Three Rules for Chasing Real Growth - TheStreet

There's tremendous faith in earnings growth right now. Not just in a one-time bounce as the economy rebounds, but a sustained acceleration that brings growth rates back to where they were before everything went south.

Take

Analog Devices

(ADI) - Get Report

, for example. The stock's up 60% this year on a spectacular earnings rebound. In the quarter that ended in January, earnings grew 167% from the same period in 2002. Second-quarter earnings increased 375% from the year-earlier quarter. But the stock's price says there must be much more to come. Shares trade at 70 times trailing 12-month earnings.

Is there more? It's the big question for former growth stars that have soared in anticipation of an economic recovery. Stocks such as

Cisco Systems

(CSCO) - Get Report

, up 46% this year so far;

Applied Materials

(AMAT) - Get Report

, up 48%; and

Intel

(INTC) - Get Report

, up 60%, trade at price-to-earnings ratios of 40, 236 and 44, respectively. Investors in Intel, for example, are counting on projected growth of 32% in 2003, 29% in 2004, and 16% on average over the next five years.

And it's an even bigger question for the fallen-angel stocks of the 2000 bubble that have returned to angel status in the current rally.

Broadcom

(BRCM)

-- remember it? -- is up 51% this year.

GlobeSpanVirata

(GSPN)

is up 56%;

Nvidia

(NVDA) - Get Report

, 83%; and

Ameritrade

(AMTD) - Get Report

, 74%.

How I Found Seven New Names

Before you go plunking your hard-earned cash down on some of these highfliers, it's important to know if this faith is warranted or mere nostalgia.

Unfortunately, as I found out when I started my annual revision of the potential high-growth stocks on the

Future Fantastic 50 list, there aren't any short cuts to separate real growth potential from fantasy. In fact, evaluating the growth prospects of these former growth stars is actually harder than starting from scratch with an unfamiliar stock. That's because these kinds of stocks come with so much emotional baggage for the investors who have ridden these stocks up or down.

So let me run you through a few important steps that I used in revising the Future 50. Seven new names have been added that I believe will produce above-average growth in earnings and above-average appreciation for investors over the next five years.

Acknowledge that the histories of these stocks make it difficult to think about them objectively.

Remember

JDS Uniphase

(JDSU)

? The stock was one of the big stars that burst in the 2000 telecommunications bubble. It went from a couple of bucks a share in the mid-1990s to an all-time high of $147 on March 6, 2000. By October of last year, it was trading for $1.62.

Revenue growth fueled those gains, though the company never did show a profit during this period. Revenue grew by 53% in 1999, 405% in 2000 and 127% in 2001.

Revenue tumbled 66% in 2002 and another 38% in fiscal 2003. For all of fiscal 2003, revenue came in at $676 million, a 79% fall from the peak 2001 revenue of $3.23 billion.

Now, if the stock could get from its current price of $2.75 to something like its old high of $147, investors would make a bundle. If sales climbed back to $3.23 billion, five times current levels, investors would cart away their gains in wheelbarrows. If the company could get revenue growth back to even 50% a year, never mind 130% or 400%, investors would be rolling in profits.

But that's all just wishful thinking. JDS Uniphase is a very different company from the one that employed 29,000 workers in 2001. It's shed businesses and shuttered operations; it now employs just 5,500. And restructuring continues. No one is quite sure just what the finished project will look like.

Start from scratch and ask, 'What in the specific situation attracts me to the company?'

For my Future 50 list, I start with a specific form of that question: I'm looking for companies with a sustainable competitive advantage, whether it's technology or sales and distribution, or brand name. Whatever your own key question, ask it of the stocks you're studying.

For example, GlobeSpanVirata, a member of the Future 50, has emerged from the horrendous shakeout among DSL suppliers as the leading specialized provider of DSL chipsets. The company was able to acquire competitor Virata in 2001 for just about cash value. That size balances the company's focus on the DSL technology to give GlobeSpan a solid sales argument that lets the company push in the Chinese and Japanese markets. Each now represents about 30% of its revenue. With the domestic phone companies pushing DSL as a way to compete with cable companies, GlobeSpan can count on solid, if often lumpy, growth in the U.S. Morgan Stanley forecasts that DSL chip sales will grow by 35% in 2003.

On the other hand,

Human Genome Sciences

( HGSI) doesn't pass this test. I added the company to the Future 50 because I believed the company's database of gene sequences gave it a unique advantage in developing new drugs. So far, though, it's been much more difficult to turn that database into actual drugs. In short, I don't see a compelling reason to put my money here.

Determine if long-term trends are working in the company's favor.

The toughest thing to nail down in the current market is the timing of a recovery. To make up for that uncertainty, an investor should feel comfortable that the long-term trend will eventually deliver the desired result. You should have a reasonable assurance, in other words, that patience will be rewarded.

Oracle

(ORCL) - Get Report

, for example, doesn't make this cut. Competition in the company's database market is heating up, and, in this round of the contest, the competitors,

IBM

(IBM) - Get Report

and

Microsoft

(MSFT) - Get Report

, have the staying power and the technology to wage a real fight. Oracle sales will probably bounce back at some point, but the long-term trends suggest that the bounce may be smaller and later than now anticipated.

On the other hand, Ameritrade's results are clearly dependent on the return of the individual investor to the stock market. The company's most recent quarterly results, while they don't prove that investors are back for good, do show that the company's business model will deliver accelerating earnings growth with any increase in trading volume. With that long-term dynamic, I'm willing to be patient.

Here's how these three rules add up for the Future 50 portfolio in this year's revision.

Out

AstroPower

( APWR) has been delisted by

Nasdaq

for failing to file its annual report and 10-K.

I'm removing Human Genome Sciences because I don't believe the company now possesses a significant competitive advantage to make up for its substantial risk and uncertain timetable.

I'm also removing Oracle because of increasing competition that has eroded the company's competitive advantage.

I'm also removing four other stocks:

Charles Schwab

( SCH),

EMC Corp.

(EMC)

,

First Data

(FDC) - Get Report

and

Waste Management

( WMI). Their relative maturity make them less-than-ideal fits for the Future 50.

In

Ameritrade. I choose this company on evidence that its platform for individual investors delivers superior returns of scale to the company as volume increases.

Ballard Power

(BLDP) - Get Report

isn't expected to be profitable for another two or three years, but it is arguably the best way to play the developing fuel-cell industry.

Paccar's

(PCAR) - Get Report

strong brands (including the Peterbilt and Kenworth truck lines) and flexible cost structure make it the leading maker of heavy-duty trucks, and Paccar is aggressively moving into the medium-duty truck market.

Diversified global mining company

Rio Tinto

( RTP) has become a key supplier of iron and aluminum to China.

Canadian oil and gas producer

Talisman Energy

(TLM)

(48% of production) has huge potential in Southeast Asia.

A younger First Data,

Total Systems Services

(TSS) - Get Report

, specializes in electronic payment processing.

Trimble Navigation

(TRMB) - Get Report

is a leader in software and hardware for global satellite positioning systems, a technology with major growth trends behind it.

Those are my seven new long-term growth candidates for the Future 50 portfolio. As always, please do your own due diligence. I haven't been able to do anything more than wave at these stocks in this column.

My mention here doesn't mean that these stocks are at a good price for a buy. I'm holding off on any buy recommendations for this portfolio until I see how August shakes out.

And finally, please note that the Future 50 is designed for the riskier edge of any portfolio. These are more speculative growth stocks that should be balanced by a core of blue-chip growth and value picks.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Applied Materials, Charles Schwab and Microsoft.