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Markets

7 Stocks for the Times

It's a changing market, and growth companies are back. Are you ready? We give the nod to seven promising stocks. Plus: Five growth funds that let you ride the revival.

It's been a long time since big was beautiful on Wall Street. The stocks of large companies have been in the doghouse ever since the 2000-02 bear market. Once burned, investors have long memories, and they have been slow to forgive. But the tide is turning for these beaten-up corporate giants.

Until recently, even big companies demonstrating better-than-average earnings growth have been shunned. The Russell 1000 Growth index, which tracks these stocks, lost an annualized 4% over the past five years. Russell indexes that follow midsize and small-company stocks each climbed an annualized 8% during the same period.

For several years, experts have predicted a resurgence of big-company growth stocks that did not materialize. Now it appears to be happening. The group outperformed the overall market for the final three months of 2005. "The category isn't sexy right now, but the opportunity is there," says Dan Foley, a financial planner in Steamboat Springs, Colo. Adds Bill Miller, manager of Legg Mason Value, which has outpaced the market 15 straight years: "Growth stocks are at the most attractive valuations we've seen since 1995."

The group seems so undervalued that you might do well by simply investing in a fund that specializes in big growth stocks (see Five Ways to Ride the Revival of Big Companies). The seven stocks we give a nod to here are particularly well positioned. All are leaders in their markets, possess strong balance sheets and are expected to post double-digit earnings gains.

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Expanding retailer

With plans to open 500 new department stores in the next five years, Kohl's is a company intent on growing. But investors appear somewhat skeptical about Kohl's prospects. The stock got hammered after Kohl's reported disappointing December sales; at $46, it trades at 16 times expected earnings of $2.85 per share for the year ending January 2007. That's less than the price-earnings ratio of the overall market and seems surprising for a company whose leaders have promised 20% annual earnings growth. Standard Poor's analyst Jason Asaeda, using a more conservative 16% earnings-growth rate, says Kohl's shares could be worth $58 by year's end.

Part of the skepticism stems from fears that high energy costs and an end to soaring home prices will dampen consumer enthusiasm for spending. Even if that turns out to be true, the impact is likely to be brief. Meanwhile, with barely any exposure in Florida and the Pacific Northwest, the Menomenee Falls, Wis., company has plenty of room to add to its current count of 732 stores.

Kohl's has bucked the decline in traditional department stores by avoiding high-rent malls and offering national-brand clothing, furnishings and housewares at moderate prices. Its convenient, big-box-store format, with wide aisles and central checkout areas, appeals to its target customer base of young married women. Kohl's has tweaked its merchandising strategy, recently adding cosmetics and offering exclusive apparel lines, such as Daisy Fuentes for women and Candie's for teenage girls. The fresher product lineup should help recapture the spotlight from a resurgent J.C. Penney, whose stock has more than doubled in the past two years. J.C. Penney opened just 18 stores last year and is not nearly the growth story that Kohl's is.

Slots specialist

The combination of gambling and technology is a match made in slot-machine heaven. From multihand video poker games to networked progressive slots with multimillion-dollar payouts, gambling machines are more complex and more exciting than ever. Result: Gamblers tend to play longer and bet more. "Our goal is to have people comment on the experience as opposed to the pocketbook side of the equation," says Ed Rogich, a vice-president at International Game Technology, the world's largest maker of slot machines.

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With 70% of the U.S. slot market, Reno-based IGT seems to hold all the cards. It spends twice as much on research and development as any rival, holds a wide array of patents and has locked up licenses for some of the most popular theme games, including perennial favorite "Wheel of Fortune."

The company gets half its revenues from popular games that it leases to casinos in exchange for a cut of the wagers. But IGT's profits and stock price, recently $32, have been in a slump for the past year. The problem: A big jump in profits spurred by the introduction of cashless slot machines (winnings are tracked on a redeemable paper ticket) has run its course. The next big thing -- games that can be downloaded and managed from a central computer -- could be even more profitable, but rollout of the games is a year or so away.

There's plenty of reason to bet on IGT now, though. After a slow period, new U.S. gambling venues should open this year in Florida, New York and Pennsylvania, boosting sales. New and expanding foreign gambling havens, such as Macau, Japan and Singapore, offer huge opportunities. Morningstar analyst Sanjay Ayer says the stock, down nearly 32% from its 2004 high, is worth $38, based on the expectation of a new wave of growth beginning in 2007.

