In a very tough year, a few stock pickers found a way to excel. Who are they and how’d they do it?
By Mary Lowengard
March 2002
Institutional Investor Magazine
A strong wind was blowing in toward home plate last year. In one of the most difficult investing environments in nearly a decade, far fewer stock picks cleared the fences. That only made more impressive the accomplishments of Institutional Investor’s annual selection of the brokerage analysts who tabbed the best-performing stocks of the previous year. After all, they excelled in the most adverse conditions in years.
Appropriately enough in such a depressing year (the Standard & Poor’s 500 index fell 12 percent, the Dow Jones industrial average 7.1 percent and the Nasdaq composite index 21 percent), one of the year’s high-flying stocks was a maker of generic Prozac (Pharmaceutical Resources, up 387.2 percent). Gone were virtually all of the major technology names that drove the great 1990s bull market. Metricom, profiled here as a home run for John Bensche in 1999, when it rose 1,415.7 percent that year, was down 99.4 percent in 2001. In their place at the top of the charts were consumer-driven shares like Blockbuster (up 201.9 percent); turnarounds like Office Depot (up 160.2 percent), J.C. Penney Co. (up 152 percent) and Best Buy Co. (up 151.9 percent); and a casino operator (Ameristar Casinos, up 388.8 percent). There were still some tech standouts, though they were hardly the household names of recent years. One was a surviving dot-com, Overture Services (up 385.5 percent), while the peak-performing large-cap and growth shares were semiconductor companies Nvidia Corp. and Genesis Microchip, respectively.
Another sign of the times: This year’s best stock pickers have been to the plate more times than some of their predecessors. Their average age is 42, whereas in 1999 the group averaged just 34. J.P. Morgan H&Q’s Joseph Arsenio II and Fahnestock & Co.'s Bernard Sosnick each boast 30-plus years in the securities business, and Credit Suisse First Boston’s Gary Balter ranked as a home-run hitter 15 years ago for his coverage of Circuit City Stores.
Here’s how we assembled our team. Greenwich, Connecticut-based FactSet Research Systems prepared two lists: the top-performing high-growth stocks (those of companies with market caps between $75 million and $1 billion) and the top-performing large caps (more than $1 billion). Companies that went public in 2001 (what few there were) were excluded, as the stocks must have traded for the full year. All stocks on the list had to be trading at $5.00 or higher at the start of 2001. Performance numbers reflect total returns, with dividends reinvested.
Next, we turned the list of the top five companies in each category over to the research and analytics group at Thomson Financial/First Call, which identified the sell-side analyst who first put a buy recommendation on each stock, along with dates and prices. II then asked CFOs or investor relations officials at each top-performing company to verify the pick. In those instances in which they pinpointed a different analyst, we asked that they justify their selection; then we decided which researcher championed the stock most prominently. We also eliminated analysts working at banks that underwrote a company’s IPO (if it occurred in the past four years), since these researchers may be duty-bound to recommend the shares.
Here then are the analysts whose stock picks sliced through the gales of 2001 and made it to the outfield seats.
LARGE-CAP STOCKS
Nvidia Corp.
Mark Edelstone
Morgan Stanley
(Nasdaq: NVDA) +308.4%
The losses are daunting - $100 billion for the 12 months ended September 30 for the global semiconductor industry. So how did Nvidia Corp. shares (pronounced in-vidia) jump 308.4 percent last year, from $16.38 to $66.90?
“The company’s execution was exceptional, as they delivered timely products and terrific earnings,” says Morgan Stanley’s Mark Edelstone, 39, Nvidia’s most enthusiastic fan. Although the $225 billion industry saw its revenues fall 44 percent in 2001, Nvidia nearly doubled its revenues, from $735 million to $1.37 billion for the year ended January 27, 2002, and increased market share to 35 percent for its core business - graphics processors for personal computers. Last year 3-D graphics entered the mainstream, which proved to be a bonanza for Nvidia. The company produced high-performance products and delivered them to the market at competitive prices. “The fact that the PC market was so challenging makes Nvidia’s success all the more spectacular,” says Edelstone.
The analyst initiated coverage of Santa Clara, California-based Nvidia on February 16, 1999 (one day before Prudential Securities’ Hans Mosesmann and 25 days after the company went public). Edelstone had long admired Nvidia’s founding CEO Jen-Hsun Huang, a former senior engineer at LSI Logic Corp. and Advanced Micro Devices, and vice president of hardware engineering Chris Malachowsky and chief technical officer Curtis Priem, who had both worked at Sun Microsystems.
