Our top capital-gains selections

6/16/2008


Dow Theory Forecasts has been published 52 weeks a year since 1946, and a goodly portion of the ink we’ve used over the years has been spent advising subscribers to avoid unnecessary risk by diversifying portfolios. Yet two weeks a year — in our midyear and year-end outlooks — we highlight our favorite handful of stocks for new buying.

We reconcile this seeming contradiction in two ways:

The customer is always right. We’ve been in business for 62 years because we listen to subscribers, and we know many of you want our single best idea. Oftentimes we’re not comfortable singling out just one pick, partly because we don’t want you to judge us on the returns of one stock. But we’re willing to meet you halfway, with a few particularly attractive buys noted on page 3 most weeks and our top handful of capital-gains selections reviewed in December and June.

Our approach seems to be working. As illustrated below, our year-end and midyear capital-gains favorites have delivered strong returns. In four of the past five years, the average return of our year-end picks beat the S&P 500 Index, assuming stocks were held from the time of our recommendation until we sold or the end of the following calendar year. The same holds true for our midyear favorites, assuming our holding period ended June 30 of the following year.

Five to eight stocks is not enough to diversify a portfolio, but it is probably enough to evaluate our stock-picking approach. Has our last batch of capital-gains favorites, in December, been a success so far? If you bought all six, you’re down 3.5% versus a 9.2% decline in the S&P 500 — not great but a solid showing. But if you only bought Humana ($48; NYSE: HUM), you sold at a 41.4% loss.

Maybe Humana will extend its rebound and make our decision to sell in March look foolish. Or perhaps the managed-care concern will issue another profit warning and completely destroy its credibility with investors. We don’t know. We do know that our approach puts the odds in our favor if we spread our bets among 15 to 40 stocks, that we’re likely to do well if we relentlessly work our system and limit our portfolios to stocks we truly like.

Our loss on Humana was not typical, but our capital-gains favorites usually include at least one stock that meaningfully underperforms the market. While five to eight stocks seem to be enough for our system to gain a reliable advantage, holding so few stocks in a portfolio will expose you to added volatility without increasing expected returns. So, our capital-gains favorites are best used as part of a broader portfolio. With that final warning, here are this year’s midyear favorites:

Freeport-McMoRan ($119; NYSE: FCX) is benefiting from favorable supply and demand trends for copper. Analysts estimate China imported nearly 200,000 tons of copper in May, the seventh consecutive month in which it bought more than 100,000 tons on the international market. International prices are higher than Chinese prices, so the country doesn’t import unless it must. Strong demand from China, the world’s largest copper consumer, should support prices even if demand from Europe and North America weakens further.

Freeport estimates that a $0.20-perpound change in the price of copper affects per-share earnings by $1.09. In 2007, Freeport averaged $3.23 per pound for the 3.88 billion pounds of copper it produced. Freeport averaged $3.69 per pound for copper in the March quarter, and copper futures point to prices above $3.40 per pound through May 2010.

The company estimates it will boost copper production by 8% in 2008, to 4.2 billion pounds. In addition, the company said copper production would pick up in the second half of the year as activities at its Grasberg mine move to more favorable sections. The company estimates it will produce 29% more copper in the second half of the year than in the first half.

Selling for less than 10 times expected year-ahead earnings of $12.34 per share, Freeport trades well below the metals and mining average of nearly 15. Freeport, a Focus List Buy and Long-Term Buy, seems likely to reach $150 over the next 12 months.


IBM ($126; NYSE: IBM) has repeatedly forecast its goal of per-share earnings of $10 to $11 in 2010. The company is well on its way to achieving that goal. Software, in particular, is key to IBM’s earnings target. The company completed its acquisition of Telelogic in April, three months after purchasing Cognos. IBM expects acquisitions to contribute 3% of its goal of 7% to 10% growth in software sales.

