McQuilling interview
COLVIN: It only happens once a year: FORTUNE names its new team of All-Star Analysts. Our program this time is all about them and their stock picks because the record shows they can make you money. The bitter truth about analysts, incredible as it seems, is that the vast majority would help investors most by taking a vow of silence. Last year, for example, the Nasdaq was up 50 percent, the S&P rose 26 percent, but the median Wall Street analyst's portfolio gained just 11 percent -- before commissions. In virtually every market subsector, listening to the analysts would have left you worse off than simply holding all the stocks in the group.
But the FORTUNE All-Star Analysts are in a different league. Their picks last year, which we reported to you, have once again beaten the market. The S&P was up 21 percent over the past 12 months, while the FORTUNE All-Stars' picks were up 32 percent on average.
We'll speak with two of this year's All-Stars in depth, and get the top picks of several more, including the company that's about to become America's largest managed-care provider; a gold play; and a computer maker that's way out of favor.
Arguably the star of the All-Stars is Andrew McQuilling of UBS, a rare three-peat on the list. He covers household products companies, and his picks last year once again trounced those of the average analyst in his sector.
COLVIN: Andrew, you have a reputation for liking stocks that everyone else seems to despise, and your current top pick is true to form. Weight Watchers is getting hammered by this Atkins diet mania. So how come you like it?
McQUILLING: That's pretty much the reason. 2003 was the year of the Atkins diet, and it really came out of nowhere in multiple forms, Atkins, the South Beach diet, the Zone diet.
COLVIN: All low-carb diets.
McQUILLING: All low-carb diets. This is a phenomenon that's happened before. In the last 30, 35 years, Weight Watchers has been impacted by four major diet events. The first was the Atkins diet in 1973.
COLVIN: Right. The same Atkins diet as today, but that's when it first appeared.
McQUILLING: And then disappeared for 30 years and has made a reappearance in 2003. In 1982, the Cambridge diet. And 1993 was the Fen-Phen diet supplement event. And so really this has happened before.
But Weight Watchers as a company is very unique. Since 1977 the company has compounded sales and profits at a 13 and 14 percent rate over 25 years since Jimmy Carter was president.
COLVIN: An incredible record over that length of time.
McQUILLING: Probably one of the only companies that's ever grown that quickly for such a long period of time. And the beauty of this one, we think they'll survive the low-carb frenzy in 2003 and 2004.
COLVIN: Now supposedly they have a big plan in the works for August, but it's kind of mysterious. Do you have any idea what they have in mind?
McQUILLING: All very hush-hush, so I'd have to speculate.
COLVIN: Yes.
McQUILLING: But what I have heard from franchisees and from other industry insiders is that they're very excited about the prospects for it, so I won't hazard a guess, but at least the people that are insiders and involved with the business are excited about the new diet's prospects.
COLVIN: And so your theory is that people will tire of the Atkins low-carb mania, as they have tired of all the other fads, and when they do, they'll come back to Weight Watchers. But why do you think they will tire of Atkins? It seems to be working for a lot of people.
McQUILLING: There is a lot of media. There's a lot of support right now for Atkins, and the food companies are now launching a number of low-carb food products. So the press will be on the side of the low-carb diet for another six months or so. What is encouraging, though, we found a data vendor that actually tracks the number of dieters, and the...
COLVIN: In the United States.
McQUILLING: In the United States, and the specific diets that they're on. What we found very encouraging is that the number, which perhaps there were maybe 1 million low-carb dieters in late 2002, the number hit 10 million in August '03, and reached a high of 20, 21 million in January 2004. But since then, the numbers since January 30th have dropped nicely, down about 20, 25 percent, to about a 14, 15 million pace.
COLVIN: And do you think it's because people have achieved their goals? Or is it because they find that living on the Atkins diet is not something they want to do?
McQUILLING: That's the key thing. So we also, we did some in-depth consumer surveys of women and discovered some shocking statistics. In mid-February, 50 percent of all the women in America who were dieting were already on a low-carb diet. Of those dieters 73 percent couldn't sustain the diet for more than 8 to 12 weeks.