Acrobatic software giant

Software maker Adobe has long exercised Microsoft-like control over the desktop- and Web-publishing businesses. Its ubiquitous Adobe Acrobat program for viewing documents is installed on most new PCs, and its image-editing software is so popular that its name is widely used as a verb, as in, "He Photoshopped his ex-wife out of the picture."

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In December, Adobe completed the $3.4-billion purchase of Macromedia, whose Flash software for displaying videos, games and other media on the Web is similarly dominant -- it is installed on some 98% of PCs. Given the growth of online publishing, the rising popularity of digital photography and video, and the emergence of video and other media on mobile phones, San Jose-based Adobe is likely to continue posting double-digit earnings gains well into the future.

Although Adobe faces competition from Microsoft and Apple, among others, it has been skillful in bundling its products to create all-Adobe packages for working with all types of media. That has the effect of squeezing out promising individual applications from competitors.

Even without including Macromedia's operations in its numbers, Adobe's fourth-quarter earnings rose 38%, surpassing the average of analysts' estimates for the 12th straight quarter. Adobe has low fixed costs, is debt-free and generates huge amounts of cash, much of which is channeled into a $1-billion share-buyback program. At $39, the stock trades at 30 times estimated earnings of $1.29 per share for the year ending this November. That seems a reasonable price given that the arrival soon of new products that bundle Adobe and Macromedia titles could help extend Adobe's long record of beating expectations.

Nuts-and-bolts purveyor

Just as its name implies, Fastenal sells just about any kind of fastener, including bolts, nuts and screws -- a product line of more than 250,000 items. And what Fastenal doesn't stock, it will make custom for its clients, which include construction firms and manufacturers, as well as farmers, truckers and governments. The Winona, Minn., company also offers a variety of tools and industrial supplies, bringing its total product line to more than 500,000 items.

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Fastenal's vast selection and high level of service -- it operates its own trucking fleet to keep its 1,800 stores well stocked -- is hard for any rival to match. No wonder its stock, at $40, trades for a pricey 29 times expected 2006 earnings of $1.36 per share. But the company is well positioned to deliver 25% yearly earnings gains over the next few years, says analyst Jeffrey Germanotta, of investment bank William Blair. He recommends the shares.

Fastenal figures that there is room in the U.S. and Canada for at least 2,500 stores. There are plenty of growth opportunities overseas, too. The company has fewer than two dozen stores in China, Mexico, the Netherlands and Singapore.

Fastenal managers excel at making their operations more efficient as the company grows. A store-remodeling program that began in 2002 raised sales per employee by more than 30%, and a new remodeling project has just begun. Other efficiency initiatives keep the growth of inventory, customer credit and freight costs below the rise in sales. Fastenal is the smallest company on our list, with a market value of $6.1 billion.

Acquisitive insurer

WellPoint, the product of a series of large mergers, is the nation's biggest health insurer, serving 34 million members. It was formed by the 2004 merger of Anthem and WellPoint Health Networks. In late December, WellPoint finalized its merger with New York insurer WellChoice.

Although there is always a risk that megamergers can go awry, the rewards in this case should be substantial. The Anthem-WellPoint merger is expected to trim costs by $250 million by the end of this year. The combination also created a company that can serve clients coast to coast, enabling it to better compete for national accounts. The addition of WellChoice will generate another $125 million in annual cost savings by 2010, and it will strengthen the national-accounts business because many of the nation's largest employers are based in New York.

WellPoint, headquartered in Indianapolis, produced annual earnings growth of 24% over the past five years, primarily through acquisitions. Executives see 15% annual profit growth in the future, mostly by signing up more members and trimming costs.

But some analysts think WellPoint can exceed the company's forecast. Moderating medical costs and the new medicare drug plan (expected to add $1 billion to the firm's $41 billion in annual revenues) could boost profits beyond expectations. The stock, at $75, trades for 17 times the $4.51 per share that the company expects to earn in 2006. Prudential Equity Group analyst David Shove thinks earnings will reach $4.85, and that the shares could be worth $90 in a year. With a market value of $46 billion, WellPoint is the largest company on our list.

