Jubak's Journal

August 20, 2004
10 best stocks for the rest of 2004

The bad news is the uncertainty should last into 2005. The good news is this is a great time to pick up great growth names on the cheap.

By Jim Jubak

If youíre looking for certainty, youíve come to the wrong economy, the wrong stock market and the wrong column.

The current uncertainty about oil prices, economic growth, the pace of interest-rate increases, corporate capital spending and company earnings isnít likely to go away anytime soon. In my opinion, it will extend well into 2005 (and investors may not like the way this uncertainty resolves itself next year).

So what do you do about setting an investment strategy amidst so much uncertainty? You embrace uncertainty and use its ebbs and flows as indicators of how to position a portfolio. In this column, Iíll show you how that works and give you my best shot at the 10 best stocks for the rest of 2004.

Contradictions abound
If youíre looking for a quick summary of the current state of uncertainty, you donít need to go further back than last Tuesday, Aug. 17. The Labor Department reported that the Consumer Price Index fell 0.1% in July, while the core rate, which excludes energy and food, rose just 0.1%. The drop in the overall CPI was the first decline since February, and the minor uptick in the core rate brought year-over-year core inflation down to 1.8% from 1.9% in June.

In a second report that day, the Federal Reserve announced that industrial production climbed 0.4% in July. That brought capacity utilization at manufacturing plants to 76.3%, up from June. And in another sign the economy is still growing strong, single-family home starts climbed 8.5% in July, and building permits, an indicator of future building activity, rose 5.7%.

So the worries about the economy (it was slowing), about the stock market (share prices were too high given weak earnings) and interest rates (they were going higher) are over, right?

Oh, come on. One monthís data donít make a trend, especially when it follows months of data pointing in the other direction or when economic indicators point in opposite directions. Which do you think defines the inflation trend: The pickup from the 40-year inflation lows of November through January? The scary jump in inflation that put the annualized rate above 5% in the March-through-May period? The July drop in prices?


And you certainly can remember the worry last week (yes, it was just that long ago) about economic growth. The thinking then was that oil prices above $45 and the Fedís interest-rate hikes and weak retail sales were signaling a slowdown in economic growth.

The data that fed those worries -- the release of advance-second quarter GDP numbers -- certainly had enough uncertainty for everyone. Second-quarter GDP growth came in at 3%, weaker than hoped, and economists immediately began to trim their projections for the revised second-quarter GDP numbers to be released next week. (The Department of Commerce issues and then reissues and then reissues again each quarterís GDP numbers and the revisions can be plenty big.) The consensus for revised second-quarter GDP growth is now 2.7%, down from 3%.

Of course, at the same time, the Commerce Department restated its first-quarter GDP estimate to 4.5% from 3.9%.

No end to the confusion in sight
And the deeper you dig into the data, the more contradictions you find: Consumer spending fell to a weak 1% growth rate, indicating a slowing economy, but business investment climbed by 9%, indicating a strengthening economy.

This data are doing a pretty good job of indicating just how confusing this economy -- and by extension this stock market -- really is. While itís clear that higher oil prices arenít a plus for the economy, no one really knows how big a minus they might be. The last time spiking oil prices sent the U.S. economy into a tailspin, the economy used much more energy per unit of economic production than it does now. And global economic growth wasnít nearly as dependent on China. Good luck on getting reliable data on the effects of higher energy prices on that economy.

Same thing goes for inflation: How much inflation can we expect if we balance the effect of the Fed creating negative real interest rates against the cutthroat cost-cutting in the current global economy? (A negative real interest rate results when the nominal interest rate is below the rate of inflation.)

And with regard to interest rates: Is the Fed so anxious to get back to a neutral interest rate of around 2.5% (so that the nominal rate is at least equal to the inflation rate) that it will keep raising rates even in the absence of evidence of inflation or in the presence of data showing the economy is slowing?

