Forget Your Stockbroker: How to Measure and Monitor the Correlation of Your Stocks Using Excel

Correlation is a measure of the degree to which a stock tends to move in the same direction as another stock or the broad market.

Normally, correlation measures use stock returns but in Excel you don’t have to use returns, as this article reveals.

The lower the correlations of your stocks with one another and with the market, the better diversified your portfolio – this does not mean the higher your returns though. Correlations range from 0 to 1 and a measure of 0.5 or higher indicates a high correlation.

When you know the correlations of your stocks, you are able to make objective buy or sell decisions.

For example, say, two of yours stocks, A and B, are highly correlated and you want to sell one of them to rebalance or reallocate your portfolio. Say stock A is also highly correlated with the S&P 500 while stock B is not. To improve the diversification of your portfolio, your best move would be to sell stock A - even if you're in love with it - because it correlates more with the market.

While you can get a stock’s correlation with the S&P on good financial information sites like Yahoo!Finance, you still need to know your stocks’ correlations with one another.

If you don’t have software that can give you these statistics at the press of a button, you can easily get them in Excel by using the “CORREL” function.

The trick is to use a system of letters or numbers to indicate up and down movements, and then apply the CORREL function to the two data sets for the two stocks in question, to get the correlation between them.

In the picture illustration below, you see that I use 1 (green shade) for upside movement and 2 (red shade) for downside movement.



To format your cells to flag high correlations – indicated by the yellow cells in the picture – you use the “Conditional Formatting” feature in Excel.

The good thing about the layout in the picture above is that you can see all your correlations in one window and make quick comparisons.

Of course, the downside to this whole exercise is that you have to manually record the daily movements of your stocks. Otherwise, you may not get accurate measurements.

The Central Bank is Killing Us!

Unemployment or Inflation: Which is the better of these two evils? Put another way, if you were the governor of a Central Bank what would concern you the most: average Joe losing his job today - unemployment - or average Joe paying much higher prices for bread and milk tomorrow - inflation? That’s a tough one, isn’t it? Well, that’s the choice Federal Reserve Chairman (or U.S. Central Bank governor) Ben Bernanke and his posse of regional governors – collectively known as the Fed - have now faced for a year.

You would probably say it’s better for average Joe to pay a higher price for bread tomorrow than to lose his job today. Well, guess what. The Fed agrees with you, which is why it’s been cutting interest rates since September 2007. Lately, the Fed has got very aggressive on rate cuts and this is making me nervous. Chairman Bernanke reportedly has reduced interest rates faster than any Fed Chairman since 1982.

However, when the subprime slime started around this time in 2007 the Fed saw things differently. Back then, the Fed was more concerned about inflation than job losses and was more reluctant to cut interest rates. So what changed the mind of the Fed? I don’t know. Perhaps it’s politics, since it’s an election year. Whatever it is the Fed has blown it. It’s now trying to prevent a recession at the risk of higher inflation tomorrow. Big mistake.

Interest rate cuts fuel inflation by weakening the dollar and thus making imports more expensive. Rising oil and food grain prices, which the Fed cannot control, also fuel inflation. So hasn’t it noticed that oil is now over $100 a barrel and that the price of wheat, which is a principal ingredient in many food products, reached a record high last week? Gold, which is a natural hedge against rising inflation, is fast approaching a record $1,000 an ounce and the price of Silver is up almost 34% year-to-date (YTD), a run-up not seen since 1980. By the way, if you don't already have some commodities in your portfolio now is not the right time to buy.

Laugh Now, Cry Later

Maybe the Fed knows something the market does not but it seems to me we already have enough inflation coming our way. In 2007, inflation jumped 4.1%, reportedly the fastest pace since 1990. No wonder the price of milk at my local organic store has crept up. Why aggressively cut interest rates to put the economy on a K-leg only for inflation to crush it two or three years from now?

