You Can't Always Get What You Want

4/13/2009


When determining the allocations of our Focus List, Buy List, and Long-Term Buy List, we’d prefer not to compromise. We’d like to see the market in a clear uptrend, and we’d like to recommend fully invested portfolios chock full of stocks with all the attributes we prize — robust operating momentum, discount valuations, strong track records and financial positions, rising earnings estimates, and superior share-price performance.

Focus
List
(%)
Buy
List
(%)
LT Buy
List
(%)
S&P 500
Index
(%)
2003
20.2
25.0
24.0
26.4
2004
17.5
18.8
8.7
9.0
2005
8.1
10.3
3.5
3.0
2006
12.9
14.8
9.3
13.6
2007
22.8
18.1
10.4
3.5
2008
(48.8)
(44.7)
(36.4)
(38.5)
2009
(2.7)
(2.0)
(5.4)
(9.7)
Since 2003 †
5.4
20.3
1.2
(7.3)
† Through April 7.    Note: Returns based on fully invested portfolios excluding dividends and transaction costs.

As the song says, you can’t always get what you want. Managing a portfolio involves compromises and trade-offs in the best of times. In times like these — with the market’s direction uncertain, corporate earnings declining, and cheap stocks abundant — striking the right balance between risk and expected return requires several compromises.

Our cash position. Partly because we know how difficult it is to time the market — and partly because we are long-term bulls on the U.S. stock market — we don’t believe in timing the market in an all-or-nothing fashion. Our cash position has rarely been as high as 50% over the past 20 years, so the 32.5% to 34% cash position of our three buy lists is high by our standards.

Our cash position depends on the market’s primary trend and the opportunities available in individual stocks. The primary trend is bearish under the Dow Theory, as the last confirmed signal was the move in early March to new lows in the Dow Industrials and Dow Transports.

While the rebounds since March 9 have not quite retraced one-third of the declines from the highs reached in May and June, we are inclined to view the recent rallies as significant. So, if the averages correct without both moving below the March 9 closing lows, the closing highs reached in the post-March rally will represent the key levels for a potential bull-market signal.

Without a bull-market signal, we will keep a good chunk of our buy lists in Vanguard Short-Term Investment-Grade ($9.76; VFSTX), a low-risk bond fund we use instead of cash. If the March 9 lows of 6,547.05 and 2,146.89 are violated, we are likely to lift our cash position.

Our sector exposures. Our Quadrix® system does a good job of identifying stocks with the attributes we prize, but top scorers are often concentrated in the same sectors. To create portfolios with acceptable risk levels, we sometimes need to include lesser names for the sake of diversity.

Energy, health-care, and technology stocks dominate the ranks of top Quadrix scorers, and all three sectors are overweighted in our buy lists relative to the broad market. But we never want a single sector to dominate a buy list, and today we are investing extra time to find attractive names outside of energy, health care, and technology.

For example, because we want some exposure to stocks leveraged to a rebound in the industrial sector, United Technologies ($45; UTX) and Airgas ($37; ARG) are being maintained as Buys — even though neither company has robust operating momentum.

Our stocks. Our ideal stock has all the attributes we prize, with both a cheap valuation and outstanding fundamentals. But earnings growth has turned negative for the average U.S. company, so building a diversified portfolio limited to profit gainers has become more difficult. Moreover, insisting on current operating momentum would keep us out of some of today’s best values.

For example, General Dynamics ($44; GD) is expected to post lower earnings for full-year 2009, partly because of weakness at its business-jet division. But the stock seems very cheap at seven times trailing earnings — less than one-half the 10-year average. General Dynamics seems likely to rebound to $54 to $57 with signs of stabilization in the outlook for aerospace and defense spending.

Conversely, we are willing to stick with a stock with a below-average Quadrix Value score — if we are convinced the stock is not overvalued. St. Jude Medical ($35; STJ) earns a Value score of 27, and its trailing price/earnings ratio of 15 is above the average of 12 for S&P 1500 companies. But the stock’s P/E is less than one-half its 10-year average, and St. Jude is among the best-positioned U.S. medical companies.

In general, we are reluctant to own stocks displaying very weak share-price action, so we will typically avoid stocks with Quadrix Performance scores below 20. Occasionally, however, we will fight the trend on a stock we feel has been unduly punished, especially if we have an exit strategy. NII Holdings ($13; NIHD) has been a weak performer, reflecting a disappointing December quarter and a recent warning about slowing customer growth. Considering the company’s still-solid customer growth and the stock’s very modest valuation, we are sticking with NII for now. If March-quarter earnings indicate margins are being squeezed more than expected by the slowdown in customer growth, we are likely to drop the stock.


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FUNDAMENTALS OF OUR BUY LISTS
Relative to the capitalization-weighted S&P 1500 Index, our equal-weighted buy lists have higher Quadrix® scores, cheaper price/earnings ratios, and better expected earnings growth for the current year and for the next five years. Numbers for our buy lists are based on fully invested portfolios.
Focus
List
Buy
List
Long-Term
Buy List
S&P 1500
Index
No. Of Stocks
11
25
30
1500
Weighted Average Score
Overall
87
88
85
66
Momentum
72
69
66
55
Value
58
66
63
54
Quality
91
91
89
71
Financial Strength
82
81
84
68
Earnings Estimates
60
50
48
44
Performance
71
67
63
62
% Of Assets
Overall Above 90
45
44
27
7
Overall Above 80
82
80
70
28
Sector Weights (%)
Consumer Discretionary
9
8
3
10
Consumer Staples
0
0
3
13
Energy
18
16
17
12
Financials
0
0
3
11
Health Care
27
24
20
14
Industrials
0
8
13
11
Materials
0
4
3
4
Technology
36
36
30
18
Telecom Services
9
4
0
4
Utilities
0
0
7
4
Valuations
P/E Trailing
12.8
11.0
11.0
12.4
P/E Est. Current Year
11.9
11.1
11.7
14.3
P/E Est. Next Year
10.8
10.3
10.5
12.4
Price/Sales
2.2
1.6
1.7
1.6
Price/Cash Flow
10.1
8.3
7.9
7.6
Growth Rates (%)
EPS Est. Current Year 
3.5
(2.0)
(5.1)
(11.4)
EPS Est. Next Year 
11.7
8.9
10.6
16.6
EPS Est. 5 Years (Annual.)
11.4
10.9
10.1
9.8
Note: Quadrix scores are percentile ranks, with 100 the best.