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Monday, November 9, 1998

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Averaging Into Downtrodden Leaders

Last Friday, we discussed some of the problems facing companies in the vitamin business and began to look at a way to benefit from such industrywide turmoil (click here to review those thoughts). When an industry "loses favor," the "wise" professional money managers immediately bail out of all stocks related to the industry, without regard for the underlying quality of the companies.

Why do these wise folks bail? They're evaluated on quarterly (sometimes even monthly) performance and are afraid to stick around in a stock that may stumble in the near term, even if the company offers terrific long-term prospects. Hmmm... might this provide an opportunity for Fools who are investing for the long term? While it's not the most pleasant experience to see a stock you own stagnate (or even decline) for a period of time, it can be worthwhile if it is a leading company in a growth industry selling at a significant discount to its future value.

The interesting thing about the destruction of an industry in the stock market (as long as you aren't already invested in it) is that the great companies get hammered along with the weaker ones. As demonstrated by the declines that have occurred over the past four months among stocks in the vitamin-related world, every stock in the industry was hit even though only two of them have reported problems. If you can find one of the industry's leading players that you believe will likely retain its dominant position, take advantage of the overreaction in its stock price and start buying into it.

Going back to vitamin-related stocks, I consider Whole Foods Markets (Nasdaq: WFMI) and General Nutrition (Nasdaq: GNCI) to be the respective leaders in their niches.

General Nutrition is basically the vitamin, herb, and sports nutrition convenience store to the nation. Its stores seem omnipresent to me, yet the company has only about 14.2% of the domestic retail supplement market. The company operates 2,566 stores (accounting for 57% of 1997 profits), franchises 1,332 stores (22%), and has a manufacturing operation (21%). The late August warning that the company was going to lower prices initiated the industrywide stock price free fall. While earnings per share at the company rose an average 36% per year between 1993 and 1997, that growth slowed down in the first two quarters of 1998, and the third quarter saw a 13% decline in profits, primarily caused by a slowdown in sales and the company's own price cuts. Nonetheless, analysts look for profits to grow 13% next year and about 20% over the next five years.

Whole Foods Markets is the nation's leading natural foods supermarket chain, operating 87 stores domestically. For those of you who haven't been into one of its stores, I would classify them as gourmet food stores with an emphasis on natural products. One leading trade publication stated that sales in the natural foods segment were $11.5 billion in 1996, having experienced 29% annual growth during the preceding five years. Unfortunately, a good breakout of sales and profits from just vitamins is not available. In addition, quarterly results have not been released since General Nutrition initiated its price cuts (they are due in the week or two), so it's hard to tell what kind of impact that action will have. That said, Whole Foods is a full-service supermarket with many departments outside of vitamins and herbal remedies. Analysts still expect earnings to grow 20%-25% over the next five years.

The two companies highlighted here are in different situations. General Nutrition is one of the instigators of the industry woes, while Whole Foods is an ancillary player that has been deflated by concerns about fallout from General Nutrition and slight delays in new store openings. The current valuations show the different woes affecting the respective companies. Whole Foods is trading at 20x earnings estimates for its fiscal year ending next September, while General Nutrition is trading at 11x estimates for the year ended in January 1999. Both companies were considered good growth companies at the beginning of the year, but now, due to what could very likely be short-term potholes, General Nutrition is trading as if it will not grow any more and Whole Foods is treated as if it will grow about the same rate as the overall market.

From my perspective, both of these companies provide interesting investment opportunities. I would not, however, recommend jumping feet first into either of these situations. Patience is usually a virtue when dealing with beaten down stocks. If you find one of these beaten down stocks worthy of investment, purchase only a portion of the position you ultimately want to own. This way, more substantial losses are avoided if the stock deteriorates further (which could provide an opportunity to pick up more of the stock if the long-term story is intact). If the stock rises, you get to enjoy the gains and have additional time to confirm that the company will remain an industry leader.

Why should you be cautious about jumping full force into an apparently beaten down, cheap stocks? For one very good reason: Mr. Market is often willing to take an unloved stock out to the woodshed for even more punishment. There are numerous examples of beaten down stocks that continue to fall further, whether deserved or not. Sunterra Resorts (NYSE: OWN), a leading timeshare (vacation ownership) company fell from $29 last November to $3 3/8 last month, while earnings estimates stayed above $1.20 per share. This just on fear of a recession. I thought the stock looked cheap at 10x (to be honest, even 15x) earnings, given that it is expected to have 20%-30% growth. Fortunately, though, I didn't back up the truck when it was at $12 on the way down. If I had, I would have been even more bummed last month when the stock was under $4! Ending with a happy footnote, Sunterra has now rebounded to about $13.

So what's the point of all this? Growth industries with problems that are temporary can present great investment opportunities. In such situations, buy into the best companies that can withstand short-term problems (that means cruisin' the balance sheet and cash flow statement!) and resume growing its earnings over the long haul. While it may be tempting to "load up" on a stalwart when you see it fall, a better strategy may be to take only a modest initial position, with the intent to pick up more (1) if the stock price falls further (and the long-term fundamental story has not changed) or (2) when some of the uncertainty has been removed from company and the industry.

If you really like the company and believe its growth prospects over the next decade or more are excellent, you may find that a pummeling by the market provides an excellent time to initiate participation in the company's Dividend Reinvestment Plan. This way, you can invest money slowly over time, utilize dollar cost averaging, and minimize transaction costs. What a deal!

One big WARNING before you try this type of investing: You need to have patience. Returns likely won't be immediate. You may trail the S&P 500 Index for a period of time. If, however, you are able to buy into great growth companies at low valuations because they are facing short-term problems, you will beat the Index over longer periods of time.

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