Bank on the Future

Best and Worst Stocks for Earnings Season September 30, 2009

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The third calendar quarter ends Wednesday, and earnings season -- a loosely defined period during which many companies report financial results -- starts in early to mid-October. Wall Street's published forecasts suggest that operating earnings underlying the S&P 500, the index that represents most of America's stock market by value, will have fallen 9% from a year ago. That would be a sharp improvement from prior quarters; operating earnings fell 19% year-over-year in the second quarter and 39% in the first, and they disappeared altogether in the fourth quarter of 2008.

Despite the improvement, investors might be disappointed if third-quarter earnings merely meet forecasts. In the second quarter, nearly three-quarters of companies posted positive earnings surprises, whether from cost-cutting or careful management of their expectations (but rarely from growth, as few companies beat sales estimates). Stock valuations suggest buyers are betting on another round of positive surprises. The S&P 500 lately has traded near 20 times its forecast 2009 earnings. Its historical average is less than 15 times earnings.

With so much seemingly riding on surprises, consider a statistical clue that can help predict which companies will please Wall Street and which will disappoint. It's not a sure thing, but it can bend the probabilities in an investor's favor. It has to do with analyst disagreement.

Stocks with analysts' earnings forecasts that are broadly scattered tend to underperform the broad market, according to a study published in 2007 in the Journal of Finance and written by Anna Scherbina, a professor at the University of California, Davis. There are a couple of theories on why. The most convincing of them holds that companies with good news share all the details with anyone who'll listen, and those with bad news keep mum. The difference in information flow leads to agreement among analysts over companies that are performing well, and disagreement over ones that might be struggling.

Below I've attempted to apply the study finding to S&P 500 companies, focusing on the 211 of them that are expected to earn at least 50 cents a share in their current fiscal quarters, and whose earnings consensuses are based on at least five estimates. Statisticians use a measure called standard deviation to judge the degree of scattering within a group of results. For each of my 211 companies, I divided the standard deviation of the current-quarter earnings consensus by the consensus itself, and expressed the result as a percentage. These ranged from less than 1% to more than 46%. A lower percentage suggests more agreement among analysts, and according to the study, an increased likelihood of market-beating returns over the next six months. A higher percentage should be read as a warning sign -- again, only one piece of evidence among many that investors should consider.

Below are listed the top 10 and bottom 10 companies from my comparison.

Top 10
Company	Ticker	Current-Quarter EPS Consensus (excl. special items)	Standard Deviation	Std. Dev. / Consensus*
C.R. Bard	BCR	1.28	0.01	0.8
Hewlett-Packard	HPQ	1.12	0.01	0.9
Praxair	PX	1.00	0.01	1.0
Baxter International	BAX	0.97	0.01	1.0
McCormick & Company	MKC	0.90	0.01	1.1
Philip Morris International	PM	0.90	0.01	1.1
Abbott Laboratories	ABT	0.90	0.01	1.1
Wal-Mart Stores	WMT	0.81	0.01	1.2
Medtronic	MDT	0.75	0.01	1.3
Torchmark	TMK	1.49	0.02	1.3

Bottom 10
Company	Ticker	Current-Quarter EPS Consensus (excl. special items)	Standard Deviation	Std. Dev. / Consensus*
Stanley Works	SWK	0.62	0.10	16.1
XL Capital Ltd.	XL	0.52	0.09	17.3
CONSOL Energy	CNX	0.65	0.12	18.5
Apache	APA	1.47	0.28	19.0
Whirlpool	WHR	0.81	0.16	19.8
Devon Energy	DVN	0.86	0.21	24.4
M&T Bank	MTB	0.73	0.19	26.0
Hartford Financial Services Group	HIG	0.79	0.25	31.6
CF Industries Holdings	CF	1.13	0.41	36.3
Freeport-McMoRan Copper & Gold	FCX	0.93	0.43	46.2

* lower = more analyst agreement

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3 Small Biotechs Priced for Buyouts September 29, 2009

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Takeovers and positive clinical results often drive big moves in biotech stocks. For example, Medarex, a human antibody specialist with 40 drugs in trials, traded at $8.40 a share in mid-July when Bristol-Myers Squibb (BMS) announced it would pay $16 for the company. (The deal closed in early September.) Shares of Human Genome Sciences (HGSI) have rocketed to $19 from $2 this year, mostly on a July announcement of positive trial results for a new treatment for lupus, an autoimmune disease that causes inflammation and tissue damage.

Stock screening software isn’t useful for sorting biotechs by the value of their drug development pipelines, either to investors or corporate suitors. This column tends to pass over small, profitless biotechs because their lack of income tends to eliminate them from most screens. Bernstein Research, a unit of giant investment manager AllianceBernstein, recently used brain power rather than computer power to search more than 13,000 biotechs for companies that seem poised for a takeout or a breakout. I’ve listed their top three finds below, partly to make up for my neglect of the group and partly because Monday’s stock news was dominated by takeovers. The Dow Jones Industrial Average jumped 131 points to close at 9796 after Abbott Laboratories (ABT) said it will buy the drug business of Belgian chemical maker Solvay (SVYSY) for $6.6 billion, and Xerox (XRX) announced a purchase of Affiliated Computer Services (ACS) for $6.4 billion.

