown. But there are still opportunities to be found.
By David Stires

(FORTUNE Magazine) – SO FAR, 2005 IS SHAPING UP TO BE A tough year for investors. Following gloomy profit reports from blue-chip companies such as IBM, Coca-Cola, and General Motors, a string of economic statistics--including slowing GDP growth--has heightened fears that the expansion is flagging. And with the Federal Reserve expected to continue raising interest rates, some fear this "soft patch" could turn into something worse. As of presstime in late April, all the major equity indexes were in the red for the year.

Things aren't likely to improve anytime soon. As we pointed out in February (see "Trouble Ahead for Stocks?" on, interest rates are rising just as profit growth is slowing--an ominous combination. And with the S&P 500 trading at 20 times the previous 12 months' earnings, higher than its historical average, stock prices remain vulnerable.

Still, choppy markets can create compelling opportunities. The trick is to find strong companies whose shares are selling at unreasonably low prices. With that in mind, we fired up a stock screen based on a well-known but little-understood profitability measure: return on equity. ROE, as it's commonly known, is a way of determining how efficiently a company uses each dollar invested in its stock. The figure is calculated by dividing a company's profits by shareholders' equity (the difference between a company's assets and liabilities). Veteran value manager Ron Muhlenkamp is one of many pros who has used this measure to deliver superior long-term returns. His eponymous mutual fund has gained an average of 15% a year since its 1988 inception, beating the 12% annualized return of the S&P 500 during the same period. (In November 2003 we employed a similar methodology and picked stocks that generated an average return of 34%; see Update at left.)

Using a stock screen developed by Zacks Investment Research, we looked for companies with ROEs above the S&P 500's average of 18%, and price/earnings ratios below the market's mean. We in- cluded only companies expected to average at least 10% annual earnings growth over the next five years with debt/capital ratios below 50%. Finally, we wanted companies that have increased sales and earnings by more than 15% annually over the past five years and have more than $200 million in sales. Only 38 stocks cleared those stringent hurdles; from that group we picked five of the most attractive. Many have been pummeled lately--too much, we believe--and seem poised to rise.

Buying shares of Countrywide Financial (CFC, $36) might seem risky. Rising interest rates could slow home sales, which would certainly harm the country's largest residential mortgage lender. But Countrywide has been diversifying. Profits at its retail bank doubled last year. And CEO Angelo Mozilo is beefing up the company's servicing business, which includes the dull--but lucrative--tasks of mailing out mortgage bills and processing checks. Servicing acts as a powerful hedge against a decline in new loans. Unlike originations, servicing fees tend to rise with interest rates because consumers become less likely to prepay their loans. The company's servicing portfolio has nearly tripled since 2001, to $840 billion. And Mozilo hopes to grow the business to $1.9 trillion by 2008. Selling for just nine times earnings, Countrywide's stock looks like a bargain.

Business at D.R. Horton (DHI, $30), the nation's No. 1 homebuilder, has never been better. The company is on pace in 2005 to be the first to sell more than 50,000 homes in a single year. Yes, worries of slowing home construction have cooled red-hot homebuilding stocks (including Horton's), but the company is better prepared for a slowdown than competitors. It already has $6.2 billion in contracts to build a total of 21,205 homes. And Horton's size--$11 billion in sales--means it can negotiate favorable deals with subcontractors and suppliers, a crucial advantage given the recent rise in labor and raw-material costs. Such leverage allowed Horton to increase its operating margin three points in its latest fiscal year, to 15%. And with a P/E multiple of eight, its stock is priced in the basement.

Harley-Davidson (HDI, $46) hit a big pothole in April when it cut its 2005 profit and production projections, citing weak demand. The stock dropped 17%, and shares are now trading where they were five years ago. There's no denying that Harley faces headwinds. High fuel costs are crimping demand for its gas-chugging hogs, while rising costs of aluminum and steel may reduce future profitability. But is Harley-Davidson a below-average company, as the market is now pricing its shares? As Morningstar analyst Philip Guziec argues, when people tattoo your brand on their bodies, you clearly have something going for you--and Harley has 25% operating margins, the fattest in the industry. Moreover, Harley is only beginning to penetrate such big markets as Latin America, Japan, and China. If the company can transplant the cultlike following it enjoys in the U.S., Harley could roar again.

For years, International Game Technology (IGT, $27), the world's dominant slot-machine manufacturer, had a hot hand. Maker of some 70% of all casino games in North America, it saw sales nearly triple in the past five years, to $2.5 billion in 2004, as casinos replaced coin-operated slots with more modern coinless versions. But the upgrade cycle is now past its peak. Profits have tumbled along with IGT's stock price, which is 40% off its 2004 high.

To boost sales, CEO Thomas Matthews is spending $140 million this year to develop new products, such as software to help casinos manage their floors. Meanwhile, U.S. growth could revive soon. Big states such as New York and Pennsylvania have passed legislation to expand the use of game machines, and California, Texas, and Illinois are considering similar bills. In addition, Argus Research analyst John Staszak forecasts that international sales could more than double in the next five years to $1 billion.

Progressive (PGR, $90) is both creative and excels at the nuts and bolts of its business--it's got the highest underwriting margins in the auto-insurance industry. The company has won praise even from competitors such as Warren Buffett, who once cited the company as Geico's biggest threat.

In the '90s, Progressive introduced a number of ideas that are now standard, such as 24-hour claims reporting. The company, with $13.8 billion in annual revenue, also pioneered the low-cost direct-sales model, allowing customers to purchase insurance online and over the phone. Competition in direct sales has grown cutthroat, so Progressive is increasingly focusing on managing claim payments, an insurer's single biggest expense. The company is fine-tuning its sophisticated pricing system, which allows it to quickly and accurately assess each customer's risk and weed out unprofitable customers. And with just 7% of the $150-billion-plus auto-insurance market, Progressive has plenty of room to grow.


Strong profits at discount prices

These stocks have above-average return on equity but below-average price/earnings ratios.