I’m optimistic in part because so many people are pessimistic!  I think the unrelenting media focus on the BP oil leak has really skewed people’s perceptions of reality.

But I can’t call it a bull market until I actually see major market trends advancing again.

Still, I’ve been busy building a Watch List.  Mine currently has 21 stocks on it, and today I’m going to tell you about the stock that’s been on my Watch List the longest … as well as the stock that was added most recently.

The graybeard is Whole Foods Market (WFMI), the leading retailer of organically grown food in the world.  Whole Foods is prospering by being what Peter Lynch called a “cookie cutter” company; find a retailing concept that works, and then build more of them, while continually experimenting with tweaks to the formula.

It’s a formula that was perfected by McDonald’s (MCD), which is still a decent investment for conservative money.  And Whole Foods, which has grown revenues every year of the past decade and now has more than 295 stores in 38 states, the U.K. and Canada, is following the recipe perfectly.

Its profit margins in the last quarter were 3.1%, obscene for a grocery store.  Its revenues grew 14% from the year before.  Its earnings grew 52%.  And after slowing store development in the recession, management is now expanding once again.  Founder John Mackey, in fact, is one of the smartest, most forward-thinking, most human-focused retailers in the business today.

Fiscal third-quarter earnings will be reported August 3 and I have no doubt they’ll be terrific.

Technically, WFMI is attractive here because it’s pulled back to nearly touch its 200-day moving average in recent weeks.  Also, 34, where the stock bottomed last week, is where it bottomed after gapping up after its earnings announcement in mid-February.

Long-term, I think it’s a winner.

The newest addition to my Watch List is a company that used to be called Network Appliance (which always made me think of toasters), but is now called NetApp (NTAP).

NetApp recently earned an appearance in Cabot Top Ten Weekly—-in fact it was named Editor’s Choice-—and here’s what editor Mike Cintolo wrote:

“NetApp built the world’s first networked data storage appliance and has been a leader in the industry ever since; 49% of its business now comes from outside the U.S. Increasingly, the business is not just about storing data but about making it instantly available to users of virtual infrastructures or cloud computing networks. Properly implemented, these technologies enable more convenient and more reliable data access with reduced costs. Business in the industry slowed dramatically in the depths of the recession, though NetApp managed to continue growing revenues on a year-over-year basis. And this year the industry has come roaring back; analysts have been increasing their earnings estimates for NetApp for both 2009 and 2010. Furthermore, after-tax profit margins were 15.6% in the latest quarter, the highest in more than four years. Properly managed, this company could go far.”

For more details on NetApp and other top stocks, click here.

On one hand, the market has built a decent-looking bottom during the past few weeks, and there are a few dozen potential leading stocks with good growth stories that resisted the market’s May-June correction.

On the other hand, the broad market and even the charts of the major indexes are in rough shape, and this latest upmove has come on super light volume; even the biggest volume day (last Tuesday, June 15) saw the Nasdaq’s total volume 12% below average.  So it’s hard to really have faith that big investors are piling into stocks.

So what do you do?  First, you follow the system–as I said, if our Cabot Tides turn bullish, I’ll be putting some money to work.  However, I think taking a gradual approach is the best course of action.  That means buying two or three small positions … maybe half your normal investment, dollar-wise.

Then, over a few days, if the market is acting well and your stocks are making you money, you can buy a little more, either of your current holdings, or new purchases.  After two or three weeks, if all goes well, you’ll be heavily invested in some strong stocks.  Of course, if the rally peters out (failures usually occur quickly and violently, so it won’t be hard to notice), you won’t get heavily invested; you’ll stop buying if your stocks aren’t showing you a profit.

One tiny company I’m keeping my eye on is Rubicon Technology (RBCN), which isn’t a household name, but is helping to lead the way forward in the LED industry.  Here’s what I wrote about the firm in Cabot Top Ten Report earlier this month:

“If MEMC Electronic Materials was the raw material supplier (silicon) that benefited greatly from the solar and chip boom of the 2005-2007 period, then Rubicon looks like the winner in supplying raw materials (in this case, sapphire substrates) for the current and upcoming LED boom. The company is a leader in producing these substrates in the Western hemisphere, and is the world leader in larger sapphire wafers, which the industry is moving toward (and which have significantly higher barriers to entry than smaller wafers). The stock is strong today because demand is miles ahead of supply–LEDs in notebooks, networks, LED monitors and TVs are using more and more LEDs, and the industry is racing to expand capacity to meet that demand. That, indirectly, is pushing prices for Rubicon’s wafers up; prices roared ahead 20% sequentially in the first quarter, and management sees higher prices going ahead. Revenues have soared the past couple of quarters and the firm just booked its first profitable quarter in two years. Eventually, this industry will over-expand and prices will fall … but management believes that’s at least a couple of years off. In the meantime, we see major growth ahead.”

