Building a Core From the Best of the '50 Best' - TheStreet
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I know buy-and-hold stocks are supposed to be timeless. Buy 'em and forget 'em, right?

Well, not exactly. The first thing I consider when I think about buying one of these "timeless" stocks is its timeliness. Even great buy-and-hold stocks run through valuation cycles. At the top of a cycle, everybody loves the stock and its

price-to-earnings ratio may be near 100. At the bottom of the cycle, everybody may have decided that the stock's best days are behind it and the P/E may be just half that.

In picking 10 stocks from my

"50 Best Stocks in the World" to become the core of the "core-and-edge" portfolio I promised to build in my

last column, I'm going to look for proven, great growth stocks that are currently trading at an attractive point in that valuation cycle. A buy-and-hold strategy is, I believe, no reason to overpay for stocks. And buying great stocks at the low end of their valuation cycle is a way to increase the returns from any buy-and-hold portfolio.

What do I mean by a valuation cycle? Well, you can measure it in a number of different ways, but the most accurate, in my opinion, is to track the P/E ratio of a stock -- using projections for future earnings -- compared to the P/E ratio of the

S&P 500 index. That reveals the valuation cycle of the individual stock independent of moves in the market as a whole.

Case Study: Gillette

Gillette

(G) - Get Report

is a great example. Based on its forward P/E ratio (using 12-month forward projected earnings per share), the stock traded, on average, at a 36% premium to the S&P 500 for the decade from 1987 through 1997. But that average includes some pretty wide swings. At the end of 1997 and into 1998, Gillette's premium (based on projected earnings) peaked at 100% to the S&P 500, while in 1992, the premium dropped to just above 2%.

Where are we now? Currently, the S&P 500 trades at a P/E ratio of 22 times projected earnings per share for 2001. Gillette trades for 24 times projected 2001 earnings per share. The premium to the S&P 500? 9%.

That's historically at the low end of Gillette's valuation range. But by itself, that number doesn't make Gillette a "buy." We're dealing with projections here, remember. Gillette has to actually produce that projected number (as does the S&P 500, for that matter). So before you decide that a buy-and-hold stock is priced for addition to your portfolio, you need to make sure that you believe that the company can achieve these projected earnings.

In Gillette's case, that earnings story includes a drop of about 12% to $1.27 a share in 2000, and then a rebound to 13% growth and $1.43 a share in 2001. What will power that rebound? Improving markets in Latin America and Asia (they account for about 25% of Gillette sales), and improving margins in the razor-blade business, should kick in during the last half of 2000, analysts believe. In 2001, new products, such as a woman's blade and a razor based on Mach3 technology, will start to contribute to the bottom line.

Those projections appear reasonable to me. Blade and razor sales increased 10% in the first quarter of 2000, and sales in Latin America climbed 29%. New controls on working capital and inventory that have combined inefficient regional systems into a unified global supply chain have begun to increase operating margins.

Nothing's Certain

But they aren't entirely certain. Gillette's Duracell battery business faces new competition from

Energizer's

(ENR) - Get Report

e2 battery, which has just started to ship, with advertising expected to begin in August. The e2 is likely to take share at the upper end of the battery market as

Rayovac

(ROV)

continues to chip away at the lower end. This isn't exactly a minor issue for Gillette, since Duracell accounts for almost 30% of sales.

And the Braun small-appliance business continues to lose money. Gillette is about to sell its stationery products division -- PaperMate, Parker and LiquidPaper among other brands -- to

Newell Rubbermaid

(NWL) - Get Report

because operating margins in that business are so low -- about 2.6%. But at least the division was making money. Braun isn't, and margins in the small-appliance industry are tight at even the best companies. I think it's certainly going to be hard to either fix or sell Braun.

How do I add up these pluses and minuses? The upside is doable, it seems to me, and the downside, while not minimal, is largely already in the stock price and in analysts' earnings projections.

Prudential Securities

, for example, which roughly matches the consensus estimate of $1.42 a share for Gillette's 2001 earnings, is calling for just 3% growth in sales at Duracell in the second half of 2000.