Geoffrey Porges, Bernstein’s head biotech analyst, focused his search on the 140 or so firms that trade on North American or European exchanges and have stock market values between $250 million and $5 billion. He zeroed in on 77 research-based companies with novel compounds that might eventually be sold in the U.S. or other big markets and key drugs in late-stage trials. From these, he selected takeout candidates by judging whether their existing partnerships would preclude or allow for a new, lucrative deal. He decided which are breakout candidates by determining whether key trial results are likely in coming months. The results include 28 takeout candidates, 10 breakout candidates and three stocks with takeout and breakout potential, which are listed below.

One caveat: Porges wrote Friday that he has no specific knowledge of takeover discussions, and that the list isn’t meant to give specific recommendations, but to “suggest a set of possible candidates in response to the inevitable question of ‘Who's next?’ for investors to examine more closely and position themselves accordingly.”

Abraxis BioScience

Market Value: $1.42 billion

Los Angeles-based Abraxis BioSciences (ABII) owns Abraxane, a breast cancer drug that studies suggest is better tolerated than Bristol-Myers Squibb’s Taxol. Abraxane received regulatory approval for the treatment of breast cancer in 2005, and is now in late-stage trials comparing it to Taxol for the treatment of a specific lung cancer. The company is trading at barely more than half its value of a year ago. A buyer would secure not only Abraxane, but the “nanoparticle albumin-bound,” or “nab” technology on which it’s based, an asset that could potentially improve the effectiveness of more drugs. Abraxis is forecast to produce $331 million in sales this year, with no profits.

Protalix BioTherapeutics

Market Value: $620 million

Israel’s Protalix BioTherapeutics (PLX) has developed a plant-based enzyme replacement to treat Gaucher’s disease, a condition in which an enzyme deficiency causes fatty material to accumulate in organs. Late-stage results for the treatment are pending, but a suitor might be more interested in the underlying technology. Protalix has developed a method for genetically engineering tobacco and carrot cells to produce recombinant proteins, which can be used to treat disease. A plant source for these proteins could prove cheaper and safer than current animal sources. Protalix has neither earnings nor sales.

Optimer Pharmaceuticals

Market Value: $474 million

Based in San Diego, Optimer Pharmaceutical (OPTR) has developed OPT-80, a treatment for clostridium difficile, an infection often acquired in hospitals that can lead to colitis. Nearly a year ago, Opt-80 proved superior in final-stage trials to Vancocin, which is currently used to treat the same disease and which captures yearly sales of about $250 million in the U.S. The company is currently assembling a U.S. sales force and plans to license the drug in Europe, where a similar trial is in final stages. Optimer is also close to filing for regulatory approval for another drug, which treats infectious diarrhea.

3 Health-Care Funds With Good Prognoses September 25, 2009

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Health care is one of the most contentious issues of 2009. Nobody denies it’s a good idea to help the more than 40 million uninsured get coverage. The debate is over how to do it. The White House and Congress each have their own plans. And for months, there has been backroom brokering. It is still unclear what form a plan would take — and when or if one will be passed.

A year ago, the health-care sector was in far better shape. After the market meltdown, many investors acted under the assumption that health-care stocks could be good defensive plays for portfolios. The thinking was that consumers would spend money on their medical care regardless of how cash-strapped they were. It didn’t quite play out like that. According to Morningstar, the average health-care fund lost 4.5% over the last year.

This week, we focus on the mutual funds trying to navigate the health-care sector. There are 87 health-care funds and share classes in our screener tool. We knocked out those that charged a sales load or high fees. We also searched for above-average track records. We were left with just three funds — one of the shortest finalist lists we’ve published all year.

When it comes to stock picking, fund managers are used to gauging competition, new products or forecasting earnings. The health-care sector has its own set of obstacles to contend with, like patent expiration, class action lawsuits and failed R&D projects. However, government regulation has always been the big wild card. It’s hard—maybe impossible—to predict what impact new regulations will have on a given sector. It is even more difficult when it comes to health care, an industry that spans technology, pharmaceuticals, managed care and biotechnology.

“It's likely reform will leave few areas of the sector untouched,” Morningstar analyst Chris Davis wrote in a recent report. “An obvious target is Big Pharma, long singled out for high drug prices. Insurers, too, could get squeezed, especially if Congress agrees to a Medicare-like public option for the uninsured. Medicare or Medicaid cuts could hit hospitals hard. Even if Congress settles on a plan that emphasizes expanded access to health care over cost containment, budgetary pressures could lead to price controls or reimbursement cuts down the road.”

