A Portfolio for Four Seasons!

Will the US economy go into recession - technically defined as two consecutive quarters of negative GDP growth - in 07? I have no idea. I’m neither an economist nor a clairvoyant. But I do know one thing: this portfolio is ready to ride out whatever Wall Street throws up.

The folio exceeded my expectations in 06. It came out of the gate in mid-September to beat the S&P500 nine times out of the 16 weeks it traded. I can’t get an accurate comparison to the S&P’s 13.6% year return - the folio regularly changes in size through addition of funds – but the return on the last trading day registered 4.70% (excluding dividends).

As an aspiring money manager I think a 56% success rate against the market benchmark is not a chest thumper but it’s not bad. I aim for at least a 70% success rate in 07. My proudest achievement in 06 was not that the folio hung in there with Wall Street but that there was not a day when all the stocks closed down. Even on days when the three major indices - the Dow, Nasdaq, and S&P - all saw red, the strength of the diversity of the folio ensured that it saw some green. This is definitely a folio I can roll with in 07.

Here’s how the stocks closed shop in 06 (MA – Moving Average):

How They Ended 2006 by Return to Date (RTD)

Stock	RTD(12/29/06)	Rank	MA(12/29/06)	Rank
NHP	10.20%	1	7.19%	3
IGE	8.71%	2	8.82%	2
EEM	7.51%	3	6.72%	4
ADBE	6.87%	4	5.08%	6
MSFT	5.44%	5	5.69%	5
EFA	4.99%	6	4.60%	8
IWR	4.52%	7	4.27%	9
IJR	3.33%	8	3.22%	10
PG	2.63%	9	1.89%	13
BAC	2.43%	10	2.36%	12
COST	2.39%	11	2.83%	11
SLV	0.66%	12	9.87%	1
PBW	-0.64%	13	1.62%	14
EBAY	-2.75%	14	4.74%	7

The Most Defensive Stock
In 2006 there were only four occasions when all but one stock closed down. On two of these occasions PG, the consumer staples giant, defied gravity. SLV and EFA closed up on the other two occasions. Conversely, there were five occasions when all but one stock closed up. On two of these occasions SLV saw red. PG, EFA and IGE saw red on three occasions.

However, PG is the only stock that’s been negatively correlated to the S&P. Therefore, PG is the most defensive stock. This makes sense. When investors are spooked and there’s a “flight to quality” PG is one of those stocks that tend to benefit. What’s the next best thing to PG for defense? SLV.

The prospects for PG and SLV in 2007 look good. PG should benefit from a slowing economy if consumers tighten purse strings. Having detergent to wash clothes and toothpaste to brush their teeth will matter more to consumers than a PS3 or a gas guzzler when pocketbooks get stretched!

Both stocks should benefit from a weak greenback. PG earns more overseas than it does in the US so those extra dollars from foreign currency conversions should do wonders for the bottom line. A weak dollar is bound to stoke inflationary pressures as imports become more expensive for US consumers. SLV, like gold, is a good play on concerns about rising inflation.

I hope you got defensive stocks similar to PG and SLV in your folio. Otherwise you’re playing Football without Linebackers. Good luck!

Technical Leaders
These stocks closed 2006 above their Moving Averages:

Stock	Size of Gap-up	Rank
NHP	3.01%	1
ADBE	1.79%	2
EEM	0.79%	3
PG	0.74%	4
EFA	0.39%	5
IWR	0.25%	6
IJR	0.11%	7
BAC	0.07%	8

Whether or not the economy loses steam NHP, a health-care real estate investment trust (REIT), should hold its own in 07. By design a REIT pays “buku” dividends, which is going to matter more when stocks lose traction in a sluggish economy, but a health-care REIT is like a covered call option on the economy. What do I mean? Well you get downside protection in form of a regular dividend, and since health-care is a growth sector – think of retiring Babyboomers – you’re perfectly placed to benefit from any upside in economic growth.

However, REITS are generally viewed as financial stocks by investors so any rate hike in an inverted yield curve environment could throw a spanner in the works of REITs. Luckily for NHP, its mortgage business accounts for only 5% of revenue so it shouldn’t be that vulnerable to any increase in interest rates. Allez NHP!

What can I tell you about ADBE? In 2007 it’s coming out with one of the most highly anticipated software products in the industry, and I dare you to find a firm that is as strategically placed to benefit from the Web 2.0 migration of digital content to mobile devices. So don’t act a fool and dump the stock once the new product is out because you’d be missing out on the real gravy train. The firm has also decided to stop giving intra-quarter guidance, which made the stock very volatile.