Edelstone predicts that Nvidia will make significant inroads into the $3.5 billion market for systems logic devices. Edelstone thinks Nvidia could realize revenue gains of 30 percent this year, with systems logic kicking in 10 percent of the total. He believes the stock could hit $90.
In December Nvidia was added to the Standard & Poor’s 500 index. Whose place did it take? Enron’s.
Blockbuster
Dana Telsey
Bear, Stearns & Co.
(NYSE: BBI) +209.1%
From her grandmother, who sold women’s apparel and accessories at Bergdorf Goodman, the swanky New York department store, and her parents, who owned a bookstore on Madison Avenue, Dana Telsey learned the rhythm of retail. “The business is in my blood,” says Telsey, 39.
In 1999 the Bear, Stearns & Co. analyst became bullish on Blockbuster, which began a turnaround that year. She endorsed the company’s change from a straight ownership arrangement, in which the chain bought titles outright, to a revenue-sharing arrangement with its vendors, which improved availability of its most popular movies. In addition, Dallas, Texas-based Blockbuster last year benefited from some hot video titles, as well as the growing popularity of DVD players. DVDs now claim 25 percent of new release rentals for Blockbuster. “By the end of 2003, we expect that half of all U.S. households will have DVDs,” Telsey says, up from just under 25 percent now. Mostly because of charges relating to the elimination of slower-selling products, the company last year posted a loss of $1.37 per share, versus a loss of $0.43 in 2000. But the gross margin increased 60 basis points to 59.6 percent for 2001. Overall, the stock jumped 209.1 percent last year.
Some analysts think that Blockbuster’s market is saturated. But Telsey is confident that CEO John Antioco, who joined in 1999 and boasts a solid retail turnaround record, will deliver good growth through the life of his contract, which runs through 2007. “Antioco is a real forward thinker,” she says.
Office Depot
Gary Balter
Credit Suisse First Boston
(NYSE: ODP) +160.2%
Office Depot’s losing streak began in 1996, when the Justice Department scrapped on antitrust grounds the company’s planned merger with fellow office supply superstore Staples. Between 1996 and the end of 2000, Office Depot’s revenue growth slowed, the chain lost market share, and top staffers bolted. When the company made the strategic blunder of lowering prices on commodity products like copy paper, profit margins eroded from 8.2 percent in 1999 to 5.7 percent in 2000.
Credit Suisse First Boston’s Gary Balter, 44, who ranked as a home-run hitter back in 1987 when he followed Circuit City Stores at Goldman, Sachs & Co., issued a buy recommendation on Office Depot in January 2001, when the stock was selling for $8. (It would rise to $18.54 by year-end.) “People just hated the stock,” Balter recalls. But Bruce Nelson, former head of the company’s European operations, had just stepped up to the plate as Office Depot’s new CEO, and Balter liked the look of his swing. “He said retail margins were too low. He said the marketplace for the business services group, which sells direct to small and medium-size businesses, was saturated. He cut the number of products. It was all music to my ears.”
The restructuring worked. By the end of 2001, BSG operating margins had improved from 5 percent to 7.7 percent year over year. Earnings per share jumped from $0.16 to $0.66. All told, the stock gained 160.2 percent for the year. “Bruce delivered,” says Balter. The analyst believes that the Delray Beach, Florida-based company will continue to improve margins through further cost-cutting and better pricing, and he sees a $20 stock by the end of 2002. “Nelson has set the stage for a few more years of great results,” he concludes.
J.C. Penney Co.
Bernard Sosnick
Fahnestock & Co.
(NYSE: JCP) +152.0%
After 30 years as a retailing analyst, Bernard Sosnick has seen the demise of many department stores. Along the way he has developed an instinct for predicting which turnaround schemes might save a struggling retailer and which strategies are doomed. In March 2001 he decided that Plano, Texas-based J.C. Penney Co. would prevail, thanks to the makeover begun by new CEO Allen Questrom, who had taken charge of the company in September 2000. “There were a few things I felt ought to be done,” says the Fahnestock & Co. analyst, “and Questrom did every one of them.”
Most important, Sosnick says, Questrom refocused on Penney’s traditional, moderate-income shopper, hired some of the best talent in retailing and invested heavily in marketing. As a result, Penney increased both customer traffic and sales after four straight years of zero growth. For the year, the stock jumped more than 150 percent.
Penney’s Eckerd drugstore chain, acquired in 1997 and then expanded through a series of acquisitions, became a managerial morass, as Eckerd’s own acquisitions proved difficult to integrate. But Eckerd CEO Wayne Harris, a former executive at Kroger Co. and Great Atlantic & Pacific Tea Co. who came on board in November 2000, has made some smart moves, Sosnick says. Among them: improving the chain’s technology.