Of course, expanded coverage could mean new customers for the industry, Davis says. “Expanded coverage means drug makers, device makers, and health-service providers could have more than 40 million new customers,” he says. “So what they lose in pricing power, they could make up in volume.” Davis recently highlighted certain health-care funds in this article.

We wouldn’t be so quick to follow his lead. Sector bets are always a risky proposition and health care takes that argument up a notch. The average S&P 500 index fund has a 14% exposure to the sector. For most investors, that's plenty.

But the daring can check out T. Rowe Price Health Sciences (PRHSX), a fund making a return appearance on our table below. Manager Kris Jenner, who has a medical degree, splits his portfolio between small-cap pharma and biotech stocks and more mature drug makers or health-care providers. The fund has returned an average annual 9.2% the last decade.

The Criteria: The health-care funds in the table are open to new money, require a minimum investment under $5,000 and charge an expense ratio less than $1.5%. In addition, they also had track records during the trailing three- and five-year time periods that put them in the top 40% of the category. They were also up more than the S&P 500 this year. As usual, we did not include load funds.

Funds in Good Health
Source: Lipper Data as of 09/24/2009
Name	Ticker	Assets ($ Millions)	YTD Return (%)	3-Year Average Annual Return (%)	5-Year Average Annual Return (%)	Expense Ratio (%)
Fidelity Select Medical Equipment & Systems	FSMEX	1167.2	24.17	5.39	6.23	0.87
Rydex Biotechnology	RYOIX	178.5	21.40	6.41	5.57	1.38
T. Rowe Price Health Sciences	PRHSX	1976.4	23.64	4.14	7.26	0.86

Recipe

Fund Type = Health care/Biotech
Annualized 3-Year Return (%) = Display Only
Rank in Classification (%) (3 year performance) <= 40
Annualized 5-Year Return (%) = Display Only
Rank in Classification (%) (5 year performance) <= 40
Expense Ratio <= 1.5%
Load Fund (type) = No Load
Minimum Initial Investment <= $5,000
Open to New Investors = Yes
Total Net Assets ($ millions) >= 50
Year-to-Date Return (%) = Display Only

3 Stocks With Recently Raised Dividends September 24, 2009

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Why are dividend yields so low? High stock valuations, scarce credit and corporate hoarding each play a role. But I’m guessing the main reason is that investors don’t seem to care.

Over the last two centuries, dividend yields on U.S. stocks have averaged 4.9%, according to a 2002 study published in Financial Analysts Journal. Today, the S&P 500 index, whose component stocks make up about three-quarters of the value of the American market, yields less than 2.1%, based on forecasted payments for 2009. If investors priced stocks according to dividend yields alone, history would suggest the index belongs at about 450, not 1060.

Perhaps prices are a bit too high. The index trades at 20 times the 2009 estimate for its underlying operating earnings. Over 128 years ended 2000, the average U.S. stock traded at 14.5 times earnings, according to a 2000 study by the Federal Reserve Bank of Kansas City. Also, the index’s underlying dividend payments are expected to fall 23% this year because 62 of its 500 companies announced cuts and 10 scrapped their dividends altogether.

Still, it’s a stretch to say that companies are scaling back payments because of financial difficulty. S&P 500 members will pay about 40% of their operating earnings as dividends this year, analysts estimate. Over 136 years ended 2007, the average payout percentage for U.S. companies was over 60%, according to calculations I made using data provided by Yale economist Robert Shiller. Standard & Poor’s reports that industrial companies in its 500 index (that is, all but financial, utility and transportation companies) hold a record amount of cash — some $700 billion, up from a range of $600 billion to $665 billion since 2004.

For the most part, it seems as if companies aren’t paying as much as they can because their investors aren’t complaining. Stock buyers have chased the 500 index up nearly 60% from its March low. Perhaps they’re betting that all that cash will go toward share repurchases, which return profits to shareholders just like dividends. But companies this year mostly missed the chance to buy low. In the second quarter, S&P 500 companies spent 72% less on repurchases than a year earlier, and the least since 1998.

If you’re the sort of contrarian investor who believes that dividends still matter, or even, as history suggests, that they’re the main component of long-term returns, the three companies listed below might interest you. Each has increased its dividend payment since the start of August. Each carries a yield of over 4% -- huge by current standards, if not historical ones.

Verizon

Dividend change: To $1.90 a year from $1.84 in September
Current yield: 6.3%

Unemployment is cutting into Verizon's (VZ) sales of business services, as companies hesitate to upgrade their networks. Meanwhile, cable companies are competing to lure home phone customers to switch to cheap voice-over-Internet service. But Verizon owns 55% of lucrative Verizon Wireless, with 87 million customers nationwide and the highest margins in the industry. The firm also continues to lay a fiber-optic network that competes directly with cable companies. This year Verizon’s sales are expected to increase 11%. The company isn’t a fast grower, but it’s suitably cheap at 12 times earnings and pays plenty to stockholders each quarter.

