How to Profit from the "Flight to Quality"

	Paul Tracy Street Authority.com
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Every investor likes to find the next big growth stock and jump on board before it takes off. And there's nothing wrong with buying growth-oriented companies. In fact, most of the market's big winners -- Microsoft (MSFT), Wal-Mart (WMT) and Coke (KO) spring to mind -- were once considered high-growth, high-risk investments.

But sometimes, as trite as it may seem, the best offense in the markets is a great defense. This is particularly true when the market and economy face major economic headwinds.

Since the beginning of 2005, the market has faced a number of such headwinds. Crude oil prices, which have been trading at or above $50 per barrel throughout most of the year, are one such concern. Higher gasoline prices act as a tax on the consumer and tend to slow consumer spending growth.

And while the U.S. economy continues to grow at a decent pace right now, it's clear that growth is slowing from last year's abnormally high levels. The same is true for corporate profits -- although S&P 500 earnings are expected to grow this year, that growth will undoubtedly be far lower than in 2004.

Finally, there are interest rates. There's an old Wall Street saying -- "Three steps and a stumble." In other words, when the Fed hikes rates at least three times, the stock market generally posts at least a brief correction. The Fed has already hiked rates a total of 8 times since 2004, boosting rates from 1% to 3%. Historically, such action from the Fed has tended to push the stock market lower or at least head off the pace of advances.

Of course, none of these factors spell doom for the U.S. markets. However, given this type of a backdrop, it's not unreasonable to anticipate at least a pause for the major averages. That's exactly what we've seen so far this year.

Fortunately, investors can still make money even if the overall market remains flat. Contrary to popular belief, not all stocks go down even in the most vicious bear markets. For example, while the 2000 to 2003 bear market was cruel to most technology stocks, some companies in other groups fared just fine. That's not to say that the S&P 500 faces anything like the 2000 to 2003 decline this year, but it does illustrate a point. As you can see in our chart, a number of stable blue-chip stocks -- including Budweiser (BUD), Coca-Cola (KO) and Starbucks (SBUX) -- managed to outperform the broader market (SPX) during the last correction.

Even as the S&P 500 fell nearly -40% over this period, both Starbucks and Budweiser actually produced positive returns. In fact, Starbucks and Budweiser offered investors annualized gains of about +16% and +30%, respectively, right into the teeth of the worst bear market in three decades.

There's good reason for this outperformance. When the economy weakens, corporate earnings growth tends to slow down, at least for most companies. Slowing growth tends to hit so-called "growth" stocks the hardest -- these companies are valued mainly on prospects for future growth and thus are most vulnerable to any changes in investor expectations.

When investors sell their more aggressive growth-oriented stocks, most of that excess cash eventually finds its way back into the market. More specifically, investors often rotate those funds back into more defensive issues -- that rotation is commonly called the "flight to quality". In other words, when the market turns sour, investors look for defensive-oriented, high-quality blue-chip stocks that should continue to deliver solid earnings even in a weak economy.

Such stocks may not be as glamorous as classic young growth companies. They're also unlikely to show ultra-high earnings growth. However, when the market is sluggish, investors are usually willing to pay up for reliability and a track record of solid performance. As a result, these quality blue-chip stocks often perform surprisingly well even as the S&P 500 falls.

How To Spot A "Quality" Blue-Chip Stock
While there's no single definition for what makes a stock a "quality" blue-chip play, there are several key attributes to look for...

First, it's often wise to invest in products that consumers will continue to purchase even if they're forced to cut their overall spending. The most obvious of these are food and drink products. Although consumers might decide to cut spending on clothing or dining out at fancy restaurants, they're unlikely to stop drinking Coke, popping open their favorite can of beer or even visiting their local coffee shop. Such products usually show constant demand even in terrible economic climates.

But makers of these staple products aren't the only high-quality stocks around – "flight to quality" candidates can come from all industry groups. They key is to look for companies with a long history of earnings growth in good and bad markets alike.

And don't forget the concept of an economic moat -- wide moats are a key feature of most high-quality stocks. When overall economic growth slows, companies will often try to grab share from competitors to maintain profitability. Companies with some sort of sustainable competitive advantage -- a wide moat -- are usually able to maintain profitability even in the face of greater competition.

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Starbucks (SBUX, $55.46)
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Business Overview
Starbucks owns and operates the world's largest chain of coffee shops with roughly 9,000 standalone retail locations throughout the U.S. and 31 foreign markets. In addition to these standalone company-operated stores, the firm has or will soon open a total of 400 smaller stores inside existing Border's Books locations. In addition, Starbucks has already licensed hundreds of overseas stores to third-party operators.

In total, Starbucks derives about 80% of its revenues from the sale of coffee beverages, with the balance coming from whole bean coffees, food and coffee brewing equipment.

