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We believe identifying industry trends with staying power may be a key to out-performance in stock investing in the remainder of this decade. With that premise as a guidepost, we asked the 17 members of our growth-investing team to identify what they believe are 10 promising industry trends and companies in the 10 market sectors they cover.
Their choices of potentially robust sector trends: shipping in autos/transportation, staffing services in consumer discretionary/ services, health and wellness in consumer staples, the supply/demand imbalance in energy, stored-value cards in financial services, artificial discs in health care, a prolonged up cycle in materials/processing, Chinese demand in producer durables, VOIP in technology, and wireless tele-communications in utilities/communication.
Nothing quite quickens the pulse of a red-blooded growth-stock investor like finding the next (choose one) IBM, Xerox, Microsoft, Wal-Mart Stores, Cisco Systems, Clear Channel Communications, eBay. There’s nothing like latching onto blockbuster stocks in their prime for adding extra return and building wealth over time. Forget about the Maltese Falcon; a great growth stock is really the stuff that dreams are made of.
We think one potentially good way to find great growth stocks is to first identify powerful industry trends with staying power. Our logic is simple: great industry trends can beget great growth companies and great growth stocks. Or as Bill McVail, senior portfolio manager/security analyst, puts it, “If you’re going to fish, shouldn’t you fish in a pond where there are a lot of big fish?”
In general, the stock market’s long-term direction has been up (in all rolling 12-month periods from 1950 to 2003, the S&P 500 Index has gained 5% or more about 70% of the time), and stocks in the fastest-growing industries tend to go up even more. To be sure, the opportunities for catching big fish may be found in any number of ponds — even in the ponds of cyclical sectors whose earnings-growth rates are often prosaic but then suddenly perk up. Just witness what’s happened to energy stocks this year; rising oil and natural-gas prices “have been a defining financial development of 2004, helping transform energy stocks from wallflowers to market darlings,” observes Bob Turner, chairman and chief investment officer. For example, share prices of energy companies such as Range Resources, Quicksilver Resources, and Tesoro have soared more than 100% in the year-to-date through November.
We think capitalizing on industry trends may be particularly important in investing over the next several years, especially if average annual stock-market returns only reach the high single digits. To us, the market seems to offer few conspicuous misvaluations to exploit currently, so the ability to discern key industry trends, pick the stocks of companies that can best take advantage of those trends, and let the winners run (or even better, gallop) becomes crucial; that ability may be what ultimately distinguishes the money managers who produce the best relative returns for their portfolios in this decade.
With that in mind, we polled the 17 portfolio managers/security analysts on our growth-investing team to obtain their insights on promising industry trends, either short term or long term in nature, in each of the 10 market sectors they cover — trends that may present above-average investment return potential. And we asked them to identify companies that may be prime beneficiaries of those trends. In all cases, the trends they highlighted enable the companies involved to wield a considerable degree of pricing power — a catalyst for generating both earnings growth and share-price appreciation.
So here are our growth-investing team’s choices of 10 industry trends in the 10 sectors that may
be the stuff that dreams are made of. (They are listed alphabetically by sector, not in any ascending or descending order of merit. And of course we can’t guarantee those dreams will be realized.)
Trend #1: shipping in autos/transportation sector
With trucking capacity limited, with the need to transport oil long distances, and with the Far East importing raw materials and exporting manufactured goods at an accelerating clip, the fundamentals look good to us for truck, air, and ocean shippers. We think shipping companies like Expeditors International, Landstar System, C. H. Robinson Worldwide, Teekay Shipping, General Maritime, and EGL should do well.
The brightest stars here may be the three “non-asset-based” shippers: Expeditors International, Landstar System, and C. H. Robinson Worldwide. These firms serve as shipping coordinators, employing their own technology and systems but using other shippers’ assets to handle the actual deliveries. With that business model, they’ve been able to produce steadier earnings growth and less volatile share prices than their competitors have.
“These firms have grown into major transportation players without owning a single truck, plane, or ship,” says Marc Bianchi, security analyst/portfolio manager. “You’ve heard of the entrepreneur’s principle of using other people’s money? Well, these firms use other companies’ shipping resources.” Their crackerjack information-technology systems have helped the non-asset-based shippers to add value by keeping customers continually informed of the status of shipments.
Trend #2: staffing services in consumer-discretionary/services sector
It used to be that staffing-services firms specialized in basic clerical and light-industrial jobs. That kind of positioning in the staffing-services field threatens to become as outdated as go-go boots. The Sarbanes-Oxley Act of 2002, which established new financial reporting requirements and internal controls for companies, has helped foster a new breed of staffing-services firm. This new breed provides experienced professionals in fields such as accounting, finance, law, and information technology who help corporate clients comply with Sarbanes-Oxley. We think that two of the best of the breed are Resources Connection and Navigant Consulting.
Resources Connection and Navigant Consulting “have done a good job of adapting to today’s corporate philosophy that tends to favor outsourcing and that balks at paying benefits for additional full-time employees,” says Bill McVail. “They are drawing on a ready pool of professional talent created by events like the consolidation of the Big Eight accounting firms, the shrinking demand for technology consultants since the late 1990s, and the downsizing of corporate payrolls.”
