A Cooler Climate for Growth Stocks

With interest rates expected to climb, S&P's Mark Basham's starts his very short list of buys with WebEx and Invitrogen

So far this year, small-cap stocks are doing better than their larger siblings. Year to date, the Standard & Poor's SmallCap 600 is up 3.9%, against 0.8% for the S&P 500. That's the word from Mark Basham, director of emerging growth equity research for S&P. However, during the second quarter, the pattern has basically reversed. And with interest rates expected to rise, Basham thinks investors will be more cautious about risks and thus somewhat cooler on growth stocks.

That outlook is part of the reason Basham has only four buy recommendations. In the small- and midcap areas, he covers technology, health care, and sporting-goods retailers. And his buys now are Cree (CREE ), which makes light-emitting diode semiconductors; WebEx Communications (WEBX ), the leader in Web conferencing; Invitrogen (IVGN ), a producer of biotech tools and kits; and Integra Life Sciences (IART ), a maker of surgical tools and other medical devices. Basham has accumulate ratings on two sporting goods retailers: Big 5 Sporting Goods (BGFV ) and Hibbett Sporting Goods (HIBB ).

These were among the points Basham made in an investing chat presented June 1 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts follow. A full transcript is available on AOL at keyword: BW Talk.

Note: Mark Basham is a Standard & Poor's Equity Analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers.

No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to spsecurities.com and click on "Investment Research," then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts.")

Q: Mark, in this market beset by worries, how have the emerging-growth stocks been doing?

A:

During the second half of May, there has been a rally in growth stocks. However, during the second quarter they haven't been doing very well since the end of March. Smaller-cap stocks, as measured by the S&P SmallCap 600, are down 2% so far in the second quarter...vs. a decline of approximately 0.5% for the S&P 500 so far in the second quarter. However, year to date the SmallCap 600 Index is up 3.9%, vs. the S&P 500's gain of 0.8%.

Q: How about defining for us the stocks embraced by your coverage? Both small- and midcap.

A:

My coverage is currently primarily...growth sectors focused on technology, health care, and sporting-goods retailers in the consumer-discretionary sector -- it's a diverse group.

Q: With so very many stocks in that diverse group, how do you select which ones S&P will cover?

A:

S&P uses a combination of both top-down and bottom-up analysis. What that means is we define which industries we think are likely to do the best. Once we have those industries, we look at traditional fundamental measures of growth to pick what we think are the best companies in those industries.

Q: What's the market cap S&P uses for small and mid categories?

A:

Small we generally say goes up to $1.5 billion. Midcap stocks we usually define as up to $5 billion in market capitalization.

Q: Mark, can you give us a couple of examples of small- and/or midcap stocks that you currently rank 5-STAR [buy] and that are also consistent dividend payers?

A:

A lot of growth stocks that we rank 5-STARS are reinvesting their profits back in the business, so they don't pay dividends. In the absence of dividends, we often look at the company's ability to generate sufficient cash flow to fund its operations. This is what we generally refer to as free cash flow.

Q: So what are some of your favorites in your arena?

A:

Currently I have four companies ranked 5-STARS. The first is Cree (CREE ), which is a maker of light-emitting diode semiconductors. These LED semiconductors are used in a variety of consumer-electronics, automobile, and household-appliance applications.

The second stock I have ranked 5-STARS is a company called WebEx Communications (WEBX ). WEBX is the leader in Web conferencing. Basically, Web conferencing allows parties in different geographic locations to hold meetings over the Internet and share voice, video, and other types of communications.

Another stock I have ranked 5-STARS is called Invitrogen (IVGN ). IVGN is a leader in the market for biotechnology tools and kits used in the drug-discovery and production markets. The last company I have ranked 5-STARS is called Integra Life Sciences (IART ). IART is a maker of surgical tools and other medical devices used in the neurosurgical and orthopedic markets.

Q: How well have the smaller tech stocks rebounded from the bubble's bursting -- and do you have any worries about high valuations?

A:

Smaller-cap tech stocks, since the current cyclical rally began in March, 2003, have performed extremely well. While valuations are in many instances not back to levels seen during the bubble, we're concerned about valuation, given the sharp rise in many of these stocks.

