5 Top Tweeners

If you've ever sought to get seriously rich from stocks, then you've owned a tweener.

A tweener, dear Fool, is like your pal Chuck. Still a great athlete, Chuck no longer rules the hardwood with his 40-inch vertical leap. He's become what we sports addicts call a gamer. He passes more. He's developed a nice shot from the corner. And though he doesn't dunk as much, or as spectacularly, as he once did, Chuck is still a force in the paint.

What we fans don't know is how long Chuck will be in the starting lineup. Chiseled veteran Abe has a wicked hook shot that won't quit. And Larry, the little guard whose hip-shaking moves smoke defenders, has the makings of a future superstar. Both are vying to cut into Chuck's minutes on the floor.

In Foolish parlance: Chuck is a tweener, Abe is a Rule Maker, and Larry is a Rule Breaker.

Growing up is hard to do
The stock market has plenty of Chucks. They'll either create billion-dollar fortunes as they come to dominate industries, as Cisco and Microsoft (Nasdaq: MSFT  ) have, or they'll be destroyed in the process, as Gateway was.

Therein lies the problem. Investing in tweeners can be dangerous and exceptionally profitable -- the trick is picking your winners well, as David Gardner has. He produced nine years of 20% average returns hunting for misunderstood multibaggers in the making. His team at Motley Fool Rule Breakers continues the tradition today.

Let's have the list
You, too, can join in the effort, thanks to Motley Fool CAPS. Each week, we'll use the database to find three-star stocks (a five-star rating is the highest possible) that are expected to boost earnings by at least 15% annually over the next five years. Here is today's list:

Company

CAPS Rating

5-Year Growth Estimate

VMware (NYSE:VMW)

***

45.1%

Green Mountain Coffee (NASDAQ:GMCR)

***

25.0%

MasterCard (NYSE:MA)

***

18.6%

Quiksilver (NYSE:ZQK)

***

16.9%

BlackRock (NYSE:BLK)

***

16.0%

Sources: Motley Fool CAPS, Yahoo! Finance.

Bear in mind that this isn't a list of recommendations. Instead, I offer these stocks as candidates for further research.

Given my personal struggles with debt, you'd think that MasterCard would be an ideal choice. Trouble is, MasterCard differs from Discover Financial and American Express in that interest isn't where it makes its money. MasterCard is better described as a transactions processor that collects fees each time one of its cards is swiped.

Investors appear to like that better. Shares of MasterCard have more than doubled over the past year, and its 2.05 PEG ratio doesn't exactly point to a bargain.

Virtual servers, real returns
So why, then, should VMware, whose software makes data centers more efficient, and its 2.46 PEG be any different? Good question, Fool. The difference is that VMware produces more free cash flow than it does net income. Behold:

Metrics

Trailing 12 Months

2006

2005

2004

Net income*

$171.0

$85.9

$66.8

$16.8

Income as % of revenue

14.9%

12.2%

17.3%

7.7%

Free cash flow*

$279.2

$227.3

$217.5

$88.0

FCF as % of revenue

24.4%

32.3%

56.2%

40.2%

Source: Capital IQ, a division of Standard & Poor's.
*Numbers in millions.

Notice the difference? Lower income skews the PEG and makes it look a lot more unreasonable than it really is. So let's come up with a better measurement: P/FCF-G, or price-to-free cash flow-to-expected growth. As with the PEG, 1.0 or lower is best, though 1.5 or lower is just fine for most high-growth stocks.

By my math, VMware's P/FCF-G for 2008 is 1.69.

Here's how I got there. First, I assumed that continued dilution would result in 350 million VMware shares outstanding in 2008. For free cash flow, I took 20% of the consensus revenue estimate, which equaled $407.5 million. Dividing 407.5 by 350 million equals $1.16 in per-share FCF and a forward price-to-free cash flow ratio of 76.6. I then divided VMware's P/FCF by Wall Street's projected long-term growth rate (45.1%) to arrive at 1.69.

Fair? Perhaps, but there are a lot of assumptions in my math. Please take what's here with a giant boulder of salt. Or take the advice of bearish All-Star luvb2b, who panned VMware in CAPS in September: "This is NOT the next Google. [Its] software is not totally unique. Microsoft has a lower end version available for free and similar products are available on Linux."

Trouble is, you could say the same about Oracle (Nasdaq: ORCL  ) . Open-source databases are everywhere. Competitors abound. Yet CEO Larry Ellison has built a business that produces in excess of -- wait for it -- $6 billion in free cash flow.

That's why I think neither VMware nor Oracle is as overvalued as the market's cheapskates would have you believe. Both serve too critical a purpose in today's network infrastructures, and there's no reason to believe they'll be displaced soon. VMware joins my CAPS watch list today.

But that's me. What would you do? Would you buy VMware at today's prices? Let us know by signing up for CAPS now. It's 100% free to participate.

See you back here next week for five more top tweeners.


Read/Post Comments (0) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 550051, ~/Articles/ArticleHandler.aspx, 12/21/2014 12:42:41 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement