Today we jump right into stocks, starting with the good news that last week Cabot’s intermediate-term market-timing indicator flashed a buy signal.  This means all our indicators are once again unanimously positive.  There’s no better time to make money than now.

But where should you invest?

I think semiconductor chips are a great sector, and there are three good reasons why.

First, business is improving.  The vast majority of companies in the sector–both those that design the chips and those that manufacture them–are enjoying fast-growing sales and earnings, and expanding profit margins.  Individuals and institutions are loosening their purse strings and buying again.  Consumers are buying cell phones, computers, televisions and cars.  Companies are buying computers, networking equipment and equipment that enables closer tracking of inventories, productivity, efficiency, etc.  And the government is buying more of everything.

Second, the chip sector is notorious for its cyclicality.  When times are good, companies in the industry expand, spending more money so they can keep up with demand.  But demand eventually slows, leaving the companies with too much overhead.  So as orders slow, they cut back (often drastically), reducing payrolls to stay profitable, some more successfully than others.  Prices fall, and eventually, demand picks up again, margins boom, and companies scramble to keep up.

In short, companies in the chip industry tend to overreact when they expand, and they overreact when they cut back.  And they have to, because the timing of every phase is different throughout the decades, so there’s no way of knowing how long each phase will last as it evolves.  The risk is that failure to adapt could be more costly than adapting too vigorously.  So the cycle goes on.

And then there’s the stock market, which is guilty of exactly the same overreaction.  Seeing margins plummet in a contraction phase, as we had in 2008, investors dump chip stocks like hot potatoes.  They get dirt cheap.  And when the turnaround comes, these stocks climb fast, as margins boom and projections of future growth are ratcheted higher and higher.  That’s the phase we’re in now.  No one knows how long it will last.  But I do know that it’s a great phase for making money, provided that you take care to exit when the trend ends.

Below are six chip stocks that look great today, presented in alphabetical order.

All are U.S. companies, all enjoy growing sales and earnings now, and all expect continued growth in the year ahead.

Atheros Communications (ATHR) of Santa Clara, California, designs chips used in wireless communications and wired networks.  Ethernet, GPS, Bluetooth and Powerline are its strengths.  The company has grown revenues every year of the past decade and it remained profitable in every quarter of 2008 and 2009.  In the latest quarter, revenues grew 89% to $186 million, while earnings jumped 265% to $0.62 per share.  The after-tax profit margin was 22.2%.  Technically, ATHR is strong, building a little base between 37 and 38.

Cree Inc. (CREE) of Durham, North Carolina, is a leading manufacturer of LEDs (light-emitting diodes).  These are the lights that will eventually take over from incandescent and compact fluorescent lights because they are far more energy efficient, last far longer and don’t contain mercury.  The company has grown revenues every year of the past decade but one (2007) and it maintained profitability throughout 2008 and 2009.  In the latest quarter, revenues grew 35% to $200 million, while earnings jumped 90% to $0.38 per share.  After-tax profit margin was 20.1%.  Technically, CREE is very strong, consolidating its latest climb just under 70.

NetLogic Microsystems (NETL) of Mountain View, California, designs chips used to accelerate the processing and delivery of content on both wired and wireless systems.  Cisco and its contract manufacturers account for 38% of revenues, while Juniper, Alcatel, Lucent and Motorola account for another 30%.  The company has grown revenues every year of the past decade and it’s grown earnings every year (impressive!) since 2005.  NetLogic stayed solidly profitable through 2008 and 2009, with earnings off just 24% in its weakest quarter. In the latest quarter, revenues rocketed 125% to $69.5 million, while earnings jumped 90% to $0.59 per share.  After-tax profit margin was 25.1%.  Technically, NETL is powerful, consolidating just above 55.

Power Integrations (POWI) of San Jose, California, is the leading manufacturer of high-voltage analog chips used in energy-efficient power conversion.  It serves a wide range of end-markets, but notably fast growing is the LED market, where Cree is thriving.  The company has grown revenues every year of the past decade and it’s grown earnings every year but one (2008).  Power Integrations stayed profitable through 2008 and 2009.  In the latest quarter, revenues climbed 56% to $66.1 million, while earnings spiked 163% to $0.42 per share.  The after-tax profit margin was 18.4%.  Technically, POWI is solidly positive, building a little base between 38 and 39, but trading volume is a little light, averaging 250,000 shares a day.

Skyworks Solutions (SWKS) of Woburn, Massachusetts, is the largest company of these six, with revenues on track to top $1 billion this year.  It’s also the most diverse, making a variety of standard and custom chips for automotive, broadband, cellular infrastructure, energy management, medical and military markets.  Skyworks had three years of revenue shrinkage in the past decade, and earnings trends are also less robust than in the companies above.  In the latest quarter, revenues grew 17% to $245 million, while earnings surged 59% to $0.27 per share.  The after-tax profit margin was 19.5%.  Technically, SWKS is quite healthy, trading between 15 and 16.  And it’s the most heavily traded of these stocks, so it’s the easiest for institutions to buy.  (Even easier are the big, well-known companies–Intel (INTC), Broadcom (BRCM) and Texas Instruments (TXN)–but their stocks are so well-known and over-owned that they can’t go up like these six can.)

Last but not least is Volterra Semiconductor (VLTR) of Fremont, California, whose chips transform, regulate, deliver and monitor the power consumed by other chips.  Big customers are Alcatel-Lucent, AMD, Cisco, Dell, HP, IBM, Juniper, Lenovo and Sony. The company has grown revenues every year of the past decade but earnings trends have been less reliable. In the latest quarter, revenues grew 56% to $34.2 million, while earnings mushroomed 278% to $0.34 per share.  The after-tax profit margin was 24.7%.  Technically, the chart is strong, with a short base at 24, but volume is light, averaging 340,000 shares per day, increases risk.

Of the six, my favorites are Atheros, Cree and NetLogic, because of a combination of fundamental and technical factors.

But I know that less experienced investors will be attracted to Skyworks and Volterra, because their stocks are lower-priced.  Trouble is, those lower prices bring greater risk.  Whatever you choose, be sure you manage risk appropriately, by buying on dips, and by keeping losses small.

Note from Editor Elyse Andrews: Last month, you heard from Chloe Lutts, editor of Dick Davis Digest and Dick Davis Income Digest, for the first time. She’s back writing again, this time about America’s obesity epidemic and a company that’s working to build a healthier America. Enjoy!

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Last month, First Lady Michelle Obama launched a campaign against childhood obesity called “Let’s Move!” The same day, President Obama created a task force to combat childhood obesity, underscoring the seriousness with which this administration is addressing America’s obesity epidemic.

The administration’s efforts include the establishment of public-private partnerships between federal agencies and the business, entertainment and medical communities to promote healthier habits for children. The program’s goals include providing healthier school lunches, increasing access to fresh food in low-income areas, improving food labeling and encouraging families to eat right and exercise. The administration has requested an additional $10 billion in funding for the program over 10 years, which would largely be spent to improve the quality of school lunches and breakfasts and to increase participation in school nutrition programs.

The first lady even appeared on Fox News last week to discuss the program with talk show host Mike Huckabee, who made fighting childhood obesity a focus of his 10-year tenure as governor of Arkansas. One aspect of the fight that Huckabee focused on in the interview was personal responsibility.

Four Pieces of the Puzzle
Personal responsibility is essential for maintaining health and well-being. It needs to be part of any lasting solution to America’s obesity problem, and could be nearly the entire solution for many individuals. Taking charge of your own health, by making wellness a personal goal, eating attentively and staying active, is basically what most people need to do to be healthy. However, on a national scale–and this problem is on a national scale–there are other important parts to the solution as well.

The responsibility for one’s health is certainly personal, but it is also social, especially when our health choices affect our society as deeply as they do. As a society, we share health resources such as doctors, hospitals and research funds. We pay into the same insurance pool. We all pay into a social safety net system for individuals in our society who are struggling. And we share airplanes, trains and movie theaters with other members of society, which makes their weight problems our weight problems.

The administration’s anti-obesity campaign will increase our social responsibility for America’s health by encouraging and rewarding healthier, more active communities. It will encourage communities to build more places where children can play and be active. It will help communities plan “Kids Walk to School” events and locate safe routes for children to travel.

Social responsibility is also an important part of the “Let’s Move” campaign’s mission to bring fresh, healthy food to so-called “food deserts.” These are urban and rural places in America, often low-income areas, where families don’t have access to fresh healthy food. According to “Let’s Move,” more than 23 million Americans live over a mile from the closest supermarket.

In partnership with communities and non-profits, “Let’s Move” seeks to make a healthy lifestyle possible in any neighborhood. Steps will include making healthy snacks available at corner stores, where many urban schoolchildren buy snacks during the day, and increasing the number and accessibility of real grocery stores and farmer’s markets in low-income areas, both urban and rural.

Social responsibility also extends to our doctors, who are an important part of a healthy society. The American Academy of Pediatrics is educating doctors and nurses about how to reduce childhood obesity, including regular body mass index monitoring and healthy eating counseling.

Social responsibility will be an especially important tool in the fight against obesity when it comes to children. Beyond the individual and community levels, though, are larger, more influential entities that are also responsible for our national well-being. One is government.

While the U.S. government can’t fix the obesity epidemic all by itself–happily, we don’t live in a country where politicians can tell you what to eat–it can take measures to positively affect our national well-being.

One is mandating that food producers disclose the nutritional value of their food, a longstanding practice that makes it much easier for consumers to take personal responsibility for what they eat. It’s hard to eat right when you don’t know what you’re eating.

The U.S. Food & Drug Administration is currently researching new nutritional labeling guidelines that would put consumer-friendly nutrition information on the front of packaged food.

The U.S. Department of Agriculture is revamping the food pyramid and making the popular myPyramid Web site even more useful to consumers.

The USDA has also created an interactive database called the Food Atlas to provide important information, like the location of food deserts, to parents, nonprofits, government agencies and businesses that can help make America healthier.

The government is also responsible for the food served in America’s public schools, which provides half of many children’s daily calories. The government has already introduced higher standards for school lunches under the HealthierUS Schools Challenge Program, and the USDA is working to double the number of schools meeting those standards over the next school year.

Major school food suppliers have also agreed to work toward the new guidelines by decreasing the amount of fat, sugar and salt in school meals and serving more whole grains and produce. Their commitment is one of corporate responsibility, the fourth piece of the puzzle.

Corporations certainly have no legal obligation to shoulder this responsibility, but as powerful influencers of what we eat, they’re an important part of the solution. Corporations are an important part of American society, with an ever-growing influence on our lifestyles. It is up to corporations to wield that influence in a way that is positive as well as profitable.

School lunch providers aren’t the only ones stepping up to the plate. Corporations are showing leadership in every area of the fight. Soda companies are offering calorie information on the front of their products and on vending machines. One of the president’s guests at the State of the Union address was a Philadelphia grocer committed to opening stores full of fresh, healthy food in low-income areas.

A Company Working to Build a Healthier America

One company that has taken a leadership position in the fight against childhood obesity is food and drink giant PepsiCo (PEP). PepsiCo, which pays an indicated annual dividend of $1.80, was featured in a recent issue of Dick Davis Income Digest. The editors who recommended the investment (the Dick Davis Digest features hand-picked recommendations from hundreds of the top investment newsletters) cited the company’s excellent management, 3% yield and low risk in their recommendation. The stock is a good value, they wrote, while the company has good growth potential. And they predicted dividend increases to come. They also cited the high potential of PepsiCo’s new line of healthy snack foods.

In addition to their corn-syrupy namesake soda, PepsiCo also makes Tropicana juices, Quaker Oats, whole-grain Sun Chips, Naked brand juice drinks and smoothies, Life cereal and many more products.

The new healthier snacks mentioned in the Income Digest recommendation are only a small part of PepsiCo’s commitment to “Performance with a Purpose.” As the slogan says, PepsiCo has taken the idea of corporate responsibility and reconciled it with a corporation’s responsibility to its shareholders. For PepsiCo, Performance with a Purpose means taking care of its employees, minimizing its environmental footprint and providing healthy nutrition for its customers.

PepsiCo is constantly researching new products that will help consumers live healthier lives–while also making the company money. It is working with the government to enable consumers to make healthier choices by improving its product labeling. It is one of several large food companies that have voluntarily agreed to restrict advertising and marketing aimed at children to products that meet specific nutrition criteria.

