Studying how you made a profit in the past may be the best way to increase your profits in the future.
That's certainly true for my
Clean Stocks portfolio, where one stock that scored unexpectedly large gains could hold the key to a long-term strategy for beating the market again and again while taking on a very modest amount of risk.
Think of this strategy as a way to improve the profitability of any buy-on-the-dip trades you make.
I'm certainly pleased that the Clean Stocks portfolio I started on Aug. 1, 2003, continues to beat the
. Since I started the portfolio, the average return for the 10 stocks in the list is 22%, vs. a 20% return for the S&P 500. The relative performance of the portfolio has been even better in 2004: The Clean Stocks have returned 11.5%; the S&P 6%.
But it's the source of that outperformance that I find most interesting -- and potentially most useful for making profitable trades in the future.
I would have expected
to be among the stars of the group. After all, this market has seen huge gains for oil stocks, so the 59% return since I added the stock to the portfolio on Aug. 1, 2003, isn't particularly surprising.
Neither is the almost 50% return on
since it joined the portfolio on Sept. 19, 2003. That stock has a long history of rocketing ahead of the market averages.
It's the No. 3 stock on the Clean Stocks hit parade that's unexpected: mutual fund company
T. Rowe Price
, which averaged a return of 8.25% per year over the last five years, and has returned 41% since I added it to the Clean Stocks portfolio on Oct. 7, 2003.
T. Rowe Price shares may be up strongly in that period for lots of reasons. For example, in its third-quarter report, the company announced that assets under management had climbed to a record $212 billion, up 26% from the third quarter of 2003.
It certainly didn't hurt that T. Rowe Price has remained untouched by the scandals that have roiled the industry and sent dollars flowing away from fund groups run by Putnam Investments, a unit of
Marsh & McLennan
. It's hard to quantify, but some part of that 26% increase in assets in the last year is a result of investors taking money from other mutual fund groups and sending it to a group perceived as being free of scandal.
Now I know that outperformance by one stock no more makes a trend than one swallow makes a spring. But I can't help thinking there's a potential strategy here that deserves testing. Perhaps we can generalize from the T. Rowe Price example and say, "The best stock to buy when a scandal taints an industry is the cleanest stock in that industry."
The Clean Stocks Model
I launched this cooperative effort to build a list of clean stocks in
July 2003. Over the months, readers helped me develop a final list and refine the set of eight rules that now form the test that stocks must pass to be added to the Clean Stocks portfolio.
In each Clean Stocks column, I put three stocks nominated by readers to the test. Those that make it get added to the portfolio. And I end each column with a request for nominees for the next round.
June 23, 2004, column proposed putting three reader nominees to the test:
The last of that group is an ideal test stock. Cincinnati Financial is one of those under-the-radar stocks that delivers market-beating returns year after year. For the last 10 years, the stock has an average annual return of 11.28%, a full 2 percentage points better on average than the annual return on the S&P 500.
But Cincinnati Financial, an insurance company, is operating in a troubled industry. Is it clean enough to survive the scandal and join T. Rowe Price in the Clean Stocks portfolio as a scandal survivor? I'll answer that question later in this column; first, let's take a closer look at Lennar and Chico's FAS.
Wrong on So Many Levels
What about Lennar? Let me count the ways this company fails the Clean Stocks test.
CEO Stuart Miller, who succeeded his father Leonard Miller in 1997, took home a bonus of $12 million in 2003. Lennar is one of the few companies I've come across that links the CEO's bonus to total pretax income rather than income per share. That means any acquisitions or other transactions that dilute the stock by creating new shares don't have any effect on the CEO's bonus, although they certainly depress earnings per share, at least temporarily. That's not a minor issue for a company like Lennar that has acquired more than 20 other homebuilders and bought five title-insurance and mortgage companies in the last decade.
The company's books are a maze of off-the-balance-sheet partnerships that hold about one-third of the company's inventories of land for development. That lets Lennar boost revenue and earnings by selling land to itself (in essence), and from the management fees that these partnerships pay to Lennar.
I'll be the first to admit that none of this matters to Wall Street and investors right now. As long as mortgage rates stay reasonably low and buyers keep stepping up to the plate, Wall Street will keep recommending the stock. Six of 10 Wall Street analysts now rate the stock a buy. That's unchanged from three months ago. But these are exactly the kinds of things that get a company, and investors, into trouble when sales growth starts to stall.
Chico's Leadership Is Lacking
Whether Chico's FAS qualifies as a Clean Stock comes down to how you evaluate the quality of the company's board of directors. The board is especially important right now because the company, which has been able to grow sales by 48% annually over the last five years, has launched an ambitious range of new ventures to keep sales growing.
The biggest is the acquisition of the White House/Black Market brand in 2003. That deal will let Chico's expand its customer base to include women in their mid- to late-20s. The company isn't simply buying sales, however, but the opportunity to grow sales: The plan is to double the number of White House/Black Market stores over the next five years.
As if that's not enough on the company's plate, Chico's also is introducing a new line of sleepwear, bodywear and activewear under the Soma label in its Chico's stores. At the same time, Chico's has to keep its existing, very loyal customer base happy: In fiscal 2003, about 75% of sales came from customers in its frequent-buyer club.
Is management up to the challenge? The board seems light on the kind of independent voices with deep industry experience I'd like to see at Chico's right now.
Four of eight board members are independent in my judgment, but of those, one is a venture capitalist specializing in technology and life sciences, one was the chairman of
Federated Department Stores
( FD) back in 1990, another has a background dominated by a career in publishing, and the fourth was CEO of the Limited Stores division of
back in 1991.
That group's just not strong enough for my money. Chico's FAS fails to make the cut.
Cincinnati Financial Gets Help From Its Board
My first reaction on putting Cincinnati Financial to the Clean Stocks test was, "Oh, no, not another board dominated by family members and the company founder." Three Schiffs sit on the board: Robert, 80, the company co-founder; John J. Jr., 60, CEO; and his brother Thomas, 56.
This, however, is not your standard family-dominated company. First, the board of 15 has, by my count, only four insiders, including the three Schiffs. It's a board with a strong local flavor (the president of the Cincinnati Bengals is a member), but it's also heavy on working CEOs.
And boy, are these guys cheap. In 2002, CEO John Schiff Jr. received a salary the compensation committee notes was just 66% of that paid to his peers. And that represented a raise from the 60% of peer salaries he received in 2001. In 2003, he got a jump of 15% to close some of that gap.
Options? In October 2003, reviewing the company and the CEO's performance, the compensation committee decided that in recognition of "excellent results" for 2003, Schiff would receive a bonus of -- ready? -- $287,500. That's a lot to you and me, but Lennar's CEO got a $12 million bonus. Oh, and it came with a suitably stingy grant of 50,000 options.
Does this guarantee there's nothing on this insurance company's books like the "finite risk" policies that are now getting
in trouble? No, but this kind of strong governance by the board sure helps. It doesn't hurt, either, that Cincinnati Financial sells its insurance through a network of independent agencies, which should keep the company on the sidelines in the current investigation of brokerage-sold insurance.
I think Cincinnati Financial looks a lot like T. Rowe Price. I'm adding it to the Clean Stocks list. May the shares prosper as much from the turmoil in the insurance industry as T. Rowe Price's did in the mutual fund brouhaha.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway. He does not own short positions in any stock mentioned in this column. Email Jubak at