Don't Settle For Second-Best

4/23/2012


The search for the perfect stock is a bit like the search for spiritual enlightenment — tough to achieve on this earth but almost certainly worth the effort.

Relentlessly looking for the best available stock will keep you engaged in the trends driving the economy and corporate profits, and force you to consider the merits of stocks you already own. Even if you keep all your money in index funds, your market outlook will be better informed if you regularly appraise the prospects of the best-positioned stocks.

If you do invest in individual stocks, remember that finding five or 10 or 25 perfect stocks is better than finding one. Spreading your bets among a basket of stocks you truly love will lower your portfolio's volatility without lowering expected return. More important, diversifying will allow you to focus on a stock's prospects — and not let your decision-making process be dominated by the impact of share-price movements on your net worth.

Also remember that you can't always get what you want. Finding a single perfect stock is very difficult, so the best investors learn to compromise, aiming for perfection but doing what's necessary to build a diversified portfolio. While academics say you need at least 30 to 50 stocks, our Focus List of 12 to 17 stocks strikes a nice balance between diversification and keeping your money in your best ideas.

Even 12 to 17 names are too many for some of our subscribers. We recently selected our favorite seven year-ahead picks for an advertising campaign, highlighting the stocks listed in the table below. As shown, none of the seven has every single attribute we prize.

Aetna ($48; AET) reported 0.4% sales growth for the December period, its first positive year-to-year comparison in seven quarters. But the health insurer's profit margins have widened steadily because of declining medical-utilization rates, allowing for eight straight quarters of at least 9% growth in per-share profits. March-quarter profits per share, due April 26, are expected to be down 3% despite 4% sales growth. But the consensus reflects Aetna's fairly downbeat guidance on medical costs, and the company has a history of conservative forecasts. The stock seems unduly cheap at nine times expected 2012 earnings — especially considering the potential for much better-than-expected results this year.


Agilent Technologies ($43; A) has a history of volatile results, though it has posted higher sales and operating income in four of the last five years. April-quarter sales and earnings are expected to be roughly flat, ending an eight-quarter streak of robust growth. Growth is likely to accelerate in the July and October quarters, and Agilent seems cheap at 14 times trailing earnings. The stock trades at a discount relative to both the electronics and the life-science groups — and relative to its own three- and five-year norms.


By the numbers, Apple ($610; AAPL) comes closest to meeting our definition of the perfect stock. The one fly in the ointment is its valuation, which at 14 times expected current-year earnings is roughly in line with the technology hardware group. But Apple has no true peers in its industry, at least when it comes to operating momentum, track record, and earnings-estimate trends. The stock has been under pressure since April 10 because of profit-taking and concerns regarding the sustainability of its smartphone business model. We view the dip as a buying opportunity.


DirecTV ($49; DTV) has seen its profit margins pressured over the past two quarters, but double-digit sales growth and share buybacks have sustained robust per-share-profit growth. Yet the stock is down roughly 8% from its July all-time high, reflecting near-term worries about saturation in the U.S. pay-TV market and long-term worries about Internet-based TV. While these concerns have some merit, they seem more than adequately reflected in the stock's valuation. At 11 times expected current-year earnings, DirecTV trades at a 20% discount to the cable and satellite group despite superior cash-flow trends and long-term growth prospects.


Intel ($28; INTC) does not have the earnings momentum of a typical Focus List selection, partly because its profit margins have narrowed over the past 12 months. Per-share earnings were down 3% on flat sales for the March quarter. But growth seems likely to rebound in the second half of 2012, and consensus estimates for the full year are rising. Cash flow has been rising steadily, allowing Intel to ramp capital spending while maintaining an aggressive share-repurchase program. At less than 12 times expected current-year earnings, Intel trades at a big discount to the semiconductor group and its own five-year norm.


Macy's ($40; M) is not especially cheap relative to its historical norms, and its track record does not compare favorably to other Focus List stocks. But the retailer has delivered eight straight quarters of at least 4% growth in sales, along with nine straight quarters of at least 7% growth in operating income. Profit margins have risen steadily since 2009, reflecting streamlining efforts and an improved merchandising strategy. The stock trades at 12 times expected current-year earnings, versus 16 times for the average retailer. With Macy's well positioned to extend its run of better-than-expected earnings, the stock is a top pick among consumer cyclicals.


Qualcomm ($67; QCOM) qualifies as a top buy on nearly every key measure we consider — except valuation. The stock earns a Quadrix Value score of 33, reflecting above-average ratios for price/earnings, price/cash flow, price/book value, and price/sales. But Qualcomm trades at only a modest premium to the technology sector based on expected current-year earnings, and the stock remains quite cheap relative to its five- and 10-year norms. In the near term, Qualcomm is unlikely to return to its five-year median trailing P/E of 23. But the company seems capable of 10% to 20% annual earnings growth in coming years, so even a flat or modestly higher P/E could translate into attractive capital gains.

OUR FAVORITE SEVEN STOCKS: A CHECKLIST
Aetna
($48; AET)
Agilent
($43; A)
Apple
($610; AAPL)
DirecTV
($49; DTV)
Intel
($28; INTC)
Macy's
($40; M)
Qualcomm
($67: QCOM)
Good value vs. peers
YES
YES
OK
YES
YES
YES
NO
Good value vs. history
YES
YES
YES
YES
YES
OK
YES
Sales momentum
NO
YES
YES
YES
OK
OK
YES
Earnings momentum
YES
YES
YES
YES
NO
YES
YES
Cash-flow momentum
YES
YES
YES
YES
YES
YES
YES
Profit-margin momentum
YES
YES
YES
OK
NO
YES
NO
Good track record
OK
OK
YES
YES
OK
OK
YES
Improving ROE, ROI, ROA
YES
OK
YES
YES
YES
YES
OK
Rising earnings estimates
YES
OK
YES
YES
OK
YES
YES
Good share-price action
YES
OK
YES
OK
YES
YES
YES

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