How to embrace the uncertainty
So weíre stuck with a roller-coaster ride as economists, investors, the Fed and consumers over-interpret not especially meaningful data in a search for uncertainty. One week the consensus swings toward slow growth on the best data we have and a month later it may well swing toward OK growth before jumping all the way back to too-slow growth. And I donít think weíre likely to have solid evidence that adds up to real trends before sometime in 2005. It will take that long for all thatís going on now to work its way into the economy in detectible ways.

Until then, investors can expect to get whiplash from this uncertainty. When everything looks grim, as it does now, investors will seek safety. When everything looks great, and I do expect us to hit another patch of exuberance before the end of 2004, investors will look to snap up the volatile, high price-to-earning ratio growth stocks in the technology sector that soar the most when investors put on their rally caps.

So all you have to do to make a lot of money in this market is plunge into Treasurys when the financial markets are about to be gripped by fear, sell when fear is peaking and then plunge into the tech sector just as investors swing toward relative optimism.

Of course, if you get this wrong, it can be pretty expensive. Just witness the beating Iíve been taking in Jubakís Picks in Analog Devices (ADI, news, msgs), Marvell Technology Group (MRVL, news, msgs) and Micron Technology (MU, news, msgs) because I mistimed the technology bottom.

My recommended alternative is what Iíd call ďembracing the uncertainty.Ē In a market like this one, high levels of fear produce huge price swings on just about meaningless news. Investors, worried about being caught on the wrong side of a trade, overinterpret news and sell big time on minor disappointments. If you need an example, look at the flogging Smithfield Foods (SFD, news, msgs) took after it said it had missed out on part of the unexpected rise in pork prices because it had used hedges to lock in the price it paid for hogs. Frankly, I donít see anything that changes the fundamentals of this company one bit. But the stock is down 16% since July 30.

This kind of volatility means that this stock market will repeatedly put great growth stocks on fire sale. Again look at Smithfield. Hereís a stock that over the last eight years (the lifespan of Berkshire Hathawayís B shares (BRK.B, news, msgs)) has returned 278% versus a 169% return on Berkshireís B shares and a 60% return on the Standard & Poorís 500 ($INX). Over the last five years, the company has grown earnings by 10.5% annually and the Wall Street consensus projection is for 10.2% annual earnings growth over the next five years. Yet, after the warning and the sell-off, Smithfield is selling for a price-to-earnings ratio of just 11.6 on trailing 12-month earnings per share.

Great growth, cheap!
The advantage of my ďembrace the uncertaintyĒ strategy is that youíll be buying great growth on the cheap. The cheap price will temper the downside if the company disappoints. The great growth will temper the downside if the economy disappoints. And the cheap price and the great growth will give you solid upside if the economy muddles through. (Which, by the way, is my prediction for the rest of 2004 and early 2005.)

So all you need is 10 great growth stocks selling at cheap prices, right?

Here are my suggestions:

 10 cheap growth plays

Company

Trailing P/E

Projected 5-yr. EPS growth

Loss in last 30 days

Deere &Co. (DE, news, msgs)

15.4

12.9%

1%

Donaldson (DCI, news, msgs)

21.7

12.5%

0%

Engineered Support Systems (EASI, news, msgs)

20.5

16.4%

25%

Middleby (MIDD, news, msgs)

19.6

20.0%

2%

Oshkosh Truck (OSK, news, msgs)

16.3

15.0%

7%

Rogers (ROG, news, msgs)

19.2

20.0%

27%

Smithfield Foods (SFD, news, msgs)

11.6

10.2%

14%

SunGard Data Systems (SDS, news, msgs)

17

15.0%

2%

Texas Instruments (TXN, news, msgs)

18.4

19.8%

5%

Valero Energy (VLO, news, msgs)

7.5

15.4%

16%

Please note: All data is as of Aug. 18. EPS projections are Wall Street consensus: You and I may or may not agree with these estimates.

Iím going to buy two of these now for Jubakís Picks: Smithfield Foods and Middleby. Several others, Donaldson, Engineered Support Systems, Oshkosh Trucks and Rogers, are already in that portfolio. Despite their recent price weakness, I donít see any reason to give up on these stocks. Several others Iíll wait on for now until the staying power of the current rally is a little clearer or the current rotation out of oil stocks looks closer to an end.

