Thursday, May 19, 2011

Stocks to Watch

Here's an update to the list of common stocks that I like* for my own portfolio at the right price. I've noted below the maximum price I'd be willing to pay for each stock.

From my point of view, the shares listed are attractive buys as long-term investments only if they can be bought cheaper than the max price (preferably well below, of course) indicated. Unfortunately, in contrast to when I first published this list, all have become too expensive to buy or, at least, are borderline.

Naturally, the objective is to buy these significantly below the maximum prices I've indicated when the opportunity presents itself.

Since creating the initial Stocks to Watch list, none of the 20+ stocks on the list is selling at a lower price. 

I don't view this as great news. It'd be safer and easier to invest right now if at least some of these stocks were selling at much lower prices. As I've mentioned many times in the past, not only does it allow the investor time to accumulate more shares below intrinsic value, the company itself can use excess free cash flow to do the same.

"When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases." - Warren Buffett in the 1984 Berkshire Hathaway (BRKb) Shareholder Letter

The stocks on this list are fine businesses (some better than others, of course) and, in my view, if held for a long enough period are likely to create solid returns for shareholders even when bought slightly higher than the maximum price I would pay. I just happen to prefer a higher margin of safety than what is being offered by Mr. Market right now.

As always, the stocks in bold have two things in common. They are:

1) currently owned by Berkshire Hathaway (as of 3/31/11) and,
2) selling below the price that Warren Buffett paid in recent years.

There are several other Berkshire Hathaway holdings on this list but they don't have the 2nd thing going for them.

Some things to consider:
- This Stocks to Watch list is intended to remain very stable over time with few additions or deletions. I think of it differently than the Six Stock Portfolio. Unlike that portfolio, I use Stocks to Watch as a list of quality businesses to monitor and, over a long period of time, build into a concentrated portfolio of 5 to 10 stocks based upon what becomes available at the biggest discount to intrinsic value in the market. After that, the intent is to hold these indefinitely as long-term investments.

- In contrast, I established the Six Stock Portfolio in April 2009 as an example of some quality stocks that could be bought relatively quickly (at prevailing market prices back then) and held long-term yet still outperform. No trading required. A sale will only become necessary if the core long-term economics of one of these businesses have become impaired/were misjudged in some material way or maybe due to rather extreme overvaluation. Otherwise, this concentrated portfolio exists to reject the idea that trading rapidly in and out of different securities is necessary to create above average returns. Basically, that the ownership in shares of quality businesses at the right price trumps trading.
(As of yesterday, the Six Stock Portfolio is up 85% versus the 59% for the S&P 500 since first mentioning these on 04/09/09. Dividends are included in that total return calculation for the six stocks and for the S&P 500 so it is an apples-to-apples comparison.)

- A term used frequently by analysts is a "price target". I never have one. Shares of businesses are not like trading cards. Returns for an investor should be driven by the core economics of the businesses they own compounding in value, ideally over a very long time, not some unique talent to jump in and out of the stock at the right moment. The ownership period of shares in a sound business can be indefinite when bought at a fair price. Again, buy/sell behavior should be influenced by material changes to the long-term economics (i.e. permanent damage to the economic moat) or when the market takes prices to extremes.

The bottom line is that these are all intended to be long-term investments. A ten year horizon or longer. No trades here.

All of the stocks on this current list were part of the original Stocks to Watch unless otherwise noted.

Stock   |Max Price I'd Pay |Recent Price|Total Return Since 1st Mention**
JNJ   |    65.00          |  66.50      |18%
WFC|    28.00         |  28.92    | 58% - 1st mention 04/09/09 @ $ 19.61/share
USB |    24.00          | 25.74     | 44%
MHK |    45.00          |   67.17    | 74%
KFT  |    30.00           |  34.88     | 34%
NSC  |     54.00          | 72.11       | 42% - 1st mention 12/17/09 @ $ 52.06/share
MCD |    63.00           | 81.50      | 36% - 1st mention 12/17/09 @ $ 61.92/share
KO    |    55.00           |  68.30     | 42%
COP  |    50.00          |  72.81      |  78%
PM    |    45.00          |  69.28      |  94% - 1st mention 04/09/09 @ $ 37.71/share
PG     |    60.00          |  67.38     |  32%
PEP   |    65.00          |  71.27     |  43% - 1st mention 04/09/09 @ $ 52.10/share
LOW |    19.00          |  25.05      |  29% - 1st mention 04/09/09 @ $ 20.32/share
AXP  |    35.00          |  51.06      |198% - 1st mention 04/09/09 @ $ 18.83/share
ADP  |    37.00          |  54.24      | 59%
DEO  |    60.00          |  82.98      | 90% - 1st mention 04/09/09 @ $ 45.54/share
BRKb|    68.00          | 79.62      | 34%
MO     |    16.00          | 27.87     | 75%
HANS|   30.00          |  68.47     | 134%
PKX   |   80.00           | 106.4      | 18%
RMCF|    6.00            |  10.58     | 37%
(Splits, spinoffs, and similar actions inevitably will occur going forward. Will adjust as necessary to make meaningful comparisons.)

