8 stocks to bank on: Black Enterprise screens the market for core holdings with potential for solid returns.

Black Enterprise screens the market for core holdings with potential for solid returns

SOMEWHERE TRADING ON THE NASDAQ, NEW YORK OR American stock exchanges, hidden among the 30 Dow Industrials or the S&P 500, is your stock. It's an anchor your portfolio has been awaiting, the core holding you're banking on to help fund your kid's Ivy League education, spark up your retirement portfolio or chip in on the down payment for a new home. It's your stake in the economy, a slice of a corporation that's primed for growth, yet still something of a bargain. Management there is lean, harvesting a nice profit while at the same time, treating shareholders to substantial gains.

Sounds too good to be true, especially after a fantastic run by the market's sturdy blue chips? Well, before you start thinking it'll take a lifetime to unearth just that kind of investment, take heart. There's value to be found in the market, especially if you remember that shopping for a company worthy of your hard-earned money is in many ways no different than sifting through the aisles at the department store for a new coat. That's because your aims--the best quality on the market, a good price, favorable comparisons with other goods--are essentially the same whether you're scouting the mall or examining annual reports.

Still, scanning the roughly 9,300 stocks available takes a bit more calculation and quantitative work than a trip to the mall. To better focus on the best companies available, you'll need some way to narrow the number of stocks you're actually looking at. For just that kind of screening tool, we turned to Zacks Investment Research, a Chicago company that compiles financial records on publicly traded companies nationwide. By visiting Zacks' Web site (www.zacks.com), we downloaded Research Marvel, a screening software covering 6,063 companies and over 600 criteria that's available to the public for $600 yearly, complete with monthly financial data updates. While other similar programs are readily available on the net--such as www.researchmag.com--we found Zacks easy to use and extensive enough to meet our needs.

Before we downloaded the software from the Net and started plugging in numbers, though, we did a little homework. First, we looked at the overall stock market to gauge just how much shares are worth these days, and how expensive share prices are compared to historical averages. Then, to whittle the huge stock market down to a manageable size, we ran several screens and applied many of the criteria money managers use when they're selecting a portfolio. We looked for solid, steady companies with a record of delivering to shareholders. We looked for shares with good growth prospects that nonetheless remain reasonably priced, even after the stampede of new money into the stock market during the last couple of years. We also looked under the hood, checking to see how lean operations have been, and how management has been divvying up the wealth with shareholders.

At the end of our research, after running three screens, we came up with eight stocks with good prospects ahead. In charts accompanying this article, you'll also find stocks we deemed to be very capable runners-up, companies that could be equally rewarding in the months ahead. As we divulge the names of the eight stocks, we'll walk you through the screening process and some of our reasoning. That way, if you return to the market at a later date, you'll be able to use the very same logic.

Before we launch into the screens, two points bear repeating. Whether it's your first time buying shares, or you're looking for the latest addition to your bundle of investments, you should aim to find a stock you can hold on to at least two years--and probably more than that. We also recommend that your first stake in the stock market be made by buying into one or more stock mutual funds. Investing in one to three mutual funds spreads your money across many different stocks in a variety of economic sectors, essentially cushioning you from a lot of the spills that can wipe away a major part of your portfolio at any given time.

TAKING STOCK OF THE MARKET

The Dow Jones Industrial Average, the benchmark almost everyone uses to take the market's pulse, has been rather volatile so far this year, up 100 or 200 points one day and down as much the next. That's likely to make more than a few of us jittery, no doubt. We'd still recommend what might seem like an aggressive stance. For one, trying to time the market is an exercise in futility; ultimately having money invested for the long-term should be your primary goal since it is the surest way to reap returns. After all, as expert money managers said at the BLACK ENTERPRISE Investment Roundtable ("... And What For An Encore?" April 1997), no matter what the market's doing, there's still money to be made if you choose the right stocks. And, as you are aware, stocks are the place to be for the long haul, proof coming in from a robust 15% average annual gain in the S&P 500 since 1970.