Philip Morris International

Dividend change: To $2.32 a year from $2.16 in September
Current yield: 4.6%

Philip Morris International (PM) sells Marlboro and other cigarettes outside the U.S. in 160 countries. It was spun off last year by tobacco giant Altria (MO), which itself was once called Philip Morris. Since the spinoff, Philip Morris International has increased its dividend twice and kept its share price just about flat, vs. a 19% decline for Altria. Altria carries a much larger yield (7.5%), but analysts say it carries greater legal risk and has dimmer growth prospects. Volumes for Philip Morris International have fallen a bit lately, as new laws spreading across Europe have forbid smoking in bars, but the company is taking greater market share in many of its markets, according to Wall Street Strategies, a research firm.

Legett & Platt

Dividend change: To $1.04 from $1.00 in August
Current yield: 5.2%

Legett & Platt (LEG) makes components for beds, office chairs, retail fixtures, car seats and much more. The company’s sales are expected to plunge more than 25% this year. That decline is mostly the result of a sharp downturn in car and house purchases and retail spending over the past year, but analysts say Legett has also exited low-margin businesses with sales totaling about $1 billion as part of an aggressive restructuring campaign. Note that the company is expected to earn 64 cents a share this year. It’s one thing for earnings to dip below the dividend rate, but quite another for management to increase payments at the same time. Keith Hughes, who covers the stock for investment bank Sun Trust Robinson Humphrey with a Buy recommendation, wrote in a Sept. 1 research note that the dividend hike “was done as a sign to investors that management is making progress in its goals.” One of management’s stated long-term goals is to pay 50% to 60% of its profits out as dividends. For the current dividend to be in that range, the company would have to earn at least $1.73 a share. Considering the company’s low capital spending, management can “easily maintain the payment,” absent “another big decline in consumer spending,” Hughes wrote.

3 Stocks Attracting Analyst Praise September 23, 2009

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“You only find out who is swimming naked when the tide goes out,” Warren Buffett wrote in a 2001 letter to Berkshire Hathaway (BRK.A) stockholders. That’s wildly inaccurate beach advice. However, taken as financial advice, it’s the sort of vague gem that always seems to apply to the crisis of the moment. It’s timeless.

Recommendations to buy particular stocks don’t last nearly as long. Investors who follow the advice of Wall Street analysts should always check the date. Dozens of studies of analyst recommendations published over the past two decades point to two broad findings. First, stocks with heaps of “buy” recommendations attached to them tend to perform no better than other stocks. Second, stocks with recent, positive changes in analyst opinions—to “buy” from “hold,” for example—tend to outperform the broad market over the following year. The difference is timing. Five “buy” recommendations issued a year ago hold less predictive power than one issued yesterday because factors like price/earnings ratios, sales growth rates and economic trends can change sharply in a year.

At least one analyst covering each of the three stocks below changed his or her published recommendation to “buy” (or “outperform”) this week.

Alaska Air

Upgraded to Buy from Hold Sept. 22
Helane Becker, Jesup & Lamont

Alaska Air Group (ALK) flies passengers to almost as many cities in California as in Alaska (and has its corporate headquarters in Seattle). Its sales are forecast to decline 10% this year. That’s not so bad when compared with giant airlines like American and United, whose corporate parents are expected to suffer 2009 sales declines of 17% and 21%, respectively. On Tuesday, Alaska Air lowered its third-quarter estimate for fuel costs and said some key sales measures (sales per passenger and per seat/mile) improved in August from July. A new baggage fee helped. Helane Becker of Jesup & Lamont upgraded the stock, citing valuation in a Tuesday note. Shares sell for less than 12 times the 2009 earnings consensus.

Gymboree

Upgraded to Outperform from Market Perform Sept. 22
Adrienne Tennant, FBR Capital Markets

Just over a year ago this column recommended shares of Gymboree (GYMB) as a safe haven in stormy markets. They’re up 27%, vs. a 13% decline for the broad-market S&P 500 index. Once a play center and now a kids’ clothier, Gymboree is increasing its sales this year, unlike competitors The Children’s Place (PLCE) and Gap (GPS). In a Tuesday investor note recommending the stock, Adrienne Tennant of FBR Capital Markets wrote that the company is gaining market share because of “compelling” products, that potential exists for sustained sales improvements at longstanding stores and that the stock is still cheap. It trades at 15 times earnings.

Dish Network

Upgraded to Outperform from Market Perform Sept. 22
Marci Ryvicker, Wells Fargo Securities

Dish Network (DISH) offers satellite television service that competes with cable and with the satellite service of Direct TV (DTV). Because cable companies sell bundled television, telephone and Internet service, satellite companies must pair with telephone companies to compete. AT&T (T) dumped Dish for DTV earlier this year, so although DTV is expected to increase its sales by 9% this year, Dish’s sales are forecast to rise less than 1%. Perhaps that difference is more than reflected in the two stock prices, though. DTV sells for 19 times earnings and Dish just 10 times earnings. In a Tuesday upgrade note, Marci Ryvicker of Wells Fargo Securities wrote that Wall Street’s expectations for the company are too low and that the share price should rise as the economy pulls out of recession.