I think the Fed’s fear of a recession is misplaced. A mild recession today is better than hyperinflation tomorrow because inflation can do much more damage to the economy than a recession. Inflation can cause a recession but a recession cannot cause inflation. The recession this year probably will be short-lived because of the “economic stimulus” tax rebates the government just approved.

Even if consumers don’t spend the bulk of their rebates businesses will reinvest their tax credits, which will boost the economy and stave off a brutal recession. So the chances of average Joe being unemployed for a long time if he lost his job today are slim. However, if we get hyperinflation in a few years…..well, just look at what is happening with food prices in Zimbabwe. Even Wall Street fears inflation more than a recession.

Yes, I know the housing sector is bleeding and the lending department at your local bank won’t give you the time of the day even with good credit. However, it was the aggressive rate cuts by former Fed Chairman Alan Greenspan that partially caused this mess we’re in today. The inflation signal is now flashing red. The Central Bank should stop leading us to the slaughterhouse again with aggressive rate cuts.

Water Please, Not Coke!

Atlanta, Georgia, HQ for soft-drink giant Coca-Cola, made the headlines a few days ago for something that’s a harbinger of things to come for all cities around the world. It’s about to run out of water, literally. In fact, unless the city takes drastic action - read mandatory rationing - it may run out of potable water in a matter of months! Here’s the soundbite from Carol Couch, the director of the Environmental Protection Agency (EPA) Division in Georgia: “Without any intervention, we are likely to run out of water in three months." Well, that was about a month ago so…sure you know what I’m thinking.

Guess what? Georgia is not alone. Cities all over the Southeastern US are sounding the same alarm about the dearth of freshwater resources due to a sustained drought. Have you heard the one about Florida butting heads with Alabama and Georgia over Florida’s desperate attempt to draw water from a shared river basin?

Dry, Dry, West

Oh, don’t even talk about California and the dry, dry, west. They already have voluntary rationing in Long Beach, and the last I heard, city officials say they may have to go mandatory to wake people up. The Colorado River, which is the lifeblood of the Southwest, is drying up and with it freshwater supplies for millions of west coasters in California, Arizona, Nevada, Texas, and Utah.

Water War I

Wait a minute. This is not just an American problem. Egypt is ready to go to war with Sudan and Ethiopia over the River Nile. The Jordan River basin remains a flashpoint because it serves Israel, Palestine, Jordan, Syria, and Lebanon. The Chinese are fretting about how they’re going to meet the water needs of 1.5 billion people in 2050 and the UN says “tensions and disagreements over water are erupting along the Mekong River in Indochina as well as around the Aral Sea in Eastern Europe.” Many analysts have for years been predicting the next World War will be over water. That’s a scary thought.

Planet Saltwater

Okay, so you get the picture. Whether or not it’s global warming the world is facing acute water shortages. Therefore, as an individual investor how can you make money from the impeding water crisis. Well, remember Samuel Taylor Coleridge famous complaint that “Water, water everywhere, nor any drop to drink."

You see, the world is running out of freshwater supplies but we’re not running out of water. Actually, water covers about 97% of the earth’s surface. The only problem is that the bulk of this is saltwater, and around the world now, there are companies investing billions of dollars to make this saltwater potable for human consumption. You’d be wise to invest in these companies not now but right now.

Play it Safe

This “water services” space, which comprises companies that provide potable water, water treatment and other technologies and services related to water consumption, is poised for phenomenal growth. Companies that stand to benefit from this growth range from well-known names like GE (US) and Suez (France) to smaller companies from India, China, South Korea, Brazil, and so on.

The water services industry is primarily a high-growth, small to medium-cap space so it is better to play it through an index fund or Exchange-traded Fund (ETF), which are baskets of individual stocks of companies involved in similar businesses. It is too risky to play the sector with a single stock, say, GE, for two reasons. First, most of the companies do not derive all of their revenue from water services. Therefore, you’d be getting too much of what you don’t want with a single stock play. Second, the industry is very capital-intensive so you don’t want to put your money in just one firm in case it goes bust.

