Five Service Stocks that Pass the Strategies of Market Legends

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Over the past several decades, America has shifted consistently and dramatically toward being a service-dominated economy. Fifty years ago, 59% of U.S. private jobs came from the service sector, with 41% from the goods-producing sector; by 1981, the gap had grown to 67.8% for the service sector vs. 32.2% for the goods-producing sector; by 1991, it had shifted even further, with about 75% of U.S. jobs coming from service sector and 25% from the goods-producing sector.

Today, 83.4% of America's private jobs are service-oriented. We rely less on people buying our cars and appliances and clothing made in America, and more on people using our cable, phone, and Internet services; shopping at stores that sell goods made elsewhere; using healthcare services like doctors and nursing homes and rehabilitation centers; and needing transportation services to move products imported from other countries.

That means service-type companies, and the service sector as a whole, have become the real bellwethers of U.S. economic activity. And lately, if you listen to the pundits, you'd think that the service sector is in dire straits, with fears of another recession -- or worse -- having dominated the headlines for the past couple months.

But guess what? The real, hard data from the service sector hasn't been that bad. In fact, some of it has been downright good. According to the Institute for Supply Management, the service sector has expanded for 21 straight months. And in August -- a month when fear seemed to be everywhere -- the sector not only expanded, but did so at a faster pace than it did in July.

Of course, the service sector depends quite a bit on the U.S. consumer -- and, for more than two years now, we've been hearing how the U.S. consumer is overleveraged and tapped out. Fortunately, the data doesn't support that notion. The latest retail and food service sales figures were flat in August, but year-to-date they are more than 8% ahead of last year's pace. And here's something few commentators are mentioning: Americans' "financial obligations ratio" -- that is, their amount of debt as a percentage of disposable income -- was 18.85% in the third quarter of 2007, right before the "Great Recession" began. The Federal Reserve's web site has data going back to 1980, and that was the highest level on record. But by last quarter, the figure had fallen to 16.39% -- the lowest level since the fourth quarter of 1993.

Of course, none of that seems to matter to most investors right now. They've been overwhelmed by European debt and double-dip recession hype. And that's created a lot of bargains among shares of strong service sector companies. Recently I used my Guru Strategies -- each of which is based on the approach of a different investing great -- to find some of the most attractive. Here are some of the best of the bunch.

AT&T Inc. ( T ): This Dallas-based telecom giant ($165 billion market cap) was already one of the largest companies in the world before its recent purchase of T-Mobile, which would make it the largest wireless company in the U.S. The deal may fall through under regulatory scrutiny, but AT&T is still a power, having taken in $126 billion in sales in the past year.

That size is part of why my James O'Shaughnessy-based value model likes AT&T. Two more reasons: AT&T is producing $6.55 in cash flow per share, nearly five times the market mean ($1.33), and it's paying a 6.1% dividend yield.

MarketAxess Holdings Inc. ( MKTX ): New York City-based MarketAxess operates an electronic trading platform that lets investment industry professionals trade corporate bonds and other fixed-income instruments. It has a $1 billion market cap.

MarketAxess gets high marks from my Peter Lynch-inspired strategy, which considers the stock a "fast-grower" -- Lynch's favorite type of investment -- thanks to its 38.7% long-term earnings-per-share growth rate. (I use an average of the three-, four-, and five-year EPS growth rates to determine a long-term rate.) Lynch famously used the P/E/Growth ratio to find bargain-priced growth stocks. When we divide MarketAxess's 25.1 price/earnings ratio by that long-term growth rate, we get a P/E/G of 0.65, which easily comes in under the model's 1.0 upper limit.

MarketAxess also gets solid marks from the small-cap growth approach that I base on the writings of Motley Fool creators Tom and David Gardner. This approach has been my best performer since its inception more than eight years ago, generating annualized returns of nearly 15%. It likes MarketAxess' strong and improving profit margins, which reached 21.5% this year. It also likes the stock's 91 relative strength, and its strong recent growth -- earnings grew 66.7% in the most recent quarter while sales grew 29.6% (vs. the year-ago quarter).

LHC Group, Inc. ( LHCG ): Louisiana-based LHC offers home health, hospice, private duty and long-term acute care service to the elderly and other homebound patients. I wrote about this small-cap ($300 million) about six months ago, and, like many other companies in its industry, it's been hit hard since. But two of my top-performing models think it's being treated unfairly.

One is my Benjamin Graham-inspired model. Graham, known as the "Father of Value Investing", was a very conservative investor, and this approach looks for companies with good liquidity (current ratio of at least 2.0) and a strong balance sheet (long-term debt should not exceed net current assets). LHC has a 2.4 current ratio, and about $70 million in net current assets vs. zero long-term debt. It also trades for just 7.2 times three-year average earnings, and just 1.03 times book value.

My Joel Greenblatt-based model also likes LHC, thanks to its 27.5% earnings yield and 80.5% return on capital. Together, those figures make LHC the 5th-most-attractive stock in the market, according to the Greenblatt-based approach.

Dollar Tree, Inc. ( DLTR ): Based in Virginia, Dollar Tree's stores offer a wide variety of discount merchandise, ranging from food items to household goods to toys to yard-care products. It has a market cap of about $9 billion, and has taken in more than $6 billion in sales in the past year.

Dollar Tree gets strong interest from my Lynch-based model, thanks to its 26.7% long-term EPS growth rate and 0.77 P/E/G ratio. My O'Shaughnessy-based growth approach also likes the stock. It looks for firms that have upped EPS in each year of the past half-decade (which Dollar Tree has done), and which have high relative strengths and low price/sales ratios. Dollar Tree (92 relative strength) fits the bill, though its 1.45 P/S ratio just makes the grade.

Advance Auto Parts ( AAP ): Virginia-based Advance Auto ($4.4 billion market cap) is an aftermarket retailer of auto parts. It has more than 3,500 stores across 39 states and some U.S. territories.

Like Dollar Tree, Advance Auto is a favorite of my O'Shaughnessy growth- and Lynch-based models. The O'Shaughnessy approach likes its history of increasing EPS (it's done so each year of the past decade) and 0.72 price/sales ratio. The Lynch approach, meanwhile, considers the it a "stalwart" -- the type of steady, solid firm that Lynch found holds up well in downturns -- because of its $6 billion in annual sales and moderate 16.4% long-term growth rate. It likes Advance Auto's 0.79 P/E/G ratio, a sign the stock is selling on the cheap.

I'm long T, MKTX, LHCG, and DLTR.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: AAP , DLTR , LHCG , MKTX , T

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