There are several tools, some of which were developed by NAIC / Better Investing, for looking at an entire portfolio.  The portfolio evaluation review technique or “PERT” takes data from individual stock selection guides and creates a table. Sorting this information allows identification of the outliers.

PERT Report. Here is the PERT Report for the Moose Pond Investors portfolio. This report is sorted on estimated total return, from lowest to highest.  Looking at the low end, several companies in our portfolio stand out as being candidates for replacement, e.g., AIG, Helmerich & Payne (HP), and possibly Illinois Tools Works (ITW).  These stocks will be discussed in future postings.

Before making any decisions based on the PERT report, it is important to understand how Toolkit 6 calculates total return.  The PERT report uses the estimated earnings per share (EPS) for the next 12 months and extends those earnings for four more years, for a total of five years, using the EPS growth rate from section 1 of the SSG.  The 5-year estimated EPS is multiplied by the estimated future PE (which is the average of the high and low PE from section 4 of the stock selection guide).  This result is an estimated price in five years.  The 5-year price appreciation then is a simple calculation — [(Future Price / Present Price) ^ (1/5)] – 1.

The total return is the the sum of the price appreciation in percent and the average dividend yield in percent.  This may sound complicated, but it is not.  The total return calculation depends on the accuracy of the 12-month projected EPS, the applied 5-year EPS growth rate, and the estimated future PE. Despite the marvelous precision of computers, PAR is just a reasoned guess based on three independent variables.

The actual return on any stock is a function of only three variables:  earnings, dividends, and valuation (i.e., the price to earnings ratio).  When we try to predict earnings or PE ratios five years into the future, we must use judgment and we are often wrong.  That is why we revisit our judgment each quarter as companies publish new earnings reports.

Trend Report. The trend report compares operations of the companies in the portfolio over two consecutive quarters relative to earnings, sales, and pre-tax profit.  This provides a simple view of the “trend of the trends.”  The report also includes total return (as described above) and projected average return or PAR.  The trend report ahs been sorted by projected average return or PAR from lowest to highest.

PAR is calculated in a manner similar to similar to total return except that we use Section 1 of the stock section guide rather than the analysts’ 12-month estimates.  There are several different techniques for estimating future EPS, but projected average return or PAR is based largely on the 5-year estimated EPS in Section 1 of the stock selection guide.  The total return and PAR sometimes differ.  This simply reflects the different approaches to calculating 5-year EPS.  Discussing which approach is more accurate invariably ends up in a lively debate.

Portfolio Allocation. It is important to understand  what asset classes are included in a portfolio.  For U.S. equities, we generally characterize companies as small, medium, or large based either on market capitalization or total revenue.  We also use fundamental analysis to characterize a stock as growth, value, or somewhere in between.  In a globalized economy, it also is helpful to know the extent to which a company’s revenue comes from outside the U.S.

Academic studies have show that small cap stocks out perform large cap stocks over time by a significant margin.  Small stocks are riskier and should provide a higher return.  Studies have also shown that value stocks tend to slightly out perform growth stocks over long periods of time.  Diversifying a portfolio over multiple asset classes tends to reduce risk and improve overall performance.  For a visual presentation of how different asset classes perform by year over time, look at the Callen Periodic Table of Investment Returns.

Morningstar provides an excellent “X-Ray” tool for looking at the style and sector characteristics of a portfolio.  Here are the X-Ray summaries for the Moose Pond Investors portfolio by style and sector.  These reports suggest that the portfolio may be over weighted in large-cap stocks.

As if these different views of our portfolio were no confusing enough, there is one more.  The Manifest Investing portfolio dashboard is helpful. It shows quality and PAR for the portfolio.  For the reasons discussed above, our calculation of PAR may not agree with those on Manifest Investing.  However, the portfolio dashboard does provide an easy way to find outliers which require more analysis. The portfolio dashboard also provides any easy why to decide where to apply additional case (i.e., those companies with high quality and high PAR that reflect a small percentage of the overall portfolio.  Conversely, the portfolio dashboard can be used to find stocks to replace (i.e., those with low PAR or quality that reflect a large percentage of the portfolio.