We try to maintain valuation discipline by focusing on free cash flow, as I mentioned before, which tends to eliminate many apparent high-growth companies that are actually unable to sustain high growth rates, and identifying other growth companies that are able to maintain high growth rates based on their ability to increase cash flow from operations.

Q: How about your sporting-goods retailers? Any names for us there?A: Yes. Currently my favorite stocks in the sporting goods retailing area are Big 5 Sporting Goods (BGFV ), an operator of stores in high-growth markets in the Western U.S. Our second favorite is Hibbett Sporting Goods (HIBB ), which operates in small- to medium-size markets, primarily in the Southern U.S. While Big 5 focuses primarily on offering competitive prices, Hibbett's strategy is to focus on providing high levels of service, particularly in the area of team sports. S&P rates both stocks accumulate (4-STARS).

Q: Have you added any growth names to coverage recently?

A:

Hibbett was actually the most recent one. Other stocks we've added recently that are rated hold (3-STARS) are Dick's Sporting Goods (DKS ) and The Sports Authority (TSA ). With Dick's Sporting Goods, I'm concerned more about valuation and therefore have it ranked 3-STARS or hold. My concern with TSA is related to the integration of the acquisition of the former Sports Authority chain.

Q: Looking ahead, do you think growth stocks will be a better investment than stocks picked on the value strategy?

A:

In general, I would expect the market to slightly favor value-oriented stocks, because S&P expects interest rates to rise over the next 12 months. With rising interest rates, often investors tend to reduce their risk exposure. This is why I'm currently only recommending buy (5-STARS) on a selective group of growth stocks. Out of the 28 companies I follow, I only have four 5-STAR stocks.

Q: Do you have any small technology stocks that look interesting?

A:

The two I mentioned before, Cree and WebEx Communications. We consider those to be small-cap technology stocks. Another small-cap tech stock we like is Helix Technology (HELX ). Our price target on Helix is $34. For Cree, our 12-month target is $35. For WebEx, our 12-month target price is $29. Another of our favorite small-cap tech stocks is MKS Instruments (MKSI ). We rank MKSI at 5-STARS (buy), with a 12-month target price of $38.

Q: Does S&P have any recommendation on how much of a portfolio should go into small and mid caps?

A:

The short answer is no. The reason why is because it depends much more on the risk profile of the individual. Generally speaking, someone who's very young and investing for the very long term, meaning 20 to 40 years, should probably allocate more of his or her portfolio to high-growth stocks. Whereas an investor who needs current income would obviously allocate a smaller portion to high-growth stocks.

This relates back to our previous point that many growth stocks don't pay any current dividends.... Generally speaking, an investor looking to have a market weight of small-cap stocks in their portfolio should likely have about 10% in small-cap stocks, with adjustments for either the need for current income or for long-term growth.

Q: Plexus (PLXS )?

A:

PLXS is ranked accumulate (4-STARS). The company is an electronics contract manufacturer, which is one of our favorite industries within the technology sector. Our 12-month target price for PLXS is $20.

Q: Since you've been covering smaller growth companies, have you seen any of your names graduate into large cap?

A:

There are a few. Probably the most notable example is a stock called Mercury Interactive (MERQ ). I've been following this stock for probably a decade, and at one point its market cap was well over $10 billion.

However, in recent years the stock has declined, and its market cap is currently about $4.4 billion. I rank this stock avoid (2-STARS), with a 12-month target price of $34. One of the negatives regarding Mercury is that the company has issued a large number of stock options, including pro forma option expense.

Q: Of course, Microsoft (MSFT ) was once a small company, and investors can always hope to find the next MSFT! Any final advice on how to pick companies with the best growth potential?

A:

I think investors should pay closer attention to investing risks. For example, Microsoft closed today at $26, which is about the same price for the stock as six years ago. So, whereas MSFT is viewed as one of the all-time best-performing growth stocks, if you bought the stock within the last six years, chances are the appreciation in the share price would not be that favorable. So I think the lesson to be learned is not to "buy growth at any price."

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