Staffing services is a highly cyclical business, but we think Resources Connection and Navigant Consulting can continue to grow even if the economic cycle dips.
Trend #3: health and wellness in consumer-staples sector
All the recent hype about the Atkins diet emphasizing foods with a low carbohydrate content points to a pronounced trend in American society: an increasing emphasis on health and wellness. Relatively small firms like Whole Foods Market have prospered by selling organic foods that cater to this trend. But even consumer-staples behemoths like Kellogg and PepsiCo are getting into the act. Kellogg, for instance, bought Kashi, a company offering “all-natural” foods (free of highly refined sugars and preservatives) such as cereals, whole-grain rice, and crackers.
“Americans are living longer, are better informed about healthy living practices, and are spending more to stay healthy,” says Halie O’Shea, security analyst/portfolio manager. “And sales of organic foods are growing at one of the fastestrates in the food category. All of that suggests the trend in health and wellness will be with us for a long time to come. You know the trend is for real when you see fast-food restaurants like McDonald’s offering more salads and chicken entrees.”
Besides Whole Foods Market, we think two other companies should wring significant benefit from the reality of this trend: United Natural Foods, a major wholesale distributor to the natural and organic food industry nationally, and USANA Health Sciences, which markets high-margin nutritional and personal-care products such as vitamins.
Trend #4: supply/demand imbalance in energy sector
This year business journalists covered the daily fluctuation of oil prices as obsessively as their tabloid counterparts routinely do the British royal family. Oil prices are now at about $40 a barrel, down from a 21-year high of $55.17 last October. We don’t think oil prices will go appreciably lower — below $35 a barrel — in 2005, mainly because demand for energy should continue to outpace supply. Current oil production is running at close to its maximum capacity, so the constraints on supply should continue to enhance energy companies’ earnings and share prices in the short term.
“As we see it, energy stocks don’t yet fully reflect that oil is selling at more than $40 per barrel,” says Don Smith, security analyst/ portfolio manager. “Even if oil prices declined to less than $40 per barrel for an extended period, we think energy stocks would still have upside potential.”
Some energy stocks for which we think the window of investment opportunity remains open: Apache and XTO Energy, oil and gas producers with large reserves, which gives them some pricing flexibility; Transocean, Core Laboratories, and Smith International, oil-services companies that help in the increasingly challenging task of finding and extracting oil; Valero Energy, a geographically diverse refiner; and Peabody Energy and Consolidated Energy, companies that sell coal, an energy source that, unlike oil, the U.S. has in abundance.
Trend #5: stored-value cards in financial-services sector
Talk about a hot trend: consumer use of stored-value, or prepaid, cards has increased fivefold in just the last year. Stored-value cards include gift cards, payroll cards, and prepaid phone cards. We think stored-value cards in fact represent a particularly profitable facet of an even larger, defining American trend: the love affair with charge cards. For instance, about 70% of all retail purchases are now made with a charge card.
Consumers have readily embraced stored-value cards because the cards help them organize their finances, have fixed or reloadable balances, provide access to cash at automated teller machines, and offer greater personal-liability protection than a debit card does in the event of theft. The popularity of stored-value cards has been to the distinct benefit of financial-transaction processors like Ceridian and Global Payments, which issue the cards and manage card programs.
For instance, Ceridian’s Comdata unit provides support services for stored-value cards to many retailers, including Barnes & Noble and Crate & Barrel. Global Payments’ DolEx money-transfer unit sells a prepaid phone card, which is ubiquitous enough that it can be bought at newsstands and drug stores. Notes Chris Perry, senior portfolio manager/security analyst: “Although we think the financial-transaction processing firms have attractive prospects in many of their services, the prospects for stored-value cards are especially attractive.”
Trend #6: artificial discs in health-care sector
The growth potential of artificial discs is based on two simple, well-known trends: America is graying and a graying America has an increasing incidence of back problems. Artificial discs, made of molded polyurethane or ceramics, can replace degenerating spinal discs and “may mark one of the most significant innovations in the treatment of back problems,” says Frank Sustersic, senior portfolio manager/security analyst.
The traditional way of dealing with back problems caused by degenerating discs is spinal-fusion surgery, which subsequently can limit a patient’s normal motion and flexibility. After obtaining artificial discs, however, many patients report that their back pain is reduced and their flexibility is maintained. Also, the recuperation time from artificial-disc surgery is about half as long as that from spinal fusion.
Some of our industry contacts estimate that the market for artificial discs for treating back (and neck) problems could be as large as $800 million by 2007 and $2.5 billion by 2010. For that to happen, however, many more surgeons need to be trained to implant artificial discs. Only a few dozen physicians in the U.S. are now qualified to perform the surgery, although Johnson & Johnson, whose Charite´ disc was approved in October by the Food and Drug Administration for use in the U.S., plans to train about 2,500 surgeons in the procedure in 2005. The Charite´ disc has earned an impressive track record, having been implanted successfully in thousands of European patients since the 1980s. Other firms that we think could excel in artificial discs are Abbott Laboratories, Medtronic, and Synthes.