The company is also a founding member of The Healthy Weight Commitment Foundation, which seeks to fight obesity by educating consumers about the importance of balancing calories in with calories out. Members include The Kellog Company, grocery store chain Hy-Vee, Coca-Cola, The J.M. Smucker Company, Unilever, Nestlé, Safeway Inc., Mars Inc., Sara Lee Corp., Bumble Bee Foods, Campbell Soup Company, General Mills, The Hershey Company and more.

PepsiCo has also committed to the “Let’s Move” initiative and announced a new beverage-labeling plan in support. Announcing the company’s support, PepsiCo chairman and chief executive officer Indra Nooyi said:

“We have learned over the years there is no silver bullet to solve obesity. No single entity can do it alone. We need a guiding coalition in which individuals, companies, health agencies, consumer groups and governments all take on their appropriate responsibilities. Major food companies such as PepsiCo are in a unique position to be leaders in health and wellness because of our resources, brands, research and development capabilities, consumer reach and logistics expertise.”

I couldn’t have said it better myself. As every member of our society begins to shoulder their responsibility to build a healthier America, I hope more companies will decide to be like PepsiCo. For now, the company’s commitment to corporate responsibility distinguishes it in a way that is proving profitable for both PepsiCo and its shareholders.

Wishing you success in your investments and beyond,

Chloe Lutts
Editor of Dick Davis Digest

Last week, both my home and the Cabot office were without electricity for 42 hours, thanks to the Thursday night storm that hit New England with hurricane force winds and put perhaps a million people in the dark for at least a while.

It reminded us how wonderful electricity is.

And it made me thankful for the Internet, and for decentralized information, which made it possible for Cabot employees to get our advice out on schedule Friday while working from home.

In any case, the vision of numerous broken power lines left me wondering once again when we will be able to transcend this 19th century architecture of poles and wires that is not only vulnerable to weather but ugly to boot.

And that reminded me of the announcement just a week ago by Bloom Energy, a California start-up, of a solid-oxide fuel cell that has the potential to enable more localized power sources.  You could have one in your basement, for example, or a larger one could power a subdivision.

There’s still much work to be done, and the price needs to come down, but the potential is there, and the announcement by Bloom should increase interest in the field, attracting money and competitors that will make progress come faster.  I can’t wait.

In the meantime, the real progress in the energy industry lies in solar and wind, where the best companies continue to grow at a rapid pace, despite the fact that the recession has curtailed government subsidies in Spain and Germany, two countries that were previously major supporters.

But that doesn’t mean these companies are great investments.  Consider First Solar.

Back in 2007, First Solar (FSLR) was our biggest winner and the company is still king of the hill in many ways.  In 2009, its revenues grew 66% to top $2 billion.  Earnings were $7.53 per share, up 78% from 2008.

And how did FSLR perform in 2009?  The stock finished right where it started, at 135.    Today it’s still in the same neighborhood, and a stock that’s going sideways is not attractive to me.

But why does a company growing this fast have a stock that’s not going up?

In short, because investors previously expected even faster growth.  First Solar’s growth is actually decelerating at a rapid rate now.  The company has gone from being a Formula One race car (sales grew 273% in 2007) to a BMW 3-Series, and the stock’s price is still adjusting to the change.  I recommend that you continue to avoid it until investors put the stock in an uptrend again.

And note this:  It’s not just because First Solar was the leader that it’s being held down now.  The vast majority of stocks in the solar power industry look even worse, because their businesses are doing less well and because money is leaving the sector.

On a side note, on my survey of the alternative energy sector, I ran into old friend USEC Inc. (USU), which operates the only uranium enrichment facility in the U.S. (in Paducah, Kentucky).  It’s the executive agent for Megatons to Megawatts, the U.S. government’s program for converting uranium from Russian warheads into enriched uranium for electric utilities.  And it’s deploying the American Centrifuge, a next-generation enrichment technology.

But the business isn’t growing, and the stock hasn’t been in a real uptrend since early 2007.  Even President Obama’s mention of nuclear power in his State of the Union Address failed to strike a spark.  To me, that’s reason enough to ignore it.

So which alternative energy stocks do I like?  None today.  I had high hopes for EnerNOC (ENOC) recently, but the market told me I was wrong.  Bottom line, most alternative energy stocks are not attractive today.  (When they are, you’ll read about it first in Cabot Green Investor, our earth-friendly but still profit-minded publication that is currently winning with some revolutionary new technology stocks.)

