List Revamp Triggers Downgrades

9/26/2011


If there is more than one way to skin a cat, I wouldn't know it. I do know this aphorism — unpleasant imagery aside — holds a lot of truth outside of taxidermy.

For investors, it's worth remembering that many have amassed fortunes betting on stocks with low price/earnings ratios — and on stocks with strong share-price momentum. Both rapid-fire traders and buy-and-holders have been successful, as have both narrowly focused and broadly diversified portfolios.

While having a good strategy is crucial, having the discipline and confidence to follow that strategy is just as important. That does not mean you can't amend your approach when circumstances change; it means you need to learn from mistakes in a systematic way, integrating everything you've learned without overreacting to what just happened.

For my money, there are two ways to manage a stock portfolio:

1. Relentlessly strive to limit your portfolio to your very best ideas, selling current holdings whenever you need to make room for a better name. Our Buy List takes this approach, aiming to hold our favorite 20 to 30 stocks for year-ahead returns. Our Focus List, with 10 to 15 stocks, represents our favorites from the Buy List.

2. Assemble a diversified portfolio of attractively valued shares of high-quality companies, limiting portfolio turnover, and selling when the original rationale for owning a stock is no longer valid. Our Long-Term Buy List, with 25 to 35 stocks selected based on 24- to 48-month potential, takes this approach.

LIST RETURNS AND TURNOVER NUMBERS
On a fully invested basis excluding dividends and transaction costs, our Focus List has gained 69.5% since year-end 2002, versus 84.5% for the Buy List and 46.3% for the Long-Term Buy List. In comparison, the S&P 500 Index has gained 36.6%. As shown, all three portfolios have had more deletions than additions in recent years, resulting in more focused portfolios.
Focus List
Buy List
Long-Term Buy List
S&P
500
Index
(%)
Year
List
Chg.
(%)
Adds
Drops
List
Chg.
(%)
Adds
Drops
List
Chg.
(%)
Adds
Drops
2003
20.2
13
12
29.2
13
16
24.6
10
14
26.4
2004
17.5
7
7
22.4
10
9
9.0
6
12
9.0
2005
8.1
7
8
13.2
15
15
4.1
8
10
3.0
2006
12.9
8
10
16.9
15
12
9.7
11
11
13.6
2007
22.8
9
8
19.2
17
21
10.8
10
16
3.5
2008
(48.8)
9
13
(46.3)
13
19
(36.5)
12
18
(38.5)
2009
40.3
10
8
37.6
15
14
30.6
13
11
23.5
2010
19.5
14
16
12.7
17
21
10.3
16
19
12.8
2011 †
(6.6)
13
14
(11.2)
11
18
(7.0)
14
16
(4.4)
Since
2003 † 
69.5
90
96
84.5
126
145
46.3
100
127
36.6
† Through Sep. 20.     Notes: Returns are fully invested and  exclude dividends and transaction costs. 

In hindsight, we've allowed the differences between the Buy List and Long-Term Buy List to blur somewhat in recent years. We've held a few Buys too long, partly because we felt some high-quality names were due for a rebound. And we've been too quick to sell a few Long-Term Buys, partly because the stocks seemed likely to move lower in the near term.

Going forward, we plan to run the Buy List and Long-Term Buy List in stricter accordance with their mission statements, even if that means the lists have fewer names in common and the Buy List sees higher turnover. As part of this plan, we're making several rank changes this week.

We're dropping four stocks from our Buy List that no longer rank among our best year-ahead picks, even though all four qualify as Long-Term Buys based on their 24- to 48-month potential. We're adding five stocks to the Buy List, including Microsoft ($27; MSFT) and four new stocks reviewed in Portfolio Review.

Microsoft's decision to raise its quarterly dividend 25% to $0.20, payable Dec. 8, disappointed some who were looking for a bigger hike. But the increase lifts the stock's yield to 3.0%, and the share price seems capable of reaching $33 over the next 12 months. Also, we're replacing IBM ($175; IBM) with Intel ($22; INTC) on our Focus List. We continue to like IBM, but we now prefer Intel for year-ahead returns.

Apache ($95; APA) is being dropped from the Buy List but retained as a Long-Term Buy. In each of the last five quarters, Apache delivered growth of at least 31% in sales and 27% in operating profits. The August dip in oil prices weighed on many energy stocks, but Apache suffered more than most. Apache shares have slumped 21% from their July highs, third-worst among independent producers in the S&P 500 Index. We still like Apache's prospects, but we are not as confident it will outperform over the next year. Chevron ($98; CVX), with higher Quadrix scores and a cheaper valuation, seems like a better bet for the next 12 months. 


BASF ($64; BASFY) is being dropped from the Long-Term Buy List. The stock has slumped since the German chemical giant reported weaker-than-expected earnings for the June quarter. Consensus estimates project per-share profits will be up 2% this year and down 5% next year. Just two months ago, Wall Street expected profits to jump 20% next year. The company's balance sheet is solid, but continuing problems in European debt markets could lead to higher funding costs. Considering all the uncertainty, BASF should be sold. On our Monitored List, the stock's rating is being dropped to B (average).


Dover ($51; DOV) is being dropped from the Buy List but kept as a Long-Term Buy. We had hoped the stock would bounce after the early September sell-off. But the maker of industrial equipment can't seem to gain traction. The Quadrix Overall score has dipped below 80, and the Earnings Estimates score continues to erode, falling to 15. Dover does look cheap, trading at less than 13 times trailing earnings. Couple that valuation with a diversified mix of businesses and the potential for long-term double-digit profit growth, and you have a textbook Long-Term Buy. But a near-term breakdown below $49 would not be surprising if industrials continue to weaken, and Dover no longer warrants a Buy rating.


Hewlett-Packard ($24; HPQ) is being dropped from the Buy List but retained as a Long-Term Buy. The Quadrix Overall score has dropped to 64, well below the 80 we use as our typical cut-off for the Buy List. The stock bounced Sept. 21 on reports the board is considering replacing CEO Leo Apotheker, who has presided over three revenue warnings in less than 11 months on the job. While we would not be surprised by a near-term move to $27 or $28, we prefer other tech names for 12-month returns.


J.P. Morgan Chase ($32; JPM) is being dropped from the Buy List, but the stock remains a Long-Term Buy based on its modest valuation and financial strength relative to its banking peers. The stock, yielding 3.1% and trading at seven times trailing earnings, seems likely to deliver attractive returns over the next 24 to 48 months. But profit estimates are under pressure, and an earnings shortfall in the September or December quarters would not be surprising. J.P. Morgan's Overall Quadrix score has dropped to 66, reflecting poor scores for Earnings Estimates and Performance.


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