Summary. We do need to take a close look at the 2 3 outliers near the bottom of the list in terms of projected performance.  Helmerich and Payne (HP) is strong candidate for replacement.  We also need to take a hard look at Illinois Tool Works.  In finding replacements for existing stocks or deploying new cash, we should look to increasing our holdings in small-cap and mid-cap stocks.

- TH

Using the performance benchmark report in Bivio, the internal rate of return for the Moose Pond portfolio was a negative 27.6% year-to-date on October 31.  In comparison, the Vanguard Total Market Index Fund was down 38.6% and the Vanguard S&P 500 index Fund was down 38.5% for the same 10-month period.

It will take a strong post-election rally to take the edge off the losses for this year.  Stock valuations are at a low for several decades.  So while there has to be pony in here somewhere, no one can be sure exactly when we’ll find it. In the interim, we should continue to follow out investment objectives and remain fully invested and commit new cash.

We do have an opportunity to replace several of our stocks with ones that have a higher projected average for the next five years.  More to follow on that.

Here are performance reports for the one month and 12 month periods ending on October 31, 2008.

AIG was the big loser, dropping 93%.  The stock is probably a lost cause.  Good thing we didn’t but any more!  The other contributors to our losses this year were Synovus Financial (-50.8%), Total System Services (-35.2%), Microsoft -28.5%), and Intel (-26.5%).

An astute reader of this blog pointed out that most of the drop in price for Synovus Financial (-50.8%) this year was a result of the spin-off of TSS in January.  That’s exactly correct.  Just looking at the price of SNV does not tell the whole story.   At the beginning of the year, our holdings in SNV had a value of $1,758.  SNV and TSS currently have a combined value of $1,392.  So the actual decline in value this year is only 20.8%.

But for the losses on AIG and TSS, we would have been in positive territory for 2008.

We do have some winners this year.  They include Helmerich & Payne (+40.3). Wells Fargo & Co. (+36.2%), Amgen (+29.1%), Sun Hydraulics (+26.4%), and Lowes (+26.3%).  This underscores the importance of diversification and quality in a portfolio.

Take a look at the portfolio dashboard from Manifest Investing.  We may want to consider selling Bed, Bath & Beyond and Brown & Brown.  At the same time, we may want to slightly increase our holdings in Microsoft, Walgreen, Transoceanic, and FactSet Research.  Each of these companies have a high quality rating and high projected average return.

Several stocks accounted for the mediocre performance.

Getty Images GYI (-38%) had a disappointing quarterly earnings report. Morningstar star reduced its fair market value estimate. Investors Advisory service recommends selling GYI, noting that the company faces increased competition in the Internet photo images market. Morningstar reduced GYI’s moat rating from “wide” to “narrow.” The visual section of the stock selection guide show the downturn. See the current stock selection guide (SSG) which shows a projected average return (PAR) of only 7.6%. My bad for recommending this one. We should probably sell GYI at some point soon.

Amgen AMGN (-26.6%) has been down for the year. However, most of the analyst reports cite its pipeline and consider it a strong long term buy. Here is the current AMGN SSG. Note that the PAR of 22.7% and that assumes a relatively modest EPS growth of 11%. AMGN is definitely a hold and probably a buy. Now if the market will just recognize what we do!

Of course we had several winners YTD as well. These include INTC (+23.7%), ITW (+24.9%), JKHY (+25.2%), and OXY (+27.8%). This highlights the importance of diversification.

Here are three transactions that may improve our portfolio performance for this year.

• Replace Stryker (SYK) with Medtronics (MDT). Stryker has advanced 22% this year. The price increase has diminished its long term prospects. Morningstar rates it two stars (a little over priced). In contrast MDT is rated five stars (a bargain). Both companies are quality medical suppliers, however, the prospects are a little better for MDT.
• Sell Getty Images (GYI). We are better off selling and redeploying the cash.
• Buy Superior Energy Services (SPN). BNP Is a diversified provider of specialized oilfield services and equipment. While oilfield services are cyclical, the prices for oil and gas have not gone down and the demand for oilfield services continues. The SSG for SPN looks strong. Neither Morningstar nor Value Line cover SPN, but it received a five star rating from Standard & Poors. We should move quickly on SNP as it appears particularly undervalued now.

