What If The Economy's Better Than You Think?

Includes: HITK, LXK, SAN, SWI, TX
by: John P. Reese

The European banking crisis, sluggish recent U.S. growth, a burgeoning deficit and national debt -- investors have had a lot of troubling issues on their minds lately. And they should; all of those are serious issues that should cause concern. But at the same time, some significant positive signs have also been popping up -- and going largely unnoticed. Retail and food service sales are 7.2% above their year-ago levels; consumers are saving twice as much as they were heading into the "Great Recession,", and are carrying their lightest debt loads since 1994; the service sector expanded at a healthy rate in August, and, while manufacturing growth decelerated, it was still positive despite all of the turmoil last month, the Institute for Supply Management recently reported.

Investors are focusing primarily on the negatives, however, which isn't surprising given that the wounds of the 2008-09 financial crisis and market collapse are still fresh. Having been burned badly, they are going to be skeptical of positive signs and seize on the negatives. Friday, for example, they collectively ignored the president's $447 billion jobs plan (which should have concrete fundamental benefits for the economy), choosing instead to speculate that the resignation of a top European Central Bank official means terrible things for the global economy.

Now, before you paint me a Pollyanna, understand that I'm certainly not saying everything is rosy. As I noted, the economy is struggling with several issues that must be addressed. What I am saying, however, is that the raw, hard data indicates that there is a very real chance that the economy is in better shape than many believe. And if the current fears turn out to be overblown and we see better-than-expected growth in the coming months, you don't want your portfolio to be completely devoid of the types of stocks -- cyclicals and smaller growth plays come to mind -- that would get a big boost. With that in mind, let's look at a handful of cyclicals and smaller growth plays that my Guru Strategies -- each of which is based on the approach of a different investing great -- are high on. These types of stocks could add some nice upside to a diversified portfolio.

Ternium S.A. (NYSE:TX): Ternium is a Luxembourg-based steel company. About 57% of its sales are generated in North America, and about 41% in Latin America. In the past year, the $5-billion-market-cap firm has taken in $8.3 billion in sales.

Ternium gets strong interest from my Kenneth Fisher-based strategy. Fisher pioneered the use of the price/sales ratio (PSR) as a value metric, and for cyclicals like Ternium, this model targets firms with PSRs between 0.4 and 0.8. At 0.56, Ternium makes the grade. A few other reasons the Fisher-based approach likes Ternium: It has a reasonable 33% debt/equity ratio; 10.5% three-year average net profit margins; and an inflation-adjusted earnings per share growth rate of more than 27% over the long term (using an average of the 3- and 4-year EPS growth rates).

Lexmark International, Inc. (NYSE:LXK): Lexington, Ky.-based Lexmark sells printing and imaging products and services in more than 170 countries. In the past 12 months it has taken in $4.2 billion in sales.

Lexmark gets strong interest from my David Dreman-based contrarian model. Dreman focused on beaten-down stocks whose fundamentals indicated they were too beaten-down. This strategy considers Lexmark ($2.4 billion market cap) a contrarian play because both its price/earnings and price/cash flow ratios fall into the market's bottom 20%. Given that it has a 2.1 this approach thinks it should be getting more love. An upside surprise for the economy could spur business spending and make that happen.

SolarWinds, Inc. (NYSE:SWI): Don't be fooled by the name -- SolarWinds is in the information/technology business, not the energy sector. The Austin, Tex.-based company provides a wide array of I/T services to more than 90,000 customers worldwide, including more than 85% of Fortune 500 companies.

Solar Winds took a bit of a hit today on an analyst downgrade, but my Martin Zweig-based growth model is very high on the $1.7-billion-market-cap stock. It looks at earnings growth from a variety of angles, and SolarWinds impresses on all fronts. The firm has grown EPS at an impressive 27.4% rate over the long term (using an average of the three-, four-, and five-year EPS growth rates), for example, and that growth accelerated to 63.6% in the most recent quarter (vs. the year-ago quarter). It's also getting its growth from revenue -- not one-time cost-cutting measures -- as revenue has grown at a 38.8% rate over the long term. Another plus: SolarWinds has no long-term debt.

Banco Santander, S.A. (STD): A Spanish financial -- sounds dangerous, no? Well, Santander seems to carry less risk than you might think. It's based in Spain, but does a substantial part of its business in the emerging, growth-rich markets of Latin America. In the first half of 2011, it got slightly more than 50% of its net operating income from Latin America, where it has more employees than it does in continental Europe and the U.K. combined. That diversity has helped Santander post far steadier profits than many of the big European banks in recent years.

Santander was also one of the highest-ranking banks on the 2011 European stress tests. Still, investors have shunned it due to the macroeconomic fears surrounding Europe. The stock trades for just 5.9 times trailing 12-month earnings and 1.06 times trailing 12-month sales -- and it offers a whopping dividend yield of 11.4%. That big yield is one of the reasons my James O'Shaughnessy-based value model is high on Santander. This approach likes large firms with strong cash flows and high dividend yields. Santander ($61 billion market cap, $41 billion in annual revenues) is certainly big enough and has a high enough yield. It's also producing $1.84 in cash flow per share, 37% more than the market average, so it makes the grade.

Hi-Tech Pharmacal Co. (NASDAQ:HITK): This three-decade-old specialty pharma firm focuses on difficult-to-manufacture liquid and semi-solid dosage forms, and manufactures a range of sterile ophthalmic, otic and inhalation products. It's also a leader in over-the-counter and nutritional products targeted at diabetics.

Amityville, N.Y.-based Hi-Tech ($380 million market cap) gets high marks from three of my models. The strategy I base on the writings of hedge fund guru Joel Greenblatt likes its 22.6% earnings yield and 54.8% return on capital. The model I base on the approach of Motley Fool creators Tom and David Gardner likes its strong recent earnings and sales growth (59% and 43%, respectively, in the most recent quarter vs. the year-ago quarter); its tiny 0.34% long-term debt/equity ratio; and its combination of hot (relative strength of 90) but cheap (0.18 P/E-to-growth ratio) shares. Finally, my Momentum Investor model also likes Hi-Tech's strong recent earnings growth and momentum, as well as its 23.6% return on equity and its position in a top-performing industry (biotech & drugs).

Disclosure: I am long TX, SWI, LXK, HITK, STD.