I don’t need to preach about EEM and EFA. The rest of the world no longer catches a cold when the US economy sneezes so if you don’t hold positions in foreign stocks in 07 then which planet are you from?!

BAC is good to go in 2007 unless interest rates start to creep up instead of down as expected by most economists. Rising interest rates will put the stock under pressure but the firm has deliberately expanded its non-consumer banking businesses to pick up the slack in the consumer banking business.

Actually, BAC seems to doing the opposite of what Citigroup is doing, which is to go on an international buying spree of commercial banks. Interesting. That BAC is also a high-yielding stock will pacify investors should sentiment turn against banking stocks.

Technical Laggards
These stocks closed 2006 below their Moving Averages:

Stock	Size of Gap-down	Rank
IGE	-0.11%	9
MSFT	-0.25%	10
COST	-0.44%	11
PBW	-2.26%	12
EBAY	-7.49%	13
SLV	-9.21%	14

EBAY, which had been riding high after reaching a low point in August, suddenly lost its mojo in mid-December when it swallowed its pride and admitted it couldn’t go it alone in China. This prompted many investors to drop the stock like a bad habit. Honestly, I’m a little concerned about EBAY. The online auctions division has lost considerable steam. Also, if the economy fizzles so will online listings.

EBAY’s performance in 07 will almost entirely be tied to the success (or otherwise) of its PayPal and Skype units. Do I think Google’s Checkout will threaten PayPal? Not in 07. Actually, PayPal has such a headstart that I doubt Checkout will ever threaten its growing popularity for online payments. I know Google keeps saying Checkout is not out to take market share from PayPal but please!

As for Skype, its future actually looks a little brighter after AT&T agreed, as part of its recent deal to acquire BellSouth, not to bundle its telephone services with internet access for Digital Subscriber Line (DSL) subscribers. Had AT&T not offered this concession, it would probably have been able to shut out Skype and other voice-over-internet-protocol (VOIP) players that have been able to offer subscribers cheaper call rates partly because they spend no money to lay wires down like Telcos do.

Skype has also started to charge for previously free calls to landlines and mobile phones in the US and Canada. So things are looking up for Skype. All told, PayPal and Skype could pick “some” slack in online listings for EBAY in 07.

Silver collapsed! This is not how I expected SLV to end 2006 but it dropped almost 10% in mid-December. The bloodshed happened in a week when investors were particularly jittery about inflation and “irrationally” sensitive to economic data. SLV is a hedge on rising inflation so when data came out that suggested inflation was easing investors bailed out of SLV in droves. I remember watching in horror on December 15 as SLV dropped like a waterfall!

However, I expect SLV to bounce back in 07 due to a weakening greenback. Interest rates are expected to go up in the UK and the Eurozone so the dollar is bound to bleed some more at least against the other major currencies.

So there you have it. The folio stumbled out of the gate in September but quickly regained its footing as I added some stocks and rebalanced – gave more weight to some stocks than others. Rebalancing will continue in 2007. I can’t assign equal weights to all stocks and just sit back and watch the folio trade; not all stocks are created equal so doing that is not an intelligent way to manage a folio for four seasons.

The worst-known manager intends to build on the experience acquired in 06 to “bring home the bacon” in 07. Do not adjust your sets!

What's the Big Deal About CostCo?

Once in a while in relationships I ask (myself) whether the reasons I’m attracted to a partner are still valid. If not, it may be time to move on. I do the same with my portfolio. And each time I’ve taken stock of the stocks COST is that one stock that’s given me second thoughts.

COST operates on razor-thin margins. I mean, discount warehousing is almost a “margin-free” business anyway – buy high and sell low - but COST’s policy of no more than 4% markup on any of its big-ticket items means that operating profit margins are always in the 2% zone - compared with Target’s 8% and Wal-Mart’s 6%.

So despite the very low margins why am I attracted to COST and are these reasons still valid? I got into COST because of 4 main reasons: CEO mentality, Treatment of employees, High net-worth membership clientele, and International expansion.

I’ve read interviews with the CEO and listened to him on earning calls. He’s got a good head on his shoulders. Not only does he have skin in the business, he’s prepared to endure short-term pain for long-term gain. He holds a long-term view of the stock - to the chagrin of some on Wall Street - and spends a lot of time in the stores, not in some C-suite or corner office overlooking the waterfalls.

An analyst once commented that it’s better to be a COST employee than a shareholder or investor. Wall Street is generally not happy that COST pays its employees much more than the industry average. Of course this bites into income but the tradeoff is higher worker productivity and low turnover – the firm has one of the lowest employee turnover rates in the industry.