3 Stocks With Fast Sales Growth September 22, 2009

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In my working-class neighborhood in New York City, most restaurants have empty tables this year at peak hours and are deserted anytime else. But one old diner that was remodeled recently into a chic bistro has a line at the door most for dinner most days, for brunch on the weekends, and for the bar starting at 3:00 a.m., when nearby bars close. Whether by skill, location or sheer luck, the place is cashing in 24/7, proving that even 2009 – with its cautious consumer spending – is a boom year for a few businesses.

The companies below are among the prosperous few. They managed to increase their sales by more than 15% last quarter versus a year earlier, not including sales that were added through takeovers of other companies. If that doesn’t sound like blazing growth, consider the climate. Last quarter, the median S&P 500 company saw its sales shrink 11%, even after acquisitions. Sure, managers largely beat Wall Street’s earnings forecasts last quarter, but only through aggressive cost-cutting. Ultimately, those managers will run out of ways to reduce spending, making genuine growers all the more prized among investors.

DeVry

Projected Fiscal 2010 Sales Growth: 23%

A scarcity of good jobs has sent students flocking to schools with a history of job-specific training and flexible, online options. DeVry (DV) reorganized its namesake school into a proper university in 2002, and today it enrolls more than 65,000 students in undergraduate and graduate programs. Demand is especially strong for spots in the company’s health-care schools, like Ross University for veterinarians and Chamberlain College for nurses. DeVry’s sales growth rate roughly doubled to 34% in its fiscal year ended June. This year, analysts foresee a 23% increase. Management has plans to diversify into new programs and expand into K-12 education. It should have plenty of money to do so. The company has no net debt and generates yearly free cash equal to almost 5% of its stock market value.

Mindray Medical International

Projected 2009 Sales Growth: 14%

If not for pesky democracy, America’s health-care reform might be easier. China earlier this year announced a $123 billion plan to extend coverage, build hospitals and buy new equipment. Local equipment manufacturers have all the business they can handle. Mindray Medical International (MR) makes machines that monitor patients’ blood pressure and breathing; diagnostic products for blood and urine; and basic imaging equipment, like portable ultrasound machines. All segments are growing. The company is still relatively small, with $608 million in trailing 12-month sales, but should benefit from rising Chinese affluence today and a shift to more sophisticated exports like medical equipment in the future. That projection is perhaps not lost on investors, with shares at 29 times earnings.

Cal Dive International

Projected 2009 Sales Growth: 13%

Cal Dive (DVR) provides manned diving, pipe laying, platform installation and salvage services for offshore drillers. Around a quarter of the Houston company’s sales come from foreign customers; the firm is getting plenty of work from Mexico and China lately. During Cal Dive’s most recent quarter, its gross margins jumped to 27.2%, up from 18.7%, suggesting its ships are seeing little rest. At 10 times forecast 2009 earnings, Cal Dive is easily the cheapest stock on this list. Its largest shareholder, Helix Energy (HLX), had a 51% stake before selling roughly half of it in June and putting the other half up for sale Friday. Meanwhile, Cal Dive has been repurchasing (and thus retiring) shares. The net result probably has been a slight drag on the stock price, even though investors should be better off in the end, with slightly fewer shares and less concentrated ownership.

10 Funds Making Big Bets on a Few Stocks September 18, 2009

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One of the selling points of mutual funds is that they offer investors instant portfolio diversification. Instead of betting all their money on one or two stocks, fund holders can invest easily in dozens or hundreds of companies.

But there is some debate over whether investing in one of these funds – which typically devote less than a percentage point to each of their holdings – shortchanges investors when certain stocks soar. Why own all of the 500 stocks in the famous S&P index when just five or 10 perform best?

That’s where so-called focused mutual funds come into play. We define focused funds as those with fewer than 50 stocks in their portfolios. Morningstar lists over 6,000 funds and share classes that fit this description. We threw out funds that charged high fees and sales loads. They also had to be open to new money and require a minimum investment of less than $5,000. In addition, because successful focused funds depend on a manager calling the shots, we limited our selections to actively-run funds, leaving out funds of funds or other categories. We think the manager component is especially important in this type of a market recovery. “It’s more important to get a stock picker to separate the good opportunities from the bad,” says Brett D’Arcy, the chief investment officer at CBIZ Wealth Management. We ultimately were left with 10 funds.

Focused funds aren’t usually recommended for conservative investors because of their narrow composition; some have over 50% of their assets in their top 10 holdings (By comparison, an S&P 500 fund will have less than half that amount in its top 10 holdings.). So that means one or two bad stock picks can easily sink a focused fund while a broad market index offering won’t be impacted as much.

