The Linchpin For Growth

Union Heritage's Derek Batts relies on return on equity for portfolio performance

Over the last two years, the growth economy of the ’90s has been replaced by a bear market that has gnashed its way through stocks and left investors reeling. Enthusiasm for the equity markets has slowed and company profits are sluggish at best.

Through it all, institutional portfolio manager Derek Batts’ view of stocks has remained steady. His aim has always been to find companies with growth that sells at a discount to the market. Batts says he starts weeding out the market by homing in on shares that sell at a price-to-earnings (P/E) ratio between 20% and 30% below the industry’s. To narrow the list further, he only focuses on companies that have a return on equity (ROE) that is favorable. With the S&P 500′s ROE currently at a little more than 20%, the money manager believes companies with a ROE of at least 30% have the ability to outperform the market. As a measure of how well a company’s management is putting resources to use to generate profits, ROE is something Batts says is a linchpin to future growth.

Batts is a 13-year veteran with the Detroit institutional management firm Union Heritage, a firm that supervises assets in excess of $150 million for institutional clients. Over the last five years, Union has solidly outshone the market. At the end of the third quarter, the firm logged an average annual return of -2.1% over the previous three years, far better than the S&P 500′s average loss of 12.9%. Over the five-year period ending Sept. 30, 2002, Union’s 3.3% average annual return beat the S&P 500′s -1.6% return for the same period.

Overall, Batts remains “cautiously optimistic” about the market. “If you look in the right places, there are good values,” he says. “You have to keep your sights on growth that is selling at a reasonable price, but there are a handful of stocks out there that fit the profile.”

For his Private Screening, Batts likes two pharmaceutical companies. First, Abbott Labs (NYSE: ABT) boasts an ROE of 35%, thanks to a pipeline of best-selling medications. Abbott’s prostate treatment Flomax, and the company’s anti-AIDS therapy Kaletra, should help fuel growth in the years ahead.

Barr Laboratories (NYSE: BRL) makes its impact in generic drugs and discount pharmaceuticals brought to market when the patents for mainstream pharmaceuticals expire. A tight reign on expenses, says Batts, has helped Barr keep its ROE hovering near 40%.

Batts likes hometown automaker General Motors (NYSE: GM) although it’s ROE is about the same as the broad market’s. GM’s low P/E of seven, as well as the stock’s lofty 5% dividend yield caught Batts’ attention. The money manager also likes the prospects for Plantronics (NYSE: PLT), an outfit that produces headsets for mobile telephones. He says consumers are likely to keep demand stoked for Plantronics’ wares, and recent legislation restricting the use of mobile phones while driving will allow the company to offer hands-free devices as an alternative.

Batts’ final pick, National City Corp. (NYSE: NCC), is a regional bank with

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