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Investing Quarterly: Where to invest for growth?

Investing Quarterly: Where to invest for growth?
(Steve Sedam / For The Times)

When Internet stock analysts at brokerage Morgan Stanley wrote their 2001 investment outlook in December 2000, they laid out glowing assessments of the future for Yahoo Inc. and rival America Online.

There would be "a few huge winners" in the long run among Internet names, and Yahoo and AOL fit the bill, Morgan Stanley said. The companies had "huge market opportunities, great management teams, good products that are constantly improved, and strong balance sheets."

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Internet use has mushroomed since 2001, of course, but shares of Yahoo and AOL turned out to be duds as Net business bets. Instead, one of the biggest drivers of growth in Web use has been Google Inc., a company that was still in its infancy in 2000. It now employs 48,000 people and earned a stunning $12.9 billion last year.

The rocket-like rise of Google also has helped drive a surge in U.S. corporate profits that has powered stocks' bull market into a sixth year. Fear that growth investments would be hard to find in the wake of the 2008 financial crisis has been quashed by the heady earnings gains of a diverse group of businesses, including technology, railroads, industrials and biotech.

With bank savings rates near zero and bond yields in the low single digits, strong corporate earnings have bolstered the sense that stocks remain investors' best hope for long-term nest egg growth — if they can stomach the risks.

The profit margin of the blue-chip Standard & Poor's 500 index companies hit 10% in the second quarter, the highest in at least 26 years, according to S&P. With the third quarter just ended, the profit run faces another test of its stamina.

A 10% margin means companies on average earned 10 cents on every $1 of sales. By contrast, during the late-1990s economic boom years the norm was 7 cents.

But U.S. companies' resilience seems to belie the economic backdrop. Weakness in much of the world this year is rekindling worries about "secular stagnation" — the idea that the global economy is condemned to suffer through a long period of dismally slow growth in the aftermath of the Great Recession.

Christine Lagarde, head of the International Monetary Fund, warned in September that world growth was "too weak, fragile and uneven."

Europe, racked by massive unemployment, is teetering on the edge of another recession. Japan is struggling to rebound after a steep tax hike caused the economy to shrink dramatically in the spring.

Of the four giant emerging markets known as the BRICs — Brazil, Russia, India and China — Brazil's economy contracted for two straight quarters in the first half, the standard definition of a recession. Russia, too, may be tumbling into recession as the West imposes economic sanctions for the country's belligerence toward Ukraine. China's growth has slowed sharply enough that its waning demand for raw materials has fueled a plunge in commodity prices this year. Only India is showing accelerating growth.

The U.S. economy rebounded in the second quarter after shrinking in the first amid a brutal winter in the East. But growth expectations remain modest. Economists surveyed by the National Assn. for Business Economics predict 2% real growth in gross domestic product for all of 2014, up just slightly from 1.9% in 2013. By contrast, the U.S. regularly grew at an annual rate of 4% or better throughout the 1980s and 1990s.

Wall Street bears see the divergence of corporate earnings and global growth as a sign that the bull market is running on fumes. They believe earnings are peaking and stocks are primed for a fall. Over the last month, markets worldwide have been shaken by economic fears, although the declines so far have been modest.

But others note that pessimists have been predicting an end to the U.S. profit-growth streak for the last two years, while earnings have continued to rise and the S&P 500 index has soared 36%. Thomas Lee, head of Fundstrat Global Advisors in New York, believes the bears still are way too early. Pent-up demand in the global economy means "there is still plenty of room for profit growth," he said.

In part, the surge in earnings over the last five years has stemmed from companies' reluctance to spend, even as sales have grown.

"It shows that companies have become very adept at cutting costs and using technology" to boost productivity, said Sam Stovall, chief equity strategist at Standard & Poor's in New York.

Super-low borrowing rates and lower corporate tax rates overseas also have underpinned earnings for many blue-chip companies. This year, the plunge in oil prices also is likely to help.

Yet there also are signs that companies are more willing to shell out cash for new hires and for capital spending. The U.S. economy created a net 248,000 jobs in September, putting this year on track for the strongest job growth since 1999.

What's more, capital spending jumped at a 9.7% annualized rate in the second quarter, continuing a rebound that began in the fourth quarter of last year but was interrupted by the harsh winter.

Market bulls such as Lee pin their hopes on the expectation that more companies worldwide are ready to put cash to work to upgrade their businesses.