Best Buy Co.
Peter Caruso
Merrill Lynch
(NYSE: BBY) +151.9%
Rounding home plate tight on the heels of J.C. Penney Co. is Minneapolis-based electronics retailer Best Buy Co., which posted a 151.9 percent total return in 2001. Peter Caruso, 43, is its most spirited fan. Caruso has worked as a Merrill Lynch retailing analyst since 1982, when, as he recalls, Service Merchandise Co., a onetime catalogue showroom giant that’s now in liquidation, was bigger than Wal-Mart Stores.
Caruso has gone to bat for Best Buy since 1994. “From day one,” he observes, “Best Buy knew how to open stores rapidly and generate sales growth,” in part through lower prices. But for many years the company was saddled with an ineffective distribution system, which lacked the requisite information networks to manage inventory. That’s a fatal flaw for any retailing operation. To its credit, Caruso says, Best Buy always had steady cash flow.
Back in 1994 Caruso contemplated the conventional wisdom about the company. “The bear story on Best Buy was that it was a cyclical electronics and PC retailer that would fall on its face once the economy weakened,” he says. “If I can prove to myself that the bear stories are wrong, that’s where I always see the biggest move.” The analyst determined that Best Buy had pulled off a rare feat: transforming itself from a store that a customer might visit once or twice a year to purchase a large-ticket item into a well-stocked entertainment warehouse that lures customers back much more frequently. “Best Buy has fundamentally transformed the industry,” Caruso says. “Their same-store sales in December 2001 were up 9 percent in one of the weakest Christmas seasons ever.”
In January 2001 Best Buy acquired Musicland Stores Corp., which owns Sam Goody. Many investors expressed skepticism about the deal because music retailing has fallen on hard times. “I know the market is a doubting Thomas,” Caruso says, “but just watch Best Buy transform Sam Goody from a music retailer into an entertainment center. CEO Dick Schulze, who founded Best Buy, and Brad Anderson, its vice chairman, are master merchants.”
HIGH-GROWTH STOCKS
Genesis Microchip
Robert Adams
CIBC World Markets
(Nasdaq: GNSS) +614.8%
Flat-panel displays - FPDs, for short - represent the cutting edge in computer monitors. Largely because it is the lowest-cost producer, Alviso, California-based Genesis Microchip dominates the market for the integrated circuits that power FPDs, with a 61 percent share.
CIBC World Markets analyst Robert Adams, 34, issued a strong buy on the company back in February 1999, when the stock was trading at $35, versus $9.25 at the end of 2000. Adams was convinced that the future of monitors was in FPDs, and he thought Genesis’ lock on the market was secure. His judgment was vindicated: The stock closed at $66.12 at the end of the year.
The Genesis story, Adams suggests, is intuitive. “Flat monitors use less power and take up less space,” he explains. “They will ultimately supplant CRTs, the traditional monitors for PCs.” Of the 108 million monitors sold worldwide in 2000, 6 million were flat panels. In 2001, 15.5 million of the 108 million total were flat panels. “You do the math,” Adams says. “This is a very definable market.” Genesis is a pure play on the FPDs, he adds, since the business kicks in 90 percent of the company’s revenues. For the nine months ended December 31, Genesis delivered earnings per share of $0.89, up 207 percent from the past year.
Scanning the company’s newest product offerings, Adams is impressed by Genesis Microchip’s scaling engine, which greatly enhances the quality of an image on the screen.
Flir Systems
Joseph Arsenio II
J.P. Morgan H&Q
(Nasdaq: FLIR) +581.7%
If you want to invest in a company that develops thermal imaging technology for commercial use, there’s only one pure play: Flir Systems. The Portland, Oregon, company designs and manufactures thermal imaging systems, a technology that allows one to see thermal energy, or heat, and is used in such applications as airborne observation, manufacturing process control and border and maritime patrol.
“Flir has an absolutely unique position in the market as the only public company focused on the commercial sector,” says J.P. Morgan H&Q’s Joseph Arsenio II, 52. That excludes the military but does include paramilitary applications like police search-and-rescue efforts. Arsenio was at Hambrecht & Quist when he took the company public in 1993 at $12. Last April, when the stock was trading at $8.81, Arsenio issued a long-term buy recommendation.