What I do like today are stocks of fast-growing technology companies like NetLogic Microsystems (NETL), which earned a spot in Cabot Top Ten Report a few weeks ago.  NetLogic falls into the classic semiconductor chip category, which to me means that in the right bull market it can make you money really fast … and that when the uptrend ends you’ve got to jump out.

Well, the company had a blowout fourth quarter earnings report–sales up 125% to $70 million and earnings up 90% to $0.59 per share–after which investors gapped the stock up to new highs on big volume.  And that earned it an appearance in Cabot Top Ten Report, where editor Michael Cintolo wrote, “NETL hit 45 back in the first half of 2006, and didn’t make meaningful progress above that level until recently. So the stock has a very long launching pad to work from, which makes last week’s earnings-induced rally more promising. NETL trades just 500,000 shares per day on average, so volatility can be extreme, but we like the prospects and the stock’s more recent four-month rest period. Try to buy a little on weakness or as the stock tightens up.”

When he wrote that, the stock was trading at 48, and the stock traded at 48 for the next three days, “tightening up,” which tells you institutions are accumulating.  And then it launched ahead, in a climb that took it up to 57 today.  I still think the future is bright, but if you like it try to buy on a normal correction of a couple points.

A couple of weeks ago, I asked Cabot Wealth Advisory readers to take a survey for us so we can better understand how to serve your investing needs. Many of you responded and I appreciate all of your feedback.

We’re going to integrate some of your suggestions into Cabot Wealth Advisory and Cabot’s other newsletters, as well as cover many of the topics you requested. In fact, earlier this week Brendan Coffey wrote about biofuels, which was one of the topics that came up frequently in the survey results.

Today, I’m going to discuss another topic that came up frequently: beginning investing.

Many of our readers are already experienced investors, but a lot of you are completely new to the game. So today I’m going to attempt to get you up to speed in the hopes that having more basic knowledge will give you the tools you need to better understand what we write about. (Note: These lessons primarily apply to growth investors, but they can be beneficial to everyone’s investing strategy.)

Why should you own stocks?

Over the long term, stocks have outperformed all other investments. From 1926 to 2008, stocks in the S&P 500 brought investors an average annual return rate of 9.6%. Stock ownership entitles you to benefit from price increases and to receive dividends the company distributes.

How many stocks should you own?

We generally recommend owning no more than 12 stocks. That allows winners to truly have a big positive effect on your portfolio, while at the same time preventing losers from sinking it completely. We advise investing equal dollar amounts in each stock to balance risk.

How does Cabot pick growth stocks?

Cabot’s growth stock selection system starts by focusing on stocks that are strong and going up faster than the general market. These stocks are said to have positive momentum. But we need to see more than that. Behind each stock, we want to see a great growth company. In most cases, we require a company to be demonstrating strong growth of both sales and earnings. And we want to find a story that convinces us this great earnings growth is likely to continue in the years ahead. This system is followed in Cabot Market Letter, Cabot Top Ten Report, Cabot Green Investor and Cabot China & Emerging Markets Report.

What is relative performance?

Relative performance (RP) is a measurement of how a stock is acting relative to the market as a whole. It is one of the tools used by Cabot growth stock analysts to gauge a stock’s momentum. When a stock’s RP line is moving upward, the stock is performing better than the general market; when the RP line is moving downward, the stock is performing worse than the market; and when the line is level, the stock is performing the same as the markets.

What is market timing?

We are strong believers in long-term market timing, mainly so we can sell stocks and avoid losing money and raise cash when the broad market enters into a major decline. Market timing is not an exact science, but we’ve had great success timing the market over the years so we feel confident in recommending that all growth investors practice it. Our three primary market timing indicators are Cabot Trend Lines, Cabot Tides and the Cabot Two-Second Indicator.

The Cabot Market Letter averages one major market-timing signal per year. If it’s a sell signal, we work to reduce risk by selling our poorest performing stocks and putting close limits on the others. The object is to reduce the risk of loss and to raise cash for the next buy signal, when bargains abound. When that buy signal comes, we invest aggressively in the best-performing stocks we can find. Interestingly, that’s the time investors are most fearful!