It's still a good idea to size up the overall stock market to check on how much company shares fetch under current economic conditions. As a calculation based on a large group of stocks, an index like the S&P 500, a composite based on the performance of the country's largest companies, is a good benchmark to review. First, a look at the average price-to-earnings ratio (or P/E) for the index tells us how much value the stock market currently puts on a company's profits. The ratio is calculated by dividing the price of a stock or level of an index by the earnings per share. Generally, institutional and individual investors are willing to pay a certain premium to lock in on a corporation's profits, tying a company's stock price to a multiple based on its earnings per share. As of this writing in mid-May, the S&P 500 was trading at 20 times projected 1997 earnings. Historically, the S&P 500's stocks have traded between nine and 20 times corporate earnings, the average figure being about 14-15, a sign that the stocks that make up the index might be a bit expensive and that share prices might be deemed too costly. Under that scenario, it's best to look for stocks that trade at a lesser multiple.

Stocks are also priced based on predictions of earnings growth, or the average percentage that analysts feel profits or net income will increase. A high growth rate portends good things to come. As earnings increase, more investors will be lured to buy company shares, which in turn will boost the stock price. A rise in profits generates more cash for a company to reinvest in operations, which in turn help fuel even higher earnings. A composite estimate compiled by Zacks shows analysts feel the S&P 500 is due for something of a slowdown the next five years, with average annual growth tapering off to the 6.7% range, down from a 12.6% clip the last few years.

There are other statistics that interested us as well. In some cases, we calculated stock's yield by dividing a company's dividend by its share price. Dividends, which are quarterly income payments companies make to shareholders, are a tonic that many money managers seek out for a number of reasons. For one, management that grows dividends successfully is essentially telling the market that business is good and that shareholders deserve a prize for sticking with the company. Secondly, if the stock market, for some reason, neglects a certain company, and shareholders don't see a great appreciation in the price of the stock they own, a dividend serves as compensation for their investment until share prices rise. Finally, we checked on return on equity, a stat that is derived by dividing a company's annual income by stockholder's equity. If that sounds confusing, think of it this way: ROE, as it's known, measures how much management made with the funds it raised from investors, an indication of just how efficient the folks at headquarters are. Currently, the average ROE for the S&P 500 is 19%, so we looked for companies that comfortably exceeded that.

CASTING OUR NETS

Having noted the market's vital signs, it's time to devise and run our screens on the 6,063 stocks listed in the Zacks software. A first consideration is company size, as indicated by market capitalization, a statistic easily calculated by multiplying a corporation's stock price by the number of shares it has outstanding. Since our aim is to home in on five core holdings, it's important to aim for companies with a large market cap of at least $300 million, a girth or wherewithal that acts as ballast when economic or industry tides turn. Another thing we looked for in each screen is low leverage as measured by a company's debt-to-capital ratio. Let's face it, any breadwinner knows that carrying a four- or five-figure credit card balance is going to saddle your budget with interest payments high enough to sap any raise you might secure at the office. The same holds true for a company out on the market. Strap huge debt service payments onto any corporation's bottom line and you're draining away capital that could buy new equipment, beef up dividends or even show up in the form of increased profits. So, with that in mind, we looked to cap debt-to-capital at 40%.

Finally, we wanted to check on what Wall Street thought of each of our picks. The big brokerage houses have tight relationships with corporations that issue stock. After all, the Merrill Lynchs and Paine Webbers of the world help bring shares to market. To help keep the world up to date and interested in a company's shares, brokerages assign analysts to run a microscope over company finances. Invariably, the reports net a wide audience, including everyone from institutional investors on down to your boss in the office across the hall. With that kind of following, we felt it was important to know just how much support a given stock had at a given time, so we looked for stocks with an average rating of "buy" or better. After all, according to the simplest of economic laws, greater demand for a limited supply helps push prices higher.

LOOKING FOR THE BARGAINS

At a time when the market seems somewhat high-priced, we decided to lead off with our screen for bargains, what investment professionals typically label as "value stocks." One telltale sign you'll find in this undervalued group is a relatively low P/E ratio, a sign that investors may well have overlooked a company and haven't yet bid up share prices. Another is a high yield. It's only logical, after all, that if a corporation's stock price doesn't move much, even while dividends are increased, that the yield on its shares will drift upward. It's a phenomenon value managers have come to appreciate since a sizable dividend will deliver some sort of income as they wait for investors to finally spot and buy up long-neglected shares.