A sound business

Harman International Industries has been making high-end audio equipment for decades. More recently, its line of sound systems for Apple's iPod music player has attracted attention -- the company sold nearly one million such systems in just four years. But someday soon there may be an even bigger market for music-enabled wireless phones. Sales of these phones, which would essentially be iPods with wireless-communications capabilities, could top one billion by 2009. "Companies that have done well with iPods have to look at music-enabled cell phones and salivate," says Sidney Harman, the 87-year-old founder and chairman of the Washington, D.C.-based company.

Meantime, more than two-thirds of Harman's $3 billion in annual revenues comes from making electronics that control navigation, climate, entertainment and other systems in luxury cars. Sidney Harman believes that these so-called infotainment systems will become indispensable, functioning as a car's "central nervous system." An emerging force in this nascent business, the company has more than $1.5 billion in contracts to provide infotainment systems to Audi, BMW and Mercedes, among others. The company also has a $200-million deal with DaimlerChrysler to install these systems in its inexpensive models in 2008 -- a signal that they will one day be as common as automatic transmissions.

Harman expects profits to rise 16%, to $3.85 per share, in the fiscal year that ends this June. Bear Stearns analyst Peter Barry says the company will produce earnings gains of 20% to 25% annually when the auto-infotainment business ramps up in 2008. At $99, the stock is down 24% from last year's peak, mostly on fears of slower vehicle sales. But the company has already secured a sizable amount of business for 2009 and 2010, says chairman Harman.

Cruise king

Carnival Cruise Lines has long been a good play on free-spending, cruise-happy baby-boomers. But rising fuel costs and Hurricane Katrina dampened enthusiasm for the stock. At $56, the stock is 5% off its January 2005 peak. But neither a 50% rise in fuel costs nor lost New Orleans-based travel seems to have stunted business. Carnival not only increased its earnings by 20% in the quarter that ended in November, but also boosted its operating profit margin (operating earnings as a percentage of revenues) to 17%, from 15% a year earlier, thanks to higher ticket prices.

That's a testament to the strength of the worldwide cruise-ship market as well as Carnival's dominant position within it. The Miami-based company is the world's largest cruise-vacation operator. With 12 brands (including Princess, Cunard and Holland America) and 79 ships, it controls more than 40% of the business. Moreover, the number of cruise-ship passengers in North America has been growing by almost 9% annually and by nearly 11% a year in Europe. Even so, just 16% of the U.S. population has ever taken a cruise, according to industry surveys, and that figure is much lower elsewhere around the world. "It is an unbelievable long-term growth story," says Mitch Rubin, who runs Baron Fifth Avenue Growth fund.

By adding new ships, Carnival could increase its capacity by as much as 24% by 2009. Absent a recession or incidents of terrorism against cruise ships, there appears to be plenty of demand for the added capacity. Carnival's occupancy in the fourth quarter of 2005 was 103%, which means its sold-out ships held three or more passengers in some of the two-person cabins.

At 18 times estimated earnings of $3.10 per share for the year that ends next November, Carnival seems reasonably priced. Factor in Carnival's strong financial position, frequent dividend increases (the stock yields 1.9%) and share buybacks, and the stock could be worth $66 in a year, says Argus Research analyst John Staszak.

Key numbers: Impressive earnings-growth potential and attractively priced stocks

Our picks range in size from the low end of large (Fastenal and Harman) to near-behemoth (Carnival and WellPoint). All seven companies are expected to deliver annual earnings growth of at least 15% over the next few years. All are also leaders in their markets and possess strong balance sheets.

COMPANY SYMBOL RECENT PRICE MARKET VALUE (IN BILLIONS) ANNUAL REVENUES (IN BILLIONS) ESTIMATED EARNINGS PER SHARE PRICE-EARNINGS RATIOlaquo; ESTIMATED LONG-TERM EARNINGS GROWTH
Adobe ADBE $39 $19.2 $2.0 $1.29* 30 15%
Carnival CCL 56 47.5 11.1 3.10* 18 15
Fastenal FAST 40 6.1 1.5 1.36 29 20
Harman International Industries HAR 99 6.5 3.1 3.93sup1; 25 21
International Game Technology IGT 32 10.7 2.4 1.19** 27 15
Kohl's KSS 46 15.9 12.8 2.85# 16 18
WellPoint WLP 75 46.2 40.5 4.58 16 15

Data to January 18. *Fiscal year ends November 30. sup1;Fiscal year ends June 30. **Fiscal year ends September 30. #Fiscal year ends January 29, 2007.. laquo;Based on estimated earnings.

Sources: Thomson First Call, Yahoo.