Portfolio Review

11/30/2009


Buy List ahead of the pack

Comprising our top 20 to 30 stocks for 12-month returns, the Buy List has been our best-performing equity portfolio since year-end 2002, gaining 62.8% on a fully invested basis excluding dividends and transaction costs — more than twice the 25.7% gain of the S&P 500 Index.


LIST RETURNS
Year
Focus
List
(%)
Buy
List
(%)
S&P 500
Index
(%)
2009 †
34.4
32.6
22.5
2008
-48.8
-44.7
-38.5
2007
22.8
18.1
3.5
2006
12.9
14.8
13.6
2005
8.1
10.3
3
2004
17.5
18.8
9
2003
20.2
25
26.4
Since 2003 † 
45.6
62.8
25.7
† Through Nov. 23. Notes: Returns are fully invested and exclude dividends and transaction costs.

While we view the Buy List’s results as evidence that our growth-at-a-good-price approach has merit, some subscribers view the Buy List’s outperformance relative to the 45.6% gain of our Focus List as evidence of a flaw. After all, the Focus List is limited to our favorite 10 to 20 stocks on the Buy List, so one could reasonably expect the Focus List to outperform.

The skeptics make a good point. Looking back over the past seven years, we have at times been slow to add high-potential Buys to the Focus List. Because of the limited number of stocks on the Focus List, we have been reluctant to add more volatile names that could single-handedly put a big dent in the Focus List’s returns. Such stocks pose a smaller risk to the more diversified Buy List. Indeed, despite the Buy List’s inclusion of these aggressive names, it has been less volatile than the Focus List.

Academic studies and our own work suggest the diversification benefits of adding another stock diminish rapidly after a portfolio has 40 to 50 names. An academic might argue that both our Buy List and Focus List are assuming unnecessary stock-specific risk that could be diversified away, but we’ve found that portfolios limited to high Quadrix scorers tend to be less volatile than similarly-sized portfolios of typical stocks. More important, limiting our portfolios to our best ideas is the best way we’ve found to enhance returns.

Still, one lesson of the past seven years seems clear: If you’re limiting the size of your portfolio (and accepting more volatility) to concentrate on your best picks, you need to make sure you’re truly in your best picks. Along those lines, we plan to get stocks on and off the Focus List more quickly.

Aflac ($45; AFL) is being added to the Focus List. Year-to-year profit comparisons turned positive again in the September quarter, reflecting write-downs on the investment portfolio in late 2008 and the first half of 2009. Cash flow and free cash flow have shown steady growth over the past three years.

Revenue rose 11% in the nine months ended September, primarily on strength in Japan (roughly 75% of sales). New insurance products and rising distribution through Japanese bank channels should sustain growth in 2010. The U.S. business (about 25% of sales) has been hurt by unemployment trends but should rebound once job growth resumes.

Aflac still has risk in its investment portfolio, given the concentration of perpetual securities issued by European banks. But the outlook for these securities appears to have stabilized, and the stock seems unduly cheap at eight times the 2010 consensus estimate. With a move to 12 times expected 2010 earnings per share — a big discount to the 10-year average P/E of 19 — the stock would trade at $64. Aflac, with a Quadrix® Overall score of 98, is also a Long-Term Buy.


A stake in NBC Universal’s movie studio and broadcast network would advance Comcast’s ($15; CMCSA) push into video content. But investors don’t share Comcast’s enthusiasm for the division of General Electric ($16; GE), and the stock has slumped 13% since news of the potential deal surfaced in late September. The selling seems overdone, and a couple obstacles could still sink the deal.

First, General Electric and Vivendi, which owns 20% of NBC Universal, must narrow the $500 million gulf that separates the two sides from settling on a price for Vivendi’s stake. GE’s latest reported offer to Vivendi suggests it doesn’t believe Vivendi could get full value at a public sale, though the French conglomerate could take that avenue. Each year Vivendi has a three-week window to sell its stake through a public offering. That window closes on Dec. 10.

GE, should it acquire Vivendi’s stake, is expected to sell a 51% interest in the joint venture to Comcast for $4 billion to $6 billion. Comcast would also contribute its cable networks to the new company. GE would move $9 billion of debt to the new company, and provisions would allow GE to leave the joint venture after three-and-a-half years and again after seven years. Comcast would control a majority of seats on the board. A deal is certain to face scrutiny by regulators.

Comcast’s diversification into programming would serve as a hedge against the rising content fees charged by program suppliers. Critics, pointing to the poor history of merging content with cable, argue that Comcast should return its profits to shareholders. We tend to agree that shareholders would do better if Comcast focused on its core business and distributed excess cash to shareholders via stock buybacks and dividends. Still, we don’t think the deal, at least as outlined in the press, would destroy enough shareholder value to justify the stock’s bargain-basement valuation.

Comcast trades at 12 times trailing earnings — less than one-half its three-year average. Based on price/sales and price/cash flow ratios, the stock trades at less than one-half its five-year and 10-year averages. At current valuations, we think the stock has a favorable risk-reward ratio. Comcast is a Focus List Buy and a Long-Term Buy.


DirecTV ($32; DTV) completed its merger with Liberty Entertainment Group, a unit spun off from Liberty Media Interactive ($10; LINTA). The resulting company gains control of Liberty Media’s 54% stake in DirecTV but also inherits net debt of roughly $2 billion. The deal simplified DirecTV’s ownership structure — and possibly cleared the path for it to become a takeover target.

Chairman John Malone says the company is not on the block but will entertain offers. The largest U.S. satellite TV operator, DirecTV has already partnered with telecom companies to sell bundled video, phone, and Internet services.

DirecTV is attractive on its own merits. Sales and free cash flow climbed during the recession as DirecTV grew its subscriber base. Earning an Overall score of 91, DirecTV is a Focus List Buy and a Long-Term Buy.

Tech review

Hewlett-Packard ($51; HPQ) grew per-share profits 11% to $1.14 excluding special items for the October quarter, in line with preliminary results previously reported. Revenue declined 8% to $30.78 billion. Sales from enterprise storage and servers decreased 17%, while imaging and printing fell 15%. The services unit, benefiting from the $13 billion EDS acquisition, posted 8% higher sales. Hewlett-Packard, which lifted modestly its profit guidance for fiscal 2010, is a Buy and Long-Term Buy . . . Microsoft ($30; MSFT) said it sold twice as many copies of Window 7 as any of its previous operating systems in the first few weeks of release. Windows represented almost half of Microsoft’s operating income in fiscal 2009 ended June. Microsoft is a Long-Term Buy.

  RANK CHANGES
Aflac ($45; AFL) is being added to the Focus List, while Laboratory Corp. ($75; LH) is being added to the Buy List. The Buy List and Focus List positions in Vanguard Short-Term Investment-Grade ($10.64; VFSTX) falls to 22.0%.

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