This article is part two in the series using the idea of bracketology and the NCAA Tournament to pick a well-diversified portfolio to beat the market. Click through to the first in the series, Using Bracketology and the NCAA Tournament to Pick Stocks, for a description of the analogy and how it can be used to pick winners outside the sports arena.
The idea behind the screening and then selection process is to find stocks with a rational chance of outperforming peers in their sector without having to spend all your time watching the financial media and sifting through annual reports. The selection of a group of possible outperformers to be combined with a core holding of sector funds is a commonly used portfolio strategy called, core-satellite and is described in a previous article, Two Proven Investment Strategies that Work and One to Avoid.
In the first article we looked at technology and consumer staples with Philip Morris (PM), Coca-Cola (KO), Apple (AAPL), and Seagate Technology (STX) winning the two brackets. More than a few investors have emailed questioning the final selection, especially the choice of Philip Morris over Hershey Company (HSY). As mentioned in the first article, I tend to be more conservative in my selections and look for stability of earnings growth with higher dividend yields. Your own portfolio will differ according to your needs as an investor.
This article covers the energy and consumer discretionary sectors, two significantly different groups in analysis and valuation. While domestic growth is much more important to some of the U.S. consumer discretionary companies, investors cannot ignore international risks when looking at stocks of energy companies. The outlook for U.S. growth and a still struggling European economy has skewed my own energy bracket to companies more focused on domestic growth.
Holly Frontier (HFC) came out strong with a dividend yield of 2.3% and the lowest price multiple of the group at just 6.2 times trailing earnings. It lost out though as it and other refiners are facing an increasingly costly and volatile market as they hit the blend wall for ethanol and Renewable Identification Numbers (RIN) spike from a few cents in January to more than a dollar in March. Several company executives have approached regulators about speculation in the credits, but there does not appear to be a solution in sight.
Apache Corporation (APA) ended up taking the win on a turnaround story and possible margin expansion from a focus to profitability in its asset portfolio. The company had one of the highest averages for five-year sales growth at 12.3% and a strong 41% operating margin. Apache has finally begun to address the $16 billion in assets bought between 2010 and 2012 that have yet to produce returns to shareholders. The $29.2 billion oil and gas producer announced earlier this month that it would hold $2 billion in asset sales to reposition the portfolio. There could be a strong bounce in the shares once a sale is announced and the stock could recover further from there as profitability improves.
Williams Partners LP (WPZ) might have made it to the final four with its strong operating margin of 12.6% and an outstanding 6.7% dividend yield had it not had to face off against master limited partnership (MLP) rival DCP Midstream (DPM) in its first match. Fundamentals at both companies are extremely close with DCP Midstream being slightly less expensive. Prices on the shares track each other closely with correlations above 0.90 in the three- and five-year periods. I ended up going with DCP Midstream for a slightly more diversified business line.
Both companies are planning a joint expansion of the Discovery natural gas pipeline system linking areas in the Gulf of Mexico to the eastern United States. The $600 million pipeline project is expected to begin operation by mid-2014. While the companies went head-to-head here, their business lines differ somewhat with Williams Partners being a natural gas pipeline company and DCP Midstream more focused on gathering & processing. Investors looking for a larger stake in MLPs may choose to include both in a portfolio.
LeapFrog Enterprises (LF) may have been the Cinderella story of the tournament. The company held its IPO just as the market was collapsing in 2008 and was fairly unknown up until mid-2011. Even after a gain of 202% in less than two years, the shares are relatively cheap at 7.0 times trailing earnings. The company's LeapPad was a bestseller last holiday season and investors are hoping the new LeapPad2 can repeat the performance by offering a faster processor and twice the memory. CEO John Barbour makes a compelling case and reiterates the company's strategic advantage in the face of competition from Toys R Us in a recent Bloomberg interview.
The runaway story in the bracket was Coach (COH) and its world-class brand name in the apparel accessories category. The company's best in class operating margin of 35%, significant cash flow and a valuation of just 13.6 times earnings makes it a strong buyout candidate, according to analysis by Real M&A. The shares have lost 35% over the last year and 18% just since January after a disappointing holiday shopping season.
Sirius XM Radio (SIRI) made a strong showing in its division with an operating margin of 25.6% and the lowest price multiple in the bracket at 6.1 times trailing earnings. The $20.4 billion broadcaster will carry every game of the 2013 NCAA Division I Men's Basketball Championship. While the uninterrupted coverage of the games may draw new subscribers, the recent power struggle with Liberty Media (LMCA) makes it difficult to forecast fundamentals going forward.
The energy and consumer discretionary sectors are extremely cyclical and may experience increased volatility should global headline risk return. That said, it's rarely a good idea to attempt market timing and investors should go with the companies they feel have a competitive advantage over peers in the long term.
We still have five sectors left in our bracketology series with utilities and basic materials to cover in the next installment. Let me know if you have any questions.