As 2014 has progressed, we have put an increasing focus on reducing portfolio risk. In January and again early April, the All Cap portfolio underperformed the market in a moderate downturn.
During the downturns, certain stocks in our portfolio would consistently be among our worst performers. Some of these names had good performance when the markets recovered.
However, we want to be sure that our performance stems from good stock picking and not from riskier names doing well in an improving market. Every week we take a deep look at the portfolio to identify where the biggest risks are hiding in the portfolio and to determine what weighting if any these names should have in the portfolio.
There are several factors that indicate increasing risk in a holding. Our process looks for stocks to buy that are undervalued with improving business fundamentals. Conversely, we look to reduce and/or sell positions that are becoming overvalued or where business fundamentals are deteriorating.
For overvaluation there are no hard and fast metrics that we use. We do compare the expected growth rate of the company in relation to the P/E as well as to other companies in the industry to calculate what we would consider to be a fair valuation for the stock.
A good sign that a company is overvalued is that we would not consider adding it as a new position. Some common signs of deteriorating business fundamentals are decreasing analyst estimates, earnings or revenues missing estimates for the quarter and declining margins.
The combination of an overvalued stock with worsening business fundamentals is a sign for us to exit the holding. Our experience has shown that over time we will be best served by finding a new idea.
Among the stocks we added recently is Meredith Corporation (MDP), which publishes magazines including the Ladies Home Journal, Fitness, Parenting and Better Homes and Gardens. The company also owns 12 television stations.
Analyst estimates have been rising and the company has met or beat quarterly earnings estimates the past 20 quarters. Meredith has paid a dividend for the past 67 years, raised the dividend each of the last 5 years and is now yielding 3.8%.
Companies with similar dividend yields typically had a much lower expected earnings growth rate than Meredith. At 13.5 times next years’ earnings, the stock looks to be reasonably priced here, though past performance is no guarantee of future results.
Another addition is Kroger Co. (KR), which operates over 2,600 supermarkets in the U.S. Projected identical store growth is 3.5% for the next 2 years and expected net earnings growth is 8% to 11% on per share basis, according to the company’s latest quarterly filing with the Securities and Exchange Commission.
For the trailing 12 months the company generated around $1 billion in free cash flow. The valuation at around 14 times next year’s earnings is fair in my opinion compared to other similarly sized companies in the consumer staples sector.
In early June we sold Whirlpool Corp (WHR). While the stock is still undervalued, earnings for each of the past 2 quarters missed consensus analyst earnings estimates. In our process this triggers an automatic sell.
DISCLAIMER: The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
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