By focusing on stocks with a projected average annual earnings growth of 10% or better, we looked to surpass the 6.7% rate predicted for the S&P 500 for the next five years. We then looked for a solid history-earnings growth, coupled with a dividend exceeding the S&P 500's 1% yield.

Our top pick was Big Dave's own Wendy's International (NYSE. WEN). According to a survey of U.S. economic sectors put out by Standard & Poor's, the near-term outlook for restaurants is turning positive. Stocks like Wendy's took a hit because of concerns over the rising price of meat and labor costs. That change in market sentiment pushed Wendy's stock price down to 14.91 times projected 1997 earnings. That's despite analysts' estimates of over 16% earnings growth in the next five years. Our other choice, Lockheed Martin (NYSE: LMT), might seem like something of an anomaly, especially given sizable defense cuts the past few years. The fact is, however, that a considerable amount of consolidation has taken place in among defense contractors, leaving Lockheed Martin as one of three surviving heavyweights in the industry, alongside Boeing and Raytheon. Lockheed's 11% growth rate and 1.8% yield both surpass the S&P 500's averages, while a P/E of 13 makes it look relatively cheap.

THE STALWARTS: BLUE CHIPS

Call them blue chips or even industry leaders. The stock market loves large cap stocks, companies that command $1 billion in market capitalization, simply because that kind of financial girth acts as a cushion. At times, when the economy shakes, large caps have the heft to remain reasonably steady and are almost guaranteed that their institutional following won't charge toward the exit the minute things get a little rough. The problem is that with the economy looking rather uncertain at the beginning of 1997, large caps' aura of stability attracted investors near and far. An example: by late April, the classic large-cap index, the Dow Jones Industrial Average, had risen 4.5%, compared to a 7.1% loss for the S&P Small Cap 600 index.

All of which made it incredibly difficult to choose solid blue chip stocks since the run on large cap stocks the last year and a half pushed their P/E multiples up to a point where many no longer seemed as cheap. As a result, we opted to alter our criteria somewhat to get good long-term holdings from our screen. We looked for earnings growth double that projected for the S&P 500, while we allowed P/E to range as high as 25%. We also sought out a dividend large enough to push yield above 1%. In terms of sheer value, toy maker Mattel (NYSE: MAT) led our list. The company's P/E of 18 ranked the lowest of our group, and wasn't too much greater than the company's projected earnings growth rate of almost 15%. That low number might be linked to the appointment of a new CEO, Jill Barad, to head the famous maker of Barbie. Still, with a reputation bolstered by its line of products linked to Disney movie releases and Hot Wheels, Mattel seems too strong to ignore, especially after buying Tyco in the first quarter. Our runners-up were Johnson & Johnson (NYSE: JNJ) and Merck (NYSE: MRK), two pharmaceutical/health care companies that should profit from well-stocked pipelines and the overall aging of the American population. The two had almost identical tallies in our screen: yields just above 1%, estimated earnings growth of 14% and slightly high price-to-earnings ratios of about 24.

SPROUTING PROFITS: GROWTH STOCKS

During much of the 1990s, growth stocks have been the rage. As computers continue to invade every facet of society and medical advances appear in the news almost daily, the shares of companies tapping new markets, blazing the lead in new technologies or devising strategies that make earnings mushroom have often tallied unbelievable increases. It's this type of stock price appreciation, called capital gains, that lures investors to growth companies and helps push P/E ratios up to levels that exceed index averages.

Money managers with an eye for growth are often willing to pay for higher multiples but only if a company's growth rate exceeds its P/E. So while we screened for companies projected to increase earnings at least 20% on average over the next five years, we also made sure their growth rate was at least 20% above their P/E at the time.

When we looked at the market in late May, many growth companies had been neglected during a rally that saw large-cap stock prices increase greatly. That helped our two picks, 3Com Corp. (Nasdaq: COMS) and Cabletron Systems (NYSE: CS) rise to the top. Both companies are key players in computer networking, an industry enabling laptop and desktop units to communicate. 3Com, which analysts predict is headed toward 31% annual growth the next five years, looked particularly attractive priced at 18.6 times 1997 earnings. Cabletron, a company analysts see growing earnings at a 24% clip, looked too cheap to pass up at 16.6 times 1997 predicted net income. One very difficult decision was to place Cisco Systems (NYSE: CSCO), the networking industry's undisputed leader, in our runners-up bin. Analysts peg Cisco to boost earnings almost 34% a year but, unfortunately, the investment world is keen on that same goal. Cisco shares, as of this writing, were trading at a 30 multiple, allowing the company to make our screen, but still making it a bit pricier than our other two choices.

