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Overlooked Stocks Portfolio for 2006

George C. Fisher

In Jan, 2003, I developed for MoneySaver an Overlooked Stocks Portfolio of companies I consider to be potentially undervalued and overlooked by many on Wall Street. The concept is simple: over time build a diversified portfolio with a long term horizon, making annual contributions on Jan 1 of $1,200 towards each selection. Ten stocks are chosen for the year’s investment contributions, with previous positions reinvesting dividends. One objective is to build a $5,000 position in each company through capital contribution, reinvestment of dividends, and equity appreciation. 

In 2005, the market seesawed up and down. The S&P 500 Index started the year at 1,216, drifted lower to 1,135 in April, rallied to 1,247 in Aug and Sept, fell to 1,181 in Oct, rallied again in Dec to 1,280, and finished the year at 1,245. Within the 3.0% gain in the index for the year, the high/low range for 2005 was only 12%, leaving little room for buying on the dips. For the big capitalization S&P 500, last year was uneventful. However, small- and mid-capitalization stocks generally outperformed the larger cap stocks. For example, in 2005, the S&P Mid-Cap 400 Index gained 11.2%, and the S&P Small-Cap 600 Index returned 6.6%. 

For 2005, three new names (AVD, CBI, THE) were initiated to the portfolio, six previous positions were increased (CNG, LOW, PEO, SZE, CME, HAVS, and SWWC) and eight positions were held with dividends reinvested (APD, WTR, EDS, IFIN, HINKY, MWV, BCO, OCR, and SEIC). Portfolio stock valuations and capital return calculations are provided by “What if I had Invested…” tool included in the company charting and statistical information of the stock research section, www.sharebuilder.com. The calculations include reinvested dividends and distributions. This is a great tool for researching dollar cost averaging and dividend reinvestment computations. 

The Overlooked Stocks Portfolio is as follows, adjusted for stock splits and dividends (company name; stock symbol; total market value as of 12/31/05 and 2005 return including dividend reinvestment; total portfolio capital invested since Jan 1, 2003 and total return on invested portfolio capital since Jan 1, 2003; industrial classification): 

Company Symbol Market Value 12/31/05 2005 Return Total Capital Invested 03 - 05 Total Return On Capital Industry
Air Products APD $1,757 2.7% $1,200 46.4% Materials
Aqua America WTR $5,345 69.3 $2,400 122.7 Utility
Cascade Natural Gas CGC $2,618 -0.8 $2,400 9.1 Utility
Electronic Data Systems EDS $1,625 0.9 $1,200 35.4 Technology
Investors Financial IFIN $2,681 -26.1 $2,400 11.7 Financial
Heineken HINKY $1,221 -5.3 $1,200 1.8 Consumer Non-Discretionary
Lowe’s LOW $4,999 16.0 $3,600 38.9 Consumer Discretionary
Mead Westvaco MWV $1,496 -14.0 $1,200 24.7 Materials
Petroleum & Resources PEO $5,795 32.7 $3,600 61.0 Energy
Suez SZE $3,891 27.3 $2.400 62.1 Utility
Brinks BCO $2,447 20.4 $1,200 106.0 Industrial
Chicago Mercantile Exch CME $8,268 66.0 $2,400 244.3 Financial
Havas HAVS $2,052 -15.3 $2,400 -14.5 Consumer Discretionary
Omnicare OCR $1,705 68.6 $1,200 42.1 Health Care
SEI Investments SEIC $1,497 17.9 $1,200 22.7 Financial
Southwest Water SWWC $3,040 14.9 $2,400 26.7 Utility
American Vanguard AVD $1,522 26.8 $1,200 26.8 Material
Chicago Bridge & Iron CBI $1,477 23.1 $1,200 23.1 Energy
TODCO THE $2,542 111.8 $1,200 111.8 Energy
Flextronics* FLEX         Technology
Thomas & Betts* TNB         Industrial
Medicis* MRX         Health Care
Ab. Asia Pac Bond Fund* FAX         Fixed Income
Total   $55,997 22.1% $36,000 55.5%  
S&P 500 ETF ** SPY $4,320 3.5% $3,600 22.1%  

Notes: * New addition for 2006. ** Includes reinvested dividends. The calculated 2005 return is higher than the media-hyped Index return of 3.0%, due to the benefits of reinvestment of dividends.

