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How to Compare Growth Stocks

There are many financial yardsticks by which stocks can be evaluated and most of the time, a blunt measurement has little value.


Bread and Circuses

How to Compare Growth Stocks


One spring day when I was 19, I hiked up New Hampshire’s Mt. Washington to ski Tuckerman Ravine. On my back were my white Hart skis with blue lettering and my red Nordica boots. And I was alone … except for the few hundred other mostly young people doing the same thing. It was a 2.5 mile hike up from the Pinkham Notch parking lot to the start of the bowl known as Tuckerman Ravine, and then a few hundred yards more to the top of the ski runs, which are naturally steep and wild … and bounded by rocks. I got in two runs, which is pretty standard, one on narrow and icy Hillman’s Highway on the left, and the other in the more open Center Gully. I felt proud, accomplished. And when I’d had enough, I walked down alone.

A few years later, I returned with a girl. But this time, looking for a new level of fun, I left my skis home and brought a large inner tube and an air pump instead.

The walk up to the bowl was uneventful. The inflation of the inner tube went as planned, though I did notice that mine was the only one there. And my hike up the bowl, in an area to the right known as The Sluice, went as planned.

But as everyone knows, you can’t steer an inner tube. And the higher I got, the more it became obvious that to avoid crashing into the rocks at the right edge of the bowl, I’d have to start my descent closer to the center. So I traversed to the center and found myself under The Lip, where the slope is steeper … perhaps 40 to 50 degrees at the steepest sections.

People were watching.

So with butterflies in my stomach, I lay down on the tube on my stomach, feet dragging behind so I could keep my eyes pointed forward … and let gravity do its work.

Which it did more quickly than I’d expected. Gravity is powerful stuff.

So there I was, hurtling downhill, my face inches above the snow, with the
bottom of the bowl approaching fast.

And then the bouncing began, as the tube absorbed the shocks of the imperfections in the terrain and amplified them through several up and down cycles, tossing me up and down just like a bucking bronco tosses a cowboy.

The tube won. It smashed my face into the snow, tore itself from my grip, and carried on without me, to be brought up short by the rope whose other end was attached to my leg.

I stood up.

The crowd cheered.

I hauled in the tube and walked back up the bowl 20 feet or so to retrieve my glasses.

And I like to think that I’ve done nothing as stupid since.

Luckily, the girl stuck with me. We’ve been married for more than 30 years.

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Which brings me to a 34-year old man named Ryan Dunn who crashed his yellow Porsche 911 GT3 into a tree in Pennsylvania two weeks ago. He and his friend both died. Police suspect that speed was a factor, given that the car was travelling at more than 130 MPH when it left the road. Also, he was drunk.

Now I confess that I knew nothing of Ryan Dunn before last week, and I’m fairly confident he knew nothing of me. It’s a big world.

But millions of people did know Ryan Dunn, who achieved fame first as a performer on the Jackass TV show, and then as a daredevil, stuntman, reality TV star and—perhaps stretching the definition a hair—an actor.

Now, I understand the lure of speed. I know the power of testosterone. And I support the right of a person to endanger his own body parts … even his life.

But what I’m wondering today is this:

Are we Americans perhaps a little too consumed by such mindless entertainment?

It doesn’t bother me (much) that Mr. Dunn chose to live and die by living on the edge. He served his market well, and he enjoyed the fruits of his labors.

What bothers me is that millions of people chose to spend their money—and equally important, their precious time—watching him, as well as other supremely moronic entertainment.

And Mr. Dunn was only the tip of the iceberg. The fact is, we’re watching more TV than ever before, consuming more electronic entertainment than ever before, and paying crazy amounts of money to watch elite athletes play games.

Conversely, we’re working less and reading less. (See last week’s Department of Labor statistics.)

Is it any wonder American students have fallen far behind their global peers and, by extension, is it any wonder the American economy is sputtering?

Too many kids have been dreaming about being the next Ryan Dunn or Tiger Woods or Tim Thomas.

And not enough have been working to become the next Reed Hastings (Netflix), Steve Ells (Chipotle Mexican Grill) or Lars Björk (Qlik Technology).

And it’s not just kids.