TAKING THE DATA TO THE BANK

In parting, we leave you with two good sources of stock company information. Should you want to check up on the stocks we've chosen, or even comb through screens of your own, you'll find that the freshest, most extensive data available is indispensable. One Web site chock-full of company-specific facts and figures (and even magazine articles) is www.dailystocks.com. And if you're looking for the same annual and quarterly documents corporations must submit to Uncle Sam, we suggest checking the Securities and Exchange Commission's database, found at www.sec.gov/edgarhp.htm.

Happy hunting.

VALUE STOCKS

                        EXCHANGE:
COMPANY                  SYMBOL     LINE OF BUSINESS

Wendy's International   NYSE: WEN   Fast food
Lockheed Martin         NYSE: LMT   Aerospace/defense
Bank America            NYSE: BAC   Money center bank
Fannie Mae Corp.        NYSE: FNM   Mortgage lender

                                       PROJECTED
                         SHARE     5-YR. EARNINGS
COMPANY                 PRICE(*)        GROWTH       P/E

Wendy's International   $ 23.63         16.1%       17.2
Lockheed Martin           94.13          9.9        12.9
Bank America             115.75         11.0        13.7
Fannie Mae Corp.          43.25         13.3        15.0
BLUE CHIPS

                     EXCHANGE:
COMPANY               SYMBOL     LINE OF BUSINESS

Mattel              NYSE: MAT    Toymaker
Johnson & Johnson   NYSE: JNJ    Pharmaceuticals/health care
Merck               NYSE: MRK    Pharmaceuticals/health care
ConAgra             NYSE: CAG    Agriculture

                                 PROJECTED
                     SHARE     5-YR EARNINGS
COMPANY             PRICE(*)       GROWTH      P/E

Mattel              $29.25        14.9%        17.7
Johnson & Johnson    59.50        14.4         24.2
Merck                91.38        14.3         24.0
ConAgra              59.88        12.7         22.8
GROWTH STOCKS

                      EXCHANGE:
COMPANY                SYMBOL      LINE OF BUSINESS

3Com Corp.          Nasdaq: COMS   Computer networking
Cabletron Systems   NYSE: CS       Computer networking
CiscoSystems        Nasdaq: CSCO   Computer networking
Atmel Corp.         Nasdaq: ATML   Semiconductors

                                 PROJECTED
                     SHARE      5-YR EARNINGS
COMPANY              PRICE(*)     GROWTH        P/E

3Com Corp.          $41.63        30.3%         18.1
Cabletron Systems    39.88        24.2          17.2
CiscoSystems         65.50        33.6          29.9
Atmel Corp.          28.00        26.9          15.6

RELATED ARTICLE: Terms of Investments

Should some of the investment and finance terms in this piece seem somewhat confusing, we've provided the following explanations:

An index is a statistical composite used to chart the stock market, much like the S&P 500, a composite based on the performance of the country's largest companies.

Price-to-earning ratio (P/E), or multiple as it is sometimes called, serves as a way of showing how expensive stocks are. To calculate a P/E or multiple, divide the company's stock price by its earning per share.

Earnings growth is the percentage that a company's profits or earnings per share increase annually.

A stock's yield is calculated by dividing a company's dividend by its current share price.

A dividend is the amount of profits a company regularly distributes to shareholders quarterly.

Return on equity is the amount of money a company earns on a sum shareholders have invested in it. It is calculated by dividing how much a corporation's common stock is worth by the amount of net income or profit made during a period.

Market capitalization shows just how much a company's outstanding stock is worth. To calculate a market cap, as professionals sometimes call it, multiply a company's stock price by the number of shares it has outstanding.

Leverage shows how much in debt a corporation is. One way to measure leverage is by calculating a company's debt-to-capital ratio. Divide a company's long-term debt by its total capital.

Capital gains are the amount a stock or other investment appreciates over time. To calculate an investment's capital gain, subtract the price you purchase you paid from its most recent price.

--J.A.A.