Trend #7: prolonged up cycle in materials/processing sector
There are business cycles . . . and then there are super cycles — cycles that remain robust for an exceptionally long time, such as the one enjoyed by the energy sector in the 1970s. Some pundits contend that certain commodities such as fertilizer, steel, copper, and aluminum are now in the midst of a super cycle, reflecting pent-up demand and stagnant supply after many tepid years of growth. To support their case, they cite how commodity prices have soared recently; for instance, from May 2003 to November 2004, prices for hot-rolled steel increased 160%; copper, 83%; and aluminum, 35%. “We don’t know if commodities are in fact in a super cycle, but we do think the current up cycle is strong and may run longer than normally,” says Robb Parlanti, senior portfolio manager/security analyst. “This up cycle has given some commodity companies a degree of pricing power that they haven’t had in years. We think it’s safe to say that their pricing power should persist for some time.”
China’s ascendance as a manufacturing colossus has been instrumental in boosting commodity prices. Indeed, China’s demand for raw materials has been such that it has been compared to the magnitude of demand resulting from the Marshall Plan’s rebuilding of Europe after World War II. We think demand from China may slow but will remain relatively high for years to come, thus helping sustain the pricing power of some of the better-managed commodity companies.
We rank among the better-managed commodity firms Agrium in fertilizer; USX, Posco, Nucor, and International Steel Group in steel; Phelps Dodge and Freeport-McMoRan Copper & Gold in copper; and Alcoa, Alcan Aluminum, and Century Aluminum in aluminum.
Trend #8: Chinese demand in producer-durables sector
Another China-related trend: China, with the world’s fastest-growing major economy, is helping create an enormous demand for capital equipment that may be sustained for at least the next three years, in our estimation. For instance, with mineral prices rising, mining companies have an incentive to buy new equipment, and Caterpillar reports that demand for its earthmovers has never been greater, due in large part to China. Also, China’s $22-billion construction and renovation program in preparation for hosting the 2008 Summer Olympic Games is a boon to producer-durables companies.
Says Tara Hedlund, security analyst/portfolio manager: “China, to continue growing its industrial base and to put on the Olympics, needs things like water purification systems, mining equipment, elevators, backhoes, and semiconductor-capital equipment that select producer-durables companies can provide. The companies that we think will succeed best in China are those with leading market shares in their industries and global distribution.”
Such firms include Caterpillar and United Technologies in big-ticket capital equipment; Headwaters, which provides technology for coal mining; Roper Industries, Pentair, and Danaher, which make water-purification systems sorely needed by Chinese industry and an increasing urban population (more than half of China’s people are expected to be living in urban areas by the end of this decade); and Applied Materials, KLA-Tencor, and Lam Research in semiconductor-capital equipment.
Trend #9: VOIP in technology sector
We think the next New New Thing in the technology sector — the next hugely successful technology — could be VOIP (Voice Over Internet Protocol, pronounced “voyp”). VOIP integrates two fundamental networking technologies, voice and the Internet, to provide more economical, convenient, and enhanced telecommunications. VOIP employs routers and special software to transmit phone calls as data on the Internet — a more efficient, economical way to deliver calls than traditional circuit-based telecom systems.
“The mantra we keep hearing in the marketplace is that the economies and benefits of VOIP are such that it’s not a matter of if VOIP takes off, only when,” says Tara Hedlund. “As we see it, VOIP should become popular in part because it encompasses not just phone calls but messages, movies, games, and other future consumer and business applications that are now just a gleam in the eyes of some research engineer.” The Yankee Group projects that by 2009 about 17.5 million consumers, or about 16% of U.S. homes, will be using VOIP.
We think a number of suppliers of VOIP products and services could flourish, including Cisco Systems and Avaya in VOIP software applications, systems, and services; Juniper Networks in VOIP network-security products; Polycom in Web conference software and network gateways for VOIP; and Sonus Networks in VOIP switches.
Trend #10: wireless in utilities/communication sector
In our judgment, wireless telecommunications will be the dominant form of communication in the U.S. Indeed, the wireless business, little more than 20 years old, is likely to surpass the wired phone business sometime in 2005 or 2006. That’s because consumer and business customers are benefiting from declining prices and a rapidly expanding roster of applications. As Chris McHugh, senior portfolio manager/security analyst, observes, “Cell phones are becoming more sophisticated; they are basically pocket computers that are making possible all kinds of new services and entertainment for consumers and business people.”
As such, we think wireless continues to represent an attractive investment trend not only in the U.S. but also in foreign markets. For instance, in Latin America, only 20% of the population has wireless service, and our industry contacts say that number should swell to more than 40% within the next four years.
Among the companies that should continue to profitably ride the wireless wave are Western Wireless (which has carved out a lucrative niche marketing its Cellular One wireless services in rural areas), Sprint Nextel (which has the most profitable and stable customer base), and American Movil and NII Holdings (which are expanding aggressively throughout Latin America). “Wireless is a global phenomenon — one that won’t be confined to the affluent or to Western businesses,” says Chris McHugh. “It’s based on the semiconductor, which is making the cell phone so cheap that much of the world will either have one or have access to one.”