A recent story in the New York Times detailed the plans to capitalize on Derek Jeter’s upcoming 3,000th hit by digging up dirt from both the batter’s box and shortstop’s patch, filling a five-gallon bucket, and sealing it with tape and tamper-proof holograms to verify that it’s the ground Jeter may have walked on … so that a company named Steiner Sports can repackage it and sell it.

Yeah, dirt.

So here’s an idea.

Roughly two millennia ago, the Roman poet Juvenal lamented that the people of Rome had over time lost interest in the operations of their own government as their rulers placated them with “bread and circuses.” Wheat was distributed for free, so poor people could eat, and elaborate entertainments—lions vs. slaves, for example—were staged to keep people amused.

Another social critic of ancient Rome around the time of Caesar, the statesman and writer Cicero, wrote this about the public “sports” of the Coliseum:

“What pleasure can a cultivated man get out of seeing a weak human being torn to pieces by a powerful animal or a splendid animal transfixed by a hunting spear? Anyhow, if these sights are worth seeing, you have seen them often; and we spectators saw nothing new.”

Nothing new. Those two words could apply to our own jaded, infotainment culture.

Eventually, like Greece before it, Rome fell, and economic leadership was assumed by Northern Europe, which over time ceded the lead to the U.S.

How long we’ll keep the lead is unknown, but if people spend less time watching moronic entertainment or coveting the dirt(!) that Derek Jeter may have walked on and more time improving themselves or the world around them, our chances are likely to be better.

Now, I’m not saying there’s anything wrong with modest amounts of escapist entertainment. We all need to relax, have a good laugh. But it’s the trends that worry me, combined with the trends away from reading and learning. (Yeah, I know there are more college graduates than ever before, but I also know today’s graduates, on average, read less and study less than any class before.)

What do you think? If you write, I’ll answer.

Note: I still slide down steep icy slopes by choice. But I wear skis or a snowboard. And I always wear a helmet.

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As to the market, last week a doctor from Long Island City, New York asked, “Is there a website where I can find the earnings estimate for the next year of a certain company? I read somewhere that the fair price of a stock = next year’s earnings estimate X 20. I would certainly appreciate your help.”

I told the good doctor he could find a decent free screener by searching Yahoo Stock Screener.

But then I told him why it probably wasn’t a very good idea, and now I’ll tell you, too.

There are MANY financial yardsticks by which stocks can be evaluated, and the one mentioned can be helpful if you’re comparing companies that are roughly equivalent—that work in the same sector, are the same size, have the same profit margins and the same growth rates.

But it’s rare to compare two companies that are so similar, which means that most of the time, a blunt measurement like that has little value. And even within industries, the differences typically outweigh the similarities.

Consider three companies in the sports apparel business.

Nike (NKE)
is well known. The 43-year-old company—which started out in the sneaker business—has $20 billion in sales, and a healthy 10.3% after-tax profit margin. But the company’s best growth days are over. In the latest quarter, its managers grew earnings at a 7% rate; for the full year, analysts are expecting earnings growth of 12%.

UnderArmour (UA)
, which started out in the “performance underwear” business, is less well known. The company is only 16 years old. But its revenues recently topped the $1 billion level, and it’s growing substantially faster than Nike. In the first quarter, earnings soared 64% from last year! For the full year, analysts expect earnings to grow 29%, and that’s probably conservative. But the after-tax profit margin has been erratic; in the latest quarter, it was just 3.9%.

Finally, there’s Lululemon (LULU), which started out in the yoga clothing business just 13 years old. Lululemon, which is based in Vancouver, has $760 million in annual sales. In the latest quarter, it grew earnings 63%. Analysts expect earnings growth for the full year of 39% (again likely conservative). And in the latest quarter, Lululemon had a stupendous after-tax profit margin of 17.1%!

Now, if all these companies traded at a multiple of 20 times next year’s earnings, it would be an easy choice to buy the fastest grower, Lululemon. But the market’s not stupid. Expecting to find that situation would be like expecting a butcher to price ground chuck the same as filet mignon.

So what the market today does is price Nike at 17 times next year’s earnings; UnderArmour at 43 times next year’s earnings, and Lululemon at 49 times next year’s earnings.