COLVIN: So you like it at today's low price.
McQUILLING: Yes, and the key event will be the launch of the new diet late August or early September.
COLVIN: Another company you cover is Gillette.
Now it's rare that a single company or a single product can make a big difference to these big consumer products companies, but this may not be the case with this. This could make a big difference to Gillette. This is the M3 Power razor, which looks like one of their regular razors, but if you push the button -- maybe if I hold it right next to the microphone people can hear -- it's buzzing because it's vibrating. Now you've used this product; I have not. Why on earth do you want a razor that vibrates?
McQUILLING: It sounds so improbable, it has to work. Now Gillette really does know what they're doing. The beauty of the product is it vibrates at an amplitude and frequency that will make your hair stand on end.
COLVIN: Literally make your hair stand on end.
McQUILLING: And, you know, stand up to be cut.
COLVIN: Right.
McQUILLING: And I guess everyone needs to learn how to use it, so my first day I was a little nervous. But after about a week, I am addicted. And the beauty of it is you have to go very slowly with it. It's essentially like mowing the lawn, but it's a wonderful shave.
COLVIN: And so they charge you a lot for this handle. They charge even more for these cartridges, right? Than for the normal Mach 3 razor cartridges, and they seem to have big expectations.
McQUILLING: The beauty of Gillette as a stock is the company gives no sales and earnings guidance, so the expectations are really only ours.
COLVIN: They're your expectations, right. But of course the other beauty of this, Gillette owns the Duracell battery business, right? And so here is a razor from Gillette that has a Duracell battery inside it.
McQUILLING: And it all helps, it all helps the business.
COLVIN: It all helps. So this could make a significant difference to Gillette. Do you like the stock?
McQUILLING: Yes, I do. Yes, I do. This was my pick for FORTUNE last year about this time.
COLVIN: You do follow other consumer products companies, and we have some of those other consumer products here. Let's take a look. Now this one, the Mr. Clean Magic Eraser from Procter & Gamble. This is the most amazing thing I've ever heard about. How does this thing work?
McQUILLING: Well, the funny bit is this may not have much of an impact on Procter & Gamble, a $47 billion company. What happens is it will actually trap the stains, whether they're crayon or other marks, scuff marks on the walls. It will trap them in the material and take them off the walls, and it's really a wonderful product and it's a lot of fun. I have a two year old and a five year old...
COLVIN: So you use plenty of these.
McQUILLING: Yeah, we go through a box every two weeks.
COLVIN: And a box costs $5, right?
McQUILLING: Yes, it does.
(Note: UBS has a financial relationship with Procter & Gamble and Gillette)
COLVIN: Yeah, nice business, too. Here are a couple of products from the Clorox company. Now this one, the Clorox Bleach pen. It looks like a wide-tip marker or highlighter, except it's bleach inside. What's the story?
McQUILLING: Well, the story here is Clorox is a much smaller company than Procter & Gamble, and the bleach pen and the other product shown, the Glad...
COLVIN: This is a new kind of Glad wrap. People maybe didn't realize this comes from the Clorox Company, but it does.
McQUILLING: Yeah, and Clorox owns the Glad brand. And these two products alone can contribute two to three points to Clorox's volume growth over the next four quarters, which is quite significant for a staple business. The beauty of the bleach pen, who knew you needed it? But they're selling about 50 million at retail.
COLVIN: $50 million?
McQUILLING: $50 million in the U.S. at retail on a run rate. And these two can have a meaningful impact on a small company, Clorox, which is trading near market multiple. Another stock we like.
(Note: McQuilling and/or his family owns Clorox stock)
COLVIN: A lot of these consumer products companies that you cover operate internationally. Now the dollar's been very weak lately. What does that mean for these and for the stocks?
