General And Specific Stock-Picking Advice

12/27/2010


If you're like most of our subscribers, you're reading this newsletter for our stock picks. You like our market commentary, news updates, and research studies, but you subscribe mainly because you want to know what to do with your stock portfolio.

Our general approach can be described in two bullet points:

• Limit portfolios to stocks we truly like, dropping any name that no longer ranks among our best ideas.

• Constantly seek to upgrade our portfolios, using a five-step process to search for new stocks:

First, we look for stocks that score well in Quadrix®. We consider all stocks with Overall scores above 80 but now mostly focus on those with scores above 90, meaning they rank among the top 10% of U.S.-traded stocks. In general, new picks also have Quadrix Value scores above 50 and Performance and Earnings Estimates scores above 20.

Second, we examine high Quadrix scorers to see whether results have been distorted by mergers or aggressive accounting, whether earnings and cash flow are both trending higher, or whether any red flags suggest Quadrix is not telling the full story.

Third, we look forward, trying to determine if the bullish story being told by Quadrix has already played out. Are the strong fundamentals reflected in Quadrix likely to endure? Has something changed in a company's industry environment?

Fourth, we consider valuation ratios again. While valuations factor heavily in Quadrix, we want to be doubly sure that a stock has attractive upside potential. At this stage, we pay extra attention to a stock's valuation relative to industry peers and relative to its own history.

Fifth, we look for a catalyst, a reason to think a stock will outperform. Catalysts include expectations of better-than-expected earnings, an improving industry environment, corporate restructurings or acquisitions, and new products.

While this five-part process sounds cut-and-dried, borderline stocks can complicate things. To illustrate, the paragraphs below explain our rationale for two rank changes and three stocks on the bubble.

Rank changes

Agilent Technologies ($41; A), a provider of instruments and measurement solutions for electronics and life sciences, is being added to the Buy List and Long-Term Buy List. The company has posted four straight quarters of sharply higher and better-than-expected earnings, including an October quarter with 36% growth in operating profits on a 35% sales increase. Orders jumped 32%.

This year's acquisition of Varian, a life-science concern, has boosted reported results. But Agilent delivered double-digit organic sales growth in all its major segments in the October quarter, including 17% in chemical analysis, 17% in life sciences, and 35% in electronic measurement. Free cash flow has rebounded sharply, and cash exceeded total debt on Oct. 31.

At 16 times expected fiscal 2011 earnings, Agilent trades at a 15% discount to the average provider of life-science tools in the S&P 1500 Index. The stock, which also trades at a discount to its historical norms, seems capable of reaching $50 over the next 12 months. Agilent, with a Quadrix Overall score of 96, represents an attractive pick for 12-month and three-year returns.


Laboratory Corp. ($89; LH) is being dropped from the Buy List and Long-Term Buy List, reflecting its 14% rally since Oct. 1 and a sharp drop in its Quadrix scores. The Overall score is 64, down from 89 on July 30 because of lower scores for Momentum, Value, and Earnings Estimates.

While profit growth is likely to accelerate in 2011, the stock no longer seems particularly cheap relative to expected profits. In fact, if LabCorp matches the 2011 consensus profit estimate and the trailing P/E returns to the three-year average of 15.4, the stock would trade at $91. LabCorp should be sold. The stock is being dropped from our Monitored List.

Stocks on the bubble

Varian Medical Systems ($70; VAR), with a Quadrix Overall score of 72, has the lowest Overall score of any stock on our Buy List. The provider of diagnostic and cancer-therapy systems has delivered solid results, and the stock earns above-average scores in five of the six Quadrix categories. But the Value score has dropped to 36, down from 67 at year-end 2009, because of the stock's 50% rally this year. The Momentum score has dropped to 55, down from 80. Operating momentum seems likely to accelerate in coming quarters, and the stock seems capable of reaching $77 to $82 if the P/E returns to historical norms. For now, Varian remains a Focus List Buy and a Long-Term Buy.


J.P. Morgan Chase's ($41; JPM) Overall score of 75, the second-lowest of the stocks on our Buy List, reflects recent declines in its score for Earnings Estimates and Performance. But consensus estimates have stabilized recently, and the stock recently rallied out of a six-month range. More important, the stock is modestly valued, with a P/E of less than nine based on the consensus 2011 estimate. Among the big money-center banks, J.P. Morgan seems the best-managed and the best-positioned for a slow-growth economy. Partly because of the diversity it brings to our portfolios, J.P. Morgan remains a Buy and a Long-Term Buy.


Hewlett-Packard ($42; HPQ) earns an Overall score of 94, partly because of a Value score of 97. But the Performance score has dropped to 9, and the stock remains out of favor because of H-P's management turmoil and expensive acquisitions this year. An ongoing bribery investigation related to H-P's foreign sales has not helped matters. Also, H-P's exposure to the commodity personal-computer business has investors worried, especially with tablet computers expected to gain more market share in 2011. Such worries are understandable but seem more than adequately reflected in the stock, which trades at eight times expected year-ahead earnings. While we typically don't emphasize deep-discount value plays, H-P is a Buy and a Long-Term Buy based on its potential for a rebound to $50.

 


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