Nike is cheaper on that basis, and the main reason is that it’s growing slower. But is it cheap enough? I have no opinion, but our value expert, Roy Ward, editor of Cabot Benjamin Graham Value Letter, does. He includes Nike in his list of 250 Highest Ranked Wise Owl Stocks, which is good. But he says the stock is only a good deal if you can buy it under 65.

As to UnderArmour and Lululemon, both have been recommended in recent weeks by growth-oriented Cabot publications like Cabot Market Letter and Cabot Top Ten Trader. And for those advisories, valuation doesn’t matter. What matters far more is the action of the chart, the likelihood that the business will keep growing at a good speed, and the likelihood that more investors will become buyers as they develop positive opinions about the company.

With Nike, that’s not happening. With Nike, investors are slowly leaving the stock, as they note that companies like UnderArmour and Lululemon are eating into its market share. Two years ago, more than 2200 institutions owned shares of NKE. Today, the number is below 1800.

At the same time, the number of institutions owning UA has increased from 325 to over 400; and the number of institutions owning LULU has increased from 244 to over 300. The trends for these companies and their stocks are positive, and there’s a lot of upside potential for both.

You can see the same situation in other industries.

Cisco (CSCO)
, for example, is the granddaddy of the computer networking industry. It trades at just nine times next year’s earnings. But in the past quarter its earnings didn’t grow at all! Investors are deserting CSCO like rats leaving a sinking ship. (And adding a touch of soap opera to the mix is shareholder Ralph Nader, who is agitating for the company to increase its dividend.)

On the other hand, a hot young company like Fortinet (FTNT), which specializes in computer network security, is growing increasingly popular, and fast! Its revenues grew 125% in the latest quarter. Its after-tax profit margin is a healthy 14.9% and it trades at 72 times next year’s earnings, which is fine with me. In fact, Cabot Top Ten Trader has recommended Fortinet.

Finally, consider the case of companies with no earnings.

Some of our biggest winners historically have been companies that were earning no money when we got on board. The champion of all was (AMZN). Remember when the online bookstore was getting started? Pundits said Barnes & Noble and Borders would crush the little online company, whose original strategy was to get big before it tried to get profitable. Well, look who recently declared bankruptcy!

Admittedly, we don’t find a lot of winners before they have earnings. But some companies have such revolutionary ideas (like Amazon) that their stocks develop unusual strength far before the numbers would seem to justify it. And when I see such strength, I pay attention.

One example today is Complete Genomics (GNOM). The company had revenues of $6.8 million last quarter. It lost $0.48 per share. But its stock is strong, and here’s why.

Complete Genomics has a proprietary DNA sequencing platform that allows the company to conduct large-scale DNA sequencing studies for paying customers, so that those customers (universities, pharmaceutical companies, researchers) don’t need to buy their own expensive machines. The customers send samples to Complete Genomics, and the company runs the tests and sends back the finished, research-quality data. The company is growing fast, and early investors are jumping on board, even though the stock only came public last November.

Bottom line: Remember that there’s no one measurement of good value, or of good growth potential. You’ve got to look at the entire package, paying particular attention to metrics that have proven valuable to you in the past. Of course, you could just listen to Cabot. But it’s also fun to think for yourself.


Finally, back on June 13, I wrote about the business of beer distribution, finishing with a profile of Craft Brewers Alliance (HOOK), the company behind Red Hook, Widmer and Kona beers. And I wrote, “No Cabot advisory has recommended HOOK. It’s simply too thinly traded. But I did find it interesting—even attractive—in light of my findings about the beer industry. If I were investing in HOOK, I’d wait for a pullback of at least 10% before buying. I’d keep my commitment small. And I’d use a strict stop in case the stock—unlike the beer—disappoints.”

Well, the stock has just completed a correction of 11%. There’s decent support above 8.5. If the stock looks tasty to you, I recommend buying in this neighborhood, with a stop under 8.5.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Editor’s Note: You could buy LULU and UA and hope for the best, or you could get Cabot Top Ten Trader Editor Mike Cintolo’s latest recommendation by clicking here now. Each week, Mike brings subscribers the market’s best stocks with full fundamental and technical analysis as well as specific buy ranges, which are good for two weeks. A new issue came out tonight, don’t miss it!

Timothy Lutts is Chairman and Chief Investment Strategist of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.