McQUILLING: It's actually very helpful, because the background broadly for my space is quite good. In the mature markets, the U.S., Europe and Japan, there's very healthy new product activity out of the U.S. domiciled staples. And for the first time really since 1997, we're seeing a broad recovery in emerging markets -- in Asia first, and increasingly in Latin America where these companies are quite large. And with an emerging market recovery, healthy, mature markets and the declining dollar, since overseas profits have to be translated back into U.S. dollars, it's actually quite a good economic backdrop for my companies, for their earnings.
COLVIN: Andrew McQuilling, thank you so much.
McQUILLING: Geoff, thank you for having me.
Housing
GIBBS: Well, here's another interesting stock idea: home builders. They've enjoyed a stellar performance over the past few years as mortgage rates hit rock bottom. But now that rates are rising, you'd expect analysts to turn cautious on the industry. But one company appears to be bucking conventional wisdom by giving home buyers what they want.
Paul Puryear, the All-Star real estate analyst for Raymond James, ranks Toll Brothers as his top choice. He joins us from Cincinnati. Sarah Susanka, an architect and author, says quality is more important than quantity when considering homeowners' needs. She joins us from Chicago.
Well, Paul, what's so attractive about Toll Brothers?
PAUL PURYEAR: Well, they're focused on the high end market. We have seen a shift in the buyer lately, because rising interest rates put more pressure on the lower price buyer.
So in a builder like Toll Brothers, about 50 percent of the buyers are paying cash. So, you know, again it's more leveraged to the improving economy and not as much dependence upon the mortgage market. And it's exactly the opposite as you move down the price point scale.
GIBBS: Well, Paul, historically we do see that housing stocks, whether the low end or the high end, start under performing the overall market when rates rise. It may be a lag of anywhere from 6 to 12 months, but they do get hurt in that scenario.
PURYEAR: They do get hurt, and in fact we have been extremely bullish on the sector, really since December of 2001. We actually first upgraded the stocks in the middle of 2000 when rates turned down and the Fed started to lower rates pretty substantially. We three weeks ago changed that call. We're more cautious on the sector now. We cover eight homebuilders. We downgraded all eight of the stocks, although we still have a buy on four companies that are focused on the higher end or active adult buyer, because that end of the market we think is going to continue to do well in this economy. At the lower end of the spectrum, the lower price point, those builders are going to start to feel some pressure.
GIBBS: You mentioned the four companies. What four companies are they?
PURYEAR: Toll Brothers, WCI, Pulte Homes -- and Pulte Homes largely because they are focused on the active adult with their Del Webb subsidiary, and we expect the active adult market to continue to be very strong. Those buyers typically pay 50 percent cash, so they're not nearly as interest rate sensitive. And Levitt, a new entrant into the public market, a Florida company which is focused almost exclusively on active adult, and again we think that market will continue to do well.
But specifically in the case of Toll Brothers, their average home sale is about $550,000, so at the higher price points, again, we think the market is actually gaining some strength here.
GIBBS: Well, earlier this week I had a chance to visit a Toll Brothers model home. Let's take a look.
(Video clip begins)
JOEL RASSMAN, Toll Brothers: Karen, if you walk around the Toll Brothers home, you'll see lots of touches to make you think about what it's like to live in a Toll Brothers home. We design houses for different kinds of customers. This is a move up home. This is a home for a family that generally has had two other houses or maybe three other houses before the family is just probably a little bit older.
GIBBS: What is the average age there?
RASSMAN: Roughly around 40 years old is the average age of a buyer in this community. And they generally will have children who are probably in just about their teen years or getting to their teen years. And the setup of this house enhances the lifestyle of a family, a 40-year-old father and mother.
GIBBS: What are you other customers like?
RASSMAN: We have products that are designed for customers who are in their 50s. Generally we call them empty nester homes. And they often have a master bedroom downstairs, all of the guest bedrooms upstairs, and often have a playroom upstairs so that when grandchildren come they don't mess up where you live. They mess up where no one sees it.