On the other hand, a hot stock or two can send a focused fund soaring passed an index fund. Fairholme (FAIRX) is a focused fund that owns just 20 stocks. According to Morningstar, it is up 31% (vs. 20% for the S&P 500) thanks to stocks like Sears (SHLD), Hertz (HTZ) and AmeriCredit (ACF). Fairholme is Morningstar’s top-ranked large blend fund over the trailing three- and five-year time periods.

Regardless of the perceived risk, research supports focused funds’ concentrated portfolios. In “You Can Be a Stock Market Genius” Joel Greenblatt, the founder of Gotham Capital, says that investors can cut 46% on non-market risk by owning two stocks, rather than just one. The risk is cut further as investors add additional companies. But once the portfolio hits six to eight stocks in different industries “the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small,” Greenblatt says.

The flip side of that argument comes from the index fund camp. Vanguard founder John Bogle says it’s futile for a manager to try to beat the broad market over the long haul. At some point, the manager is bound to lag a diversified index. So investors would be better off just buying a cheap index offering, sitting back and relaxing.

That said, the funds on our list are run by seasoned managers. They sport below-average fees and top performance track records. Those are the hallmarks we look for in a fund. Fairholme, FMI Common Stock (FMIMX) and Yacktman (YACKX) are making return appearances to this screen. They would make a good starting point for any investor interested in focused funds.

The Criteria: The funds on the table below have portfolios that own fewer than 50 stocks. They are open to new money, require a minimum investment of less than $5,000 and charge an annual expense ratio less than 1.5%. In addition, they have performance track records during the trailing three- and five-year time periods that put them in the top 25% of their peer groups. They were also beating the year-to-date return of the S&P 500. Finally, we limited ourselves to actively managed funds, leaving out funds of funds.

Betting Big on a Few Stocks
Source: Morningstar, Lipper Note: Data as of Sept. 17, 2009
Fund	Ticker	Assets ($ Millions)	ytd Return (%)	3-Year Average Annual Return (%)	5-Year Average Annual Return (%)	Expense Ratio
Aston/Optimum Mid Cap	CHTTX	759.7	47.81	2.84	5.62	1.16
Fairholme	FAIRX	9988.9	31.18	3.86	9.24	1.01
FMI Common Stock	FMIMX	799.3	34.05	4.06	8.24	1.22
Laudus U.S. Large Cap Growth	LGILX	135.6	35.38	2.25	5.74	0.80
Old Mutual Focused	OBFVX	62.0	27.15	-0.36	5.14	1.12
Parnassus	PARNX	330.2	43.49	2.13	3.52	0.99
Pin Oak Aggressive Stock	POGSX	86.6	68.24	5.29	5.33	1.25
Transamerica Premier Focus	TPAGX	63.2	35.54	0.85	5.26	1.37
Westport	WPFRX	160.4	28.22	2.95	7.93	1.37
Yacktman	YACKX	846.9	49.07	6.37	7.56	0.95

3 Stocks That Have Tripled This Year September 17, 2009

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Suppose you look at some basic numbers on a stock and find plenty of promising signs. Sales and profits are growing quickly and the company’s managers earn an excellent return on the capital they invest. The stock’s valuation is a touch higher than you’d like, but still reasonable considering the company’s growth potential. You like everything you see—until you realize that the stock price has more than doubled since January.

Which should you do?

1) Disregard the stock, since you already missed out on the big gains.
2) Favor the stock even more, since it has plenty of momentum.
3) Keep the stock in mind, but wait for a pullback.
4) The answer depends on the type of stock, and the state of the broad market.

No. 3 might sound like the best choice, but the evidence says No. 2 is better. Personally, I’d keep No. 4 in mind, too.

A landmark study on momentum investing published in 1993 showed that stocks that have recently soared tend to continue beating the market. A follow-up study nearly a decade later documented something called long-term reversals; a basket of stocks with stellar recent returns indeed tends to continue outperforming, but only for a few years, after which it tends to lag. Finally, a 2004 study pointed to a stock’s closeness to its 52-week-high price as being a better gauge of momentum than past-year performance. A stock that’s up 80% over the past year might have initially climbed 120% and then backed off, suggesting the momentum has cooled. A stock that’s hitting new highs is still hot. Perhaps for that reason, the study found that a basket of stocks hitting new highs tends to keep outperforming for longer—more than five years.

So recent, impressive gains are a good sign, even if you missed out on them. But don’t just chase highfliers. Plenty of signs matter more than momentum, like valuation. Also, the type of company matters. A few stocks are up big this year because of impressive growth. Many top gainers, though, are companies that recently approached financial collapse only to narrowly escape—for now. Those can’t quite be called momentum stocks. Finally, while pundits love to argue over whether growth stocks beat value stocks and vice versa, it mostly depends on the market. Popular growth stocks usually outperform in a rising market, and value stocks tend to win in down markets (the past year being a notable exception). If you suspect the market is headed for a tumble, stay away from stocks that have recently soared.

