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Invest in innovation — 5 stock picks

  • By Paul R. La Monica,
  • CNNMoney.com
  • – 01/21/2014
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Investing in the cutting edge is inherently risky. But these five firms — either technology companies working on breakthoughs or mature businesses benefiting from new trends — are best positioned to turn innovation into profits.

3D Systems

"Printing" objects out of thin air

The idea of being able to replicate an actual three-dimensional solid object from a digital model used to be something straight out of Star Trek. Today 3D printers aren't just real, they can be found at your neighborhood FedEx (FDX) or UPS (UPS) Store to create anything from tools to models to parts. McDonald's (MCD) is even considering using 3D printers to build Happy Meal toys on site.

The hope is that soon you, too, may want a 3D printer in your home.

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That is where 3D Systems (DDD) comes in. This South Carolina company has a leg up on competitors such as Stratasys (SSYS), ExOne (XONE), and Germany's Voxeljet (VJET) because it not only offers high-end devices marketed to manufacturing giants like General Electric (GE), but also sells affordable, mass-market printers, says Sandy Villere, who owns the stock in both the Villere Balanced Fund (VILLX) and the Villere Equity Fund (VLEQX).

Those printers, marketed under the Cube brand, aren't cheap. The devices go for nearly $1,300 at retailers such as Amazon, Staples, and Office Depot. And that's not factoring in the cost of the cartridges with the materials required to fabricate your objects.

As with all consumer technology, the price is expected to decline quickly as adoption grows. Last year 3D systems sold roughly 24,000 printers, up from 5,300 units in 2012, according to Bank of America Merrill Lynch analyst Wamsi Mohan. "When you look forward, I really don't think it's a question of if people will have 3D printers in the home. It's whether it will be in the garage or the kitchen," Villere says.

The big risk: Competition is heating up. Rival Stratasys recently acquired MakerBot, a hot 3D printing startup with a strong consumer business. Plus, HP (HPQ) is even thinking of jumping in.

Also, this stock trades at a P/E of more than 60, based on 2014 estimated earnings. With a valuation that high, volatility is a given. For example, after the stock hit an all-time high in mid-November, it plunged 20% in just two days.

Why it's a buy: Villere notes that profits are expected to rise 25% a year for the next few years. Part of the company's secret is an old-fashioned razor-and-blade model. The big profits — with margins as high as 75% — are in the cartridges needed for printing. (By comparison, margins on the printers themselves are about 45%.) Wisely, 3D Systems switched over to proprietary materials a few years back.

Gilead Sciences

Fighting infectious diseases one new pill at a time

A decade ago patients with HIV, the virus that causes AIDS, often took a cocktail of different drugs to manage their illness. In recent years this giant biotechnology company has come to market with three single-tablet medications to keep the disease in check: Atripla, Complera, and Stribild. The last of those treatments was approved by the Food and Drug Administration in 2012.

"These drugs make it easier for HIV patients to adhere to the regime," says John Barr, manager of the Needham Aggressive Growth Fund (NEAGX), which counts Gilead (GILD) among its top holdings. "The medical results have been stunning." Barr adds that Gilead's profit growth — 15% a year for the past five years — has been fueled by these innovative treatments.

John Lutz, a manager for the Frost Growth Equity Fund (FACEX) and a Gilead shareholder, expects a "monster launch" from hepatitis C drug Sovaldi (also known as sofosbuvir), which the firm acquired when it purchased rival Pharmasset in 2012. Piper Jaffray analyst Joshua Schimmer says it "may be one of the most important drugs ever for the biotech industry." Hepatitis C affects 150 million people worldwide and kills more Americans each year than HIV.

The FDA just approved the drug, and advisers for the European Union have issued a positive opinion on it. If it gets the greenlight abroad, the drug could soon double Gilead's revenues and profits. Barclays analyst C. Anthony Butler says the company's hepatitis C-related sales could hit $7.4 billion by 2015 and $9.8 billion by 2017.

The big risk: Sovaldi still awaits official European approval. Expectations are so high, any delay could harm the stock.

What's more, Gilead's work in treating AIDS is politically charged. The company is being pressured by AIDS activists to lower the cost of its HIV drugs (annual doses of Stribild run around $28,000), especially for those who need it in the developing world. If Gilead is forced to cut prices or work more closely with generic-drug makers to develop cheaper knockoffs, that could pressure profit margins.

Why it's a buy: While its 22 P/E isn't cheap, earnings are expected to grow more than 30% annually for several years. Lutz says the market is underestimating Sovaldi's potential, particularly in the first few years of release.