In review, most positions (12 out of 19) outperformed the S&P 500. However, the year was not without its problems, demonstrated by the negative returns of IFIN, MWV, and HAVS. Inherent with a diversified investment approach, these losses did not materially impact the performance of the overall portfolio.

This year presents interesting investment challenges. In late Dec 2005, the interest rate yield curve became momentarily inverted (this occurs when short-term rates are higher than long-term rates), sending a strong signal of the potential for an economic slowdown. Long bond yields have not responded equally to the consistent uptick in short rates, which, in turn, have supported stock prices. I think the two keys to the overall stock market action this year will be the trend in long bond rates and the outlook for economic expansion in late 2006 and into 2007. We are in the mid- to late-stages of the current economic expansion cycle, and investment selections should be focused as such.

Energy was the easiest ticket to growth in 2005, and our portfolio reflects these gains. In addition, stock exchange and water utility companies continue to attract investor interest, creating potentially overvalued positions. A few portfolio positions have reached the intermediate goal of $5,000. As a cornerstone of my personal investing style, it is important to develop a diversified list of companies, with adequate representation in each industrial category. By design and due to timely stock selections, the portfolio is currently over weighted in Utilities, Financials, and Energy, and is under weighted in Consumer Non-Discretionary, Tech, Health Care, and Industrial. 2006 could be a good time to realign the portfolio, directing new investment contributions into these areas.

For 2006, I would hold off allocating additional capital to Utilities, Financials, and Energy stocks. Generally, current valuations seem to be historically high for these groups based on the underlying economic fundamentals, and better values with lower potential risks may be found elsewhere. The benefits of slower, more stable growth historically offered by Consumer Non-Discretionary companies may be preferred to the earnings cycles of Consumer Discretionary firms. A large section of the Health Care industry remains in turmoil and Technology has hopefully awakened from a fitful sleep. Materials and Industrial companies have experienced several years of expanding profits, and it may be time for many firms to take a breather.

With a portfolio value in excess of $50,000, fixed income investments should begin creeping into the discussion. Although I usually loath mutual funds, closed-end funds with low turnover and low fees may provide an interesting investment vehicle. For example, PEO is a closed-end fund focused on oil exploration and production, and provides diversification without many of the inherent problems of more actively managed open-ended funds. One dilemma many investors encounter is how to initially develop a fixed income position. Stockbrokers usually require a minimum bond investment that may exceed investor’s resources, while bond funds usually accept smaller contributions. However, there are risks associated with non-maturing bond funds versus buying a bond with a specific maturity date, along with yield-reducing fund management fees. I use bond funds and retail investor structured corporate bonds (priced in units of $25 that trade like stocks) as a vehicle to accumulate capital over time until there is sufficient capital to purchase a specific US Treasury bond, usually $10,000, at my broker. The US Treasury offers an electronic-based direct investing program for new bond issues. Investments start at $1,000 each, but interest is not reinvested and each purchase is a different issue and maturity. This makes the Treasury Direct program cumbersome for those attempting to build up a bond portfolio. More information can be found at www.treasurydirect.gov.

As I researched closed-end fund opportunities for individuals to buy bond assets in smaller quantities, I uncovered the Aberdeen Asia Pacific Fund (FAX), and have added it to the portfolio in 2006. FAX currently trades at a 10% discount to Net Asset Value, invests about half the assets in Australian government bonds, and the balance is spread among Asian countries bonds. The fund holds a bit more than 15% in US Treasury bonds. Bond maturities are laddered for an intermediate term focus (7 to10 years), with approx 6% to12% of assets maturing and reinvested annually. Current yield is around 7%, of which a portion is reported as return of capital. There are many other intermediate-term, closed-end foreign bond funds worthy of investigation. As with most foreign bond funds, investors should be aware changes in the US dollar versus these currencies may positively or negatively impact distributions and asset value.