There are about four or five ETFs focused on the water industry but the manager personally is invested in the PowerShares Global Water Portfolio ETF (PIO), which currently holds 40 international stocks that generate at least 50% of their revenue from water or water-related services. PIO currently is the most international of the ETFs. Companies are added or removed from this fund regularly (rebalanced) to make sure they all meet the minimum 50% revenue requirement and thus remain focused on water services.

So talk to your broker or investment adviser about water. Invest in water now so when mandatory rationing comes to a town near you, it would not feel so bad to go without a shower for a couple of days!

Shorts Slaughtered!

OMG! If there's any proof that it pays to be a long-term, buy-and-hold investor, today's action on the Street is it. It was a broad market rally, not just a Dow wow wow. The volume of stocks traded was also higher than usual, which gave today's surge some credibility and suggested there may be follow-up mini-rallies in the coming days.

Had you panicked and got out of the market on Tuesday when the indices tanked, then you are probably licking your wounds right now. And if you sold short Tuesday, thinking it's just going to be a summer of discontent as usual, then you are probably not going to have a good weekend.

Yes, the market often goes south in the summer but that doesn't mean it will always go down each summer. Besides, the manager's never really understood the whole "sell in May and go away" mantra. Okay, so maybe in the summer investors take more money off the table to get away from it all but I think it's a self-fulfilling prophecy that often accentuates normal market gyrations during the summer.

It works something like this: The summer is coming. Oil prices start to rise because summer is the peak driving season. Investors panic because they fear higher oil prices will hurt consumer pocketbooks. So investors start to take money off and hedgies and traders start to sell short big time. Corporate executives start to exercise options as their stocks bleed from all the selling. Investors get more panicky as executive sales could mean bad Q2 results and/or depressing forward guidance. So this induces more bloodletting. And so it goes.

However, as today's rally indicates, the market often defies gravity, which sends the shorts into a buying frenzy - and the market soaring - as they rush to cover their positions. So just like the manager never gets depressed about down days on the Street, the manager doesn't get euphoric about days like today. It all evens out in the long-term as the folio grows.

That said, if you must play the market short-term, the manager believes options - calls, puts, and their variants - offer a saner way to do this than short-selling, whether naked or not. It's even better when you play options on the stocks you hold long-term. That way, you don't have to borrow stocks to sell short. The bottom line, though, is that it pays to stay in the market long-term. Otherwise, when the proverbial tide goes out, you will be found out swimming naked.

CNBC $M Challenge: Plenty Guts, Tough Glory!

The worst-known portfolio manager battled over a million other players in the CNBC Million Dollar Portfolio Challenge that ended May 25th. In the end the manager finished top 2% in the first round and was on track for a top 1% finish in the second round - results yet to be announced.

Anyway, CNBC, you outdid yourself with this challenge! Thank you for the 10-week "vocational training" course in trading.

Do you know how many traders and hedgies will have come out of this?!

I won the competition - against myself!

I look forward to the next edition. Big up CNBC!

IPhone or Not, I Still Prefer Adobe to Apple

Ever since Apple (AAPL) announced it was getting into the smartphone business, many analysts have yapped about how the IPhone – or whatever it ends up getting called – will take competitors to the cleaners. PPPPleaseeee! I’m so tired of the claptrap that I feel compelled to offer my take on AAPL’s decision by revisiting my most favorite tech duel of the moment: ADBE vs. AAPL.

The duel is rooted in the early days of the folio. Back in October when I wanted to spice up the folio with a tech stock more volatile, relative to the S&P, than MSFT (Beta 0.71) but less so than EBAY (Beta 3.91) – ADBE (Beta 2.31) and AAPL (Beta 2.40) were the prime candidates on a list of 25 IT firms examined; yes, full-throttle Google was considered but I can’t quite see through the maze of how it makes money. Naturally, AAPL’s smartphone decision has prompted me to reexamine my allegiance to ADBE.

