Among the many features found in each week’s edition of Value Line’s Selection & Opinion service is a list of the seven best and worst performing industries over the past six weeks. These rankings can be found on the inside back cover of Selection & Opinion. The roughly 1,700 stocks in the Value Line universe are currently divided among about 100 industries. Notably, for the purposes of calculating these results, the performance of each stock is equally weighted to the others in its industry (i.e., irrespective of market capitalization).
The equity markets have endured some minor bumps and bruises so far in the third quarter. The leading market benchmarks, several of which reached all-time highs during the first half of 2014, finished in the red during the timeframe for our latest Industry Price Performance rankings, which stretched from July 1st to August 12th. The S&P 500 Index fell 2.0% between July 1st and August 12th. The decline of the Value Line Arithmetic Average was even more pronounced, 4.1%, as investors were particularly cool toward small-cap stocks. From an industry perspective, the weakness was fairly widespread, with only a dozen of the roughly 100 industries that we follow finishing in the black for the period. Medical Services claimed the top spot, rising 3.8%. Investors also continued to look favorably on some long-suffering commodities groups. Precious Metals was the second best performer, climbing 3.7%, while a 2.6% advance by Metals & Mining (Diversified) was good for fourth place. Also securing a spot among our top seven were Steel (+3.3%), Shoes (+2.2%), Wireless Networking (+2.0%), and Internet (+1.9%).
In looking for investment ideas among the seven best-performing industries, we are taking a closer look at Internet stocks. More conservative investors are likely to approach this group with trepidation. The industry is comprised of relatively young companies, competing in markets subject to rapid technological changes. Moreover, most of these equities trade at lofty valuations that make them more vulnerable to sizable price declines if a company’s business model hits a bump in the road or if the broader equity market experiences a downturn. Income-oriented investors, in particular, will have their work cut out for them with this group. As it stands, only three of the stocks we cover, EarthLink (ELNK), Expedia (EXPE), and IAC/InterActive (IACI), currently pay a dividend.
Despite these caveats, investors will still want to consider allocating some portion of their portfolio to this space. The appeal here is largely the potential many of the companies possess for rapid advances in sales and earnings as we move through the second half of the decade. Given this, businesses that are able to execute well in their respective markets stand a good chance of growing into their current valuations and providing enviable long-term price-appreciation for shareholders with a 3- to 5-year investment horizon.
Investors looking to invest in the Internet industry, but seeking to limit their downside exposure will likely want to take a closer look at the industry’s biggest player, Google (GOOG). The company’s rise to prominence has been powered primarily by its Internet search engine. Revenues are generated largely from the sale of advertising connected to its search results and will likely reach $67 billion this year. Amazon.com (AMZN) currently generates more revenues, about $90 billion in 2014, but Google by most other measures, including profitability and market capitalization, is the industry’s darling. Despite its lofty status, the search juggernaut has been in existence for less than 20 years. It was founded in 1998 by Stanford graduate students, Larry Page and Sergey Brin. Together, the two still control about 55% of voting power through their ownership of Class B shares, which carry extra voting power (10 to 1) relative to Class A shares. Mr. Page currently serves as Google’s CEO, as well.
The company produced June-quarter results that were largely in-line with our expectations and remains on track to deliver healthy sales and earnings gains in 2014. Cost-per-click (the fees advertisers pay for each ad that gets clicked on) has been declining, but this weakness has been more than offset by surging ad sales volumes, which climbed 25% year over year in the second period. The balance of 2014 ought to follow a similar script, allowing full-year sales revenues to reach $67 billion (a 12% improvement from 2013). Meanwhile, after several years of erosion, the operating margin should rebound a bit, providing an additional boost to earnings, which will probably climb more than 20%, to $22.00 a share.
GOOG currently doesn’t pay a dividend, but its stock is otherwise suitable for most accounts. And the company’s finances are the envy of most. It had over $55 billion in net cash (cash minus debt) on its books at the year’s midpoint. Too, a sizable and predictable cash flow stream gives Google added flexibility as it looks to capitalize on growth opportunities through in-house initiatives or acquisitions. As with most other Internet stocks, valuation looks to be the big sticking point. GOOG shares trade at about 25-times expected 2014 earnings, well above the recent Value Line median of 17.9-times. Still, based on our projections, profits will reach $45.00 a share by 2017-2019—a high-teens annual growth rate—which should provide the boost needed to lift these shares to loftier heights and allow investors to realize worthwhile price appreciation in the 3 to 5 years ahead.