Since that time RBCN has broken out powerfully from a choppy base, successfully completed a share offering and, importantly, has refused to give up ground during this week’s slide in the market.  The stock is relatively thinly traded, but business is picking up in a big way, and if the LED trend continues for a few more quarters, Rubicon will have a bright future.  I think a little could be bought around here, or preferably, on a pullback toward 30.

In my opinion, it’s saying that the downward market phase that began six weeks ago with worries about Greece, and that accelerated as the BP oil spill worsened, is over.  The bad news has done its job, raising the level of fear in the market while correcting numerous overbought situations.

Hardest hit were some of the indexes.

But the market’s internal strength remains intact, as illustrated by the reading of Cabot’s Two-Second Indicator.  And the action of numerous leading stocks is extremely encouraging.

One of my favorites is Isilon Systems (ISLN), a Seattle company that’s growing fast by providing Network Attached Storage (NAS) to a wide variety of industries that need to store increasing amounts of data while enabling easy and fast access.

Isilon powers the research activities of the world’s foremost cancer research facility.

Isilon provides delivery services for many of the world’s leading entertainment and media companies.

Isilon supports huge galleries of images and other user-generated content for numerous consumer web sites.

And Isilon gives major manufacturers the ability to consolidate vast amounts of complex CAD into shared pools of knowledge, giving engineers immediate shared access to critical data.

In short, as the world’s store of data grows, the needs for services like Isilon’s grow along with it.

And the results are now becoming apparent in the company’s bottom line.  Isilon was founded in 2001 and came public in 2006, and it’s grown revenues every year.  In the past twelve months, it’s brought in $136 million in revenue.  But the company was a regular money-loser until recently, more intent on growing than on making a profit.

Now that’s changed, as economies of scale are truly kicking in.

In fact, Isilon has just posted two consecutive quarters of positive earnings.  Revenues are now growing at an accelerating rate (46% in the first quarter), and the profit margin is expanding (7.5% in the first quarter.)

Finally, the stock’s chart reveals strong support by investors who are learning about this young company’s potential.  Since gapping up to 14 after the release of a terrific first quarter report in late April, the stock has spent two months digesting that gain.  In the depths of the market correction, it had pulled back to its 50-day moving average at 12.

But buyers stepped in, and last week the stock soared on the heaviest volume in weeks, right back up to 14 and more, where it’s primed to break out to new highs.

ISLN was featured in Cabot Top Ten Report back on May 17, when it was trading at 12, so subscribers who followed the advice of editor Mike Cintolo have a nice profit today.

If you’re not a subscriber, perhaps you should be.  To get started with a trial subscription (backed by our money-back guarantee) click here.

The first stop on our trip was the Great Smoky Mountains National Park, which was lovely. We enjoyed a nine-mile hike on Rich Mountain, an 11-mile bike ride through Cades Cove and a trip down the Little River on inner tubes to relax and cool down after all that exercise.

The park was breathtaking, extremely clean and the people we met were incredibly friendly. We even saw a bear! Luckily, it was from a decent distance and we were safe in our car.

After getting our fill of nature, we headed to Nashville: Music City. We happened to be there on the night of the Country Music Television Awards, so the town was extra festive. We went to Hatch Show Print, one of the oldest working letterpress print shops in America, which has produced posters for greats like Hank Williams and Johnny Cash. Down the street from there, we went to Gruhn Guitars, where you can buy an instrument that costs as much as a car. And of course, we strolled down Music Row before eating some of the best brisket I’ve ever had at Jack’s Bar-B-Que.

Also in Nashville, I saw something I’d never seen before: A Redbox at a McDonald’s.  If you’re not familiar with Redbox, it’s a movie rental kiosk usually found at the front of grocery stores where you can rent DVDs for only $1 per night.

Netflix has done an excellent job meeting people’s desires to have movies delivered to their homes either through the mail or on demand via a device such as a computer or video game console like a Nintendo Wii. But Redbox picks up the slack for those people who still like to go out and pick up a movie to watch. Redbox is part of Coinstar, which popularized the coin-counting machines at the front of grocery stores. And now it has done the same with movies.

Editor Michael Cintolo recently featured it in Cabot Top Ten Report, where he wrote:

“Coinstar was founded in 1993 with an interesting business plan: Put big, green Coinstar boxes that count people’s change in the front of grocery and other big-box stores  and take a cut of the total. Now the company is using that foot in the door to place Redbox dollar-a-night DVD rental kiosks–24,000 of them to date–in Walmarts, McDonald’s,  groceries, pharmacies and other locations across the U.S. (93% of revenue) and internationally (7%). The company also has a network of financial services facilities that allow consumers to make payments, buy prepaid debit cards and perform money transfers. But there’s no doubt that the dollar videos are the big deal right now, with most of the hottest titles available just 28 days after DVD sales begin. Q1 results showed an impressive 254% jump in earnings on a 47% gain in revenues, with Redbox results providing most of the boost. With Movie Gallery announcing its own demise in May, Blockbuster in rocky shape and Netflix moving toward streaming delivery, the future looks bright for Redbox and Coinstar.