Sotheby's

Promoting art as a fine investment

Whether you think fine art is a legitimate asset class or not, the fact is the über-wealthy do. Art already makes up around 4% of high-net-worth individuals' total wealth.

Only two major auction houses truly cater to the super-rich. Remember Francis Bacon's "Three Studies of Lucian Freud," which sold for a record $142 million last year? That was handled by Christie's. Andy Warhol's "Silver Car Crash," which went for $105 million, was auctioned at Sotheby's. Of the two, only Sotheby's (BID) is public.

Earnings for this auction house are expected to grow around 20% annually for the next several years, thanks in part to surging demand for art worldwide, fueled by growing wealth in Asia and the Middle East. Today sales from China account for around 14% of Sotheby's revenues, but analysts at the brokerage Stifel note that China accounts for roughly 30% of global art transactions.

The big risk: If wealth creation in China slows, that could crimp the company's growth. The more pressing concern is that Sotheby's continues to trail its rival in overall sales. If Christie's is able to win the rights to a greater share of the market's truly prized pieces, Sotheby's commissions will suffer.

That could lead to even more pressure from the firm's largest investor, the activist shareholder Dan Loeb of hedge fund Third Point. Loeb has called for the CEO to resign, citing the company's "deteriorating competitive position relative to Christie's." In a statement, Sotheby's officials claim they've been producing "superior results" and called Loeb's comments baseless.

Why it's a buy: In addition to global growth, pressure from Loeb could be a good thing. "It doesn't hurt to have investor agitation," says Sandy Villere, who owns the stock. Shares of Yahoo (YHOO) and Sony (SNE) surged after Loeb targeted those stocks.

IMAX

Breathing new life into 3D films

After starting off in the late '60s supplying giant screens to museums for educational documentaries, this company is now cashing in on Hollywood's love affair with superheroes, sequels, and 3D.

IMAX tickets tend to cost 50% more than a regular film, yet sales remain strong, says Eric Wold, a senior analyst with B. Riley & Co.

With 785 giant screens up and running globally, IMAX (IMAX) has two key areas of growth, Wold says: China, plus new theater installs in the U.S., which include elaborate home theaters for the affluent. The systems can run from $250,000 to $2 million, with a profit margin as high as 75%, projects Wold.

The big risk: Companies have stumbled making inroads in China, so IMAX's path isn't certain. Plus, the firm's main movie business is dependent on the quality of Hollywood content.

Why it's a buy: Profits are expected to climb 45% this year and 23% annually for the next several years. They could grow even faster. IMAX is nearly finished investing in a new laser projection system that will upgrade older theaters to an all-digital format. That will allow the company to show the hottest new films on more screens.

Patterson-UTI

Riding the shale gas boom

Huge formations of natural gas found in shale throughout the country are expected to help propel the U.S. toward energy independence in the coming decades.

And Patterson-UTI (PTEN) operates rigs with pressure pumping drills used for hydraulic fracturing, or fracking, in regions with some of the biggest deposits. They include the Marcellus and Utica shale in the Appalachians and the Permian and Eagle Ford basins in Texas.

Bryant VanCronkhite, co-manager of the Wells Fargo Advantage Special MidCap Value Fund (SMCDX), which owns the stock, said that as long as energy companies are eager to pump out more oil and gas, Patterson-UTI will benefit from strong demand for its drilling rigs.

Scott Barbee, manager of Aegis Value (AVALX), which also owns the stock, says the shale boom has made it easier for Patterson to lock up long-term lease deals from oil and gas companies for its equipment. "The energy business has shifted more from exploration to production," Barbee says. "Companies want to accelerate the drilling, and that boosts demand for Patterson."

The company's core drilling business should also benefit from a continued rebound in natural-gas prices from depressed levels in 2012.

The big risk: It's not a given that states with rich shale resources will continue to allow fracking, which is opposed by just about every major environmental group. Some could join New York, which has a moratorium on the practice. Also, if the economy were to slow, causing the price of natural gas and oil to fall, demand for Patterson's drilling rigs would almost certainly suffer.

Why it's a buy: VanCronkhite concedes that Patterson's profit growth is likely to be flat in the short run. Revenues, though, should soar on the back of the fracking boom. And that growth will eventually boost earnings, he says, especially after Patterson is finished investing in a major push to upgrade its rigs to stay competitive in shale.

At the moment Patterson's P/E is a higher-than-average 21. The stock, however, trades at a big discount to rival Helmerich & Payne (HP) on a price/sales basis. H&P is valued at 2.5 times estimated revenues for its next fiscal year vs. 1.2 times for Patterson.

That makes Patterson the rare example of an innovator whose valuations are cheaper than average.

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