Mid-Year Portfolio Review

Portfolio review is a constant activity and one that merits more time than the selection of individual stocks. Let’s look at the Moose Pond portfolio at mid-year. (Also, see Mid-Year Performance Report below.)

Diversification. The portfolio includes 24 companies in 5 sectors: consumer discretionary (20.3%), Energy (3.9%), financial (26.1%), healthcare (24.4%), information technology (23.8%). Within these 5 sectors are 16 different industries. Except for UTSI which has declined in value to 1.3% of the portfolio, the individual stock holdings range in value from 3-6%. We are 96% invested.

As to company size (based on revenue), the portfolio includes large companies (58%), medium companies (38%) and small companies (4%). Conventional wisdom would suggest larger holdings in small companies. However, large companies, especially quality companies, currently seem to offer better value. Just look at the number of large quality companies that Morningstar recently has rated as five-star.

Several recent articles have suggested that the near future looks brighter for growth stocks. See the article “Quality Socks Are Now on Sale” by Pat Dorsey of Morningstar (password required). Also, see articles by Jim Jubak and Timothy Middleton of MSN.

Offense and Defense Reports. The offense report generated by Toolkit 5 shows whether the projected return of stocks we hold meet our targets. This report is simply a sort by projected total return. If projected total return is less than the target return, Toolkit highlights the entry in pink. While the current report highlights five stocks, only one of those stocks shows a significant variance. (ORLY has a projected total return of 11.3% against a target return of 15%.) ORLY’s EPS growth has slowed and it currently has a projected average return of 6.9%. We will have to examine ORLY further.

Looking at the defense report (sorted by EPS growth), also generated by Toolkit 5, we see that the portfolio contains a number of stocks for which the earnings have failed to grow in the near term (last 12 months). These include MMC, PFE, LNCR, UTSI, CAH, FITB, PDCO, COF and IFIN. We have looked at each of these stocks individually and consider their long term prospects to be very positive. That’s why we bought them. However, the current problems faced by these companies have driven their price down. This also explains why the Moose Pond portfolio has not kept up with the major indices like the S&P 500 or the Russell 2000 for the first six months of this year.

Changes in Fundamentals. Several stocks in the portfolio need further study. Projected revenue growth has slowed for HDI to 5.7%. This slow down is reflected in the current price. However, the question is whether we should replace HDI with another quality stock with better long term growth prospects. ORLY also appears somewhat over-valued now with a projected average return of 6.9% although it remains a high quality stock with good growth prospects. Finally, JCI’s projected revenue growth has slowed to 7.6%. JCI remains a good quality stock but its projected average return is only 10.5%. It may be better to continue to hold these three stocks but they warrant a close look.

Summary. We need to take look further at ORLY, HDI and JCI and decide if any of those stocks should be replaced. Also, note that we have taken something of contrarian position on MMC, PFE, LNCR, UTSI, CAH, FITB, PDCO, COF and IFIN. We are holding them in spite of near term issues with earnings. If our long term assessments for even a majority of these stocks are correct, the Moose Pond portfolio should substantially out perform the indices in the next year or so. The key is patience and keeping the long term view in focus.

Mid-Year Performance Report

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.

Portfolio Summary Updated

The portfolio summary has been updated. The portfolio has a projected average return of 15.0% and a quality rating of 71.4 (out of 100). Three stocks with relatively low PAR are ORLY (7.4%), PDCO (10.1%) and BRO (10.8%). These might be candidates for replacement with companies with higher PAR values.

The portfolio is diversified across five industries but with most of the holdings in four industries. The portfolio has some redundancy in the financial sector (banks – FITB and CBH ), healthcare sector (drugs – PFE and AMGN) and information technology sector (chips – MXIM and LLTC). See diversification report.

Several other NAIC reports are helpful in reviewing a portfolio. See Portfolio Evaluation Review Technique (PERT) Report (sorted by total return), and Trend Report (sorted by percent of portfolio).

Sold Commerce Bancorp (CBH)

We sold CBH on June 12, 2007. Primary reason was declining on return on assets.

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Additional Shares Bought

We added to our positions today in PFE, CBH, FISV, BBBY and MXIM. With the additional shares, each company will represent about 6% of the total portfolio.

Quality Growth Screen

Here is a Quality Growth Screen using Value Line data. Projected average return was calculated from Value Line data in two ways One calulation sued projected EPS growth, the other used projected sales growth.

Teva Pharmaceutical Ind.

The April 2005 Better Investing magazine featured Teva Pharmaceutical Industries as a stock to study. Here is a PowerPoint presentation and stock selection guide analyzing Teva.

Here is the bottom Line: TEVA is a good quality stock. Value Line financial strength is A but earnings predictability is only 55, RQR is 58.5. It currently has an upside/downside ratio of 4.3 and a relative value is 106. It has an estimated total return of 20.4% (assuming a 5-yr high PE of 24.8) and projected average return of 16.0%.

Recent Transactions

We sold all of our shares in Fannie Mae (FNM) at $54.23. Fannie Mae still might be a good contrarian long term investment, however, we decided to exchange the shares for a more stable, high quality bank. We bought Fifth Third Bancorp (FITB) at $42.93

We purchased additional shares of Pfizer Inc. (PFE) at $26.35.

We also purchased additional shares in Commerce Bancorp Inc. (CBH) at $29.86.

Recent Transactions

Yesterday we purchased an initial postion in Chevron Texaco (CVX). We also sold all of our shares in the NASDAQ 100 index fund (QQQQ) to free up cash for other purchases. We had a net gain in QQQQ of 37% from May 2003.

ChevronTexaco (CVX)

SSG and PERT A (07-06-2006) | Google Stocks | Company Website

Growth. ChevronTexaco is not a classic growth company. However, the increasing demand for energy, the increase in energy prices and acquisitions have caused CVX’s revenues to grow at an annualized rate 16.5% over the past ten years. Earnings have grown at 12.2% over the same period. The attached SSG assumes a 5-year revenue and EPS growth rate of 5.7%. Value Line projects 5% revenue growth and 11.5% earnings growth. The First Call consensus projects EPS growth at 7.1%. So the SSG rate of 5.7% is convervative.

Valuation. Valuing energy companies is a specialty. Classic NAIC-type analysis is helpful but not very. So let’s look at what the experts say. McDep Energy Investment Research makes it energy stock recommendations and investment research available to the public (with a slight time lag from its subscribers). The “McDep” ratio provides a relative measure of whether an energy company is over or under valued using futures prices and assumption about energy reserves. Of the so called “mega caps,” CVX has the lowers McDep ratio (lower is better). See page 5 of the McDep “Meter Reader” report. Also the McDep web site have posted several reports discussing CVX

Bottom line. If energy prices recede, CVX will show a modest return. CVX currently pays an annual dividend $1.60 (3.13% yield) and earnings should grow at about 5%. Under this scenario, the projected average return for CVX is 12.2%. (This assumes a projected high PE of 12.1.) If energy prices remain the same or increase, CVX has considerable price appreciation potential.
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