My Friend’s Enemy is……

Currently there are about one billion internet users around the world. But there are even more mobile phone users, reportedly 2 billion and growing faster than internet users. One of the major technological shifts currently afoot is the shift of desktop content and digital software to mobile devices. I’ve said before and I’ll say it again: ADBE has such a commanding share of the computer digital software market, ceteris paribus, that it’s better placed than many competitors to make a killing in this increasingly unwired world of ours.

Right now AAPL’s competition with ADBE is limited to the latter’s Creative Suite product, which includes the ubiquitous Flash Player. AAPL’s foray into smartphones could lead to more cooperation with ADBE, thereby building on existing software licensing partnerships. But the move is likely to bring more head butts with ADBE than kisses.

The adoption of Flash Lite technology, which is ADBE’s signature product for mobile devices, has been particularly strong over the past year. The firm announced last week that the number of Flash Lite enabled devices shipping worldwide has tripled since January 2006, to reach more than 200 million, most prominently in Japan as a result of a partnership with NTT DoCoMo. The Japanese lead the world in mobile phone technology so you know whatever “blows up” there usually takes off elsewhere. Sorry I digress for a New York minute.

The success of Flash Lite has been driven by ADBE’s key relationships with players like Nokia, Motorola and Samsung. These are the 400 pound gorillas AAPL will be going up against with the IPhone. I know AAPL’s reputation and success are built on market disruption but I have a feeling it’s about to bite more than it can chew.

A Good Swimmer in Shark-infested Waters

With a return-on-equity of about 25% - ADBE’s ROE is 14% - and strong brand recognition AAPL is a tempting stock. Macs are flying off the shelves and IPods keep getting more nanos, shuffles and whatever else. But is AAPL getting drunk off IPod juice? I mean, it may have 75% of the portable digital musical player market but the smartphone market is a much more competitive landscape.

Sony took the blowout by the IPod on the chin perhaps because it had other businesses to fall back on and it wasn’t a “do or die” with the Walkman. But the smartphone business is the bread and butter for pure players like RIM and Palm, and increasingly so for handset OEMs like Motorola, Nokia and Samsung. Actually, Samsung and LG Electronics have already unveiled “IPhone killers.” In fact, LG’s version uses ADBE’s Flash technology to enhance user experience. These firms will not lay the red carpet for AAPL.

Some have argued that AAPL intends to target the “high-end” of the smartphone market to avoid much competition. Well, what exactly is the “low-end” of the market? These phones typically retail for over USD500! AAPL is going to go from a market it dominates – portable digital music - to a market where it’s just another player. Its profit and operating margins are definitely going to come under pressure.

The smartphone business is definitely a growth area for IT firms with the right value proposition. But unless you are already a mobile hardware manufacturer, the best bet seems to be in software development and content creation for mobile devices. AAPL is going to find this out the hard way.

Watch Your Tech

Why not just hold both stocks and close shop? I guess I could but such a move will make the folio too overweight in tech stocks for my liking. More importantly, it will break my cardinal rule to keep the folio no more than 25% weighted in tech. To be a good investor one must exercise discipline no matter the temptation. Right now the folio is 24% weighted in tech – MSFT 16%, EBAY 3% and ADBE 5%; the S&P is 15% weighted in tech.

Cardinal rule aside, the bottom line is this: I see AAPL’s foray into mobile handset manufacturing as bearish for the stock. Just because one is a good warrior doesn’t mean one can fight any war!

CostCo Flies Under the Radar in January

On Wall Street they say as January goes so does the rest of the year for the stock market – 85% of the time that is. Since the S&P ended January on a banger a blowout for stocks this year may be in the offing, if you happen to be in the right sectors of course. The folio is very diverse across sectors and market capitalizations so I’m assured a spot on any gravy train.