Competitive Advantages
The coffee retail business has relatively low barriers to entry. Other companies can and have opened coffee shops that look similar to Starbucks and offer a similar menu.

But, as with most retail-oriented businesses, Starbucks' main competitive advantage lies in its well-recognized brand name and convenient store locations. Starbucks was the first major coffee chain to go nationwide in the U.S.; most coffee shops in the nation are still one-off locations or small regional chains. As a result of its dominance, Starbucks benefits from extremely strong consumer recognition across the country.

What's more, Starbucks has been very innovative and adaptive to shifting consumer tastes. The company offers one of the most complete lines of specialty branded coffees you'll find anywhere, including an iced Frapuccino drink and a line of caramel chocolate coffee concoctions.

Growth Drivers
Starbucks' management team has stated a long-term goal of opening a total of 15,000 locations in the United States alone -- more than double its current domestic store count. So far, there is little sign that the company's expansion has cannibalized existing stores.

Although domestic expansion will remain important for Starbucks, the firm's most dramatic growth should continue to come from outside the U.S. Starbucks currently operates about 1,500 international locations in 31 foreign markets, including key cities throughout Europe, Asia and Latin America. And going forward, that figure is poised to grow as high as 15,000 or more over the next five to ten years.

The Asian market represents a particularly exciting growth opportunity for the firm. The firm opened its first Asian store in Tokyo, Japan back in the 1990s. And while at first glance Japan might seem like a saturated, fully developed market, the average Starbucks store there does about twice as much business as the average U.S. location.

In addition, management has focused considerable attention on China right now -- a market that's possibly the most exciting growth story for consumer products in the world today. As I outlined earlier, coffee consumption in this market is growing rapidly and consumption tends to rise along with household income -- as China grows, more and more Chinese will be able to afford a cup of Starbucks coffee in the morning. In the meantime, China already boasts an estimated 200 million middle and upper class consumers.

Starbucks has already expanded aggressively in this market by opening about 300 licensed locations in China and Hong Kong. These stores are branded Starbucks but are licensed to third-party operators. And in late April, Starbucks opened its very first company-operated store in that nation.

Valuation and Outlook
Starbucks typifies a high-quality blue-chip stock. While consumers might well cut back spending on eating out if the economy weakens, the average consumer spends on a tiny portion of his/her disposable income on coffee. And given its somewhat additive properties, if the economy slows down, coffee is not the first product most consumers will cut spending on.

What's more, the firm's international operations will act as a hedge against any slowdown in the U.S. As the company expands into a number of key high-growth Asian markets, growth there stands to make up for any sort of a slowdown in the U.S.

SBUX trades at nearly 39 times fiscal year 2006 earnings. Meanwhile analysts expect the firm to post +22% annual growth over the long haul. At first blush, a PEG (P/E-to-growth) ratio near 2 would seem to suggest the stock is expensive. However, I believe the company's outstanding track record and defensive growth are enough to warrant a significant valuation premium.

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Coca-Cola (KO, $44.23)
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Business Overview
Coca-Cola is the world's largest producer of carbonated soft drinks. The company's signature Coke brand is well recognized by literally billions of consumers, and Coke is sold in almost every country in the world -- more than 200 countries worldwide.

In addition to its core Coca-Cola brand, the company also sells Dasani bottled water, Sprite, Minute Maid and a host of other soft drinks. The firm sells its drinks both directly to consumers in cans and bottles, as well as in syrup form to bars, restaurants and other commercial establishments.

Competitive Advantages
Coca-Cola sells a very simple product. Contrary to popular belief, the company's beverage recipe isn't really much of a secret: Coke is made of water mixed with corn syrup and a host of artificial flavorings. So, why then is KO able to sell an aluminum can full of simple ingredients that cost just a few cents for $0.50 or more?

The reason is simple: branding. Consumers reach for Coke beverages time and again because they recognize the firm's brand name. The brand is so well known, in fact, that it's often used to describe cola drinks in general. Although similar private-label store cola brands generally sell for much less, consumers have shown a willingness to pay a premium price for Coke's well-recognized brand.

And that's not true just in the U.S. -- Coke has been peddling its wares internationally for decades. Even consumers in developing countries are very familiar with the firm's brand. It would be difficult for any competitor to match Coke's brand equity worldwide. Coke has been around for about a century and it has taken years for the firm to develop a truly global brand and reputation. Brand names with that sort of staying power are very difficult to duplicate, giving Coke a distinct, lasting advantage over the competition.

Growth Drivers
Going forward, my staff and I see two major growth drivers for Coke. One is the flavored Colas that the company has been launching over the past several quarters, including Vanilla Coke, as well as Coca-Cola with Lime. These new flavors have proven popular among consumers, and Coke has been able to leverage its core Coke brand to create instant recognition for these Cola flavors. These newer brands should help breathe some life into sales in developed markets.