I also have a list of a few stocks that fit this group on everything but price: Theyíre up and Iíd like to see them down. This group-in-waiting includes Equifax (EFX, news, msgs), Paccar (PCAR, news, msgs), Main Street Banks (MSBK, news, msgs), Middleburg Financial (MBRG, news, msgs) and Northern Trust (NTRS, news, msgs).

Stocks like these are the core of my position for an economy and a market like this. You can add more risky positions around this core if market conditions look favorable. More on those riskier edge positions in biotechnology and technology later.

New developments on past columns


The companies you hate
Just in case anybody was thinking that the current poor state of customer service was an accident: ďI truly enjoyed your article on the deterioration of customer service. Being in a service industry, I have dealt with this issue over the last 35 years. My take on this is that the numbers have been crunched and the calculations have been made. The point at which the churn is acceptable has been determined. As dissatisfied customers leave one customer-service-deficient company, they show up at the next customer-service-deficient company, which has just lost a customer for the same customer-service-deficient reasons. And on it goes.Ē -- Martin Geffon, COO at Motor West, Caldwell, Idaho

Changes to Jubakís Picks


Sell ChevronTexaco
It may seem odd that oil stocks have been in retreat (modest, Iíll grant you in most cases) while the price of oil itself has been climbing. But there is a logic to it. The traders who dominate the low-volume August market believe that the price of oil is about to peak and that, therefore, the oil stocks have had their run. In the short term, thatís quite possibly true -- and thatís why Iím selling ChevronTexaco (CVX, news, msgs) here. In the long term, I think the traders are dead wrong, so Iíll be looking to buy back into the sector after this rotation is finished. I have a 4% price appreciation in the shares since I added them to Jubakís Picks on June 15, 2004. Iíve also qualified for one dividend payment, payable to shareholders of record as of Aug. 19. My total return on this position is 5%.

Buy Smithfield Foods
Letís try this one again and hope for the same kind of results. I bought Smithfield Foods (SFD, news, msgs) in early 2003 and sold it about a year later at $25.58 for a 30% gain. This time Iím starting at a higher price, but Smithfield since 2003 has solidified its hold on the pork-processing market and the company now commands a 27% share. The stock is down 16% since July 30 with the big killer an Aug. 4 warning that earnings for the quarter that closed on Aug. 1 would come in at 45 cents to 50 cents instead of the 58 cents Wall Street had projected. The drop is due to losses on hog contracts that Smithfield used to hedge against a drop in hog prices. As hog prices went up, the company lost money on the contracts and gave up some of the gains from higher hog prices. At recent prices, the stock trades at 11 times projected earnings per share for the year that ends in April 2005. The company reports earnings on Aug. 26 and cautious investors might want to wait until after that date to buy the stock. As of Aug. 20, Iím adding the shares to Jubakís Picks with a March 2005 target price of $28.50 a share. (Full disclosure: I will buy shares of Smithfield Foods three days after this column is posted.)

Buy Middleby
Letís see: Middleby (MIDD, news, msgs) now sells for 19.6 times trailing 12-month earnings per share and Wall Street projects that the company will grow earnings by 20% a year over the next five years. That price looks even more reasonable if you realize that this conservatively managed company regularly beats Wall Street estimates (four out of the last four quarters) and grew earnings by 47% annually over the last five years. Middelby has shown up twice in recent columns: once in my Aug. 13 column, ď10 inflation-fighting stocks,Ē because its cooking systems save its restaurant customers money, and in my May 19 column, ď5 stocks inflation will help.Ē As of August 20, Iím adding the shares to Jubakís Picks with a target price of $63 by March 2005. (Full disclosure: I will buy shares of Middleby three days after this column is posted.)

Editor's Note: A new Jubakís Journal is posted every Tuesday and Friday.

E-mail Jim Jubak at jjmail@microsoft.com.