On the basis of this analysis -- combining a look at where Gillette is in its valuation cycle with a study of how likely the company is to meet projections -- I say that this is a reasonable time to add Gillette to a long-term, buy-and-hold core for a portfolio. By buying Gillette right now, an investor is getting exposure to the consumer group -- important for diversifying a long-term portfolio -- and ownership of one of the great global brand names.

Other Solid Material For the Core

Using this same combination, what else among the "50 Best" gets a "buy" rating for addition to the core of a "core-and-edge" portfolio?

In the technology sector, I'd flag

Intel

(INTC) - Get Report

,

Microsoft

(MSFT) - Get Report

and

Texas Instruments

(TXN) - Get Report

. None of these stocks are exactly cheap on current earnings, but after the technology bear market that started in March, they're priced near the middle of the valuation cycle. Texas Instruments, for example, traded at a premium of just 25% to the S&P 500 index (on projected 2000 earnings per share) back in June 1999. And it traded at a premium of 170% to the S&P 500 in March 2000. The current premium is about 106%.

(Editor's note: Microsoft owns and publishes MSN MoneyCentral.)

My other additions: In telecommunications,

WorldCom

(WCOM)

; in the financials,

Citigroup

(C) - Get Report

; among consumer companies,

Walt Disney

(DIS) - Get Report

and, as I noted above, Gillette; in retail,

Home Depot

(HD) - Get Report

and

Wal-Mart

(WMT) - Get Report

; from the drugs,

Pfizer

(PFE) - Get Report

.

New Developments on Past Columns

A buy in this market?

Gee, I guess Wall Street really hated the

Sprint

(FON)

deal, and the MCI merger to boot. In the days after the

Department of Justice

and the regulators of the European Union said, "Over our dead bodies!" to WorldCom's proposed acquisition of Sprint, WorldCom's stock climbed from 37 1/2 at the close on June 26 to 44 11/16 by noon on June 28. That's a jump of almost 20%. This isn't just another example of stock market perversity, in my opinion. I think investors are reacting to the possibility that WorldCom might decide to do nothing at all in wireless, and might even decide to get out of the consumer long-distance market completely by spinning off the long-distance business it acquired with the purchase of MCI. Apart from the corporate long-distance business, that would leave WorldCom with just its Internet and data divisions -- the two fastest-growing parts of the company. In this scenario, WorldCom exits the slow-growing consumer long-distance market and stops having to spend all that money marketing a commodity with a falling price. Noting that WorldCom has the biggest Internet backbone on the planet, respected

Salomon Smith Barney

analyst Jack Grubman reiterated his "buy" rating on the stock and set a target price of 87 on June 28. Now, let's see if WorldCom is listening to what the market is saying.

Take the Qualcomm challenge.

Hey, Mary, you're on. OK, you pick

Qualcomm

(QCOM) - Get Report

; I'll take

RF Micro Devices

(RFMD)

, and we'll see which stock is up the most in a year from the closing prices on June 19 (the date you bought Qualcomm) and June 30 (for RF Micro Devices). I'd like to change the stakes, though, since I don't have any use for another wireless phone. (My Nokia works just fine, thanks.) How about the loser pays the winner the difference in price appreciation between the two stocks after a year? I don't like this kind of one-stock bet much, I have to admit. I prefer to pick portfolios instead of single stocks, since I believe that even the best single pick can get blindsided by events (and the worst rescued by luck.) But I can't pass up a direct challenge. And besides, it gives me a chance to issue one of my own.

I've read a number of references -- the latest in your June 21 column,

Testing the waters in 4 sectors -- to your portfolio. From what I can tell, right now you hold 11 stocks, the

Nasdaq 100

tracking stock

(QQQ) - Get Report

and six mutual funds, plus 50% cash. How about tracking that portfolio, or any other you'd like to build, online, so we can all see how your strategy as a whole stacks up against a benchmark or two? I think your readers would also benefit from seeing your trades as they happen, rather than days or months afterward. What do you say?

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Intel, Home Depot, Microsoft, RF Micro Devices and Texas Instruments. He welcomes your feedback at

mctsc@microsoft.com.

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