Replacing our low PAR Stocks

Using data from our portfolio dashboard on Manifest Infesting, here are some proposed changes to the portfolio.

First, sort the portfolio by projected average return (PAR) to show which stocks have the highest and lowest PAR. You do this by clicking on the PAR column heading or look at this PDF file.  (Place your mouse over the embedded yellow note in the PDF file.)

The six stocks on the bottom (highlighted in yellow in the PDF file) have the lowest projected average return. Looking at these stocks, that is not surprising. Two are bank stocks (WFC and SNV). The current housing market adversely impacts LOW.  Similarly, a decrease in consumer spending impacts BBBY and WMT.

We should consider replacing all of these except JNJ. (JNJ is a high quality blue chip stock despite the mediocre PAR.  It is a keeper.)

Now we can add to our positions in stocks we already own with stocks that have a higher projected average return than those we are replacing.

Look at again at our portfolio dashboard. Now sort by the value this time, so our largest positions are on top and our smallest positions are on the bottom. Look for stocks for which we don’t yet have a 5% position and which have a projected average return of more than 20%. We can would increase our position in those shares to about 5% or $2,000 total.

This PDF file shows the idea. The candidates for replacement are shown with struck through text. These are the five stocks with the lowest projected average return or PAR. The candidates for additional shares are highlighted in yellow.

There are several additional stocks we may want to consider, including ADBE, AAPL, PCP, and PTR. More to follow on this.

Portfolio Update

As of this past Friday, we survived the market turmoil. The internal rate of return for Moose Pond Investors was 2.4% for the year to date. This slightly lagged the S&P 500, which was up 4.3% for the same period. See performance report.

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.

Proposed Portfolio Changes

Between our cash position (4.5%) and funds temporarily invested in Vanguard’s Total Market Index ETF (9.3%), we have sufficient funds to take new positions in up to four companies. Here are several suggestions.

Adding to Existing Positions. It is always a difficult question whether to add to existing positions or buy new companies. Look at our Manifesting Investing dashboard. Of the stocks that account for less than a 4% position in the portfolio, three companies show a good projected average return (PAR > 13.7%) and high quality (quality rating > 65). They are AMGN, BBBY, and GYI. We could add to these positions, perhaps adding the equivalent of 1% of the total portfolio value to each.

Analysts have reassessed Amgen’s drug pipeline and have reduced their earnings projections for Amgen. As a result, the price has declined about 20% this year. With the bad news largely priced in, Amgen may be a bargain. (Of course, I still have the scars from catching other falling knives.)

A Stock to Sell or Exchange. Commerce Bancorp has been a good performer in our portfolio. It has appreciated at an annualized rate of 14.3% since we acquired it in August 2003. However, the fundamentals for CBH seem to be declining. Its return on assets (ROA), one of the key measures of a bank’s performance, has declined to 0.70%. (The ROA was around 0.90% when we purchased CBH.) Margin on net interest income, the return it makes from lending, has also declined. Year-to-date the price is down 3.5%. While declining prices should never be the reason to sell a company, declining fundamentals are. The declining price is probably confirming what we see in the fundamentals. Here is a current stock selection guide for CBH.

The SSG for CBH does not scream “sell” rather it is a “hold.” However, there probably are better opportunities in the financial sector. Two companies to consider as replacements are American International Group (AIG) and Wells Fargo (WFC). WFC pays a 3.2% dividend and has a ROA of 1.7%. For a number of different reasons, AIG’s price has remained relatively static for the past three years while earnings have continued to grow. Look at the two stock selection guides.

Stocks to Consider Buying. The portfolio might benefit from a little more exposure in the technology sector. Two quality large-cap stocks with relatively high PAR are SAP and Microsoft. Microsoft has a near monopoly position in a number of different PC market niches including office products. SAP is probably the last major competitor to Oracle for enterprise software. Like Oracle, SAP has captured a large installed base of customers who annot easily or inexpensively change. Comparing stock selection guides for SAP and Oracle, SAP seems to be the better bargain now. Here are the stock selection guides for Microsoft and SAP.

The final stock to consider buying is General Electric. The stock price has moved sideways, while earnings growth slowed to 7% over the past five years. Value Line projects 7% sales growth and 12% earnings growth over the next 3-5 years. GE’s foreign sales are a plus. Here is a stock selection guide for General Electric. Boring, yes, but the 3.2% dividend, international exposure exposure, financial strength, and steady earnings growth make it a solid core holding.

Summary. Here are the various proposals.

• Add to existing positions in AMGN, BBBY, and GYI when these stocks are in the buy range shown on the stock selection guide. Currently AMGN and BBY are in that range.
• Replace Commerce Bancorp with either American International Group or Wells Fargo.
• Buy one or more of the following: Microsoft, SAP, and General Electric.