However, international sales will prove to be the key to future growth over the long term. Coke has been very aggressive globally, acquiring brands in markets like Russia, Bulgaria and Kenya. It has also aggressively marketed and slightly altered the formula of its basic Coke brand to fit local tastes.

As nations become wealthier, consumers tend to buy more packaged foods and drinks. This bodes well for Coke. For example, by grabbing Russia's second-largest fruit juice maker, Coke has managed to capture a great local distribution network and a solid local brand in this nation. As Russia develops, Coke will have a strong foothold in this growing market.

It should come as no surprise that Coke's sales are growing much faster in these foreign markets than in the U.S. In recent quarters developed markets like Germany in the U.S. have seen slow sales growth or, in some cases, outright sales declines. But internationally case volumes have jumped a solid +2 to +4%, led by such markets as Russia, China and Brazil.

Valuation and Outlook
After falling steadily over the past few years, Coke is now starting to look more and more like a classic value stock. I believe the recent share price pullback is unjustified, as Wall Street has not carefully considered the potential for faster-than-expected growth from new, innovative products, as well as from booming overseas markets.

Coke also wins points for being one of the most cash generative companies on Earth -- the company pulled in nearly $6.2 billion in operating cash flow over the past year. This strong cash flow has allowed Coke to aggressively repurchase shares and, more recently, raise its annual dividend payout to $1.12 per share.

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Anheuser-Busch (BUD, $47.29)
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Business Overview
Anheuser-Busch markets and sells beer in over 30 different countries. The firm not only sells its recognized global brands -- Budweiser, Bud Light and Busch -- but also owns a variety of local brand names that are sold exclusively in certain countries.

The company is the market leader in the U.S. with a more than 50% market share -- fully 20 percentage points above its closest competitor.

Competitive Advantages
Anheuser Busch benefits from one of the most widely recognized brand names on the planet -- Budweiser. Budweiser's wide economic moat is a direct result of the company's powerful brand and enormous size.

BUD was founded over 140 years ago. As a result, Budweiser has been well known to most American consumers for decades. However, Budweiser has never allowed its brand to become stale -- the company spent more than $2.5 billion marketing its products worldwide in 2004 alone, more than double its nearest competitor in the beer market.

Budweiser can afford to spend that sort of cash thanks to its enormous size -- BUD's annual sales now exceed $15 billion. The company's constant marketing efforts help to reinforce its brand image in consumers' minds. This high-quality, well-recognized brand gives the firm a lasting economic moat.

For BUD, size also has its privileges. The company demands exclusivity from 60% of its distributors -- meaning that the distributors are only allowed to sell BUD products. This gives BUD a lock-hold on a large portion of its distribution network, providing the firm with yet another wide economic moat.

Growth Drivers
Like Starbucks, the bulk of the BUD's growth will come from overseas. In particular, BUD has aggressively targeted the fast-growing Chinese market. In China, consumers are rapidly becoming wealthier and better able to afford luxury products like alcohol.

And young working adults are exactly the demographic that BUD traditionally targets with its core brands. Last year, BUD bought Harbin, a Chinese company with 18 breweries in northeast China; this is likely the beginning of an even more aggressive push into Asia.

And Asia isn't the only market where BUD is expanding. The company owns half of Grupo Modelo, a Mexican brewery company that produces, among other brands, Corona beer. Corona is the most popular imported beer in the U.S. What's more, Corona is also popular across Latin America, another exciting growth market.

Valuation and Outlook
BUD trades at roughly 16 times forward earnings and sports a long-term growth rate of +9%. That gives the stock a PEG ratio of 1.75.

Although that might seem expensive at first glance, the firm's valuation level is actually fairly resonable. The company is the largest player in the beer market with a dominant share of almost every market in which it competes. The firm also has a long (more than 100 years) track record of posting solid growth even in weak economies. These factors suggest a premium valuation is warranted.

And it's not unreasonable to think that the company can better estimates for long-term growth of +9%. For years beer volume – the actual quantity of beer sold -- has been flat in markets like the U.S. and western Europe. But China and other emerging economies are growing much faster. As emerging markets account for a bigger and bigger chunk of BUD's revenues, the firm's growth should accelerate.

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First Data Corp. (FDC, $39.70)
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Business Overview
First Data is one of the world's leading providers of credit, money transfer and electronic payment processing services. FDC sells equipment and services to retailers and other merchants that enable them to process Visa and MasterCard credit transactions. However, the company is perhaps best known for its Western Union money transfer business, which enables consumers to wire money to over 100 countries worldwide.