Have you ever visited a COST parking lot? It’s filled with luxury cars – the type of cars that park themselves! The highest level of membership at COST is Executive - there's also Gold and Business - and according to the firm at the end of fiscal 2006 executive members, who fork out $100 in annual membership fees, represented 23% of its primary membership base and generated about 45% of all sales. That’s 45% of almost $60 Billion; do the math!

On the Q1 fiscal 2007 earnings call last Thursday the company revealed that Gold membership stood at 17. 7 million, up from 17.2 million year-on-year, and that more members were spending more at a faster rate. But the icing on the cake is that more members are switching to executive membership. As long as COST continues to pack the wealthy in it will be able to operate on tight margins.

Finally there is COST’s international ambition. When I was searching for a discretionary stock to add to the folio, Target was the first firm to come to mind. But I quickly switched to COST when I discovered that Target had no plan to expand overseas soon. No thanks.

An international presence helps to cushion weaknesses in domestic sales and also brings foreign currency exchange income. International operations – 133 of its total 504 warehouses - already represent 18% of sales. Four new international stores will open before the end of this year with more to come in calendar 2007.

All told, COST remains attractive to me for the same reasons I got into it. Sales have grown by an annual average of 12% over the past four years; membership continues to grow; employees are some of the best paid in the industry; and the boss is fanatical about the discount warehouse business. The stock doesn’t move in giant leaps but it has appreciated about 24% over the past five years, versus 25% for the S&P500. COST is a tortoise, not a hare. That's the big deal. I’m still down with it.

Adobe Flashes Cash

Inflation is back! This week the bogeyman of investors and consumers alike made news on Wall Street; actually it made Wall Street. Inflation “appears” to be trended downwards, which means a higher spending power for consumers going forward.

If consumers can keep up their spending binge the economy may not slip into recession in 2007. At least that’s what the bulls think. However, I would say another month’s data is needed to really clarify where inflation is headed.

Nevertheless, the tide that lifted boats on Wall Street this week didn’t leave the folio behind. The manager is back to winning ways this week, thanks in part to ADBE, after two weeks of playing second fiddle to the S&P:

Worst-known +1.30%
S&P +1.22%
Dow +1.12%
Nasdaq +0.81%

ADBE sizzled this week. The “acrobatic” software powerhouse released fiscal Q4 2006 and fiscal 2006 results on Thursday and the stock just took off. The acquisition of rival Macromedia in December 2005 has started to filter to the bottom line.

A quick run of the annual numbers reveal a mixed picture overall. Key profitability indicators – NOPAT margin (net operating profit after tax/sales), earnings growth, and return on equity (ROE) - have become depressed:

Period Ending	NOPAT Margin	Earnings Growth	ROE
12/01/06	19%	-16%	14%
12/02/05	29%	34%	37%
12/03/04	26%	69%	36%
11/28/03	20%	39%	30%

This is not surprising after such a major acquisition. Earnings were particularly hit by stock-based compensation expenses and acquisition-related costs. The company’s target for operating margin in fiscal 2007 is 25% to 27% – this will get margins up to pre-Macromedia acquisition levels. I think this is doable with the planned release of a major product.

An immediate benefit of the acquisition is a buffed-up balance sheet, so ADBE now has more money to burn on R&D and further acquisitions.

Back in October when I decided to get into the stock instead of Apple, http://worst-knownportfoliomanager.blogspot.com/2006/10/beta-on-my-mind.html, and http://worst-knownportfoliomanager.blogspot.com/2006/10/new-portfolio-ready-for-holiday-season.html, I wasn’t aware of how huge the opportunities that await the firm were.

Other investors may be buying into ADBE because in fiscal Q2 2007 it’s going to release Creative Suite 3 (CS3), which is its most ambitious product and will be the biggest revenue driver yet, but this isn’t my primary motivation.

As I’ve done more homework on the application software industry and the worldwide migration of digital content to mobile devices, my conviction that ADBE could make a killing in this environment - provided it doesn’t lose its mojo - has got stronger. This firm thrives on innovation and adaptability. This is why am into ADBE.

Despite the absorption of Macromedia, it can still comfortably grow revenue by about 14% in fiscal 2007. I feel comfortable with this stock going forward.

Bank of America Shows Me the Money!

Next week the folio ka-chings! No, not the way you thought. The worst-known manager has picked Bank of America (BAC) to carry the banner for financials. For a long time I wanted to play financials with an Investment Banking stock. I was wary of the commercial (or consumer) banking sector because of its susceptibility to a flat or inverted yield curve, which makes banks’ borrowing costs higher than their lending costs.

However, I-banking stocks tend to behave like growth stocks and generally have higher Betas than their commercial banking counterparts. The folio is really growth-biased but I feel like a very low Beta (volatility) stock is needed to give it some balance.

