Your Favorite Questions Answered

1/24/2011


While I've answered a lot of questions in my 16 years as editor of Dow Theory Forecasts, the six below almost certainly rank among the most frequently asked:

Q Where is the market headed?

A Because the market's primary trend is bullish and because quality U.S. stocks are available at attractive valuations relative to other assets, I think the major U.S. averages are headed higher. I don't know where the Dow Industrials will end 2011 — and I won't insult your intelligence with such pinpoint forecasts. If conditions change, so will my outlook for the market.


Q What is your favorite stock?

A In general I'm reluctant to answer this question. I prefer to be judged based on the stock-picking system we've developed over the past 20 years, which works best when we spread our money across a basket of high-potential stocks. My favorite 12 to 20 stocks are on the Focus List, and on page 3 I will often highlight a few names that seem especially attractive for new buying. Today, my top five picks are Aflac ($57; AFL), Agilent Technologies ($44; A), Ameriprise Financial ($61; AMP), Apple ($342; AAPL), and IBM ($151; IBM).


Q Why do you recommend so many stocks on your Buy List and Long-Term Buy List?

A According to most academic studies, at least 30 to 40 stocks are required to adequately diversify a portfolio. All else equal, an investor can lower expected volatility without diminishing expected return by expanding the number of stocks in a portfolio — until it has 30 to 40 names. After that, the diversification benefits of adding another stock diminish rapidly.

Of course, all else is never equal. In our own work, we've found that fewer stocks are required for diversification if we stick to stocks with high Quadrix® Overall scores. Our Buy List, typically with 25 to 30 stocks, and our Long-Term Buy List, with 30 to 40, are diversified portfolios designed to take nearly full advantage of the free lunch provided by diversification — while limiting our picks to our best ideas.

Our Focus List, typically with 12 to 20 stocks, is not fully diversified. The Focus List is a great choice for investors using our recommendations as part of a broader portfolio. Since year-end 1995, the Focus List has been about 13% more volatile than the Buy List based on the standard deviation of monthly returns, according to the independent Hulbert Financial Digest. Both portfolios have displayed less volatility than the Wilshire 5000 Index of all U.S. stocks, yet both have delivered higher returns than the index.


Q If your Quadrix stock-rating system is so great, why don't you limit your recommendations to stocks with the maximum score of 100?

A First, limiting our buy lists to stocks with perfect or near-perfect scores would result in a highly concentrated, poorly diversified portfolio. Among the more than 4,000 stocks in our Quadrix universe, only 15 stocks earn Overall scores of 100 — including seven from the technology sector.

Second, Quadrix is only the first step in our stock-selection process. Before we recommend any stock, we take a closer look at individual company fundamentals to see if Quadrix is painting an accurate picture. While our new picks typically have Overall scores of at least 90, we'll stick with a recommendation with a lower score if we're convinced it has superior prospects. We're more likely to stick with a stock with a score of 75 or 80 on our Long-Term Buy List, which aims for two- to four-year gains among larger, investment-grade companies.

Occasionally we'll stick with an even lower-scoring stock based on a trading call, like we're doing with Varian Medical Systems ($72; VAR) today. We're sticking with Varian despite its Overall score of 67 because of its share-price momentum and our optimism regarding Varian's near-term profit prospects. The company reports December-quarter results on Jan. 26, and our current plan is to sell the stock if results fail to impress or the stock trades up to $75 or 80.


Q Why would you stick with a loser like Research In Motion ($65; RIMM), which is down nearly 7% since you recommended it in March?

A Twice a week (for the newsletter and hotline posted on Wednesday evenings, and the hotline posted before noon Central time on Friday), we look at all the stocks on our Buy List, asking whether they rank among our favorites for 12-month returns. For the Long-Term Buy List, we want only our favorites for 24-month to 48-month returns.

When a stock drops because a company disappoints in some way, we take a fresh look to determine if the stock still ranks among our best ideas. Our initial purchase price is not central in this analysis; what matters is whether we think a stock will deliver superior returns going forward. Recommending Research In Motion at $70 was a mistake. But, at this point, given the stock's very modest valuation and the company's outstanding operating momentum and solid growth prospects, we think it would be a mistake not to buy it at today's price of $65.


Q I'm not sure what to do with the target weights you present in your buy lists on page 7. Do you really expect me to keep my portfolio weights in line with the target weights? What should I do when you drop or add a stock?

A First, pick the list you want to mimic. Second, apportion the money you are committing to this portfolio based on the target weights. For example, if you are mimicking the Buy List, put 3.0% of your money in Abbott Laboratories ($47; ABT) and 3.7% in Aflac ($57; AFL). Third, when we make a change, try to get your weights roughly in line with our weights.

Don't worry if your weights are slightly off, as you need to consider your trading costs relative to the benefits of rebalancing. As a rough rule of thumb, positions within 0.5% of our weights are close enough. So, when we make a change, see if you can get your weights roughly in line with ours by trimming any positions that are heavily overweighted and adding to those very underweighted.


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