In addition to FAX, this year’s portfolio additions expand on the strategy outlined above: Flextronics (FLEX, Technology Manufacturing), Thomas and Betts (TNB, Electrical Component Manufacturing), and Medicis (MRX, Specialty Pharmaceutical). FLEX is a leading contract manufacturer of electronics focused on the continuing trend of outsourcing component and finished product manufacturing. TNB was the subject of the Overlooked Stocks article in Aug 2005, and is a leading manufacturer of electrical components. As the US ramps up capital spending on our sagging electricity infrastructure, TNB is anticipated to benefit handsomely over the next few years. MRX is a specialty pharmaceutical firm focused on dermatological, aesthetic, and podiatric conditions. MRX currently has a strong balance sheet, heavy towards its cash position of $640 million or around $12 a share, and is in the hunt for acquisitions. In addition, MRX was recently the target of an unfriendly and inadequate takeover offer.

From the current portfolio list, the balance of the 2006 annual contributions could be divided between EDS, HINKY, BCO, HAVS, OCR and AVD. EDS (EDS, Technology Services) continues to focus on its business turnaround. GM remains a key client, but management has strived to diversify its client base. Beer producer Heineken (HINKY, Beverages) came up flat in 2005, with earnings slipping around 8%. 2006 should improve, with EPS growth back on track in the 7% to 9% range. Brinks (BCO, Industrial Services) sold its underperforming BAX air transportation unit. The proceeds will allow for further reduction of debt and faster funding of their Legacy Trust, both long-term positives for the company. Now the fun begins as management hones in on its growth platforms of security services. European advertising giant HAVAS (HAVS, Advertising) is still in the midst of a business turnaround. While its recovery has been erratic, new management has little patience. If profitability does not reach its potential over the next few years, I believe management will not hesitate to sell or merge the firm. Although share prices of Omnicare (OCR, Drug Distribution) skyrocketed in 2005, the future looks bright for continued earnings growth. Investor risks going forward appear to be a fully valued share price along with a growing dependence on Medicare reimbursements. Management at American Vanguard (AVD, Agricultural Chemicals) continues to expand its chemical product offering and market penetration of a proprietary closed-system application approach. The stock has been a solid performer over the past few years, and should continue to reward long-term investors.

Almost half the companies in the portfolio will be held and dividends reinvested. After these adjustments, the portfolio should look like this:

Company 2006 Beginning
Balance
  Company 2006 Beginning
Balance
APD $1,711   HAVS $3,252
WTR $5,345   OCR $2,905
CGC $2,618   SEIC $1,472
EDS $2,825   SWWC $3,040
IFIN $2,681   AVD $2,722
HINKY $2,421   CBI $1,477
LOW $4,999   THE $2,542
MWV $1,496   FLEX $1,200
PEO $5,795   TNB $1,200
SZE $3,891   MRX $1,200
BCO $3,672   FAX $1,200
CME $8,268      

In my opinion, the bottom line for equity performance in 2006 will again be based on stock selection and there will be no year-long rising tide to lift all boats. This year will be a transition year either into an economic slowdown/recession, or into another spurt of growth in 2007. Mid-year data should give investors a clearer picture of the intermediate-term future of the economy, along with stock and bond prices.

In the interest of full disclosure, I currently own, or have owned in the past, small positions in most of the companies listed. I believe this personal exposure serves my readers, as I have a private stake in the performance of my suggestions. Over the years, I have developed a first-hand appreciation for the management directing these companies, especially from a shareholder’s vantage point.

George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr. Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.