It's a situation that continues to perplex investors: If the markets are supposed to reflect the future economic climate, then why have stocks performed so well when the broader economy is anything but robust? For those worried that the next step forward could be a turn for the worse, BlackRock Capital Appreciation Fund lead manager Jeffrey Lindsey advises looking beyond conventional wisdom for clues to what's ahead.

To be sure, Lindsey does not have a rosy view of the economy. Employment and real estate prices are still woefully lagging. He's also concerned that crushing debt levels will bring on inflation and higher interest rates will be a negative for companies that can't pass on higher prices to their customers.

Yet Lindsey is bullish on stocks. His optimism has nothing to do with gross domestic product or Fed policy; instead, he focuses on what individual companies have been able to achieve in such trying times. "Stocks have done well," he says, "but earnings have done even better."

The result is that many companies are in better financial shape than they have been in years, with strong balance sheets, ample cash reserves and modest valuations due to those impressive earnings. In 2010, for example, the S&P 500 returned 15.1%, but earnings per share soared 39%, according to Standard & Poor's.

How do they do it? Large companies are increasingly looking beyond the American market and the bedraggled U.S. consumer. A growth investor like Lindsey is emboldened by the shift toward economies with better prospects. The U.S. GDP growth rate of 1.8% in the first quarter pales in comparison to China's 9.7% and Brazil's 7.5%. Although experts have wondered for years if these economies can continue at such an accelerated pace, the consensus is that emerging markets will grow faster than either the United States or Europe.

Lindsey is used to finding fast-growing companies in challenging environments, as the fund's performance the last few years demonstrates. For the three years ended May 31, the fund's average annual gain has been 2.9%, beating 63% of large-cap growth funds, according to Morningstar. Over the last five years, the $5.3 billion fund returned 5.9% a year annualized, outshining 84% of funds in its category. Last year, the fund posted a gain of about 19%.

OPPORTUNITY KNOCKS

To help identify potential buys, Lindsey divides the portfolio into core names that have stable growth rates and opportunistic issues that can grow faster. The core portion normally comprises about two-thirds of his holdings.

Lately, though, Lindsey has skewed the opportunistic portion of the portfolio to a range of 40% to 45%, reflecting the impressive prospects of some firms. "We use a bottom-up approach," he explains. "As we're looking company by company, we're just finding a greater number of these faster-growing opportunities that we have confidence in."

Technology, which is by far BlackRock Capital Appreciation's largest sector weighting, with a 38% allocation, sits squarely in this camp because of the economic recovery. Corporations are spending again on tech upgrades, but mostly in targeted areas.

Lindsey points to two names that benefit from companies' growing willingness to invest in cloud and virtual computing, which can help reduce information technology spending. First is Salesforce.com, which distributes enterprise software to clients through the web. Doing so eliminates the need for small- and medium-size businesses to have capital-intensive IT departments to maintain their software. Instead, it's delivered on a subscription basis, providing Salesforce.com with a reliable revenue stream.

The other pick is NetApp, which provides storage and data maintenance that allows companies to achieve computer virtualization. "When you want to implement the cloud, that's one of the companies you go to," Lindsey says.

Salesforce rocketed 83.7% over the last 12 months, while NetApp surged 56.3%. Of course, such performance comes at a price. Salesforce, for example, sells at dizzying price-to-earnings ratio of about 75.4 times forward earnings. NetApp trades at a P/E ratio of about 18.

Lindsey isn't bothered by the valuations. He believes that, unlike the bloated multiples tech darlings sported during the dot-com era, when some companies had yet to achieve profitability, today's tech leaders are providing important products - and have the sales and earnings to show for it.

SMARTPHONES, SMART STOCKS

Similarly, Lindsey sees strong trends regarding smartphones and tablets. "People want to access all their information wherever they are," he says. "It's become an unstoppable trend. When they do that, suddenly they are using 100 times more bandwidth."

STILL IN LOVE WITH APPLE

Apple is Lindsey's top holding. Despite several years of mind-blowing profit gains, Apple continues to post better numbers on the strength of its products. "I think people are underestimating how much the iPad will eat into the PC market," Lindsey says.

Lindsey thinks Apple's P/E ratio of 12 times forward earnings is a steal given its spectacular growth rate. He acknowledges that some investors are dubious. "The stock price reflects a lot of suspicions about whether Apple can keep growing at the rate that it has," he says. Lindsey notes that the tech trendsetter's cash horde of $70 billion also merits investor attention.

While Apple is front and center on technology trends, Qualcomm, a behind-the-scenes player, also stands to benefit. Although focused on semiconductors for the wireless industry, Qualcomm is also the inventor of code division multiple access technology, the 3G telephony standard. That means it collects licensing royalties on every phone operating on the 3G network.

Qualcomm stands to profit from the conversion of cellphones to smart- phones. Lindsey believes Qualcomm's greatest opportunity is in emerging economies. "Qualcomm is the single biggest beneficiary of the move toward smartphon es," Lindsey says.

Over the last 12 months, the stock returned 65.2%, although its P/E is just 16.3% times forward earnings. In the second quarter of 2011, net profits zoomed 29%.

Another big focus for BlackRock Capital Appreciation is the consumer discretionary sector. "It's not a reflection of the strength of the U.S. consumer," Lindsey says. "We're looking at companies that are gaining market share."

One such company is Amazon.com. "The big story there is international growth," Lindsey says. The Internet commerce pioneer is clearly in growth mode again. It's added staff to prepare for more expansion and bulked up on real estate, saying it would add more facilities to the nine warehouses it built this year if revenues continue to rise.

The cost of expansion is taking a toll on Amazon's short-term results, however. In the first quarter, net income fell 33%, well below analyst estimates. Revenues, however, rose 38%. Shares are up 6.9% since the beginning of the year.

Lindsey is also betting on the return of shopping with an investment in UPS. "More packages are being shipped, and they're getting heavier," Lindsey says. That means higher revenues for the shipping giant, which should find its way to the bottom line. Lindsey also likes that UPS can levy fuel surcharges as a way to deal with rising energy costs and is growing its international business. That segment rose 4% in the first quarter. The stock is up 1% this year.

As the economic recovery continues in fits and starts, companies with strong growth potential and solid earnings will likely excel in the markets. Many of those companies will probably be household names with strong international presences. Lindsey just has to pick the right ones.

 

Ilana Polyak, a New York financial writer, contributes regularly to Financial Planning.

 

 

Jeff Lindsey

Age: 48

Credentials: B.S. in commerce, University of Virginia; MBA, Emory University

Experience: Portfolio manager, BlackRock Capital Appreciation Fund (2002-present); managing director and chief investment officer for growth, State Street Research and Management (2002-2005); managing director, Putnam Investments (1994-2002); analyst and portfolio manager, Strategic Portfolio Mgmt. (1987-1994)

Ticker: MDFGX

Inception of fund: December 1997

Style: Large growth

Assets under

management:

$5.3 billion

Three-year performance as of May 31, 2011: 2.9%

Five-year performance as of May 31, 2011: 5.9%

Expense ratio: 1.13%

Front load: 5.25%

Minimum investment: $1,000

Alpha: 2.91 vs. S&P 500