"The fact that investment spending has been so low for so long means that, in our view, there is a strong likelihood of significant pent-up demand, not only from the lack of capital spending, but also increasingly due to obsolescence," Lee said in a recent report.

That sentiment has stoked optimism about the prospects of many major industrial firms that investors might not typically view as high-growth companies.

The Jensen Quality Growth stock mutual fund in Portland, Ore., owns classic consumer-focused companies such as Colgate-Palmolive Inc. and medical-devices maker Becton Dickinson & Co., but its top-10 holdings also include manufacturing giants 3M Co. and United Technologies Corp., and industrial-gases producer Praxair Inc.

"Clearly, capital spending is improving," said Robert Zagunis, co-manager of the Jensen fund. "Industrials see a lot more orders for their products."

If the rest of the world economy shows even modest improvement next year, and the U.S. continues to turn in decent growth, the bullish case is that any pickup in revenue could further extend the corporate earnings streak — particularly for industrial companies.

"Bull markets turn into bear markets when economic booms turn into busts," said Ed Yardeni, a veteran economist and head of Yardeni Research Inc. in New York. "This time there hasn't been a boom, so the odds of a recession remain low" in the U.S., he said.

If he's right it would bode well for the railroad business, which has enjoyed a growth renaissance over the last decade. Revenue and earnings have surged as rail titans retooled themselves to better compete with the trucking business, and as shale-oil development in the Midwest boosted demand for moving crude by rail.

Investors like what they see: An S&P index of four major rail stocks — CSX Corp., Kansas City Southern, Norfolk Southern Corp. and Union Pacific Corp. — has jumped 96% since the end of 2010, compared with a 56% rise for the S&P 500 index.

Investment research firm Morningstar Inc. in Chicago says the railroad industry has become a "wide moat" business, meaning it has built up competitive advantages that make it difficult for rivals to successfully attack it. That helps foster strong profit margins.

The industry's winning streak isn't likely to end soon, said Keith Schoonmaker, an analyst at Morningstar. The biggest railroad, Union Pacific, is on course for "more record-setting margins in coming years," he said.

Still, even the biggest optimists about the economic outlook acknowledge that plenty of things could go wrong. An improving U.S. economy could hasten a decision by the Federal Reserve to begin raising short-term interest rates in 2015. How markets would react is anyone's guess.

Meanwhile, weak growth in the rest of the world is encouraging global investors to favor U.S. markets, boosting the dollar's value versus foreign currencies. Foreign money inflows could help buttress American stocks, but a rising dollar also hurts U.S. multinational companies by making their products more expensive for foreign buyers.

And if struggling Europe falls into another deep recession, the effect on U.S. companies could be severe: The European Union buys 17% of all exported U.S. goods.

For some investors the biggest concern isn't about earnings growth, but that stocks may have already priced in the growth expected in the near future. At 1,967.90 on Friday, the S&P 500 index was priced at 16.7 times S&P's estimate of 2014 earnings per share and 14.9 times the 2015 estimate. The historical average is about 15 or 16, depending on how earnings are defined.

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Share prices relative to earnings "are severely stretched" for many growth stocks, said Stephen Yacktman, co-manager of the AMG Yacktman Fund in Austin, Texas. To reduce risk, he said, his fund has "focused on companies where we think the market isn't appreciating that profit margins are staying up or getting better."

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Major holdings of the AMG Yacktman Fund include tech giants Microsoft Corp. and Oracle Corp., food and beverage titan PepsiCo Inc. and medical-devices manufacturer C.R. Bard Inc.

But in the long run, what will draw investors to stocks is faith that the economy still can produce spectacular growth stories. In 2000, virtually no one expected Apple Inc. to eventually be the nation's most valuable company, worth $600 billion. Or that global business-to-consumer e-commerce sales would be poised to hit $1.5 trillion in 2014.

Lawrence Kemp, head of fundamental research for large-capitalization stocks at BlackRock Inc. and co-manager of the Laudus U.S. Large Cap Growth fund, said the ability of entrepreneurs worldwide to reach potential customers over the Internet means new growth ideas can come to the fore faster than ever.

"With the speed that costs are coming down, more companies are being started on a shoestring," Kemp said. That doesn't mean they'll all succeed, of course. But it provides fertile ground for growth-hungry investors who are willing to take on risk.

The rise of the Internet in connecting investors and entrepreneurs also may be a powerful force against the threat of secular stagnation taking hold in the global economy.

"Innovation is a function of imagination," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities in New York. "And imagination is limitless."

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