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Paul Sullivan

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Beauty is only skin deep

Paul Sullivan


I'm starting this column with a confession. My palms still get a little sweaty when I recall, (only nine or 10 times a day now) chasing IPIX, a nifty little Web cam company that was supposed to cash in on the post 9/11 security boom. I bought in at $10 (U.S.), just after the Homeland Security czar made a positive reference to IPIX in a speech. Last Monday, NASDAQ stopped trading IPIX stock at 50 cents after IPIX filed for bankruptcy protection.

This may not be the best way to launch a discussion on growth stocks, but recalling IPIX (I'm over it, really) keeps me humble and underlines the number one caveat when formulating a growth stock investment strategy … expect growth stocks to be volatile. The other term for growth stocks is glamour stocks, and beauty is in the eye of the beholder. Beauty is only skin deep, etc. Whatever you do, don't get dazzled by the glamour.

There are certain fundamental principles to follow when sizing up growth stocks, none of which I bothered to put in play when I threw money at IPIX. I even ignored a single-minded campaign on the Motley Fool to keep me from buying a dog. There's a thin line between a growth stock and a speculation, and sadly, I crossed the line on IPIX.

I could argue that I had just done very well on ATI, mainly after noticing all Dell computers were enhanced by ATI video cards, and I was ready to bet my superior knowledge of Internet technology against the caution of a bunch of professional stock pickers, and that I had used IPIX web cam technology on a number of web sites I had built, but I now understand very clearly that as soon as you think you're smarter than everyone else, you're not.

I could also argue that the best way to get into growth stocks is to pick out the top-performing growth funds and assign some RRSP money to growth in a diversified portfolio that includes value stocks. This is rational and sane. If you're up for a growth fund, here are a couple of handy links, good places to start: http://biz.yahoo.com/p/top.html and http://www.morningstar.ca/globalhome/main/index.asp. But where's the fun in that? Investors are drawn to growth stocks because of the potential for big returns. And just as IPIX will remain my foremost historical cautionary tale, another ATI (bought at $4 (U.S.), sold at $17 (U.S.); see: I can't resist) remains the Holy Grail.

Nothing deters us. Not the NASDAQ meltdown of 2000. We just picked over the rubble looking for bargains. Not the value investing renaissance prompted by Warren Buffet, patron saint of the wise investor. Sure, he made his bones with Wal-Mart, not a typical "value" stock. In fact, St. Warren has said that value and growth stocks are "joined at the hip".

Conventional wisdom calls for investors to hunker down, stockpile basic commodity stocks like fuel and food, and wait out Armageddon, 2007. But there's nothing conventional about the risk-courting investor. Here's our motto: when growth is scarce, investors will pay real money for growth, which means that all we need is a winner.

There are always winners. And they're ridiculously easy to find. Starbucks for instance, is everywhere. If you invested $1,000, Starbucks in 1994 after sampling your first triple grande non-fat latte and finding it good, your compound annual growth rate has been 31 per cent; your percentage return has been 1,908 per cent and you're sitting on a cash return of $80K plus, all US dollars, which as Gordon Pape rightly points out is not such a big deal these days (see End of the Cycle, August 1, Globe InvestorGold). Still…

Today, the pickings may be slim, but there's still gold in them thar hills. Just don't buy gold stocks, except maybe Goldcorp, the Vancouver-based miner that has gone from $19 to $45 back to $34 (and rising) on the TSE in a single year. But if you hitched a ride on Wheaton River Minerals back in 2004 before it merged with Goldcorp, your returns would have been much better. You might want to stay away from other precious metals and energy while you're at it. Is there an upside to $700 gold? Most analysts don't think so and the market agrees-it's trading back down at $657.

Growth stocks do not have to be ridiculously overvalued to qualify as growth stocks, but once they've established themselves, they can get pretty pricey. Something called Hansen Natural Corp. (HANS-Q on NASDAQ) is the greatest growth stock of the past decade (who knew?), returning 24,185 per cent (!) between 1996 and 2005. The price is $44+ US, and I would be tempted to go after it, as there's still lots of room on the supermarket shelf for its all -natural beverages, but it has just been downgraded by Citigroup because it has appreciated 42 per cent in four months. You have to sell a lot more fruit soda to make money at that price.

And while we're on the subject of the next Starbucks, what's wrong with the current one? Well, despite the fact that it has posted 170 consecutive months of growth, analysts are beginning to read the entrails and wonder if it's a go for 171. July same-store sales have slowed down, and Marc Greenberg of Deutsche Bank tells MarketWatch that while the company's quarter was "spot-on, a slowdown in July same-store sales stole the show. He added a warning: "Growth may come harder as the company moves away from its core coffee business." On the strength of that apparently tiny little canary in the mineshaft, Starbucks shares lost 14 per cent on Thursday, August 3, when the results were posted.

A cockeyed optimist - and you have to be one to pursue growth stocks - would argue that Starbuck's vitals are still terrific. Starbucks forecasts that even-same store sales will grow 3 to 7 per cent for the year, and with new stores factored in, the company calls for revenue growth of 20 per cent. Starbucks is on track to open at least 2,000 new stores in fiscal 2006, a net increase of 200. And that's without a Starbuck's outlet on every street corner in Shanghai. Not only that, Starbucks reports that it's having trouble meeting the demand for those bizarre green tea smoothies with whipped cream -aka cold drinks, and they've never seem demand like it. And at a 14 per cent discount, it's hard to say no. Remember, consistent growth is insanely attractive, and Starbucks $4 coffee seems sublimely unaffected by the economy. There are many theories about that, but we're just interested in growth, and it seems a bit odd to reject a solid track record for growth if you're looking to bet on more.

Still, you may be like me. You don't have a lot of money to risk (you blew it all on IPIX) so you're looking for the next Starbucks under the 10 dollar rock. Well, that's $10 (U.S.), because it's probably on NASDAQ - there's just not enough action on the TSX Venture board - and there is more than a little tasty bait on the board. Consider Sycamore Networks (NASDAQ: SCMR), which is on a list of cheap growth stock from Tim Beyers at the Motley Fool. It fits his criteria: market cap of at least $100 million (U.S.), sales growth average of at least 30 per cent over the past three years (35.6), gross margins greater than 50 per cent, (55.2) institutional ownership less than 50 per cent, (35.3) and CEO ownership of at least 2 per cent (21.6). And here's the best part: a steal at $4.22 per share. What does it do? Uh, "develops and markets products that transport voice and data traffic over wavelengths of light." Gotta love it! Of course, it hasn't made a dime in three years, but look at that sales growth; look at those gross margins.

Still, NASDAQ is a pretty rough neighbourhood. Don't go there without your Kevlar vest, manufactured by Dupont (DD-N), trading at $39.88 US, with a three-year growth rate of 5.13 per cent, not a company we'd otherwise be interested in.

Paul Sullivan is a longtime Vancouver journalist and president of Sullivan Media. He also writes for The Globe and Mail.

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