How One Pro Finds "Great Companies"

Jim Huguet looks for undervalued stocks in companies with double-digit earnings growth potential, but takes his time buying them

Earnings growth and valuation are key to finding good stocks, but other factors make a company "great," according to Jim Huguet, president and co-CEO of Great Companies in Tampa. The money manager holds 25 stocks in his large-cap portfolio because it's hard to find ones that pass all of his tests. "Not all great companies are great investments," he says.

Huguet starts by studying a company's five-year earnings record and evaluates whether the stock is trading at a discount to its projected five-year earnings growth. Then he determines whether the company is led by a terrific CEO, operates in outstanding businesses, has strong protective barriers such as patents and brand franchises, is innovation-driven, has global reach, is people-oriented, and embraces sound corporate governance (see, 6/14/04, "Good Governance, the Best Investment").

"If you look at great companies that have solid earnings growth over a long period, it's almost like there's a DNA in the makeup of the company—it's part of the culture and what they do," he says.

His strategy has reaped impressive returns in both bear and bull markets for his clients. During the bear market from 2000 to 2002, his large-cap portfolio rose 1.8% (cumulative), while the Russell 1000 tumbled 55% and the S&P 500 lost 37%. In the bull market from 2003 to 2005, the portfolio rose 57% (cumulative), vs. 45% and 49%, respectively. Since the portfolio's inception in 1993, his annualized return is 13.4% (after expenses 12.7%), vs. 10.3% for the S&P 500 and 8.29% for the Russell 1000. Huguet says he's planning to launch a fund within the next three months or so.

Karyn McCormack of met with Huguet in New York recently to talk about his favorite stocks. Edited excerpts follow.

What's your investing philosophy?

We believe that if you look at companies with great earnings, that are trading at a discount, and have all the qualities of a great company, you will end up getting great returns. What we look for are companies that historically have had solid earnings growth, will continue to grow their earnings going forward, and are trading at a discount. Earnings determine the market price.

For example, Coach (COH) has historically grown earnings at 46.2% since 2000, and the return has been 52.5% for investors annually. Weatherford (WFT), an oil services company, has had 29% growth in earnings and a 25.9% return. Stryker (SYK) had 24% earnings growth and 25% return. Over the longer term, you'll see for companies that are increasing earnings, their market prices will increase at approximately the same rate.

Goldman Sachs (GS) is trading at a discount to its true value. Historically, Goldman has increased earnings at about 13% a year. Going forward, the estimate from 19 analysts that follow Goldman is it will increase earnings over the next five years at 15% a year.

So here's a company trading at a discount that is going to slightly increase earnings growth—if it were to do that you would look at an annualized return over the next five years of about 19.5%. That's the kind of company we want to invest in.

What are the other criteria you look for?

The traits we look for include: a terrific CEO, is it a great business, does it have strong protective barriers, is it a global company?

What are some of your favorite holdings?

We think Weatherford is a very well-run company.

We like Coach. If you look at the earnings line, just like Goldman Sachs, this company has historically increased earnings at 46% a year, from 2000 to 2006. That's going to slow down, we think, to 20% a year. But given where the stock price is, we think you're looking at returns over the next five years of around 15%.

What's the most important thing you look for?

In our premises for investing, No. 1 is earnings determine market price. No. 2 is we want to have companies showing double-digit earnings over time. That's really our definition of a great company—that over time, it's growing at double-digit rates, 14% to 15%.

No. 3 is it's trading at a discount to its value. Then you're going to make money on that investment, somewhere in the 15% to 20% range, because there's a direct correlation between earnings growth and returns.

But by the same token, great companies don't stay great forever. Managements change and businesses change, and you could have a situation where a company becomes overvalued and you want to sell and get out of the stock.

Procter & Gamble (PG) is a terrific company—with great brand franchises, wide moats, innovation, outstanding management, global—they're everything. But the stock is trading above its earnings growth rate.

Furthermore, earnings growth is expected to slow from 17% to about 11% going forward. Because it's overpriced and earnings are slowing down, your return on Procter over the next five years is probably going to average around 3%—not a particularly attractive return. It's a great company, but not necessarily a great investment.

Take UnitedHealth (UNH)—another one that I think is a great company. The stock price is trading at a discount—it got hit as a result of the backdating of options and the CEO making a lot of money. If you look at their earnings growth rate going forward at 17%, now you're looking at a return over the next five years of 14% to 15%.

They're both great companies, but one is a great investment and the other isn't.

What are some of your newest positions?

Goldman Sachs and Weatherford are new. They were bought within the last three months. Coach we added fairly recently also.

How many stocks do you own?

We have 25 stocks in the large-cap portfolio. The challenge that you find, quite frankly, is the difficulty in finding companies that have really solid earnings growth and are trading at a discount.

For companies like Procter—a predictable, solid company—people pay a premium for that kind of certainty, vs. companies that are volatile in terms of pricing and what their earnings might be. So it's hard to find really great companies that are trading at a discount. But they're out there if you look hard enough.

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