Competitive Advantages
FDC's most important and most dominant franchise is Western Union, as this money transfer brand controls 75% of the global money transfer business.

And size is a major advantage when it comes to this market. FDC has been very aggressive in signing up retailers as agents for Western Union all around the world. This is particularly true in fast-growing markets like China and India where the company has been signing up new agents for years. The end result: there are nearly a quarter million Western Union agents globally, about three times the number of FDC's closest competitor -- Money Gram.

This gives FDC what some analysts call a "network advantage." Because the company's network is so large and dominant, it is often the only money transfer option in certain markets. And even in markets served by several money transfer agencies, Western Union is often the most convenient.

Best of all, it has taken years for FDC to built up that type of extensive network. It would be very hard for a competitor to build up a similar network and compete effectively with FDC.

Growth Drivers
Growth from overseas should remain a key driver for FDC. As markets like China and India grow and businesses spring up, demand for money transfer services should rise. Western Union is well placed to capitalize on that trend thanks to its dominant position in many of these promising markets.

And Western's network is likely to just keep growing. Agents are more likely to want to sign up with Western Union than the competition because it offers them access to more markets. As the network grows, so will FDC's revenue base.

Valuation and Outlook
With a 2006 estimated P/E of less than 15 and projected long-term growth of +13%, FDC looks very reasonably valued at current levels. One factor that has been hanging over FDC is its credit card processing business, as a number of new competitors have recently entered this market. However, FDC still controls 50% of the credit card processing market globally, a dominant share. And once a retailer signs up for FDC's service and buys all the needed equipment, it's expensive to switch. This is still a growing, profitable business for First Data.

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American Express (AXP, $54.18)
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Business Overview
American Express is best known for its signature American Express charge card. In addition, this diversified financial firm offers travel services, loans and business services.

Competitive Advantages
The average American Express cardholder spends nearly $10,000 annually on his/her card. That's well more than twice what the average Visa or MasterCard holder spends. This makes American Express customers far more valuable for merchants -- these customers are the biggest spenders, and as a result, merchants need access to AMEX's customers.

For this reason, AMEX charges a 2.6% transaction fee to its clients -- roughly a full percentage point higher than Visa and MasterCard. That higher rate is proof positive of AMEX's wide economic moat.

AMEX holds onto its valuable clientele in a number of ways. For starters, most consumer surveys suggest that AMEX offers superior customer service. In addition, the company offers special rewards to its cardholders, such as free travel insurance and theft protection. AMEX has also had considerable success with its Rewards points program -- customers enrolled in this program tend to spend more and have better repayment records.

Finally, AMEX does not rely on third-party credit processors to process transactions. Instead, American Express processes its transactions through its in-house network. Not only does this curt down on expenses -- AMEX doesn't have to pay a third party for processing -- but it also enables the company to collect more data on consumers. More specifically, American Express gets to see both sides of every transaction -- the merchant's side and the consumer's side.

Growth Drivers
In many ways, financial services in markets like China and India look similar to that of the U.S. 30 years ago. Credit cards are still a novel payment method and consumer loan products like mortgages aren't even all that common.

But just as credit card usage has exploded in the U.S. since the 1970s, it's also likely to gain traction in these emerging markets. As consumers in these markets become wealthier, they'll spend more and start buying products from the Internet and over the telephone. Credit cards are the most common payment choice for these types of transactions. As a result, global credit card usage should continue to expand at a fast clip in the years ahead.

And at home, AMEX has been aggressively expanding its customer base. Most recently, AMEX signed a deal with MBNA to start issuing co-branded cards that will be processed over the AMEX network. That gives the company access to an even wider base of customers.

Valuation and Outlook
AMEX trades at 15 times 2006 earnings and sports a long-term projected growth rate of +13%. That gives the company a PEG of only slightly over 1 -- extremely cheap for a company with such a dominant global brand.

AMEX is somewhat insulated from economic weakness in the U.S. because its client base is wealthier that that of most other major U.S. credit card issuers. These high-quality customers are more likely to be able to pay their bills even in a weak economy. Meanwhile, the potential for growth in markets like India and China is significant. As such, I believe AMEX's long-term growth rate could well exceed estimates.

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I sincerely hope you've enjoyed today's look at several quality blue-chip stocks that should continue to perform well even if the overall market struggles in the coming months. Please stay tuned for our next full issue, which we'll publish on Monday, June 20th. In it, my staff and I will perform a relative valuation analysis on a variety of important market sectors and industries. After comparing each stock to the rest of its competitive field based on a host of different valuation metrics, we'll bring you a closer look at the single most undervalued security in each of these key industry groups. Good investing in the week ahead!

Paul Tracy will be available to take your questions until Monday, June 13. Please use the form below to submit your questions.