Charges and Caps
Investors must be constantly aware of sector strength, as that is the closes tie that stocks have with the economy. There are, however, other factors to take into consideration when considering the types of stocks you want in your portfolio. One such factor, capitalization, is an axis along which investors should be sure to diversify. Investors should also use relative performance of companies with differing market capitalization to guide the timing of new purchases. Discover what capitalization stocks that relative performance points to right now and one other factor that you should be aware of in the earnings report of the companies you own.
Picking Market Caps
Many times in this space I have cited Experts who insist that stock-picking, and not index investing is the best way to make money in this market. Those same experts stressed broad diversification, but argue that simply buying index funds is not the way to accomplish it. Richard Moroney, editor of Dow Theory Forecasts warns that the Dow Jones Industrial Average is only 30 companies and the S&P 500 is dominated by just 50 stocks, or 10% of that average. Moroney thinks investors can outperform those two indices “without much additional risk…by diversifying broadly and looking for attractive stocks in all corners of the markets.”
According to Moroney, the 25 companies in the S&P 500 with the largest market capitalization have delivered an average YTD total return of 1.8% through October 12th, versus 5% for all stocks in the index. For stocks in the S&P 1500, which includes the S&P 500, MidCap 400 and SmallCap 600 indices, the YTD return is 5.7%. The 50 largest stocks, among those 1500, trade at 19x forward earnings, in line with all stocks in the index.
Moroney does concede that a number of factors may be holding large cap stocks back including a median growth average of just 14.1% vs. 19.4% among the S&P 1500. Second, the 50 largest stocks are concentrated in pharmaceuticals and technology and will have a difficult time producing double digit earnings growth. Moroney thinks that in spite of those strikes against them, the largest cap stocks merit attention.
Something about Charges
Sometimes the bottom line is not the bottom line. Richard Moroney notes that nonrecurring charges are excluded from companies’ quarterly earnings statements. While corporate boards exclude those charges because they do not feel the charges present an adequate picture of their companies’ earnings, Moroney notes that “charges may offer advance warning of poor share-price performance.”
“In a back-test of more than 14 years of charges serial chargers tend to underperform companies who do not take charge…In the 165 rolling 12-month periods between January 1990 and August 2004, the median top-quintile stock of the S&P 1500 outperformed more than three-fourths of the time. Average outperformance was more than 4%. Companies with no or few special charges tended to outperform and three and six-month holding periods, though the relationship was stronger among 12-month periods.”
The items most commonly listed as special charges include merger and restructuring costs, losses from natural disasters, past earnings from businesses or properties sold, or write-offs of assets declining in value.
Clean & Less Than Clean Earnings
Moroney feels the following stocks have solid track records of clean earnings.
Dell ( NASDAQ: DELL - Analyst Report ) has gained share in the personal-computer market every year since 1995 and is the world’s leading seller of PCs, with an 18% share. Over the last five years, sales have grown at an annualized rate of 23% and earnings have increased at a 20% clip. While the pricing environment for computer hardware remains aggressive, demand for PCs has improved. And Dell’s competitive advantages leave it better-positioned than most peers to survive a price war. The company is expanding internationally and moving into new markets, such as consumer electronics and printers. Dell says it has garnered a 10% share of the U.S. ink-jet printer market since it entered the business a year ago. Dell generates strong free cash flow — nearly $3 billion in the last four quarters. The company boasts a healthy balance sheet, with $5.5 billion in cash and investments and long-term debt equal to just 7.4% of total capital. The stock is a Long-Term Buy.
Delphi Financial Group (NYSE: DFG - Analyst Report ), a leading provider of group employee benefits, is benefiting from rising demand for excess workers’-compensation insurance. More employers are self-insuring because the cost of primary workers’- compensation insurance continues to rise, and Delphi’s policies protect such employers from catastrophic claims. Delphi expects this trend to continue and demand in this segment to remain strong. Excess workers’-compensation insurance premiums jumped 32% in the June quarter, helped by a 12% average price increase on products sold in the first six months of 2004. The disability-insurance market is improving, and disability premiums at Delphi rose 22% in the June quarter. The company plans to expand its sales force by more than 15% in 2004, which should help boost profits in coming quarters. Before 2000, Delphi managed a fairly aggressive investment portfolio. Since then, the company has sold off its riskier assets, reducing volatility and smoothing earnings. The stock is a Focus List Buy.
Harley-Davidson (NYSE: HDI ) dominates the U.S. market for heavyweight motorcycles with its widely recognized brands, holding the largest share since 1986. Harley bikes account for about half of all new U.S. heavyweight motorcycle registrations. The company continues to expand its manufacturing capacity and increase production, but demand for Harley motorcycles often exceeds supply, forcing consumers to wait to purchase a bike at list price. While demand has abated somewhat over the past few years, consumer interest in Harley bikes remains high. Harley has introduced six new 2005 models, including the Sportster. Priced lower than most Harleys, this model has sold well. The company has posted sales growth of at least 14% and pershare profit growth of at least 20% in each of the last eight years. In the September quarter, Harley’s earnings rose 24% to $0.77 per share, $0.02 higher than the consensus estimate. Revenue rose 15% to $1.3 billion. Consensus estimates project profit growth rates of 18% in 2004 and 14% in 2005. The stock is a Long-Term Buy.
Moroney feels the following large cap stocks do not offer a clean earnings picture.
| Company | # of Charges, Last 8 Qtrs. | Charges as a % of Operating Income |
| AT&T ( NYSE: T - Analyst Report ) | 8 | 33% |
| AT&T Wireless (NYSE: AWE ) | 7 | 71 |
| Avaya (NYSE: AV ) | 7 | 114 |
| Computer Assoc. (NYSE: CA - Snapshot Report ) | 7 | 72 |
| Donnelly (R.R.) & Sons ( NYSE: RRD - Snapshot Report ) | 8 | 35 |
| DuPont (NYSE: DD - Analyst Report ) | 8 | 64 |
| Electronic Data Sys. (NYSE: EDS ) | 8 | 69 |
| International Paper (NYSE: IP - Analyst Report ) | 8 | 32 |
| Qwest Commun. (NYSE: Q - Analyst Report ) | 8 | 98 |
| Williams Companies (NYSE: WMB - Analyst Report ) | 8 | 52 |
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(Editor's note: Trace Johnson is a market commentator for Zacks Investment Research. He's also a regular contributor on WebFN, First Business and CNBC-Europe. He can be reached at tjohnson@zacks.com)