Stars, Dogs, Cash Cows and Problem Children: What's in Your Portfolio?

Editor's Note: We are pleased to introduce David Edwards' Portfolio Manager's Toolbox, a biweekly column on practical tools for managing stock portfolios. In upcoming columns, he'll tackle portfolio strategy, diversification, risk management and tax planning. Let him know what other areas you'd like him to address.

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After a long week researching stocks and strategizing for clients, I like to give my brain a rest on the weekends and get my hands dirty. Whether building a birdhouse with the kids or framing a window at the weekend place, there's great satisfaction in seeing a tangible product at the end of the day.

Over two decades, I've acquired quite a collection of power and hand tools. Still, many times I've found myself standing in the Home Depot HD tool corral, fondling a $400 combination power chisel/drill and wondering what project I can undertake to justify its purchase. No matter how many tools I have, there's always another tool that has the potential to make my weekend projects better, go faster and cost less.

So it goes with portfolio management. No matter how many methods I learn for analyzing companies, trends and markets, there's always the opportunity to add to my collection of methodologies -- what I call the Portfolio Manager's Toolbox. I keep an open mind in acquiring these tools; some are derived from conventional accounting and investment-management sources, others are derived from the management consulting industry, sometimes even from the study of natural sciences (as you'll see in my next column).

There is no one right way to build a chair, and there is no one right way to assemble a portfolio. In these columns, I would like to describe the tools in my toolbox and illustrate their use with practical examples drawn from my daily work.

Here's a typical situation: A new client arrives with an existing portfolio. I can't just liquidate the portfolio and start from scratch -- these portfolios are often taxable with large unrealized capital gains. You may be in this situation if you inherit a portfolio or are thinking of doing some housecleaning in an existing portfolio. I may know most of the companies in the portfolio or I may know none. There are six or seven ways I would evaluate this portfolio. (It usually takes an afternoon.) One of these evaluations is what I call the star/cash cow/problem child/dog analysis.

Back in the early 1970s the Boston Consulting Group came up with a concept for helping clients determine which product lines a company should put its resources behind. Markets were identified as high growth or low growth, and products were classified by whether they used cash (to support marketing initiatives, set up distribution channels, etc.) or generated cash.

The result is illustrated by this chart:

	Generates Cash	Uses Cash
High Growth Company/Market
Low Growth Company/Market

"Stars" were promoted, "dogs" were divested, "cash cows" were harvested to support other initiatives, and "problem children" were monitored carefully in the hope they would become "stars." But obviously the risk remained that they would turn out to be dogs.

General Electric GE was one of the early practitioners of "product portfolio management"; this practice, in part, accounts for GE's success in a broad array of markets.

I found this concept simple to adapt to portfolios of companies as opposed to portfolios of product lines. I divide companies into high growth and low growth. (A high-growth company has an analyst's five-year growth-rate forecast of at least 20%.) On the company's statement of cash flows, if operating cash flow is positive, the company is a cash generator. A company generating cash from operations is in an excellent position to extend its market share because funds are readily available without going to the capital markets to fund research, marketing, channel support, pressuring the competition, paying dividends and buying back the stock.

The statement of cash flow is the third table in a company's annual or quarterly report after the income statement and balance sheet. Unlike the income statement, which includes noncash activity such as depreciation, the cash flow statement explains where the company's money comes from and where it goes. Cash can be used or generated by operating activities, investing activities (like building a new factory) or financing activities (cash proceeds from floating a bond).

Let's say a portfolio contained just eight stocks: CMGI CMGI, CDnow, CDNW, General Electric, Federal National Mortgage FNM, Sunbeam SOC, General Motors GM, Cisco CSCO and Microsoft MSFT.

We can quickly categorize these companies using tools on TheStreet.com site. For cash flow data, for example, enter a ticker symbol, click the "financials" tab, then the "cash flow" tab. This produces the cash flow page for Microsoft. (Note that Microsoft's cash flow is greater than that of its next 10 rivals in the software industry.) For the five-year growth rate, enter a ticker symbol, and click the "research" tab. First Call's 5-year median estimate is at the bottom of the page. Here's an example for Sunbeam.

The following chart shows how the eight stocks rate:

Personality Profile
Company	Cash flow	5-year growth rate	Category
CDnow	Negative	50%	Problem Child
CMGI	Negative	50	Problem Child
Cisco	Positive	30	Star
Microsoft	Positive	25	Star
General Electric	Positive	14	Cash Cow
Fannie Mae	Positive	14	Cash Cow
General Motors	Positive	7	Cash Cow
Sunbeam	Negative	10	Dog

We can see instantly that Sunbeam will be dumped from this portfolio. We have to do some more research on CDnow and CMGI, the problem children. Fannie Mae, GE and GM, the cash cows, are keepers (actually, Fannie Mae and GE are core holdings in all our clients' portfolios).

What about Cisco and Microsoft? For the time being, both are stars. Unfortunately, 20%-plus growth is rarely sustainable by any company for more than a few years. (Microsoft is a rare exception, growing better than 20% a year for the last 15 years.) Cisco's market is still in the toddler stage, so you can expect high growth for some time to come.

Microsoft's market is mature, and with the distraction of the federal antitrust lawsuit, it's hard to see the company coming up with a revolutionary new product capable of boosting revenue sharply. So expect Microsoft to shift to the cash cow category in the next few years. When that happens, a company's price-to-earnings ratio usually shrinks, with deleterious effects on its stock price. I'm not selling Microsoft yet, but there's more risk in that stock than meets the eye.