At the end of June 2005, the Moose Pond Investors portfolio had declined in value for the first six months of the year by 5.1%. In comparison, the S&P 500 was down 1.7% and the Russell 2000 was down 1.25%. The unit price for the portfolio is exactly where it was at the end of November 2004.
Although the portfolio underperformed the major indices, the portfolio remains well positioned with the following weighted averages: projected average return of 15.3%, relative value of 94, (RQR) quality of 71.7 and projected revenue growth of 11.8%. See portfolio snapshot. The portfolio is diversified across five industries: consumer discretionary (20.3%), Energy (3.9%), financial (26.1%), healthcare (24.4%), information technology (23.8%). The portfolio is further diversified among industries in these sectors. See diversification report.
You may be asking the question, if we had such a good portfolio, why did it under perform the market averages for the first half of this year? Great question. The best way to answer that question is to look at the stocks that significantly over or under performed. In the first 6-months of this year, several of stocks in the portfolio declined significantly: UTSI (-66.0%), FNMA (-44.4%), IFIN (-23.2%), HDI (-16.7%), MMC (-14.8%) and ACS (-14.2%). Unfortunately, only one stock strong positive gains during this 6-month period : ORLY (32.4%).
Looking at the past 12-months, we see that several of these same stocks have lagged the market: FNM (-29.3%), HDI (-18.3%) and IFIN (-10.4%). However, we also held a number of stocks that did well during this 12-month period: ORLY (32.0%), LNCR (24.5%), JNJ (18.6%), PDCO (17.9%), COF (17.2%) and CBH (16.0%). The portfolio had a positive return of 1.5% for this 12-month period but still lagged the major indices.
The “rule of five” embodies the conventional wisdom that if you hold five stocks, one stock will perform better than expected, one will perform worse than expected, and the other three will perform about as expected. In our portfolio, we had several more stocks performing worse than those performing better than expected. This should be a passing anomaly. (The “rule of five” is an observation — not an immutable law of nature.)
We need to be careful not to over react and make rash decisions based on poor price performance for one or two quarters. Instead, we should stay focused on company fundamentals (revenue growth, pretax profit margins, return on equity, etc.) across the entire portfolio. The overall portfolio looks strong in terms of both quality (71.7) and projected average return (15.3%).
Let’s take a quick look at the laggards in the portfolio.
UTSI. This was our most speculative stock. (And yes, UTSI aptly demonstrates the price volatility of speculative stocks.) UTSI has had a very poor quarter based on loss of revenues in China. This bad quarter was followed by lowered earnings guidance for 2005. As a result the price tanked. While the near term earnings projection does not look good, Value Line projects the 3-5 year revenue growth at 15.5% and the net profit margin in at 6.9%. Using the preferred procedure (pre-tax margin of 9.2%, tax rate of 25% and 130m shares outstanding) the 5-year EPS would be $3.25. Assuming a 5-year high PE of 22.5 and a low PE of 12, projected average return of 48%. Value Line (July 1, 2005) still rates UTSI’s financial strength an “A” and it has an RQR quality score of 51.1. Although UTSI has declined in value to 1.3% of the portfolio, holding it is probably the right answer unless its fundamentals deteriorate further. See stock selection guide and price chart for UTSI.
FNM. We sold FNM on March 24, 2005 and do not plan to repurchase it.
IFIN. A soft quarter was responsible for much, if not all, of the recent price decline. See recent discussion of IFIN. It has a projected average return of 21.5% and quality rating of 65. The near time price weakness appears temporary. We purchased some additional shares on June 14. Price chart.
MMC has been impacted by the investigation into industry pricing practices but seems to be recovering. Similarly, ACS has seen a near term decline in stock price due in part to a near term softness in revenues. Both companies seem poised to do well. MMC has a projected average return of 11.8% and quality rating of 65 while ACS has a projected average return of 17.5% and quality rating of 71.
In summary, a handful of stocks reduced the performance of the portfolio for the first half of this year. However, these stocks (except FNM) should remain in the portfolio for now. We are going to watch UTSI and the other stocks closely.