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 continue to forge ahead in 2013, with most market benchmarks showing year-to-date gains in the mid- to high-teens. The Value Line Arithmetic Average, for instance, has advanced 19.5% so far this year, including an 8.2% increase for the period covered in our latest Industry Price Performance rankings (April 9th to May 21st). In this environment, an industry needed to climb 14% over the past six weeks to qualify for a spot in our top seven. The Foreign Electronics / Entertainment group was the top performer over this stretch, rising 24.1%. Internet (+18.4%), Auto Parts (17.8%), Power (+17.5%), Insurance (Life) (+14.7%), Maritime (+14.4%), and Toiletries/Cosmetics (+14.0%) stocks did well for investors, as well.
In looking for investment ideas among the best-performing industries, we are focusing our attention on stocks in the Internet space. The obvious place to start is with Google, Inc. (GOOG), the industry’s biggest name. The company, which developed and operates the world’s leading Internet search engine, was founded less than two decades ago by Stanford University graduate students Larry Page and Sergey Brin and now has a market capitalization of roughly $300 billion. Officers and directors, including Mr. Page, who currently serves as Chief Executive Officer, own 94% of Class B common stock. These shares account for 18% of the total share base, but are entitled to ten votes per share, versus one vote for each Class A common stock, giving the Class B shareholders voting control over the Internet-search giant.
Google generates most of its revenues through targeted advertising. Its top line has risen at a rapid clip and now surpasses $50 billion a year. The impressive growth was evident again in the March quarter. Revenues rose 31%, to more than $14 billion, and earnings climbed 13%, to $9.87 a share. Aggregate paid clicks were up 20% from the prior-year period. Cost-per-click, which measures how much advertisers pay Google each time an ad is clicked, was down 4%, but this represents a modest improvement from the December quarter, which showed a 6% decline in the same metric. The balance of 2013 should bring strong results for the company, including continued growth in paid clicks and improving trends in cost-per-click. This ought to help lift full-year revenues at the search provider to $60 billion, up 20%, while earnings also figure to advance about 20%, to $39.00 a share.
The long-term outlook appears bright as well. Granted, we expect revenue growth to moderate somewhat over the long haul, but still think double-digit annual growth on both the top and bottom lines is well within the company’s reach in 3 to 5 years ahead. Healthy increases in ad revenues, driven by healthy increases in paid clicks and further improvement in cost-per-click, should underpin the progress. Too, the company will likely continue to expand its offerings in other areas, such as mobile, via its Android platform.
Google stock has been among the Internet issues enjoying stronger support from investors of late. Its share price has risen about 23% year to date, including 17% over the past six weeks. The company’s recent operating results appear to have eased concerns about its ability to monetize the mobile advertising market, which is growing in importance with the proliferation of smartphones and similar devices. At the current valuation, GOOG stock trades at more than twenty times estimated earnings for 2013. This is quite typical of an Internet equity, but still represents a sizable premium to the broader market (median P/E: 17.5x). With this in mind, investors focusing on total return potential to 2016-2018 may wish to wait on the sidelines until a more attractive entry point emerges.
Another stock that has contributed to the Internet industry’s prominent place among the best-performing industries over the past six weeks is Netflix, Inc (NFLX). The company operates the largest online entertainment subscription service in the United States, with over 100,000 DVD titles for rental. Its various subscription plans allow users to stream movies or rent DVDs, with no due dates or late fees.
Netflix shareholders have endured quite a roller coaster ride in recent years. Support for the stock collapsed in the second half of 2011, but investors began flocking back last summer. In all, the share price has more than tripled over the past nine months, including a 40% advance in the past six weeks. The company has benefited from improvements in content, in the way it processes payments, and in the recovery of its brand. Netflix has posted healthy top-line advances in recent quarters, on solid growth in domestic and international streaming membership. The bottom line should also rebound nicely in 2013, though full-year share net, estimated at $1.20 a share, figures to still fall well short of the 2011 peak of more than $4.00.
Despite the recent positive strides, the company still faces considerable challenges ahead. Costs associated with international expansion will probably pressure profit margins in the near term. Netflix is using income from its domestic business to fund international expansion. This strategy of prioritizing long-term gains over short-term profitability may well pay off in time, but it creates uncertainty in the near term. Moreover, the company operates in a highly competitive market that is subject to rapid technological change. Barriers to entry for the increasingly important streaming business are relatively few, as well, which could bring more rivals into the fray over time.
Overall, NFLX stock appears best suited for momentum investors. Long-term investors will need to proceed cautiously. We do anticipate revenues will continue to climb at a healthy clip in the years ahead, with annual earnings reaching $6.00 a share by the 2016-2018 timeframe. That said, our view of the future remains somewhat tentative, given the risks to the business model cited above. Moreover, the equity’s valuation is very rich following its extended run-up, leaving it with limited appreciation potential for the next 3 to 5 years, in our view.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.