Removed from the list:
  • BNI - I liked purchasing BNI up to $ 80/share. It was bought out by Berkshire Hathaway for $ 100/share in late 2009. Deal closed in early 2010.
The max price I'd pay takes into account an acceptable margin of safety***. That margin of safety differs for each company.

In other words, I believe these are intrinsically worth quite a bit more than the max price I've indicated in this post and in prior Stocks to Watch posts. I also believe most of these companies generally have favorable long-term economics (i.e. the best of them have high and durable return on capital) and, as a result, intrinsic values will increase over the long haul. Of course, I may be misjudging the core economics and that margin of safety could provide insufficient protection against a loss. Still, a year or so from now I would expect to be willing to pay more for many of these based upon each company's intrinsic value growth over that time frame.

Though I could easily be wrong, at the right price I consider these stocks appropriate for my own portfolio (i.e. not for someone else's) given my understanding of the downside risks and potential rewards.

So these don't make sense for others unless they do their own research and reach their own similar conclusions.

Even if not wildly overvalued, these stocks are mostly too expensive to buy right now. The margin of safety is too narrow for my money. There has been no shortage of chances to buy these at a discount to value in the not too distant past. That was the time to act. The risk of missing the chance to own a well understood investment when a fair price is available (error of omission) can be more costly than suffering a short-term paper loss (though, due to loss aversion, many focus much more on the latter). Hopefully, at least some of them will get cheap again.

Here are some thoughts on errors of omission by Buffett from an article in The Motley Fool.

Also, from the 2008 Berkshire Hathaway shareholder letter:

"During 2008 I did some dumb things in investments. I made at least one major mistake of commission and several lesser ones that also hurt... Furthermore, I made some errors of omission, sucking my thumb when new facts came in." - Warren Buffett

In other words, not buying what's attractively valued to avoid short-term paper losses is far from a perfect solution with your best long-term investment ideas.

To me, if an investment is initially bought at a fair price, and is likely to increase substantially in value over 20 years, it makes no sense to be bothered by a temporary paper loss. Of course, make a misjudgment on the quality of a business and that paper loss becomes a real one (error of commission).

There is no perfect answer to this problem. When highly confident that a great business is available at a fair price it's important to accumulate enough while the window of opportunity exists.

Sometimes accepting the risk of short-term losses is necessary to make sure a meaningful stake is acquired.

Finally, above average long-term returns at lower risk is the objective. Performance over the complete market cycle without needing to trade.

For me, performance during a down market and tough economy matters more. Truly good businesses should become stronger in a tough economic environment.

Having said that, I am not tempted to trade from "defensive" to "cyclical" stocks (or anything similar to that approach) depending on the market environment. Too much trading leads to unnecessary mistakes. This is about part ownership of businesses.

I'll let others play the trading game.

I believe this approach will do just fine in the long run even if it offers a little less excitement.

Adam

* This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here are never a recommendation to buy or sell anything and should never be considered specific individualized investment advice. In general, intend to remain long the above stocks (at least those that at some point became cheap enough to buy) unless market prices become significantly higher than intrinsic value, core business economics become materially impaired, prospects turn out to have been misjudged, or opportunity costs become high.
** Calculated using the May 18, 2011 closing price compared to the average selling price from the date each stock was first mentioned as being attractively priced on this blog. The total return includes dividends. 1st mention was 07/21/09 unless otherwise noted.
*** The required margin of safety is naturally larger for a bank than for something like KO. When I make a mistake and substantially misjudge a company's economics, the margin of safety may still not be sufficient. Judging the durability of the economics correctly matters most. If the economics remain in tact but the stock goes down that is a very good thing in the long run.
 
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