How much gravy I get to scoop is another matter. If January is any indication I’ve my work cut out for the rest of the year; on gains I ended January in the dog house:

Nasdaq 2.01%
S&P 1.41%
Dow 1.27%
Worst-known 1.06%

Is COST Riding the Minimum Wage Bill?

I support a higher federal minimum wage. It’s a well established fact that the federally mandated minimum wage, which has been stuck at $5.15 since 1997, hasn’t kept up with the rise in the nation’s productivity, much less with inflation – it should be about $6.75 as of January 2007 had it kept up with inflation. By 2009 Congress wants it to be $7.25, which is roundabout where it will need to be by then to keep up with inflation – assuming a 3% annual rate of inflation.

So what would Americans do with all this new money coming in? Since Americans hardly save the money is likely to be spent at consumer discretionary stomping grounds like CostCo.

Although COST has been trending higher since it broke a key resistance level back in October it didn’t really take off until the second week of January when economic data showed that the national average hourly earning rose more than expected. So it’s fair to say investors view rising hourly earnings as bullish for consumer discretionary stocks.

With Congress set to mandate a rise in the federal minimum wage I think COST is getting a minimum wage “bounce”. In January it had the biggest gain when measured by moving average (MA) of Returns to Date (RTD):

Change in MA of RTD (12/29/06 to 1/31/07)

COST +4.71%
NHP +3.60%
MSFT +2.28%
IWR +1.93%
PG +1.03%
IJR +0.51%
EFA +0.01%
EEM -0.83%
BAC -1.33%
ADBE -2.63%
PBW -2.88%
IGE -3.74%
EBAY -4.82%
SLV -8.74%

In December and January while many on the Street were fixated on techs it seems smart money was moving into discretionaries perhaps in anticipation of a rise in the minimum wage.

P&G: An Elephant Starts to Dance

Do you know that elephants can dance? Well I didn’t until a strategy professor at B-school recommended for bedtime reading Lou Gerstner’s business classic, “Who Says Elephants Can’t Dance?”, which details how as CEO Gerstner gave comatose IBM the kiss of life in the early 1990s.

Amongst other things Gerstner got rid of Big Blue’s “untouchables” culture – at the time many employees felt IBM was too big for clients to mess with; eliminated the internecine divisional rivalries; aligned performance incentives of division managers with the performance of the whole firm – rather than with individual divisions; and took a gamble to make Big Blue a more services-oriented company – services is now the biggest and second most-profitable division!

Big Apples and Oranges

No, PG is nowhere near where Big Blue was in 1993 when Gerstner took the helm, and the two companies are obviously not in the same line of business. It’s just that Gerstner’s tale reminds me of the danger of complacency that iconic firms face when they get very big.

By any measure PG was already big in 2005. For instance, 16 of its brands each generated at least $1bn annually in global sales. The acquisition of Gillette in January 2005 made the firm even bigger. However, it made investors somewhat skittish.

When a big company gets even bigger through a major acquisition Wall Street starts to wonder if the acquisition is a signal that organic growth, which excludes mergers and acquisitions, has lost steam. For a multinational with commanding market share a lack of organic growth may be symptomatic of complacency because such growth really speaks to how innovative a company continues to be.

Unloved Staples

Anyway PG has underperformed the S&P over the two years since the announcement of the acquisition. From January 28, 2005, when the deal was announced, to January 16, 2007, PG has returned about 20%, compared with 22% for the S&P and 3% for competitor Johnson and Johnson (JNJ), which sports a higher dividend yield.

However, large cap consumer staples have not been in favor on Wall Street over the past two years so it is unclear whether PG’s underperformance has been due largely to concerns about the digestion of Gillette - would it go smoothly and can management really squeeze out revenue and cost synergies of “about $14bn to $16bn”? - or to a general snub of consumer staples (also called non-cyclicals) - as the table of price appreciation for the S&P and consumer staples below indicates.