And we also have homes that cater to the active adult, which is a slightly older clientele, which is generally over 60. And the active adult and the empty nester homes often have amenities associated with them, so they'll have golf clubs or marinas, club houses to entertain with so that you don't always have to entertain in your own home. You can entertain in someone else's location and they can clean up for you. So, lifestyle is very important to a Toll Brothers customer whether it's a move up house, or an empty nester home, or an active adult home, or in fact our newer product lines which includes second homes or urban in-fill luxury homes.
GIBBS: How do you find out what a customer wants?
JOEL: We do a tremendous amount of survey work.
This is the living room, and as you can see the living room is smaller than old living rooms used to be. And today we have conservatory additions and large family rooms. We learned that people like to entertain in a very comfortable setting and like to have free flow traffic so you can walk in and out of rooms without a lot of barriers.
We've found over time that customers sometimes talk about what they want, but when you offer it to them, they don't always select it. So when we had a very big energy crisis about 20 years ago, everybody claimed that they wanted to have energy efficient homes, but when you put it as an option, very few people were willing to pay for an energy efficient home. But they pay for molding and they pay for lifestyle.
(video clip ends)
GIBBS: Sarah, are home buyers really able to articulate and get what they really want?
SARAH SUSANKA: Well, that's a great question. I, as an architect serving the residential marketplace for 20 years, realized that a lot of people have a sense of what they want, but they only can describe it in terms of what they've seen before. And so I would often, when I was working with a customer, sit across the table from them and they'd be telling me what rooms they needed, and I started to hear that a lot of things they wanted were actually for resale. They weren't (wanted by customers) because they used them.
And so I gradually started realizing that what people needed was a different footprint, a different blueprint basically for the way that we actually live today. And in some ways, what we just saw from Toll Brothers was the beginnings of an understanding of that.
The family room has become the main living space, and the formal living room is atrophying. It's basically what I call the no living room in many, many houses. So what I always suggest to people is build the rooms that you use every day, and if you use a room less than four or five times a year, consider leaving it off and using those dollars instead to personalize the space that you really love and the place that you really live.
GIBBS: Sarah, the house that we just looked at that I visited had about 6,000 square feet. Are you saying that we really don't need that much space?
SUSANKA: Well, I'm saying that for a lot of people, if they could see an option that allowed them to have a sense of spaciousness but not necessarily that much square footage, space that's really tailored to the way that they actually live, they might be able to be much more comfortable. In that case, a family that lived in that house might perhaps build 3,000 to 4,000 square feet and find that it lived just as large.
GIBBS: Paul, what do you think about that illusion-versus-lifestyle issue?
PURYEAR: Well, we're seeing it from the production builders. And it's kind of hard to describe Toll Brothers as a production builder because they offer so many options and ways to personalize the home, but they're probably at the leading edge of that trend.
But we're clearly seeing more focus on space utilization: Fewer floor-to-ceiling walls, so the ceiling is open; cathedral ceilings; fewer living rooms and formal dining rooms. So it's a trend that we're seeing, and the builders are adapting, but by the same token, they're building for the most part for the masses, so it's difficult to come with an approach that allows them to customize each home and to continue to gain the benefits of mass production.
SUSANKA: Paul, one of the things that I wanted to interject here is that I think that what a lot of people need is some language to describe some of the things that they like in a home, and we don't. We have a real dearth of that in our culture. So actually some of the books that I've written have started to give some names to qualities and character space that when people see it they go, oh yeah, I want that. And so I think what the production market is actually going to start moving into what I call a more tailored interior. They're making some of the beginning steps, but I think there's a lot more that will happen over the next 10, 20 years.
GIBBS: Sarah, can you give us some examples on that, expand upon that thought?
SUSANKA: Sure. I'll give you a couple of different options. One is what I call ceiling height variety. We're as a culture today in love with the tall ceiling, and in fact you'll often see real estate ads that talk about tall ceilings, cathedral ceilings. Well, that's all very well, but for a lot of people that's too big. It's nice if you've got 30 people over for a party, but when it's just you and your husband or wife sitting in that living room, it can feel somewhat overwhelming.