How do I know when to sell a growth stock?

The most important rule in growth investing–and the hardest to learn is, “Cut your losses short.” That means if your loss in a growth stock exceeds 15% or 20% at the end of any trading day, you sell. Period. In general, we also believe it is wise to sell a stock when it has underperformed the market for eight weeks. The stock’s RP (relative performance) line is a good indicator of this.

On the other hand, you will have many winners, and knowing when to sell them is more difficult. These are stocks in which you already have doubled your money–or more, and still see the potential for great appreciation in the future. In such cases, you should hang on to your stock through corrections, confident that the long-term results will prove rewarding. If you can do this, you’ll benefit mightily from the magic of compounding.

Is it risky to buy stocks hitting new highs?

In the long run, no, because a trend, once established, tends to persist. So if you’re convinced a stock’s trend is up and you’re convinced the company is capable of great earnings growth in the years ahead, you should buy. But better yet is waiting for a normal correction, and buying a stock when it touches its 25-day moving average.

What are options?

An option gives you the right to buy or sell shares of a stock if it reaches a specified price by a set date. Cabot does not provide specific advice on options. But because we set buy and sell prices for the stocks we recommend, Cabot stocks work well for options traders.

Which Cabot newsletter is right for me?

In addition to Cabot Wealth Advisory, which is free, Cabot publishes nine other newsletters covering a variety of investing strategies. We understand that it can be difficult to decide which one best suits your investing needs, so we created a quick quiz. You can take it here.

That’s all for today. I hope you learned something that will help you become a more successful investor. Again, thanks to everyone who filled out the survey … expect to see more topics pulled from the results in the future!

Benjamin Graham is known as the father of value investing. He influenced many modern investors, including Warren Buffett. Ben Graham wrote books, taught investment courses and created several methodologies to help investors evaluate stocks.

I have used one of Benjamin Graham’s methods for the past seven years in the Cabot Benjamin Graham Value Letter with great success. The method is based upon minimum price-to-earnings ratios, price-to-book value ratios and measures of quality. The full description of this analysis can be found in Benjamin Graham’s book, “The Intelligent Investor.”

Mr. Graham suggested that investors should buy stocks that fit all of the following criteria:
(1)  The current price-to-earnings (P/E) ratio is 9.0 or less.
(2)  The price-to-book value (P/BV) ratio is 1.20 or less.
(3)  The long-term debt-to-current assets ratio is 1.10 or less.
(4)  The current assets-to-current liabilities ratio is 1.50 or more.
(5)  Earnings per share growth during the past five years is 1% or more.
(6)  The company currently pays a dividend.
(7)  The Standard & Poor’s Quality Rank is B+ or better.

The list of seven requirements is somewhat long, but several stock screening sites, as well as your favorite broker, can find stocks that meet most or all of them.

Using this analysis, my recommendations have soared 64% during the past 12 months through January 29, 2010 and have easily beaten the stock market indexes during the past seven years.

One of the stocks that currently stands out, because it easily fits all of the criteria, is Reinsurance Group of America (RGA).

RGA is a reinsurer and offers life, annuity, critical care and group reinsurance. The company guarantees insurance contracts for insurance and other financial companies. RGA sells its products in 26 countries around the world. The reinsurance industry has declined during the past several years because of the availability of competing reserve financing solutions including derivatives. I believe this downward trend has begun to reverse recently because of the turmoil in the financial markets and the problems with derivatives.

Reinsurance Group is in position to capitalize on the significant growth opportunities provided by the resurgence of the reinsurance industry in the U.S., as well as China and India. The company has over $2.2 trillion of life reinsurance in force backed by a strong balance sheet with conservative bond investments. Revenues increased 15% in the quarter ending 12/31/09, which was well above our estimate. Earnings per share were up 17%, which also exceeded our estimate. I believe the reversal has begun and that EPS growth of 14% is realistic in 2010.

RGA is the second largest provider of life reinsurance in the U.S. The company’s shares are undervalued at 8.1 times current EPS with a 1.0% dividend yield. RGA shares sell at 0.86 times current book value. The balance sheet is strong, and the Standard & Poor’s Quality Rank is A-. Reinsurance Group’s shares offer a solid investment choice for dividend income and stock price appreciation during the next two to three years.