Portfolio Activity

We made some adjustments to our portfolio this quarter to improve portfolio quality and increase diversification. In the energy sector, we replaced Occidental Petroleum and ChevronTexaco with ConocoPhillips and Helmerich & Payne. This split our energy holdings between a mega-cap energy company that both produces and refines, and a quality company that provides contract drilling services to oil and gas producers.

In the financial sectors, we replaced Commerce Bank and Capital One Financial with American International Group. (There is nothing inherently wrong with CBH and COF, although COF has a low return on assets; we just wanted realign our financial stocks.) We exchanged East West Bancorp for Wells Fargo & Co.

We added to our position in Getty Images, Bed, Bath & Beyond, and Amgen. Unfortunately, BBBY reported mediocre earnings after we increased our position. This clipped our overall portfolio earnings for the quarter a little. See chart. However, BBBY remains a high quality company.

Finally, we added information technology holdings with new positions in Microsoft and SAP. We sold UTStarcom. All these transaction together raised the quality rating of the portfolio to 72.2 (out of 100 with 65 being excellent) and the projected average return to 13%.

Most Recent Quarter

Our biggest winners for the quarter were Intel (+24.7%), Maxim Integrated Products (+14.2%), and our energy stocks, Occidental Petroleum (+16.2%) and Chevron Texaco (+10.0%). We had several stocks that did not earn their keep this quarter, Bed, Bath & Beyond (-12.4%), Brown & Co. (-6.8%), Stryker (-4.9%), Synovus (-4.5%), and Walgreen (-5.0%).

The Past 12 Months

It is always interesting to look back over the past year. We had some outstanding winners,Stryker (+50.4%), Factset Research (+45.3%), Chevron Texaco (+34.1%), and Jack Henry & Assoc. (+32.2%). Two stocks disappointed, Amgen (-15.5%) and Brown & Co. (-13.3%).

Looking Forward

Not being a market prognosticator, I’ll leave it for others to predict where the stock market is heading. Morningstar had a very readable outlook, that included a sector by sector analysis. Morningstar observes that some of the mega-cap stocks, like Walmart and Johnson& Johnson are very cheap.

Projected Average Return and Quality

As individual investors, we need to stay focused on our portfolio and the individual stocks in it. Let’s take a look. The Manifest Investing dashboard provides some key information. The portfolio dashboard shows the quality and projected average return (PAR) for each stock and for the overall portfolio. For the portfolio, the quality rating is 72.2 out of 100, which is very good. High quality will give us some downside protection if the market is off for the second half of the year. The projected average return if 13.0%, also very good.

If you pay close attention to the portfolio dashboard, you will notice two stocks with low PARs, Factset Research (6.2%) and ConocoPhillips (4.3%). Factset Reasearch has had great performance, increasing 45.3% over the past year. So we are caught between two conflicting wall street adages: “Let your profits run” and “No one ever went broke taking a profit.”

Here is the stock selection guide (SSG) for Factset Research. You can see that it has had strong revenue and earnings growth. You also can see that it is selling near its all time high price. Value Line projects earnings and revenue growth of 16.5%. (We were more conservative than that in the SSG.) Morningstar estimates a fair market price of $64, making it fully valued at its current price; thus Morningstar gives Factset Research only 3 stars. Since Factset Research only makes up 4.3% of our portfolio, I am inclined to hold it as long as its fundamentals do not change. (Note: The risk of holding a growth stock with a high PE, like FDS, is that if earnings stumble, even for a quarter, the stock will sell off rapidly.)

ConocoPhillips (COP) also shows a low projected average return. Manifest Investing characterizes COP as a cyclical stock (hence the little squiggly symbol “~”). Manifest Investing uses Value Line data for its projections. Value Line assumes that long term oil prices will drop significantly. For example, Value Line projects only 2% revenue growth for ConocoPhillips. This low projection drives down the projected average return. I am not an analyst but Value Line seems to be unreasonably pessimistic about energy stocks.

For another view of ConocoPhillips see the McDep Associates stock report on COP from April. Kurt Wulff makes his energy news letters available on line. His weekly Meter Reader newsletter is very informative (and free). Also, see past Stockherd article about his methodology.

The bottom line is that holding some energy stocks provides needed diversification. COP pays a dividend of 1.6%. We should continue to hold it. The McDep ratio suggests it is significantly undervalued. Another reason to continue to hold it.

