Portfolio Review

5/31/2010


Two downgrades

Spooked by fears regarding the European debt crisis, China’s efforts to slow its economy, and the prospect of war between North and South Korea, investors have hit the panic button. Both the Dow Industrials and Dow Transports moved below the closing lows reached May 7, heightening the risk of a more substantial market decline.

Stocks of all stripes have suffered, but those with rich valuations have been hit especially hard. With potentially tighter credit conditions diminishing the likelihood of a robust global economic recovery, a continued migration out of the most richly valued and speculative stocks seems likely.

Our buy lists are well-positioned for such a shift and have held up relatively well amid this year’s tumult, as shown in the performance table below. Still, few stocks are likely to be spared completely in a market sell-off. As a partial hedge, we boosted our cash position on the May 21 hotline by selling two of our more richly valued recommendations — Cognizant Technology Solutions ($49; CTSH) and Dolby Laboratories ($62; DLB). The sales lifted Vanguard Short-Term Investment-Grade ($10.70; VFSTX) to a 16.3% position on our Focus List and Buy List, while our Long-Term Buy List has 15% in this relatively low-risk bond fund.

Both Cognizant and Dolby have staged huge rallies over the past year, bringing their Quadrix® Value scores below 40. As a consultant and outsourcer operating primarily in India, Cognizant enjoys cost advantages over rivals drawing from pricier labor pools. Dolby is leveraged to high-growth consumer electronics, the personal-computer upgrade cycle, and the explosive potential of 3-D media. Growth prospects for both companies remain bright, but their current valuations and today’s market climate suggest investors should lock up profits and sell Cognizant and Dolby. On our Monitored List, both stocks are now ranked B (average).

LIST RETURNS
Year
Focus
List
(%)
Buy
List
(%)
LT Buy
List
(%)
S&P 500
Index
(%)
2010 †
1.8
(1.2)
(4.1)
(4.2)
2009
40.0
37.6
30.6
23.5
2008
(48.8)
(46.3)
(36.5)
(38.5)
2007
22.8
19.2
10.8
3.5
2006
12.9
16.9
9.7
13.6
2005
8.1
13.2
4.1
3.0
2004
17.5
22.4
9.0
9.0
2003
20.2
29.2
24.6
26.4
Since 2003 † 
54.5
82.1
36.8
21.4
† Through May 26.
Notes: Returns are fully invested and exclude dividends and transaction costs. 

News roundup

Abbott Laboratories ($47; ABT) agreed to pay $3.72 billion in cash for the branded generic-drug business of India’s Piramal Healthcare, pushing its emerging-market exposure above 20% of annual sales. Abbott Laboratories is a Buy and a Long-Term Buy.

General Dynamics ($66; GD) was awarded a share of a contract with the Defense Intelligence Agency worth up to $6.6 billion for the 11 companies involved in the work. In other news, General Dynamics, Boeing ($63; BA) and ITT ($48; ITT) won contracts totaling $4.4 billion to modernize air traffic. General Dynamics is a Buy and a Long-Term Buy. Boeing is rated B (average).

Retail report

Ross Stores’ ($53; ROST) profits surged 61% to $1.16 per share in the April quarter, while same-store sales advanced 10%. Ross expects growth of 16% to 21% in earnings per share in the July quarter, though the consensus called for 22%. Ross is a Focus List Buy and a Long-Term Buy . . . GameStop ($22; GME) earned $0.48 per share in the April quarter, up 14% and a penny better than the consensus. Same-store sales dipped 1.6%, while total revenue climbed 5%. GameStop is a Buy.

Tech and telecom review

IBM ($125; IBM) said it will pay $1.4 billion for Sterling Commerce, which helps 18,000 clients manage external servers and securely transfer electronic files. IBM is a Focus List Buy and a Long-Term Buy.

According to research firm Gartner ($24; IT), Apple ($245; AAPL) and Research In Motion ($59; RIMM) took share in the mobile handset market as global sales rose 17% in the March quarter. Apple is a Long-Term Buy. Research In Motion is a Buy and a Long-Term Buy.

Financial-reform bill up for debate

The U.S. Senate passed a financial-reform bill, with the hope of preventing the confluence of factors responsible for the 2008 financial crisis from derailing the economy again. The house passed its own version of reform in December, and the final product will require compromise from both sides. Key provisions of the Senate bill include:

Forcing banks to spin off derivatives businesses into separate subsidiaries.

Forming a council to keep banks from becoming too big to fail and to prevent asset bubbles.

Creating a consumer-protection division within the Federal Reserve to curb abusive lending practices.

Allowing the government to seize failing companies and sell off their assets, protecting taxpayers but potentially wiping out shareholders and creditors. The reform bill is likely to have a huge effect on the biggest U.S. banks, though the nature of the changes depends on the final version of the bill. The Forecasts will review the banks in the June 7 issue.

Oil-spill update

Oil from BP’s ($43; BP) ruptured deep-sea well, now leaking for more than a month, has begun to wash ashore. The stakes are rising, and the involved parties are taking different tacks to protect their reputations.

U.S. officials, facing political pressure but lacking the expertise to fix the problem themselves, criticize BP for failing to contain the leak. The oil giant began to try a “top kill” on May 26, pumping in drilling mud to hopefully plug the well.

Anger is also being directed at Transocean ($59; RIG). A group of U.S. senators asked Attorney General Eric Holder to review Transocean’s special dividend of $3.11 per share, scheduled to be paid out in four quarterly installments. Transocean says the dividend, announced Feb. 16, will not impact its “ability to meet its legal obligations.” The company says it has insurance to cover claims related to the accident.

While Halliburton ($26; HAL) doesn’t expect to incur any damages from the accident, BP finds new ways to blame Transocean. BP executives told The Wall Street Journal that contractual documents prove Transocean — not BP — was responsible for monitoring the well. But the Journal says Transocean’s Emergency Response Manual appears to indicate joint control.

While the sell-off in Transocean shares seems overdone, it is certainly understandable. At this point, sterner government oversight seems all but certain, as does a barrage of litigation. The government announced immediate inspections of all deepwater rigs in the gulf and banned new offshore projects until the spill is investigated.

Still, the stock appears to be discounting huge payouts from Transocean, and most legal analysts say the company’s liabilities from the spill are probably limited. According to The New York Times, Transocean’s contract states that BP agreed to “assume all losses, expenses, fines and claims for pollution or contamination. And under the Oil Pollution Act, the well’s owners, principally BP, are responsible for paying for cleanup costs.”

Transocean, trading at seven times the lowest Wall Street profit estimates for 2010 or 2011, is a Long-Term Buy. BP is rated B (average). Halliburton is rated C (below average).

  RANK CHANGES

On the Friday, May 21, hotline, Cognizant Technology Solutions ($49; CTSH) and Dolby Laboratories ($62; DLB) were dropped from our buy lists.


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