The next bargain

First, a confession: we’re not really growth stock investors. That’s not to say we avoid stocks with strong earnings growth. It’s just that growth is not the only attribute we look for in a company.

We prefer to buy quality companies run by good managers at valuations that make sense. If they happen to pay a healthy dividend, so much the better. While it’s more difficult to find dividendpaying growth stocks (growth stocks tend to need all their capital to fund the growth), there is certainly no shortage of quality companies in the growth stock category. Valuation, however, is a bit more problematic, as growth stocks have a tendency to sell at a premium. But what if you could buy a stock with growth characteristics and qualities without the valuation premium?

Typically, this happens when a company’s product life cycle matures and revenue growth begins to slow. Investors start anticipating the investment story is over. The company’s competitive advantage is gone and its profit margins are in for a steady—and in some cases, quick—decline. There are, however, many broken growth stocks that are still good, profitable companies. Sure, they may not get back to their previous earnings growth levels, but they can still earn very healthy free cash.

Instead of using all its free cash flow to finance growth, some can now be returned to investors. And at the right valuation, these stocks can make great long-term investments. Given the market volatility, you don’t even need to buy broken in order to find stocks with attractive valuations. The market’s been providing opportunities to buy some very attractive non-broken growth stocks at small premiums to the average market valuation.

Growth is a great attribute to find in a company and is one of the key variables in determining the valuation of common stock. But it’s not the only variable. A company can have great revenue growth, but if its expenses are growing even faster, the company will never be profitable. Eventually, a company has to produce free cash flow, either to buy back shares, pay dividends or invest back into the company.

The other problem with growth stocks is that because they produce premium growth rates, they typically carry premium valuations. Fair enough, you get what you pay for. The question is how much are you willing to pay for superior growth?

It’s important to answer that, because in a slowing economy it tends to be-come harder to find companies that can consistently deliver superior earnings growth. Investors ultimately end up paying higher valuations for the few companies they think can come through with the goods and the valuations get over-inflated. No company can grow consistently above 20% forever. The law of large numbers eventually catches up to even the best ventures.

Investors must avoid playing the great fool: buying a stock they know is expensive in hopes of selling it to someone else at an even higher price. Such momentum games can be profitable if you’re nimble, but the consequences can be devastating if your timing is poor

What’s more appealing is to buy a company that has a proven business model, but is no longer selling at its premium valuation. The restaurant industry can provide a fertile area for both existing and broken growth stocks. A successful restaurant can easily duplicate its success by opening an ever-increasing number of locations, constrained only by available capital and locations. Eventually, however, the market gets saturated or consumer tastes change.

While McDonald’s might not be thought of as a traditional growth stock now, for many years it provided investors with steady earnings growth as it aggressively expanded, first across North America and then internationally. But in early 2002, the stock price came under pressure as earnings began to decline. Overexpansion resulted in some pullbacks and a health craze changed eating habits in key demographics. But while earnings growth had stalled, the company was still able to churn out attractive cash flow and dividends.

Two things helped turn around the fortunes of McDonald’s. First, the diet fad (as all fads do) ended and most people went back to their burgers and fries. Second, McDonald’s was able to re-invent itself. It bought back stores from unreliable franchisees and closed unprofitable locations. Then it tweaked the menu, and focused on international markets. Eventually, growth returned.

Of course, it wasn’t RIM or Apple type growth, but it was consistent, and more importantly, the company had strong free cash flow. Even better, Mc- Donald’s is perceived to be recession proof. Consumers view the chain as a bargain when times get tough. Now McDonald’s is preparing to enter the coffee market. Will it be successful? We don’t know, but their plans are bad news for a competitor that hasn’t had a lot of good news lately: Starbucks. The gourmet coffee giant currently looks to be in a situation similar to McDonald’s in 2002. Good core business, but the growth story is ending.

Like McDonald’s, Starbucks undertook ambitious expansion plans and now has more than 15,000 company-operated and licensed stores worldwide. With just over 2,500 foreign locations in 40- plus countries, Starbucks has many years of expansion ahead. And its model works well overseas. Like McDonald’s, Starbucks was also deemed recession proof. During the Tech Wreck-led recession, unemployed software programmers would go without lunch before eliminating their $4 daily latté.

Will it be the same this recession? So far Starbucks has been experiencing a slowdown in sales. That’s unprecedented. Failed experiments with breakfast sandwiches and other distractions took the firm’s eye off its core market. So they’ve cut back on store expansion and begun experimenting with new coffeerelated products.

Fortunately, investors have other options, such as Research in Motion (RIM). We think wireless is one of the most attractive growth industries available to investors, particularly the smart phone market. True, Apple’s new iPhone is a formidable competitor, but it isn’t positioned so much to steal market share from RIM as it is from traditional handset manufacturers such as Nokia and Motorola.

In summer of 2008, RIM was trading near $150 per share as a lot of good news was already priced into the stock. Closer to $60 just a few months later, the growth premium has been virtually priced away. But mind you, this isn’t a broken growth stock. Earnings estimates may have come down in the short term as RIM trades off some profit margin for market share (a strategy that worked well when the company rolled out the BlackBerry Pearl), but revenue growth is still projected to be strong.

With RIM expected to earn just under $4 per share over the next twelve months and its shares trading around $60, RIM’s P/E multiple is just under 16 times. Alternatively, the S&P 500’s earnings multiple is just under 12. Not bad when you consider RIM earnings are estimated to grow in excess of 30% while the market will be lucky to grow in the single digits.

What do you pay for companies that have such pent-up potential? It’s a tough question, but the lesson still remains: the potential for free cash is your first hint of future growth.