So what I talk about is the need for contrast, that you can have some smaller spaces or lower spaces that make you feel comfortable in contrast to some of the taller areas. And in combination, they feel much more comfortable. It's a much more livable environment.
GIBBS: Interesting that you mention that, because cathedral ceilings, although they're quite the rage, they're not very energy efficient, and they certainly carry noise through. So, Sara, how come we haven't seen the use of technology really push smart houses to the forefront?
SUSANKA: Well, you know, as with any change, it's coming gradually. I'm a huge advocate for energy efficiency and sustainable construction, and I think that we're beginning to see how to employ those ideas in mass market housing, but it's a gradual process. First of all, we have to have easy access to the materials that are sustainable, understanding of what makes for an energy-efficient house, and then gradually people start to ask for those features. And my belief is they need to be seamlessly integrated into the house.
GIBBS: Sarah Susanka, Paul Puryear, thank you very much for joining us.
SUSANKA: Thank you.
PURYEAR: Thank you.
Rynecki interview
COLVIN: So now we know which stocks Paul Puryear and Andrew McQuilling like, but how about the rest of the All-Star Analysts? If their picks are nearly as good as in past years, we're looking at another market-beating portfolio.
The man who identified the All-Stars is my FORTUNE magazine colleague David Rynecki, who joins us from New York. David, I noticed that at least a couple of these other picks are both in the health care industry, though widely different parts of it. What are they?
RYNECKI: One is called Anthem. It was the pick of Tom Carroll, who is an analyst at Legg Mason. Tom picked Anthem because he feels the money's going to be made in managed care in the next few years.
Seattle Genetics is a biotech company. It comes to us from Jason Kantor who is an analyst at Hambrecht and Company. Jason likes this company for reasons that have some long-term appeal but some short-term risk. Seattle Genetics doesn't have any products yet, but it is developing drugs that will attack cancer tumors. If it brings those drugs to market -- and that's a big if -- then that could be a big winner for investors.
COLVIN: David, one of the companies on this list is Lear, which I gather makes the insides of automobiles. Is that right?
RYNECKI: Exactly. Lear was the pick from Morgan Stanley analyst Stephen Girsky. What Lear does is it makes the heated seating systems, all the things that make your car look so nice. It turns out that what's inside the car is what matters the most.
COLVIN: And tell us about EADS, the big European company that's the parent of Airbus.
RYNECKI: Joe Campbell, an analyst from Lehman Brothers, likes this stock above all others. EADS is coming out with a 555-seat jumbo jet that's going to go head on against Boeing.
COLVIN: We have two financial services companies in this group. What are they?
RYNECKI: Bank of America, Chris Blum, who is an analyst at Edward Jones, a St. Louis based company, a very decent firm. He likes the diversity of this company. As the economy rises, it will gain, but also as interest rates rise, it won't be as hurt as, say, some of your smaller banks that are much too dependent on lending money.
COLVIN: And then Prudential Financial. Is this a demographic play?
RYNECKI: It absolutely is. That came to us from Colin Devine, who is from Smith Barney. Colin picked Prudential last year -- he did great with it -- and he's picking it again because of 77 million baby boomers who are retiring. They need to know that their money is not going to disappear like it did disappear in 2000, 2001, 2002.
COLVIN: Now part of the art of picking these stocks is having the courage to pick a stock that is out of favor, but Sun Microsystems strikes me as going out pretty far on a limb.
RYNECKI: I think it's about as far as you can get. This is a company that a lot of people think won't exist for much longer. The exception is Richard Chu, who is an analyst at S.G. Cowen. What Richard figures is that Sun does have a decent product. It is selling that product. It's a risky bet, but it's also one of those things that could play out very well.
COLVIN: Another risky bet is Newmont Mining, a gold play.
RYNECKI: Yes. Michael Dudas, who is an analyst at Bear Stearns, he thinks that Newmont is a play on inflation and the recovering economy.
COLVIN: David Rynecki, thank you. Next week we will probe deeper into why gold stocks shine so brightly in the estimation of All-Star analyst Michael Dudas.
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