	2006	2005
S&P 500	13.6%	3.0%
Consumer Staples	11.8%	1.34%

Whatever PG’s malaise has been since the $57 billion purchase of Gillette the consumer staples giant has started to “dance” over the past six months or so, and “late-to-the-party” analysts and investors have taken notice. What has got investors salivating over PG? I think it’s these three factors: Deeper foray into the health-care sector, faster-than-expected integration of Gillette, and a renewed emphasis on collaborative innovation.

Notice I don’t mention falling oil prices. That falling oil prices will benefit PG – in form of lower raw material costs - is a no-brainer. But falling oil prices come and go so it’s not a fundamental, strategic benefit.

A "Healthy" Blue Chip

PG is a “blue chip”, which means it’s one of these big companies that investors have come to rely on for slow but steady growth, stable earnings, and stellar dividend payments in a bull or bear market – just think the Dow Jones 30! What do you get when you add a fast-growing sector such as health-care to a blue chip? You get moolah – bigger earnings and dividends.

Competitor JNJ has better gross and operating margins than PG because of its health-care operations. By health-care I don’t mean Olay or Band-Aid. I’m talking pharmaceuticals and medical devices. As I see it JNJ is primarily a health-care company with a personal care business – pharmaceuticals and medical devices accounted for over 80% of revenues in 2005. On the contrary PG is primarily a personal care company with a health-care business – health-care accounted for about 1.5% of 2005 revenues.

Since margins in health-care are higher than margins on personal care products, PG could improve its margins by expanding its health-care business. And that’s exactly what it’s been doing. Recently in December it formed a multi-million-dollar joint venture with a leading global developer of advanced diagnostic devices to develop and manufacture medical diagnostic devices, which is a huge money-making business for JNJ. Then just two weeks ago it bought a stake in a private provider of health-care services in Florida. As PG expands its health-care business expect competition with JNJ to heat up.

Razor-sharp Integration

The merger of two conglomerates is never easy, even when there are few overlaps: it's now widely accepted that the merger of AOL and Time Warner in 2001 was a huge blunder. According to observers “familiar with the matter” the integration of Gillette has been much faster than anticipated, bearing in mind that PG operates in over 80 countries while Gillette operated in just as many if not more countries.

To me what really signaled the rapid pace of the integration was the announcement last week or so to fold Gillette’s Blade and Razor and Braun businesses into the Health and Beauty business unit, and the Duracell battery business into Household Care, effective July 1 – nine months after the official completion of the merger on October 1, 2005! This can only mean one thing: that $14bn in revenue and cost synergies that PG touted way back in January 2005 should start to really fatten the bottom line from the latter part of this year. Can I get an Amen?!

Innovate or Die

Finally investors are salivating over PG because of a growing emphasis on “collaborative innovation”. In the consumer products business you have to innovate or die and PG is already big on innovation. Now, rather than depend heavily on products developed entirely in-house the firm plans to partner more with suppliers, entrepreneurs and even competitors to develop new products that can be brought to markets faster.

This strategy was adopted six years ago under the pseudonym “Connect and Develop” but lately some Wall Street analysts have dubbed it the “Go-to-Market (GTM)” approach. I think the successes of the newest “Mr. Clean” lines, which employed GTM, have made PG management really take notice of the potential of this strategy. More products should emerge from the GTM “academy” in the foreseeable future, some of which will probably end up as global billion-dollar brands like Pampers or Gillette; I just hope quality is not compromised.

Like I said before, investors have held off somewhat on PG over the past few years due to concerns about the integration of Gillette and/or a general rotation out of staples. With Gillette almost fully digested the company has started to dance again.

Historically PG’s been viewed as a slow-growth, “defensive”, not too sexy, stock. But its health-care division is expanding fast. This may make PG a little more volatile in the distant future – with a corresponding rise in its Beta (or measure of volatility relative to the S&P) – but it certainly could give it more oomph to command a higher valuation than JNJ. When PG reports fiscal Q2 2007 results on Tuesday, January 30, keep an ear out for some dance tunes!

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.