John Dorfman—Results in Picking Growth Stocks Haven’t Been Half Bad

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With my own money and with that of clients, I tend to invest like Scrooge McDuck. The stocks I buy are usually, in a word, cheap.

Once in a while, however, I am willing to pay a reasonable price for a stock I think has particularly good prospects. In other words, I stray from a pure value approach into a so-called GARP approach growth at a reasonable price.

The GARP school of investing occupies the middle ground between value investing (the quest for cheap stocks) and growth investing (the quest for stocks with rapidly growing earnings).

Each year in late November, I devote a column to GARP stock picks. The timing is mostly coincidental. I wrote a GARP column in November 1998 and my three picks rose, on average, 62 percent over the ensuing 12 months. After that, I decided to make a GARP column an annual November tradition, like Thanksgiving turkey.

The success of the first year’s recommendations was due entirely to one stock. Tiffany & Co. rose 222 percent. That more than made up for declines in Tommy Hilfiger Co. and International Game Technology.

The average gain of 62 percent compared with a gain of 22 percent for the Standard & Poor’s 500 Index.

The second GARP outing ran on the Bloomberg newswire Nov. 23, 1999. I recommended American Management Systems Inc., Outback Steakhouse Inc. and Southwest Airlines Co.

Southwest has returned 84 percent since then, and Outback Steakhouse is up 12 percent. American Management Systems has fallen 34 percent.

Thus, the average result for GARP, Round 2, was a gain of 21 percent. Over the same period, the S & P; 500 lost 3.4 percent, including reinvested dividends.

Again this year, I will say what I said in 1999: If my picks do half as well as they did last year, I will be pleased.

Anyway, let’s see if we can beat the market three years in a row. Here are my GARP picks for the coming 12 months: Linens ‘n Things Inc., Black Box Corp. and Harrah’s Entertainment Inc.

Queen-sized balance sheet

Linens ‘n Things, based in New Jersey, has been public since 1996. It has about 250 superstores in 40 states, selling towels, sheets and other textiles, as well as assorted kitchen and household items.

The merchandise is medium priced to high priced; among the brands sold are Laura Ashley, Wamsutta, Martex and Bill Blass. The chain is opening about 40 stores a year, and is ably commanded by Norman Axelrod, a former Bloomingdale’s executive.

For the past five years, earnings have grown at a 24 percent annual clip. Analysts expect 25 percent annual growth for the coming five years. I suspect that’s too optimistic.

Suppose Linens ‘n Things’ profits grow 20 percent a year instead. That would bring profits to about $129 million in 2004, which would probably support a $2.5 billion market value. The current market value of the stock is $1.2 billion, which is a little less than 20 times the past four quarters’ earnings.

The balance sheet looks as beautiful as the queen-sized sheets in the stores. As of Sept. 30, debt is less than 4 percent of stockholders’ equity.

Linens ‘n Things and its chief rival, Bed Bath & Beyond Inc., between them control only about 4 percent of the market for linens. I think the two specialty chains will gain additional market share from department stores, discount stores and others.

Black Box installs and services computer networks, and provides technical support both on site and by telephone. Among its customers are Target Corp., OfficeMax Inc., Best Buy Co. and Home Depot Inc.

Black Box shares are trading at 21 times the past four quarters’ earnings and less than 19 times estimated earnings for the fiscal year in progress, which ends in March.

That’s more than I normally like to pay, but I think Black Box might be poised for an acceleration in earnings as it garners more nationwide contracts from corporate clients.

Analysts peg the average annual growth rate for the coming five years at 21 percent. The Bloomberg recommendation database shows seven analysts with official opinions on the stock: Each rates it a “buy.” That kind of unanimity makes me nervous, and in general analysts tend to be too optimistic.

On the other hand, I take some comfort in the fact that, so far, the brokerage houses covering the company are small and medium in size. The big securities firms don’t seem to have discovered the stock yet.

Also encouraging are some recent insider purchases. In July, August and September, four directors purchased shares. So did Chief Financial Officer Anna Baird and Chief Executive Frederick Young.

Solid bet

Harrah’s Entertainment is the third-largest U.S. casino company (after MGM Mirage Inc. and Park Place Entertainment Corp.). It operates some 21 casinos in 10 states, under the names Harrah’s Showboat and Rio. I recommended Harrah’s in March at just below $19. Since then it has moved up to about $28.

When I recommended it in March, Harrah’s was a value stock, trading at about 13 times earnings. Now it fetches about 17 times earnings, which puts in more in GARP territory.

Despite periodic scares that Las Vegas or Atlantic City is overbuilt, the American public’s thirst for gambling has yet to be slaked.

The company’s balance sheet is a weak point. Debt was twice as big as stockholders’ equity as of Sept. 30. Another weak point is the company’s casino in New Orleans, which opened last year, late and over budget, and so far is losing money.

To get permission to build the casino, Harrah’s agreed to a tax arrangement that, in hindsight, appears harsh. The tax deal may be renegotiated, however. And I think investors are focusing a bit too much on New Orleans and not enough on Harrah’s variety of profitable properties.

John Dorfman is president of Dorfman Investments in Boston and a columnist for Bloomberg News.

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