The company had been floundering, saddled with more than $90 million in acquisition-related debt and a weakened capital structure, as well as a revenue recognition problem that required several restatements. Arsenio figured that a new CEO, Earl Lewis, an alumnus of Thermo Electron Corp. and a member of the board of directors at Flir, would move quickly to turn the company around - and he did. “Lewis did all the right things,” Arsenio says. “He improved cash flow by reducing debt through reduced inventories; he rationalized operating expenses by collecting on receivables; and he quickly restored the gross margins, which had deteriorated. This was a classic turnaround.” For the third quarter of 2001, earnings per share hit $0.41, up from a $1.25 loss the previous year.
The analyst thinks that Flir could be a $50 stock, up from a recent $44, by the end of this year. One reason for his forecast: He assumes that Operation Homeland Security will be good for business.
Ameristar Casinos
William Schmitt
CIBC World Markets
(Nasdaq: ASCA) +388.8%
Executives at Ameristar Casinos don’t roll the dice. “Management is very low key, very straightforward,” says William Schmitt of CIBC World Markets. In August 2000 he began coverage of Las Vegas-based Ameristar, which owns and operates five casinos in Iowa, Mississippi and Nevada. Schmitt upgraded the stock to a buy last October, when it was trading at $6, versus a year-end $20.50. “What can I say?” Schmitt says. “There’s lots of money to be made in gambling.”
The $475 million October 2000 Station Casinos transaction - essentially an asset swap of Ameristar’s Reserve Hotel and Casino in Henderson, Nevada, for Station Casinos’ two Missouri riverboats - sealed the deal for Schmitt, 42. He was convinced that the transaction was a “bold decision,” since riverboats offer superior growth prospects and a better return on capital. “In small towns, riverboat gambling is like going to the movies. You get a good meal, drink a couple of beers and play the slot machines,” says Schmitt.
With a minuscule float of just 2 million shares, Ameristar traded at $4 in October. Then in December Ameristar issued an additional 6 million shares at $20.50, using the money to pay down debt. The additional float should improve the company’s valuation, Schmitt argues.
What do the cards have in store for Ameristar? “I think the easy money has been made,” Schmitt says. “I expect them to hold up well, but I can’t say they’ll be a double.”
Pharmaceutical Resources
Robert Uhl
Leerink Swann & Co.
(NYSE: PRX) +387.2
The original management team at Spring Valley, New York-based Par Pharmaceutical went to jail back in the mid-1980s for submitting fraudulent research data to the Food and Drug Administration. The firm’s current parent, Pharmaceutical Resources, made a name for itself as one of the first companies to manufacture a generic form of the antidepressant Prozac - a happier chapter in this company story.
Two years after Pharmaceutical Resources announced in 1999 that it planned to sell fluoxetine, a generic form of Prozac, Leerink Swann & Co. analyst Robert Uhl organized a survey of more than 100 pharmacists to see if the drug would be a strong seller in tablet form, versus a capsule for brand-name Prozac.
Uhl, 42, initiated coverage in May 2001, when Pharmaceutical Resources traded at $17.55. Many investors were skittish about the stock, having been burned in the 1980s. But Uhl thought that generic Prozac, as well as the company’s efforts to develop generics for other blockbuster drugs, would help drive the stock to $30. In fact, it ended the year at $37.92. Fluoxetine represented about 40 percent of the company’s 2001 revenues and more than 40 percent of profits.
“It’s a good sign when people are so skeptical they don’t want to listen to you,” the analyst chuckles.
Overture Services
Safa Rashtchy
U.S. Bancorp Piper Jaffray
(Nasdaq: OVER) +385.5%
It’s not making money yet, but Overture Services, the former GoTo.com, is the rare dot-com that hasn’t been abandoned by investors. In fact, its stock almost quintupled last year to $35.43, reflecting a boom in revenues from the search engine’s listing service, which displays the names of paying advertisers when a user clicks on a keyword for a search query. In 2000 the company lost $48 million on revenues of $103 million. In 2001 it is expected to edge into the black.
U.S. Bancorp Piper Jaffray analyst Safa Rashtchy began covering the stock with a buy in February 2000, when the stock was selling for a now-implausible $72. (The stock hit $26 on its first day of trading in June 1999 and peaked at $109 five months later.) Looking back, Rashtchy says, GoTo.com was one of the first dot-coms to realize that building an Internet portal, or destination, would be hugely expensive and unprofitable (among the failed portals are AltaVista and Excite). “Now the smart model is to just be a search engine.”
Rashtchy, 41, thinks that consumers will eventually pay to use search engines. Overture Services generates revenues from advertising. “It’s my belief that we will pay for these services. The Internet is so deeply woven into our lives we can’t do without it.”
