Seek Fast-Growth Stocks
By James K. Glassman
Sunday, February 28, 1999; Page H01
David Post is a money-manager in San Francisco who is more interested in how fast a company's profits are growing than in what the stock costs. This strategy – the growth investor's credo – has been extremely lucrative over the past five years, and especially in 1998. But it sounds like heresy to many investors. Isn't the idea to find good companies that are cheap and wait patiently until the market recognizes their value?
While it still makes sense to search for undervalued stocks, the market these days – and perhaps for a long time to come – is rewarding growth. If you don't have fast-growers in your portfolio, you're making a big mistake. I say this as a bargain-hunter who, only lately, has learned the joys of booming earnings.
"People have discovered growth," Post told me as we looked out from one of those skyscrapers in the business district, north to the Golden Gate Bridge. "If you get the earnings right, you get the price right. It catches up."
Post is a partner in the firm of Harris Bretall Sullivan & Smith, L.L.C., which manages $3.5 billion for individuals and for institutions like pension funds. While the firm's culture is conservative and deliberative, it loves growth stocks.
Last year, Harris Bretall earned a net return for its clients of 36.2 percent, compared with 28.5 percent for the Standard & Poor's 500-stock index, which tracks the performance of large companies. Over the last five years, the firm's average annual returns have been 23.4 percent, compared with 24.1 percent for the S&P and just 17.4 percent for the average mutual fund, according to Lipper, Inc.
The firm's portfolio is full of big, beautiful growth stocks: Microsoft Corp. (MSFT), the software company, is the largest holding, followed by Charles Schwab Corp. (SCH), the discount brokerage firm, and Cisco Systems, Inc. (CSCO), which dominates the market in computer networking products.
At the end of last year, the average price-to-earnings ratio (P/E) of Harris Bretall's 44 stocks was 52, meaning that it cost $52 to buy $1 worth of a company's profits. By contrast, the P/E of the S&P was 29.
But there was another difference. Harris Bretall stocks were increasing their earnings at a rate of 18 percent a year while S&P stocks were growing at just 10 percent and Dow Jones industrial average stocks at 9 percent.
"We don't say that Cisco and Microsoft are cheap," Post told me, and he doesn't care that much. Microsoft, with earnings now increasing at 25 percent annually, has risen by a factor of 14 over the past five years.
As for Cisco: It offers an interesting case study. In July 1997, it was trading at $36, with a P/E of 37. On Thursday, it closed at $98.50, with a P/E, based on estimates of earnings for the fiscal year ending July 1999, of 67. Earnings have been growing at 30 percent a year, according to Bloomberg Business News, and the market adores it.
Now take a classic value stock: Caterpillar, Inc. (CAT), maker of construction equipment. In July 1997, it was trading at a price of $55 a share and a P/E of just 14. On Thursday, Caterpillar closed at $45.69 a share, with a P/E, based on estimates of this year's earnings, of 13. Profits are up, but not by enough to thrill investors. The company's long-term growth rate is 10 percent annually.
Is the market overvaluing growth? Could be. But you should never underestimate a company whose earnings are zipping along. Even if the stock seems to be expensive by conventional measurements, growth holds the trump card – thanks to the power of compounding.
Here's what I mean. Take a stock that trades at $200 a share and has earnings of $4 a share. It's expensive at a P/E ratio of 50, but its profits are growing at 15 percent a year.
Let's say that the day after you buy the stock, it plummets to $120 a share as the market suddenly decides that the P/E of growth stocks should be 30, not 50. Bang – a loss of two-fifths of your investment in 24 hours. But you really shouldn't mind as long as profits are booming.
At the end of 10 years, growing at 18 percent, earnings per share will reach $21. Assume that the market continues to value those earnings at a P/E of 30. The stock, then, should be worth $630 a share. So you have tripled your investment – despite that terrible one-day loss when the market readjusted its valuations.
Of course, there are no guarantees that a company whose earnings have been growing at a fast clip for the last five years will do the same for the next five. But it's a good indication – especially for large-capitalization companies with strong positions in their industries.
In a recent issue of his newsletter Personal Finance, Stephen Leeb pointed to firms with long-term records of both stability and growth, including Pfizer, Inc. (PFE), which has increased its earnings at a 19 percent annual rate for the past five years; Bank of New York Co., Inc. (BK), 15 percent; Johnson & Johnson (JNJ), 14 percent; Coca-Cola Co. (KO), 14 percent; and Intel Corp., 21 percent.
Harris Bretall owns all of these but Bank of New York, but Post says he has a positive view of many financial stocks, including Citigroup, Inc. © ,formed last year from the merger of Citicorp and Travelers; American International Group, Inc. (AIG), the giant international insurer; and three San Francisco-based companies, BankAmerica Corp. (BAC), Wells Fargo & Co. (WFC)-whose largest single shareholder is Berkshire Hathaway, Inc., Warren Buffett's firm-and Schwab.
These financial stocks appear to be delivering both growth and value. BankAmerica, for instance, is increasing its profits at a rate of 15 percent annually, but its P/E (based on 1999 estimates) is just 14. (Don't scoff at 14 percent growth; it means that profits will double in five years, octuple in 15.)
While Post wants to see a strong track record, the firm is willing to buy modern high-fliers, including Dell Computer Corp. (DELL), whose growth rate Harris Bretall pegs at 25 percent, and America OnLine, Inc. (AOL), at 35 percent.
Nearly all of the firm's holdings are very large-cap stocks, but it does own Starbucks Corp. (SBUX), a mid-cap, and estimates its rate of earnings growth at 35 percent with a P/E of 42. Starbucks, the coffeehouse chain that's been a favorite stock of mine, has quadrupled in price over the past five years but is down nearly 15 percent from its July high.
Harris Bretall does not run a public mutual fund, but it manages "wrap" accounts, or personal stock portfolios, for clients of brokerage firms. The firm's style is tax-efficient: Its annual turnover rate is 30 percent, indicating the average stock is held for more than three years (Microsoft and Intel have been owned for more than 10), and the current dividend yield is just 0.7 percent.
Among the best of the large-cap growth funds is Janus Twenty (1-800-525-8983), managed by Scott Schoelzel, who last year notched a return of 73 percent and is up 7 percent already in 1999. His portfolio, highly concentrated, is headed by Dell, America OnLine, Microsoft, Time Warner, Inc. (TWX), Pfizer, Warner-Lambert Co. (WLA),pharmaceuticals, and Nokia Corp. (NOK/A), the Finnish telecommunications equipment company whose shares trade as American Depositary Receipts. Together, these seven stocks represent half of Schoelzel's assets.
A less conventional choice for growth stocks is General American Investors Co. (GAM), a closed-end fund, which you buy on the New York exchange through a broker. The fund has returned 34 percent over the past 12 months, compared with 20 percent for the S&P, and an annual average of 31 percent for the past three years, against 27 percent. The fund trades at a discount of 9 percent to the actual market value of its portfolio.
Top holdings are Home Depot, Inc. (HD), Pfizer and Wal-Mart Stores, Inc. (WMT) – all holdings of Harris Bretall as well. Home Depot has an earnings growth rate of 24 percent; Wal-Mart ("a machine!" says Post) at 12 percent. Home Depot has returned 83 percent in the past year; Wal-Mart, 81 percent.
How long can it last?
"As long as they deliver good earnings, the chances are, these stocks will go up," says Post. So far, anyway, he's been right on the money.
Glassman's e-mail address is jkglassman@aol.com.
© Copyright 1999 The Washington Post Company
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