From 2002 to 2007, mainframe sales averaged 6% growth, but sales fell in three of those years, including 2007. The March quarter showed no improvement, as sales in the division fell 7%. But, with energy prices up, IBM sees an opportunity with its new, energy-efficient Z-series mainframe. Server sales have been spotty, but IBM’s sales force translates server revenue into two to three times as much in software and systems revenue. IBM, with the potential to reach $155 to $165 over the next 12 months, is a Focus List Buy and a Long-Term Buy.


In late May, Enodis accepted a $2.1 billion takeover offer from Manitowoc ($42; NYSE: MTW). Another competing offer from Illinois Tool Works ($50; NYSE: ITW) is possible, but Manitowoc seems intent on completing the deal. A takeover will significantly diversify Manitowoc’s revenue away from the booming crane business. The foodservice segment — accounting for 56% of revenue just eight years ago — would represent about 36% of sales following an acquisition of Enodis, up from about 11% today.

The acquisition makes strategic sense, as the crane cycle could reach the end of what would typically be its seven-year growth phase in 2010. Buying Enodis also puts Manitowoc in a unique position in the foodservice market, adding overseas exposure and making Manitowoc a leading player in both hot and cold foodservice. However, in addition to the typical risks of an acquisition, Manitowoc also must deal with struggling restaurant industry and rising steel costs.

Concerns about the acquisition and the crane cycle seem reflected in the stock. Manitowoc sells half of its cranes outside the U.S., and foreign sales are expected to grow 12% this year, suggesting the company will continue to profit from the global infrastructure buildout. With a trailing P/E ratio of just 14, Manitowoc, a Focus List Buy and Long-Term Buy, seems likely to reach at least $50 in the next 12 months.


Third-generation wireless networks, which offer faster data transmission, got a surprising go-ahead from Chinese officials last month. The decision could provide a significant boost to Qualcomm’s ($47; NASDAQ: QCOM) earnings over the next 12 months.

China plans to restructure its telecom industry by consolidating six companies into three, then issuing licenses to build third-generation networks. The news was unexpected, and estimates from most Wall Street analysts do not incorporate third-generation sales in China before 2010. With more than half a billion subscribers, the Chinese market provides a huge growth opportunity for Qualcomm.

India, with more than 250 million subscribers, also represents a massive opportunity. Third-generation services should roll out in early 2009.

In the U.S., the anticipated launch later this year of third-generation versions of such popular “smart” phones as the Blackberry and iPhone should boost demand for the technology. The higher functionality on these phones means higher prices, and that should translate into higher royalty revenue on Qualcomm’s technology licenses.

Legal disputes still weigh on Qualcomm shares. Near-term profit margins may be pressured because Qualcomm now must pay for the use of Broadcom ($27; NASDAQ: BRCM) patents, at least until Qualcomm develops its own replacement technology. Nokia’s ($26; NYSE: NOK) nonpayment of royalties will continue to depress per-share earnings by $0.04 to $0.05 per quarter until the dispute is resolved. A trial regarding Nokia’s use of Qualcomm’s patent begins in July, and any resolution should remove some uncertainty. Qualcomm, capable of reaching $57 within 12 months, is a Focus List Buy and a Long-Term Buy.


Transocean ($146; NYSE: RIG), with nine new oil rigs under construction and a leading position in the deepwater category, is well positioned to benefit from surging demand for deepwater drilling. Years of underinvestment have left oil producers unprepared to boost production. In the last five years, only 10 new ultra-deepwater rigs entered the market, compared to the 65 rigs set to be deployed over the next three years. Most of the world’s known untapped reserves are deep undersea.

Of the company’s nine new rigs, five are currently contracted for deployment as soon as construction is complete. Transocean’s quarterly average rates for its rigs have been rising 5% to 10% every three months, giving the company favorable leverage in contract negotiations.

With contracts extending seven to 10 years, and sometimes longer, Transocean’s revenue outlook is impressive. Backlog grew from $31 billion in February to $34.2 billion in May. Not surprisingly, consensus profit estimates are rising. The stock trades at 10 times forward earnings, well below its three-year average of 15 and the current oilfield-services average of 13. Over the next 12 months, we expect Transocean shares to reach $190 to $210. The stock is a Focus List Buy and a Long-Term Buy.


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