Portfolio Diversification

The Morningstar”X-Ray” report is helpful in looking at a portfolio as a whole. Here is a summary of the portfolio by asset class (which Morningstar calls styles):

The portfolio weighting is probably where we want it to be. It is split between large and mid/small cap stocks with large caps having a slightly higher weighting. Also, the portfolio tilts toward growth rather than value, which is expected with an NAIC/BI approach.

Here is a breakdown by sector and industry.

The portfolio is overweighted in the services sector and underweighted in the information technology and manufacturing sectors. As we replace stocks in the portfolio, we should look to the underweighted sectors for replacements.

This month we sold UTStarcom (UTSI) for a loss of $717 and Investors Financial (IFIN) for gain $199.  We are 6.8% in cash.  We will be using some of that cash to round out our holdings of Walgreens (WAG) and will park the rest in the Vanguard Total Market Index (VTI).

Getty Images really took off this month, up 15%.  They did better than the analysts expected.  We are back in the black for that stock. 

We have two stocks that have doubled since we bought them.  Lowes (LOW), one of our first stocks, is up 248% for an annualized return of 22.4%.  Factset Research Service (FDS) is up 123% for an annualized return of 32.3%.  We need a few more stocks like them.

You can see the entire portfolio at Manifest Investing.

More information about the performance of individual stocks in 2006 can be found in the diversification report and performance report.

How we are doing depends on the index to which we compare our portfolio performance. Here is a table showing year to date return data taken from the Wall Street Journal as of Wednesday, November 22.

Note that value stocks and small stocks have out performed both large and growth stocks. This has been a trend for a number of recent years. If you want to compare investment returns by asset class (large, small, value growth, etc.) take a look at the Callan Periodic Table of Investment Returns.

As you can see from the matrix on the right, our portfolio is weighted heavily toward large growth stocks. It was only some recent purchases of GYI and VTI that improved our style balance. Large growth stocks have not done as well as the smaller stocks and the value stocks this year. We need to include more small and medium size companies in our portfolio. It may be inconsistent with an NAIC approach, but we also need some value stocks. Value stocks are generally defined as ones have lower price to earnings or low price to book ratios.

The next two graphs compare our portfolio return over the past 12 months with two Morningstar indices. The first graph compares our return to the Morningstar large growth index. Our return tracks that index fairly closely.

The second graph, below, compares our return with the Morningstar U.S. market index. This is a broad index that includes all stocks. We are not doing as well as that index.

In looking across the portfolio, two, possibly three, companies seem like good candidates for replacement.  These are Marsh & McClennan (MMC) and Affiliated Computer Systems (ACS).  The third possibility is Pfizer (PFE).  We may want to consider replacing these companies with smaller quality companies with better growth prospects.  Also, we should look at adding to our position in some of our better holdings.

Marsh & McClennan has not yet recovered from its myriad of regulatory problems. Click here for a SSG.  It has failed to re-establish growth in either revenues or earnings. Return on equity and pretax margins have dipped significantly, with no immediate sign of recovery.  It may be a good value stock (Morningstar rates it 4-stars) but it currently fails as a quality growth stock.  MMC is a prime candidate for replacement.

Affiliated Computer Systems seems unable to move forward.  Click here for a SSG.  As the chart below shows, it seem it has been unable to grow its revenue and earnings in any significant way over the past 4-5 quarters.  It is now mired in an options pricing mess and will have to restate its earnings.  ACS failed to fully report its current quarter and instead offered up instead “non-GAAP” (GAAP = generally accepted accounting principles) metrics of performance.  Its TTM pre-tax margin (10.5%) is below the industry average (15.8%).  Morningstar still rates ACS 4-stars but also rates it F for stewardship.  ACS may be a decent company about to turn the corner — assuming its options pricing problem doesn’t get worse — but it seems to be another prime candidate for replacement.

Pfizer is no longer a classic growth stock. It’s price has rebounded in the last 12 months up more then 22%.  However, both growth and quality of earnings are in doubt gonig forward.  Sales projections over the next 5 years vary from 2.6% to 6%. Click here for a SSG.  PFE might be a good candidate for replacement.