Below are three stocks that have more than doubled in price this year, but which still seem reasonably priced.

Western Digital

YTD price gain: 218%
Forward P/E: 11

Hard-drive maker Western Digital (WDC) sells for more than $36 a share today, up from less than $12 at the end of last year. If that sounds worrisome, consider a few things that should give investors comfort. Hard-drive inventories look lean at the moment, and while prices have fallen over the past year, Western Digital in its most recent quarter shipped 14% more drives than a year earlier. The company sits on net cash equal to 16% of its stock market value, and generates close to 10% of its value in free cash each year. And shares, even after their run, sell for less than 11 times earnings, a discount of some 40% to the broad market.

RF Micro Devices

YTD price gain: 630%
Forward P/E: 18

Having cut costs and trimmed underperforming units over the past year, RF Micro (RFMD) today is financially stable and focused on its core business: making the tiny radios that cellphones use to carry calls and fetch data. The company might be on the verge of a profit jump. The rise of 3G (third-generation) phones has brought not just a change in radios but demand for more of them. A typical “smart” phone, for example, is designed to be backward-compatible with 2G technology, to operate on several frequency bands and to handle Wi-Fi and Bluetooth signals. As all phones gradually become smart phones, RF is positioned to profit, and to diversify its revenue mix away from handset maker Nokia (NOK), which in the past has contributed more than half of the company’s sales.

Cott

YTD price gain: 501%
Forward P/E: 13

I can’t quite understand how a liter of water can come to sell for twice as much as two liters of carbonated water mixed with sugar, flavoring and dye. Whatever the reason, soda doesn’t seem to carry much pricing power. And yet, Coca-Cola (KO) manages to turn more than a quarter of each sales dollar into operating profit. Toronto-based soda maker Cott (COT) is nowhere near as successful, but it’s improving after a long slump. By reducing costs the company returned to profitability this year, and operating margin recently jumped from 3% to 9%. Cott makes RC Cola, having bought the brand in 2001, but mostly it makes private-label soda for stores. Management has far exceeded Wall Street’s earnings forecasts of late. If the operational momentum continues, expect the stock to follow. Relative to company sales, Cott shares are still discounted to Coke by more than 90%.

3 Safe Stocks That Look Underpriced September 16, 2009

Posted by Jack Hough in : Uncategorized , comments closed

On the whole, would you say that cheap stocks are safer or riskier than expensive ones?

If you say safer, you might be a financial heretic like me. A half century of widely accepted, Nobel prize-winning economics research says that safety-seeking investors must pay dearly, and that only daredevils should look for bargains.

You see, investors have always understood that risk and returns are related—that some bets carry a small chance of a big payoff, but a large chance of a loss. In the 1950s, though, mathematicians began putting the relationship down on paper. Greater reward comes only through greater risk, they figured, but the difficult part was quantifying risk. Early models used stocks’ past trading volatility to gauge risk, but that turned out to be an incomplete measure. Researchers realized, for example, that companies with modest stock prices relative to the value of their assets tend to outperform the broad market even after adjusting for past trading volatility. So mathematicians concluded that low valuations are just another measure or risk—that cheap stocks are cheap because they’re unsafe, not because they’re mispriced. Stocks are for the most part priced correctly, the theory goes, because the stock market is efficient, almost perfectly so.

“I’d be a bum on the street with a tin cup if the markets were efficient,” Warren Buffett once said. Under his management, the investment vehicle Berkshire Hathaway (BRK.A) increased its book value by 362,319%, over 42 years ended 2008, vs. a 4,276% return for the S&P 500 index. Mathematically speaking, that record alone isn’t proof that it’s possible to beat the market by selecting cheap stocks. So large is the universe of stock investors that statistics suggest a tiny few will always produce astounding long-term results through luck, not skill. But Warren Buffett seems skilled to me, and anyhow, recent events have left the stock market looking not-so-efficient. A market that always gets prices right probably doesn’t lose more than 50% and then gain more than 50%, all within the space of two years.

For investors who believe it’s possible to find cheap stocks that are also safe, or even that cheapness is a sign of safety, below are three stocks to consider. Each has a modest price relative to both earnings and book value, and a greater-than-average dividend yield.

Consolidated Edison

Forward P/E: 13
Dividend Yield: 6%

Consolidated Edison (ED) provides electricity, gas and steam to New York City and Westchester County. The stock price has increased only about 60% over the past two decades, but with dividends, shareholders have made more than four times their money, easily beating the broad market. Sales and profits for the company are trending lazily higher, as usual, and the dividend yield demands notice, at 6%. The company has increased payments in each of the past 35 years.