Furthermore, since the folio is going to have direct exposure to only one US financial stock – the folio is indirectly exposed to foreign banks through EFA and EEM – it might as well be an “integrated” bank, which combines I-banking with commercial banking.

So an integrated bank it is. Okay, but then why not Citigroup (C) or JPMorgan Chase (JPM), BAC's erstwhile competitors? As a long-term investor I’ve used some of my most favorite fundamental metrics to rank C, BAC, and JPM – actual data points can be found at Yahoo Finance. Check this out:

Metric	Citi	Bank of Am	JPM Chase
Profitability
Profit Margin	2	1	3
Operating Margin	2	1	3
Management Efficiency
Return on Equity(ROE)	1	2	3
Growth
Quarterly Revenue Growth	3	1	2
Quarterly Earnings Growth	3	1	2
Balance Sheet
Total Cash	1	3	2
Total Debt	3	2	1
Cash Flow
Operating Cash Flow	1	2	3
Dividends
5-yr Avg Div Yield	3	2	1
Payout Ratio	2	1	3
Forward Annual Div Yield	2	1	3
Stock Volatility
Current Beta	0.42	0.47	0.67

I suspect the reason BAC is not top billing in ROE is its small global exposure. In 2005 it earned about 7% of revenue from overseas operations, compared to C (67%) and JPM (21%).

Now, I’ve examined BAC’s annual reports for the past three years – with particular attention paid to the Chairman’s letters, gleaned news archives and studied analyst reports that I can lay my hands on. There is no doubt that BAC plans to go global in a big way soon. En fait, it has to go global if it really wants to grow big. Right now, it is pushing against the regulatory ceiling for its core consumer banking business in the US.

BAC is well known for its generosity when it comes to dividends, but I decided to get into the stock really because of its growth potential and long-term performance. When you look on a global scale at where BAC is missing in action, Europe Middle East and Africa (EMEA) just jumps out at you. There is no smoke without fire and the recent rumor about a possible acquisition in Europe is not without merit. Bank of Am is on a treasure hunt in Europe; period.

In terms of performance over the long-term BAC has trumped C and JPM in stock appreciation on a trailing five-year basis. Not bad for a stock more known for being a dividend cash-cow. This historical feat is certainly no guarantee of future performance but here’s the real kicker about this stock going forward: I may not be a sucker for dividend income right now but baby boomers (1946-64) are.

When boomers start to draw income as they retire over the next few decades – there goes social security – stocks like BAC will be top of their list. I can’t think of any demographic change with the potential to benefit cash-cow stocks like BAC as the retirement of boomers. The demand for BAC stock is clearly going to do wonders for its appreciation.

On the balance sheet front, BAC’s smaller cash position compared to the other two banks doesn’t bother me as much as the huge debt. However, since the bank is numero uno in US deposits and a top-five wealth manager this makes sense.

Bearing in mind my aversion to the vulnerability of commercial banking to compressing net interest margins I take comfort in the fact that BAC’s revenue base is the least weighted in commercial banking - at 51%, compared to C (59%) and JPM (54%). My feeling is that BAC aims for a majority non-commercial banking revenue base, based on the growth rates of the firm's individual businesses. I certainly hope so.

In terms of growth expectations integrated banking stocks are fairly valued right now but are cheap compared to the overall financial sector. On a forward price/earning (P/E) basis, BAC is the cheapest of the three banks and the pull-back on Friday was an opportunity to buy a solid financial stock that is going places.

It was definitely a close call between Bank of Am and Citi. In the end, however, the long-term growth prospects for BAC did it for me.

So there it is. The financial stock vacancy in the folio has been filled. Next stop. Africa, the motherland!

Season Greetings Season Numbers

Last week the six-week winning streak of the manager over the S&P ended. This week, I actually end up in the doghouse, no thanks to the lingering effects of the collapse in techs last week. Here are the numbers:

Nasdaq +1.00%
S&P +0.94%
Dow +0.93%
Worst-known +0.92%

The Labor Department released November non-farm payrolls on Friday and Wall Street’s reaction was muted. The S&P advanced a paltry 0.2% and volume was nothing fancy. Many investors were probably skeptical of the higher-than-expected numbers. I was.

Apparently, about 15% of the 132K jobs created in November were in retail, the most for the sector this year! Ditto bars and restaurants; hotels and motels. These sectors accounted for the bulk of the gains in the payrolls but I bet you many of these jobs are temporary.

Once the holiday season ends, heads will roll in retail. The “hospitality” sector may not see as many job losses as retail because the choleric dollar continues to boost tourism. So check back with the Labor department in March before you put your faith in the strength of fourth quarter job numbers.

