Checking Out Five Winners for Winner-Take-All Market

Winner take all. Sounds good, doesn't it? Who wouldn't want a few of those in the portfolio?

In my last column, I argued that in the slow-growth, low-inflation, harshly competitive global economy that will characterize the next decade, companies already at the top of their industries have a chance to increase their dominance. Because these companies are currently more efficient and more profitable, many will be able to put more money into even more well-organized plants and into developing new products than their competitors.

So how do you identify even a few of these potential winners for your portfolio?

R&D Is Key

The most reliable indicator is a company's spending on research and development. R&D represents a company's internal projections of its future opportunities. Companies that see big future markets up for grabs tend to spend more on developing products that can capture those markets. Companies that increase their spending, especially when times are tough, have the kind of aggressiveness that's needed to win it all.

Not that R&D numbers are easy to use. They're unfamiliar to most investors because they aren't widely or prominently reported. And unless they're put in context, they're worse than useless. Just knowing how much a specific company spent on R&D or even the recent trend in R&D spending at a company can be misleading in isolation, making companies look weaker or stronger than they are.

Let's start by developing six rules that will help us use R&D spending to find winner-take-all stocks. When we're done, the rules, in turn, will lead to a list of five potential candidates for my portfolio.

  • The perfect winner-take-all stock does exist, but it's rare. The company has a dominant market share plus accelerated R&D spending that could bury competitors with a big-cap name that every investor recognizes. Johnson & Johnson (JNJ), for example, raised R&D spending every year from 1999 through 2002 in both absolute dollar terms and as a percentage of revenue. R&D spending that was already a huge $2.6 billion in 1999 climbed to $4.1 billion in 2002. From 9.5% of revenue in 1999, R&D spending grew to 11.3% in 2002.

    In a period when the company saw revenue grow by 32%, rather than easing off on spending to develop new products, Johnson & Johnson pushed the pedal to the floor. That aggressiveness builds market share, even for a company that is already a dominant player in many of its business segments. In the last three years, Johnson & Johnson is the only company out of 111 stocks that shows the kind of year-on-year increase in R&D that offers such perfection.
  • A winner-take-all company needn't be huge. Dominating a smaller niche will do just fine. Take a look at Applied Films (AFCO). This company makes equipment that deposits the thin films onto glass that are at the core of flat-panel displays; it's hardly a household name. But the company dominates key parts of the equipment market for a product that's experiencing exploding demand.

    Needham Co. estimates that Applied Films has a 60% market share in Taiwan, which has emerged as one of the top two production centers for flat-panel displays. In a market like this one, where constantly falling prices and constantly increasing quality of displays make change relentless, Applied Films has shown willingness to increase R&D spending the way an investor would like to see. Revenue grew 265% from 2000 to 2003, but R&D spending jumped 771%. That spending seems to be paying off, because Applied Films has recently won contracts from L.G. Philips and is in the running for an order for Samsung's new flat-panel plant.
  • Look for companies operating in a market where R&D counts. That includes more than the traditional technology sector these days. I certainly didn't expect a company like Donaldson (DCI), known for its automotive filtration business, to show up on a list of companies raising R&D spending. It does, though. R&D, which has led to a slew of patents and increased proprietary content in Donaldson's newest systems, has enabled the company to raise prices, increase margins and deliver a better product to customers.
  • Judge R&D spending against industry standards. Compared with Johnson & Johnson, Schlumberger (SLB) looks like an R&D piker. The oil-drilling services company with its $512 million in 2002 spending (after subtracting R&D at the soon-to-be-divested SchlumbergerSema technology business) simply isn't impressive vs. Johnson & Johnson's $4.1 billion.

    Compare apples against apples, however, and Schlumberger looks much better. The company spent more than twice as much on R&D as Halliburton (HAL), the No. 2 R&D spender in its industry in 2002, with $233 million. And Halliburton produced more revenue than Schlumberger in 2002.

    The same goes for judging R&D as a percentage of revenue. Johnson & Johnson's climb to 11.3% of revenue spent on R&D looks huge, but not compared with a tech company like Altera (ALTR), where R&D spending hit 26% of sales in 2002. Now that's comparing apples with oranges. But recognizing how exceptional 26% R&D spending is helps an investor understand the extraordinary commitment to R&D at a market leader such as Avid Technology (AVID). Avid has consistently kept R&D spending near 20% of revenue recently.
  • Give more weight to how much a company spends when the going gets tough. Avid Technology's dedication to R&D is particularly impressive because swings between profit and loss haven't changed the company's R&D budget.

    But for a real dedication to R&D in tough times, look at Sun Microsystems (SUNW). Sun's revenue plunged from $18.3 billion in 2001 to $11.4 billion in 2003. But R&D spending as a percentage of revenue rose from 11.5% in 2001 to 14.4% in 2002 to 15.8% in 2003.

    Now, absolute R&D spending during that same period fell from $2.1 billion in 2001 to $1.8 billion in 2002 and 2003. But any technology company that can cut R&D spending by just 14% while revenue falls by 38% is clearly committed to R&D.

    An investor who wants a true picture of a company's R&D spending, especially for a technology company that went through the boom and bust of 2000-01, should take out the effects of the boom year when everybody had cash to spend on everything. Thus, it's very important that EMC's (EMC) 2002 R&D spending of $780 million (14.2% of revenue) equaled the $780 million (8.8% of revenue) the company spent on R&D in 2000. Critics will point out that the company spent $929 million on R&D in 2001. That, however, was at a time when the company thought the tech boom would never end.
  • Important caveat: Not all increases in R&D spending are good signs. Increasing R&D spending can be a sign that a company is in the competitive fight of its life. Sun CEO Scott McNealy has ignored Wall Street analysts who have called on him to cut R&D, because he knows the company is toast if it doesn't keep spending.

    Similarly, Altera's increase in R&D in both absolute and percentage terms from 2000 to 2002 (from $179 million to $182 million), despite an almost 50% drop in revenue, is a sign of the company's dogfight with Xilinx (XLNX).

    Xilinx's R&D spending has jumped from $124 million to $205 million. And it has gone from trailing Altera in R&D by roughly $50 million in 2000 to leading by about $22 million in 2002.

    The battle at Sun is by no means over: The company may win its risky bet, but this is a company in a battle for survival rather than a market leader strengthening its position. The battle between Altera and Xilinx is also by no means over. Although Altera is being outspent, the company is currently more profitable than Xilinx, with a gross margin of 67.8% to Xilinx's 60.8%.
  • My Five Candidates to Buy

    From the companies I've mentioned here, I'd put these as potential candidates to buy:

    • Johnson & Johnson

    • Applied Films

    • Donaldson

    • Schlumberger

    • Avid Technology

    As always, please remember that what I've provided is by no means complete due diligence on any of these stocks; I haven't even mentioned issues such as valuation. You'll need to complete that work before you can decide if these are a buy for your own portfolio in the currently very unsettled stock market.


    Please note that due to factors including low-market capitalization and/or insufficient public float, we consider Applied Films to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

    At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Donaldson, Pfizer and Schlumberger. He does not own short positions in any stock mentioned in this column. Email Jubak at jjmail@microsoft.com.

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