Four Great Stocks

Trouble comes from where it’s least expected

Four Great Stocks

One Niggling Thought

One of my favorite sayings, which applies to both life and the stock market, is “Trouble comes from where it’s least expected.”

I was reminded of this as Hurricane Irene plodded through New England 10 days ago. Residents of coastal areas, thoroughly warned about the potential dangers days before, were well prepared and damage was, for the most part, far less than feared.

And where did Irene do the most damage?

In hilly Vermont, folks had assumed that the power of the storm would have petered out by the time it hit the state, and that cleaning up would be a simple matter of clearing away broken tree limbs.

Instead, they suffered the greatest floods the state had seen since 1927!

The bottom line: despite all our digital sophistication, weather remains unpredictable, and when people say, “it’s supposed to …”, you should mentally translate it as “Some talking head said there’s a good chance that … but he or she might be wrong.”

In the stock market, similarly, when a fear is shared by the majority of people, the collective actions of those people cause the market to adjust. So instead of joining them in their worries, it’s far more profitable to watch the action of the market, and the action of individual stocks.

Speaking of stocks, I received the following from a loyal subscriber recently:

“Just for fun, I would really appreciate a column on Apple (AAPL), Baidu (BIDU), Google (GOOG) and Netflix (NFLX). Their fortunes seem to be intertwined, so a fiscal group hug might be illuminating. I have a little difficulty believing that AAPL and NFLX can continue their march upward. The power of market leaders is sometimes like viewing Niagara Falls … breathtaking, but hard to grasp for such a limited intellect.”–G.R., Racine, Wisconsin

A modest man, G.R. And a good suggestion.

So let’s start with a quick overview, fundamentally.

Apple is the reigning king of personal technology, having hit home runs with its iPod, iTunes Store, iPhone and iPad. I’ve been a fan since 1986 and have bought more Apple products, for personal use, family use and company use, than I can count.

Baidu owns the Internet search business in China, though government authorities recently gave a sharp tug on its leash. I’m not a user; I don’t speak Chinese.

Google is the king of Internet search and advertising in most of the world, but it pulled out of mainland China last year … and recently announced its entry into the smart phone field by buying Motorola Mobility. I’m a big user personally (like most people, I don’t pay a thing for Google’s wonderful service) and Cabot has been an advertiser for years.

Netflix crippled Blockbuster with its innovative DVD-by-mail rentals, and now it’s transitioning fast to a streaming model … while taking baby steps into the content business. I’ve been a satisfied customer since 2003.

And now let’s look at some numbers.

Apple is the elephant in the crowd, with $28.6 billion in revenues in the latest quarter, but it’s dancing like a ballerina, growing revenues a simply stupendous 82% and earnings per share a fantastic 122% in the last quarter. And it has a fat profit margin–huge for a technology hardware company–thanks to its premium prices.

Baidu is the baby of the group, with just half a billion in revenues. Its growth rate is on a par with Apple (extremely good), and its after-tax profit margin is the best of the group by far.

Google’s $9 billion in revenues tells you it’s a full-grown company, and its relatively slow growth rate in this crowd is a red flag. Also troubling is the fact that its profit margin is shrinking slightly–it’s low for a software company–and may shrink even more as the company enters the competitive smart phone market.

Netflix stands out for its low profit margin, a reminder that a lot of its revenues pass through to content owners. But its growth rate is excellent, and its small size means it can get a lot bigger faster if management makes the right choices.

But which is the best investment?

To some extent, that depends on you. It depends on your goals, on your risk tolerance, on your preferred style of investing, and on what is already in your portfolio.

Now, some people will say, “I just want to make money,” and I understand that feeling. But I also know that some of those people are the most surprised when a stock that was touted as a great investment heads down and sticks them with a loss, leading them to complain, “I can’t afford to lose any money!”

In short, none of these stocks is “the best investment,” but some are more suited than others for various investing systems.

For aggressive growth investors who want to hit home runs and are quick to sell when things don’t work out, I’d nix AAPL, because the company is so well loved (and therefore vulnerable to becoming less well-loved), and I’d nix GOOG for the same reason, as well as the company’s slowing growth and its shrinking profit margin.

That leaves the two smaller companies, Baidu and Netflix. Being smaller, they mathematically have greater growth potential. And between those two, the hands-down choice in my opinion is Baidu, which is growing faster and has higher profit margins.

Now, there is an unquantifiable risk in the fact that the company is Chinese. We know from experience that the Chinese government from time to time will change the rules in various industries, in the spirit of protecting the Chinese people–for example by knocking down potential monopolies. Baidu has 75% market share of Internet search in China and just last month a government-owned broadcaster quibbled about the way the company’s advertising defrauded customers.

But every investor in the stock knows all that, so you shouldn’t worry about it; you should just look at the action of the stock to see if it’s a problem … and the stock says it’s not.

BIDU has been holding up quite well through the broad market’s sufferings in recent months, and it’s now just 13% off its high.

Additionally, BIDU is one of the stocks in Cabot Stock of the Month, which I edit. Since I recommended buying 13 months ago, the stock is up 84%.

But BIDU might be too hot for you. You might be a conservative, value-oriented investor, and in that case, the other stocks are worth looking at. And for that purpose, I’d use the lens of Cabot Benjamin Graham Value Letter, which every month publishes a table of the 250 Highest Ranked Stocks.

Editor Roy Ward crunches a lot of numbers to create these tables, and the result is nothing short of spectacular. Both his recommended portfolios beat the market over the long run, and they do so not by hitting home runs but by knocking out a steady stream of singles and doubles.

The key is buying low, holding patiently (perhaps for years) and selling high.

And here’s what Cabot Benjamin Graham Value Letter says about these four stocks.

Netflix isn’t mentioned. It’s not well established enough.

Baidu is listed, because it does have a great record of sales and earnings growth. But Roy says Baidu, currently trading around 145, is way too expensive to buy now. His Maximum Buy Price (the highest price you should pay) is 82, while his Minimum Sell Price (the lowest price you should sell at) is 174.

So the growth and value systems agree. BIDU is a good hold here.

As to Apple, Cabot Benjamin Graham Value Letter says it’s a buy under 395 (it’s very close to that now), and a sell above 838.

And Google? It’s a buy under 562 (again, very close to today’s price), and a sell above 888.

Assuming these stocks reach their Minimum Sell Prices, and those prices don’t change, AAPL would bring a gain of 119% and GOOG would bring a gain of 67%. Not too shabby.

But the Minimum Sell Prices will change, and the direction of their change depends on the changing fortunes of the companies, as well as investors’ perceptions of these changes … which is a way of saying, your profits could be bigger or smaller. Also, these stocks might hit their Minimum Sell Prices in three months or three years, so patience is definitely required to follow the system.

And you can get more info on my Cabot Stock of the Week Report by clicking here.

Finally, I can’t resist mentioning one niggling thought. In many bear market phases, such as the one we’re in now, there are a handful of high-quality stocks that look fine right up until the end. As investors jettison lower-quality stocks and poorer-performing stocks, their buying keeps these select stocks afloat. After all, institutional investors have to own something. But eventually, there are no buyers left, and these stocks collapse.

So the niggling thought today is that AAPL, which continued to trade just fine even after the greatest fear of investors came true (Steve Jobs is so sick he’s stepped down from the CEO position … see my thoughts on greatest worries), might be the big high-profile stock whose collapse signals the end of the bear market and the start of the next upleg.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Timothy Lutts

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