January Transactions

The stock market drop this past week has provided a buying opportunity. Moose Pond has some cash to invest

Proposed Purchases for January

We recently considered several companies: Stryker [SYK], Microsoft [MSFT], and Kohl’s [KSS], and decided to purchase Stryker.

In addition, three defensive stocks look attractive: Coca-Cola [KO], Gannett [GCI], and Illinois Tool Works [ITW]. These stocks have several things in common. Their prices have gone nowhere or down over the past several years even though their earnings are solid and have continued to grow. Comparing their current price earnings ratio (P/E) to their historical P/E, current P/Es are at an all time low. Value Line rates their financial strength A+ or better, and their earnings predictabillity 85 or better. All three stocks pay dividends, which provides some downside price protection. These three stocks are currently out of favor in spite of their fundamentals. All three have a projected average return of more than 13% which is excellent for a large company.

Coca-Cola has an enormous franchise in its name and also has a strong international marketing and distribution network. Gannett, which publishes USA today, has been suffering from rumors of the early demise of print media and the ascendancy of the Internet. Companies like Gannett will be awash with a Tsunami of political cash as we move into the next presidential election cycle. Illinois Tool Works is a 100+ year old tool company that is the clear leader in almost every market in which it sells tools.

Weeding and Feeding the Stock Garden

These are several good, quality stocks whose prospects are not as good as the others in the portfolio. These are Cardinal Health and Brown & Brown. (Harley Davidson and Capital One Financial are borderline on joining that group.) We are considering selling Cardinal Health and Brown & Brown sometime in the next two or three months after the market recovers from its current bounce down. We plan to reinvest the proceeds in several of the stronger existing stocks.

Summary

Here are the proposals:

1. Buy Stryker (taking a full position over 2 months buying half each month)
2. Buy Coca-Cola, Gannett, or Illinois Tool Works (talking a full position over two months)
3. Sell Cardinal Health and Brown & Brown when the market recovers from last week
4. Reinvest the remaining cash in current stocks with a quality rating above 65 and projected average return above 13%

Portfolio Rebalancing

We are finally moving close to positive territory for portfolio return for the year in spite of or losses in UTStarcom and Pfizer. See year-to-date return report. Pfizer will most likely bounce back, but a recovery by UTStarcom is much less certain. Internal rate of return for the portfolio for the year to date is 0.5%. The S&P 500 is up 1.9% for the same period.

Most companies have reported their third quarter earnings. This is a good time to take a close look at the Moose Pond portfolio. The stock selection guides (SSGs) for all holdings have been revised. Go to the portfolio summary and click on the links for each stock to see the individual SSGs. Also, look at the current diversification report.
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Portfolio “Rack and Stack”

To borrow a military expression, I thought it might be helpful to “rack and stack” our portfolio. We should do this at least quarterly, if not more frequently. It is fairly easy to do with the computer. The attached spreadsheet contains key portfolio management metrics.

Out of our 22 stocks, 14 are still in the “buy” range. We have selected good stocks because a number of these stocks have appreciated in price but are still considered “buys”. Our all time winners are LOW (+205%) and JCI (+143%). The other 7 stocks are slightly out of the buy range but are definite “holds.”

In managing a portfolio, we try to identify stocks that no longer meet our objectives (including future earnings prospects) or have declined in quality. We should replace those stocks. There are other factors to consider as the NAIC web article on when to sell points out, but these two are the primary factors.

We should compare stocks in the portfolio to see whether it is possible to replace a low quality stock with a higher quality stock and/or replace a stock with a relatively low projected return with a stock with a higher projected return. Our current portfolio looks fairly good in terms of quality and projected return. I don’t see any immediate candidates for replacement but we need to continue watch closely and reevaluate each quarter.

We can compare relative value and upside downside ratios to see if any stocks in the portfolio have become overvalued. We don’t appear to have any in the overvalued category now.

We also need to look at sector and industry diversification. (Sectors are made up of related industries.) We are diversified across four sectors. We also are diversified by industry within each of these four sectors. Our size diversification breaks down as follows: 42% in large companies, 45% in medium companies and 5% in small companies. (This doesn’t add up to 100% because we also have a small position in a NASDAQ 100 index fund.) We probably ought to be looking harder for small companies.

A final “rack and stack” consideration is how much each stock represents of the total portfolio value. In our portfolio the average stock is valued at a little more than 4% of the total value of the portfolio. This type of diversification protects our overall portfolio return by limiting the damage any one stock can do to the overall portfolio return. A stock that drops in value by 50% will only reduce total portfolio return by about 2%.

Hope these comments are helpful.