It's so tempting. Everyone except you made millions on Yahoo! (YHOO
) and Microsoft (MSFT
) in the 1990s. Now the stocks have fallen hard, and you want in. But before you phone your broker, ask yourself: Which ones have the right stuff to pull out of the dive?
Figuring that out is no mean feat, particularly when you're dealing with growth stocks. These shares generally command higher valuations because their earnings and revenue growth are greater than other companies'. For instance, the average stock in the Russell 1000 Growth Index of large growth companies has an expected earnings growth rate of 22.1% over the next five years, almost double the 12.6% expected growth of Russell 1000 Value Index stocks. But growth stocks can fall very hard when they miss--or are expected to miss--their performance markers.
So-called busted growth stocks usually drop out of the BW 50 as their performance slips. In 2000, Microsoft, Gap (GPS
), Lucent (LU
), and Home Depot (HD
)--37 stocks in total--left the list. That remarkably large turnover owes much to the slowing economy as well as the aftershocks of the technology rout.
But some of the stocks were deservedly beaten down because of internal problems that may take much longer to fix. Lucent Technologies, for instance, made several bad loans to emerging telecom customers that are now facing bankruptcy. The loss of that business has hurt its bottom line. In addition, competitors such as Nortel Networks (NT
) and Ciena (CIEN
) have stolen much of its lucrative network-equipment business. ``I think Lucent has structural and management problems across the board,'' says manager David Alger of Spectra Fund. Another way to look at it is that Lucent has lost what money managers call ``franchise value''--its industry leadership position. The company has ceded that to Nortel, and the change could permanently hamper its growth.
In contrast, Home Depot's shares have plummeted as the economy has slowed, but it remains an essentially sound retail giant. If the economy picks up as rates decline, its share price is likely to recover. Over the long term, it has been a great franchise, says Alger. ``They've destroyed every company that has tried to compete with them.''
GREAT BUYS. Buying powerhouse franchises that have stumbled because of the sluggish economy is a smart strategy for long-term investors. Alger also thinks dominant players such as Cisco Systems (CSCO
) and Intel (INTC
)--both fallen BW 50 members--have been oversold. Of the busted Internet names, eBay ``in the low 30s is a great buy,'' Alger says. ``It's dominant in the area of online auctions, which is rapidly replacing the newspaper classifieds.''
Still, a strong franchise only goes so far. The toughest part of analyzing a busted stock is figuring out what its future earnings growth will be--and whether its current valuation overstates or understates that growth. A useful statistic for comparing busted growth stocks is the price-earnings growth (PEG) ratio. Calculated by dividing a stock's forward p-e ratio by its forward earnings growth estimate, the PEG ratio helps determine whether a growth stock warrants a higher valuation than its peers. PEG ratios lower than 1 are considered cheap.
Let's apply this to McDonald's Corp. (MCD
), a company whose franchise seems unassailable but whose growth rate is slow. Zacks Investment Research, which pools Wall Street analysts' estimates, anticipates only 11.8% annual growth over the next five years. McDonald's forward p-e, meanwhile, is 17.5, giving it a PEG ratio of 1.5. Compare that figure with the PEG ratio of fiber optics giant, Corning (GLW
). Its forward p-e, at 17.2, is close to McDonald's. But analysts expect Corning's earnings to grow 26.1% annually over the next five years, so its PEG ratio is 0.7.
Such bargains are rare among industry leaders, however. Even after last year's slide, the companies in the Standard & Poor's 500-stock index have an average PEG of 1.6. Of 400 large U.S. companies with market capitalizations greater than $5 billion, only 60 have PEGs lower than 1, according to Bloomberg Financial Markets. Only 28 are growth stocks. That's why some growth managers compromise by buying smaller franchises. ``Our strategy is to buy an industry's No. 7 company that's heading for the No. 3 spot,'' says manager Foster Friess of Brandywine Fund.
One industry that could provide a promising hunting ground is semiconductors. Despite the slower economy and falling demand for PC chips, the long-term growth estimates for many chip companies remain high as markets for new kinds of processors expand rapidly. Apart from Intel, several chipmakers and chip-equipment makers make the under-1 PEG ratio cut, including Applied Materials (AMAT
)--a BW 50 member--Teradyne (TER
), Cypress Semiconductor (CY
), International Rectifier (IRF
), Advanced Micro Devices (AMD
), and Novellus Systems (NVLS
). Electronic component makers Vishay Intertechnology (VSH
), SCI Systems (SCI
), and AVX (AVX
) are also extraordinarily cheap, with PEGs less than 0.5.
PROMISING. Although not the cheapest in the group, the dominant player in the semiconductor equipment industry is Applied Materials. ``You cannot make a semiconductor without having equipment supplied by Applied Materials,'' says manager Ed Vroom of Reserve Small-Cap Growth Fund. Vroom is also a big fan of Vishay Intertechnology, which is ``the largest passive component manufacturer in the world.'' These components control the current flow in electrical devices. ``Semiconductor stocks look like they've bottomed at this point,'' says Vroom. ``That's a very good sign.''
In other industries, BW 50 newcomer ADC Telecommunications (ADCT
), which is 80% off its one-year high and has a PEG of only 0.7, is promising, too. Manager George Mairs of Mairs & Power Growth Fund says the company is superior to Lucent because of its versatility in supplying equipment to regional Bells, long-distance, and cable companies. ``I have a strong conviction in ADC's franchise,'' he says. ``It has a broad range of products that address virtually every segment of the telecom industry.'' Because cable and regional Bell companies are currently battling over Internet business, selling products to both is a distinct advantage. Unlike Lucent, ADC does not use its own capital to finance its customers. Yet the market has treated it almost as badly.
Of course, the PEG ratio should not be your only reference point--since growth estimates become more error-prone over greater periods of time. Looking at a company's price-to-sales (p-s) ratio and its price relative to its book value (p-b)--the value of its underlying assets--allows you to balance future expectations with the current reality. By that measure, Gateway (GTW
), which has a p-b ratio of 2.1, is substantially cheaper than Dell Computer (DELL
), which has a p-b of 9.4, even though the two company's PEG ratios are close.
It helps to compare companies in the same industry, however, as companies in certain industries have more tangible assets than others. A lot of the value of a software maker is intangible--it's in the minds of its programmers--while a car manufacturer owns factories and equipment.
Still, it may take a while before any of these busted companies come back. ``If you're buying tech stocks now, don't expect them to perform well till the second half of the year,'' says Ronald Hill, chief equity strategist at Brown Brothers Harriman. ``We're only beginning to see the downward earnings-revision trends'' caused by the economic slowdown. Nevertheless, Hill thinks now is a good time to buy. Calling a precise bottom on these stocks is almost impossible, he says.
Unfortunately, some companies will never recover. Yahoo has a double hex on it. The slowing economy and the bankruptcy of many dot-coms mean reduced Internet ad revenues. And the newly merged AOL Time Warner (AOL
) is shaking Yahoo's franchise to the core. Analysts expect AOL to dominate the Internet media industry in the future. So buying Yahoo at this point isn't like snatching low-hanging fruit. It's more like taking a big leap of faith. Careful, lest you fall.
Copyright 2001, Bloomberg L.P.
Printer-Friendly Version