Are Techs Done for The Year?

Historians say December has statistically been the best month for stocks but there’s an increasing view on Wall Street that the December gravy train has already come and gone this year. The market rallied in September and October, when stocks typically dud.

So it's a wrap. Bears expect the market to be uninspiring and range-bound to the end of the year. Apparently today’s run-up – Dow up 0.7%, Nasdaq 1.5%, S&P 0.9% - is typical of high-octane starts to December. In other words don’t let it go to your head bull.

The bears may be right. Who knows? History may or may not repeat itself. But it does look like technology stocks are done. As October dawned I picked out the technology sector and the natural resources sector to shine this quarter. The rationale was that techs would get a holiday season bounce while the oil sector would benefit from colder weather as usual, all else being equal.

However, a quick analysis of my humble folio indicates techs appear to have lost steam over the past few weeks while natural resources has powered ahead. Over the past four weeks, EBAY, MSFT, and ADBE have posted average return-to-dates (RTD) of 7%, 6% and 5% respectively. Meanwhile SLV, IGE and EEM, which is weighted 17% in energy, have posted RTDs of 15%, 8% and 7% respectively.

Techs seem to have had their bull run. With all the talk of a slowing economy next year uncertainty – and fear of job losses - has crept into the minds of many consumers. It’s a bit too early to tell what December holds for techs but they have slowed their roll since October, when the Nasdaq posted a whopping 4.8%, it’s biggest monthly gain for the year so far.

Mind over Matter: Techno-crafting

This week my six-week winning steak over the S&P comes to end, albeit on the downside. Here are the numbers for the week:

S&P -0.30%
Worst-known -0.37%
Dow -0.70%
Nasdaq -1.91%

Who is responsible for this aberration? It’s technology stocks. But I’m a sucker for growth so there’s no love lost and I can’t do without them.

There’s a reason technology stocks often have high betas (or volatilities) – sensitivities to market swings: they can give up gains as fast as they earn them. For this reason always have, in addition to small-cap and/or mid-cap tech stocks, large-cap techs like MSFT, Intel or IBM in your portfolio.

These elephants tend to have “blue-chip” (or low) betas that will limit your downside risk when the market tumbles. To illustrate, consider the following table.

Top Five Stocks by Average Weekly Return to Date (RTD) for the past 5 Weeks

Stock	RTD(this week)	Rank	RTD(last week)	Rank
SLV	14.54%	1	13.32%	1
EBAY	7.70%	2	9.15%	2
IGE	7.63%	3	6.52%	3
EEM	6.19%	4	5.95%	5
MSFT	5.74%	5	5.97%	4

The top billings of EBAY and MSFT show they were among the best folio performers when the market soared in October and November. So it pays to hold technology stocks when everything is gravy in the market. However, when things fall apart as they did on Wall Street this week, tech stocks get hit hard because of their high betas.

Now, looking at the table above you might think that MSFT and EBAY, in particular, hung in there through this week’s bloodletting in the equities market but the table above masks their collapse. Here’s a ranking of the change in RTD from last week to this week – in decreasing order of magnitude:

SLV +4.81%
IGE +4.60%
EFA +1.38%
EEM +0.31%
IWR -0.49%
NHP -0.73%
IJR -0.99%
PBW -1.03%
PG -1.34%
MSFT -2.31%
COST -2.54%
ADBE -5.69%
EBAY -6.11%

Obviously tech stocks get slayed big time in market downturns. But notice that MSFT, which is a large-cap tech stock with a beta of 0.79 – the closer to 1 the less sensitive – fares much better than mid-cap techs ADBE (beta 1.81) and EBAY (beta 3.88!).

Were it not for the restrained negative reaction by MSFT my losses this week would’ve been greater since the folio is 15% weighted in the stock. So if you’re growth-oriented but eager to limit the downside not only does it pay to go tech, it pays to go big in tech.

Remember, the Trend is Your Friend

Wall Street takes a drubbing today to end the week down following the release of some weak manufacturing data. Investors overreacted in my opinion, though I understand the fear: the weak housing sector is starting to spill over into other sectors of the economy previously thought to be unaffected by the downturn in housing.

But some caution need to be exercised for two reasons. First, the data is only for one month, which does not signify a trend. Second, since manufacturing accounts for only 12% of economic growth why all the fuss?! It is consumer spending, which accounts for two-thirds of economic growth, which matter the most.

I'm not sushi. A downturn in manufacturing will mean job losses and thus less consumer spending but, like I said, a month's data is not indicative of a trend. Bears need to slow their roll.