The following is the second of a two-part series. In the first part, Mr. Merkel explains the philosophy and criteria he uses when reshaping his portfolio. The following outlines the portfolio additions and subtractions he made based on those criteria.
We left off yesterday with the construction of my
final list. (Click "no" for any query boxes that may pop up. The sheet will appear regardless.)
Companies in my portfolio are highlighted in yellow, except for the middle company,
, which is orange. Why the difference? No company above the middle company can be sold, and no candidate below it can be bought, except in rare circumstances, in which valuation cannot be adequately measured by the ranking model.
Working up from the bottom, I decide what to sell. If I'm not selling something that rates low, I have to have an explanation for why I am keeping it.
What I Did Not Sell
St. Joe : This didn't score well. The land is considerably more valuable than the share price would indicate.
SPX Corp , Sara Lee : These are still in turnaround mode. The metrics don't look good now, but should improve.
Sappi : The underlying-asset value is not reflected in the metrics. South Africa is out of favor.
Dow Chemical : It's still cheap, and there are probably transactions that can unlock value.
DTE Energy : My one U.S. utility. It would benefit from a sale of its energy production arm. I'm close to selling, but not quite there yet.
Premium Standard : The Smithfield merger will go through, and they will be able to take out costs. I think cost pressures have reached their maximum here, and profits will improve more than Street estimates.
What I Sold
ABN AMRO : Barclays may do the deal or not. ABN Amro is fully valued here, and then some.
Devon Energy and Apache : I like them both, but their valuations have risen, and I have other places to deploy money.
What I Did Not Buy
After this, I look from the top down for replacement candidates from the list. If I reject a highly rated name, I have to have a reason:
Group 1 Automotive : I already have Lithia Motors and Sonic Automotive . It's in less desirable areas of the country, so I will pass for now but revisit at a later date.
Georgia Gulf : It's cheap, but I worry about the balance sheet, and I already own Dow and Lyondell .
Thornburg Mortgage : It would give me conflicts of interest with my employer.
Optimal Group : This is the most interesting of the ones I did not buy. They have some interesting payments technologies, but the earnings estimate momentum was negative, and I could not discern what competitive advantages they had.
Encore Wire : It's a bit of a cult stock. I just don't like the business they are in.
Arkansas Best and P.A.M. Transportation : I own YRC Worldwide , and these are not appreciably cheaper.
Foot Locker : Too many earnings disappointments.
Spectrum Brands : Lousy set of brands and a poor earnings history.
Stolt Neilsen : I own Tsakos , and I think it has better growth prospects.
National Coal : Too small. I don't like buying companies with under $100 million of market capitalization.
Home Solutions of America : I don't like their business, given my view of the housing market.
What I Bought
Bronco Drilling : Seems to be a cheap land driller and replaces some of the exposure I lost selling Apache and Devon.
Komag , Nam Tai Electronics and Vishay Intertechnology : Cheap technology stocks that are near the beginning of the technology food chain. The businesses are more stable than those who buy their products.
Here are the key ideas:
Systematically rank your portfolios for valuation, neglect (out of favor), and earnings quality (NOA).
Do swap trades to force improvement in your portfolio.
Make swap trades in bunches, and not too many of them at a time, to avoid overtrading. Good ideas take time to work out.
Focus on industry selection, because it is 60% of the game.
Think about how each company that you add and delete will affect the portfolio on the whole.
If you do these things consistently, your portfolio will stay fresh, you will not overtrade and you will end up with a good balance of cheapness and growth potential due to industry selection. Individual company risk gets reduced by a focus on balance sheet quality and NOA. This is how I avoid risk, which enhances return.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Lithia Motors, Optimal Group, P.A.M. Transportation, Spectrum Brands, National Coal, Home Solutions of America and Bronco Drilling to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Merkel and/or his fund was long Vishay Intertechnology, Komag, Nam Tai Electronics, Bronco Drilling, Barclays, Lithia Motors, Sonic Automotive, Dow Chemical, Lyondell Chemical, St. Joe Company, Sappi, SPX Corp, Sara Lee, DTE Energy, Premium Standard Farms, YRC Worldwide, Tsakos Energy Navigation and Allstate, though positions may change at any time.
David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback;
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Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.
Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.