“CSTR gapped up from 38 to 44 on that great earnings report on April 30, and the stock has acted well since then. CSTR worked its way to as high as 58 on May 13, and has pulled back slightly, closing last Friday at 53. This is impressive strength in the face of a grumpy market, and CSTR looks like a good buy right here, but a great buy on a pullback toward 50.”

“When you get time (!) could you elaborate on why you don’t average down on growth stocks?  I’ve heard two “experts” in the last two days saying to average down on good stocks.”

D.B.
Portland, Oregon

This is a great question, because it gets to the heart of the reason we own particular stocks.  And the key is right there in the question, in which D.B. refers to “growth stocks” and “good stocks,” phrases that are not always interchangeable.

In Cabot Top Ten Report, which recommends 10 strong stocks every Monday, a “good stock” is one with a strong chart and a great growth story, like Netflix (NFLX) today.

Netflix, which revolutionized the home video-watching industry once and is now doing it again streaming content online, saw revenues grow 26% in the latest quarter, saw earnings jump 63%, and has analysts projecting earnings growth of 32% (which is probably conservative) in 2011.  The company’s after-tax profit margin typically runs around 7%.

So NFLX trades at a typical growth stock valuation.  Its price/earnings ratio is 45 and its price/sales ratio is 3.2; to buy this business, which had revenues of $1.77 billion in the past 12 months, the market says you’ve got to pay $5.62 billion (3.2 times sales)!  Some analysts call this markup the “growth premium.”

And Netflix is not unusual; the best growth stocks always seem expensive.

Meanwhile, in Cabot Benjamin Graham Value Letter, a “good stock” is one with a proven business model and experienced management that is selling at unusually low valuations, like Archer Daniels Midland (ADM) today.

Archer Daniels Midland is one of the biggest food and grain companies in the world, and it pays a reassuring 2.4% dividend (the company has raised its dividend for the past 34 years).  But revenues grew just 3% in the first quarter, and analysts are projecting earnings growth of only 1% in 2011, and the company’s after-tax profit margin typically runs around 3%.

So ADM trades at a typical value stock valuation.  Its price/earnings ratio is 10 and its price/sales ratio is just 0.26; to buy this business, which had revenues of $62.5 billion in the past twelve months, the market says you’ve got to pay “only” $16.3 billion!

And ADM is not unusual; the best value stocks always look cheap.

So, to recap, to a growth investor, NFLX is a “good stock” because it’s strong and because the company has great prospects for growth of both revenues and earnings.

And to a value investor, ADM is a “good stock” because the company has a proven business model and experienced management and the stock is cheap today.

But what about D. B.’s question about averaging down, meaning buying more stock at a price lower than where you previously bought it?

Averaging down makes perfect sense in a value stock like ADM, given that there’s confidence the stock will be higher eventually, if not immediately.  Most recently, in fact, ADM has been trending down.  It was trading at 33 back in November, and now it’s down to 25.  Cabot Benjamin Graham Value Letter editor Roy Ward says the stock is a good buy anywhere under 28.11, so it makes sense that you’ll get an even better bargain if you can buy more (average down) at 24 or 23 or 22.  Value stocks, in that sense, are like bananas.  Cheaper is better.  And unlike bananas, stocks don’t go bad a week later.

But good growth stocks can seldom be bought cheap, and as long as their prospects for growth are intact, a high valuation is no reason to avoid investing.  NFLX, to return to our example, was an expensive stock six months ago when it was trading at 55, when it earned a spot in Cabot Top Ten Report; it’s been expensive in the three occasions it’s appeared there since (trading at 59, 65 and 98); and it’s even more expensive today trading above 110.

The right way to play NFLX, and the right way to play all the best growth stocks, is to buy more stock at higher and higher prices (averaging up) as the months go by, holding on tight until you decide the uptrend has ended.

By contrast, consider Research in Motion (RIMM), the maker of the Blackberry.  RIMM used to be a great growth stock … before Apple came out with the iPhone.  And by the numbers, Research in Motion is still a decent growth company; revenues were up 18% in the first quarter, and earnings grew 42%.  But that alone is not enough to make it a good growth stock.  The main problem, as I see it, is that RIMM was once well-loved, but growth is now slowing.  In fact, analysts are projecting earnings growth of 24% in 2011 and only 9% in 2012.

So investors have been reacting to the expectations that Research in Motion will be a slower grower by slowly and steadily moving elsewhere, to stocks like AAPL and NFLX.   As a result, RIMM has underperformed the market for the past two years; it was trading near 150 two years ago; it was at 86 one year ago, and now it’s near 60.  And as a result of that, the stock’s growth premium has shrunk.  RIMM’s price/earnings ratio is now down to 13, and you can buy the company for $34 billion … or 2.3 times sales.

So if you had been averaging down in RIMM over the past two years, you might not be very happy today.

Bottom line, averaging down is fine for investors in value stocks, but dead wrong for investors in growth stocks.

Note: Eventually, if RIMM’s downward trend continues, it could be a good value stock, but the transition period from one phase to the other is usually too long (many years) for most mortals to tolerate.