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Stock Strategist

Stocks for the Growth Watch List

These names have recently appeared on GrowthInvestor's radar.

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Our Growth Leaders and Emerging Moats lists are an integral part of the Morningstar GrowthInvestor newsletter. These lists contain our best growth ideas, and at the right price, I would gladly purchase these stocks for the Growth Portfolio. So to keep our radar screen up to date, here are some of the new stocks I've added to both of our watch lists.

 Silicon Labs (SLAB)
 Marvell Technology (MRVL)
To build a moat in the semiconductor industry, you must have world-class engineering talent, and these two companies have more than their share. Both Silicon Labs and Marvell have a twofold advantage because they are experts in high-performance chip design on the CMOS process. Their chips incorporate a significant amount of analog circuitry to process real world phenomenon such as sound or radio waves, and experienced analog engineers are in short supply. Few college students study analog engineering and it takes years of on the job training to become skilled. This is why analog chipmaker  Linear Technology (LLTC) earns 103% returns on invested capital, and its chairman can say, "If you would have a billion dollars, you could compete with Intel, but if you had $10 billion, you still couldn't compete with me, unless you hired my people." In addition, companies with a critical mass of engineers benefit from a network effect because good engineers want to work with other good engineers, and rookie engineers want to learn from a talented team.

The second facet of these firms' moats is their focus on using the industry standard CMOS manufacturing rather than more exotic processes. Analog circuit design is hard, but analog circuit design in CMOS is even harder. However, CMOS has advantages over other manufacturing processes in cost, performance, and time-to-market. This gives Silicon Labs and Marvell a leg up on the competition. Both firms also pursue a strategy that plays to their strengths by targeting large established markets where they are able to introduce a truly differentiated and disruptive product in terms of cost, size, performance, and power consumption. A competitive response is difficult to mount because other chip companies do not have the requisite engineering talent to design for the CMOS process.

The growth of both firms has been truly astounding. Silicon Labs' sales have quadrupled since 2000 to more than $400 million, while Marvell's sales have increased more than tenfold to $1.5 billion. As both firms use their competitive advantages to attack more markets, I fully expect their sales to grow and moats to widen.

 Gen-Probe (GPRO)
With its superior nucleic acid test (NAT) technology, Gen-Probe has taken more than 80% of the U.S. blood screening market, and there is still plenty of growth ahead. The basis for this growth is the firm's proprietary NAT platform, which allows for faster and more accurate disease detection than older diagnostic methods. In addition to blood screening, Gen-Probe is targeting new diseases and markets. The firm's new hepatitis B test is aimed at international markets such as Western Europe and Japan where its major competitor, Roche, is currently dominant. It's estimated that these two markets screen 25 million units of blood annually, or nearly twice the 14 million screened in the U.S. Fast-growing areas such as China and India account for another 20 million units of potential demand.

Gen-Probe is investing aggressively in R&D to fund development of tests for West Nile, cervical and prostate cancer, and the potentially huge industrial microbiology market. The firm can invest heavily for the future because its business is very profitable. With 70% gross margins, Gen-Probe can plow 25% of sales into R&D and still be left with 30% operating margins.

 Nasdaq Stock Market (NDAQ)
 NYSE Group (NYX)
As evidenced by the Nasdaq's recent (but unsuccessful) bid for the London Stock Exchange, consolidation will be a defining industry theme over the next few years. We expect both the Nasdaq and NYSE to widen their moats and increase profits by playing a key part in the global consolidation trend. For-profit exchanges are a case study in the network effect where liquidity begets more liquidity in a virtuous cycle. New entrants would find it difficult to build the critical mass of buyers and sellers needed to compete. The Nasdaq/Instinet and NYSE/Archipelago mergers have created two massive pools of liquidity, and this increases the likelihood that a trade can be executed without being routed to another exchange, which improves profitability. The specter of destructive price competition is also moderated with only two dominant U.S. equity exchanges.

 Google (GOOG)
Few stocks have attracted as much attention as Google has over the past year. The firm is well-positioned to capitalize on the shift of advertising dollars online, and it deserves a place on our Growth Leaders list. Google makes money by selling ads on its Web sites and on third-party Web sites. I think the revenue Google receives from placing ads on third-party sites is much more vulnerable to competition.  Microsoft (MSFT),  Yahoo (YHOO), and  IAC's  (IACI) Ask are all developing competing ad networks, and Web site owners will join the network that offers the highest revenue share.

On the other hand, Google's iconic search engine enjoys the benefits of an entrenched brand. Google is now synonymous with search, and with each passing day, people's search habits become more engrained. I think the most important metric for Google investors should be the firm's share of search queries. Despite attempts by Microsoft and Yahoo to close the gap, Google's share rose to 42% in February 2006 (according to market researcher ComScore). As long as Google can keep its brand at the top of people's minds, its moat in search will continue to widen.

However, one cloud on the horizon is the move to offer incentives for search engine users.  Amazon.com (AMZN) already offers a small discount to users of its a9 search engine, and Yahoo and Microsoft are rumored to be following suit. When combined with a relevant search product, this may be the nudge that breaks users of their Google habit.

Toan Tran does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.