J.M. Smucker

Forward P/E: 14
Dividend yield 2.6%

Don’t be fooled by the 21% sales growth J.M. Smucker (SJM) is forecast to produce in its current fiscal year, which ends in April 2010. Much of the growth stems from the company’s acquisition of Folgers coffee from Procter & Gamble (PG) in 2008. But even without its new coffee business, Smucker has impressed. Its share of the peanut butter market has gradually swelled to 46% from 42% in 2003, according to Jefferies & Co., an investment bank. Shares are up more than 50% since March, but there’s still much to like about the stock, even beyond the still-low P/E and healthy dividend. Peanut butter, jam, cake mixes and coffee aren’t terribly sensitive to economic slowdowns, so even if the economy fails to pull out of recession just yet, Smucker’s sales shouldn’t suffer. And the company has far surpassed analysts’ earnings forecasts of late—a sign of operational momentum.

Capstead Mortgage

Forward P/E: 6
Dividend Yield: 16.3%

Capstead Mortgage (CMO) owns securities backed by home mortgages. Those have been proven far less safe than assumed over the past year. Ironically, that might make now a fairly safe time to invest in them. Consider that most of Capstead’s portfolio is backed by principal guarantees from government agencies, putting credit risk on taxpayers, not shareholders. Note, too, that the Federal Reserve is using powerful tools to ensure that big investors like Capstead continue to find mortgage securities profitable. Finally, think about how the bad news on mortgages over the past year has beaten Capstead’s shares down to less than one-fifth of their value two years ago. The dividend yield tops 16%.

3 Stocks Priced for Takeovers September 15, 2009

Posted by Jack Hough in : Uncategorized , comments closed

August was on pace to be the slowest month for corporate takeovers in 14 years, until the final day of the month. That morning, Disney (DIS) announced a cash-and-stock purchase of Marvel Entertainment and its stable of comic heroes, while Baker Hughes (BHI) said it would snap up a fellow energy services firm, BJ Services, for mostly stock. Those deals, valued at $4 billion and $5.5 billion, respectively, elevated August to merely the slowest month for transactions in six years.

The revival has continued into September, with Deutsche Telekom and France Telecom agreeing to combine their British wireless operations, and cheese maker Kraft (KFT) chasing (unsuccessfully so far) after chocolatier Cadbury. Optimists say managers are less fearful about the economy, and that target companies are still cheap. I say that too few companies are truly cheap, but that with the broad market up more than 50% from its March low, managers are keen on spending their companies’ reclaimed stock wealth.

Whatever the case, stock investors looking to add to their holdings might want to start their search by thinking like merger pros. To that end, below are three companies with low EV/Ebitda ratios. EV is enterprise value, or the cost to buy all of a company’s shares and pay off its debt, while applying its cash to the transaction. Ebitda, which stands for earnings before interest, taxes, depreciation and amortization, looks at current profits while ignoring some charges related to past transactions. The companies that follow have low takeover prices relative to their profit potential. And since the point of this screen is to find long-term holdings, not guess on takeovers, I made sure each company pays a dividend.

Cardinal Health

EV/Ebitda: 4.4

A giant in the drug distribution industry, Cardinal Health (CAH) recently spun off its medical products business, CareFusion (CFN). It retains a stake in CareFusion worth more than $700 million, though, which it intends to gradually sell in coming years, boosting cash flow. In addition, Cardinal generates more than $1 billion in free cash a year—close to 11% of its market value. Consolidation among drug stores means huge chains like CVS Caremark (CVS) can negotiate for lower prices, a negative for Cardinal. But the company is working to add more independent druggists, who pay higher prices. Sales are stable at the moment and the stock is about 25% cheaper than the S&P 500 relative to forecast 2009 earnings. It carries a dividend yield of 2.6%.

Cooper Industries

EV/Ebitda: 7.7

According to the industry categorization scheme used by data companies, Cooper Industries (CBE) is a conglomerate. Increasingly, though, the label doesn’t fit. The 170-year-old firm spent the first three of the past four decades diversifying into scattered businesses, but over the past decade has pruned its manufacturing lines to electrical products and tools. Those industries have seen better days; sales for Cooper are forecast to fall 22% this year. Shares are trading at 16 times this year’s meager earnings forecast, but just 10 times what the company earned last year. Cooper owes little, which will help it weather the current manufacturing downturn. Investors who tuck shares away and wait for an economic recovery collect a 2.7% dividend.

ConocoPhilips

EV/Ebitda: 3.8

Berkshire Hathaway (BRK.A), Warren Buffett’s investment vehicle, lost plenty by betting on shares of ConocoPhilips (COP) last year when crude oil was well over $100 a barrel. Today’s buyers might fare better. The stock’s price is a third lower than a year ago. Based on measures like sales and earnings, Conoco is the cheapest of the major diversified energy producers. Using this year’s depressed profit forecasts, for example, Conoco trades at 13 times earnings, vs. 18 times earnings for Exxon Mobil (XOM). And Conoco comes with a much bigger dividend yield: 4.1%.

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Best and Worst Stocks for Earnings Season September 30, 2009