This article is part three 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 first article includes the winners of the technology and consumer staples sectors while the second article in the series contains the winners within consumer discretionary and energy.
This article covers utilities and basic materials, two sectors generally considered at opposite ends of the risk-return continuum. Since utility companies are usually heavily regulated, growth is limited to the rate increases that can be passed through to customers. The monopoly status that comes with regulation means that utilities generally have stable cash flows and an extremely low risk profile. Companies in the basic materials sector, on the other hand, rely on the cyclical demand of the market for raw materials. Beyond normal cyclicality, these companies may also face secular changes to demand for their products as is the case currently with coal companies in the United States. Combined in a portfolio, the two sectors spin off a decent amount of income while still offering growth and capital appreciation.
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. After selecting the best picks from each sector, an investor would normally fill out the portfolio with sector funds to provide a general market exposure. This helps the portfolio to track market returns while maintaining the chance to outperform on the individual picks.
As I mentioned in the other articles, my investing style targets long-term holdings with significant return from dividend yield and so the picks tend to skew more conservatively. Your own portfolio will differ according to your needs as an investor.
Windstream (WIN) started strong in the tournament with a return on assets almost double that of Frontier Communications (FTR) and an extremely interesting 11.6% dividend yield. The shares are slightly more expensive than peers at 17.9 times trailing earnings but earnings growth has been strong over the last five years. Besides an aggressive acquisition strategy, the company has been ramping up capital expenditures, which should translate to stronger revenue growth in the future. CapEx grew by 56.8% in 2012 to 1.2 billion, and has averaged 53% growth since 2009. The company has recently finished a management restructure and has reiterated its commitment to the $1 dividend.
Exelon Corporation (EXC) cut its dividend by 41% in February, a move that was widely expected and after the stock had lost almost 22% over the preceding year. Even after the cut, the nation's largest competitive energy provider and nuclear operator still pays a respectable 3.7% annually. Earlier this month, regulators accepted an application by Exelon to increase output at its Peach Bottom plants by 12.4% to 1,261 megawatts (MW). The U.S. Nuclear Regulatory Commission now has 18 months to review the application. The increase is much higher than the 1.6% output increase the company has sought at other reactors. Exelon just edged out Duke Energy (DUK) on a lower price multiple at 11.7 times trailing earnings though its operating margin was considerably lower.
Vimplecom (VIP) easily beat Telefonica Brasil (VIV) for its valuation and geographic diversity of revenue. The company reported strong fourth-quarter earnings on cost reductions and revenue increase on new customers in Asia and Africa. Overall subscribers increased by 5% over the same period last year to 214 million, with an 8% gain in the Africa and Asia segment to 85 million. The company operates in 18 countries, largely in emerging markets. Vimplecom could have made a run against Exelon, but I already had an aggressive growth communications company in Windstream so chose to diversify into electric generation.
Potash Corporation of Saskatchewan (POT) had the highest operating margin of the final eight in the sector at 31.4% and a respectable 2.1% dividend yield. While it is well off its recent lows, the shares are still down 15.5% over the last year, largely due to a decline of 9.6% in revenue last year. Higher planted acreage and continued tight supply of grains on the global market should lead to higher revenues this year and a rebound in the shares. The long-term trend in demand makes it a great holding when you can get in on the dips. The company is currently trying to buy the remaining 86% of Israel Chemicals that it does not own in the largest takeover in the Middle East. The workers' union has committed to fighting the merger on grounds that management claims are unrelated to the deal. Potash has been preparing a package of concessions since earlier in the month but has yet to release terms.
E.I. du Pont de Nemours (DD) is a diversified investment across agriculture, industrial biosciences, personal nutrition, and other chemical products. The decline in natural gas prices in North America has become an important structural cost advantage for the company and should help margin improvement. The company has been expanding its agricultural segment over the last few years with Pioneer Hi-Bred now accounting for 29.6% of 2012 sales. DuPont announced its intention to sell its performance coatings unit in the first quarter of 2013 and use proceeds for a $1 billion share buyback. While the shares are relatively expensive versus peers at 13.7 times trailing earnings, the 3.5% dividend yield is stable and the company's product line is more diversified than competitors.
Freeport-McMoRan (FCX) had the highest dividend yield of the final eight in the sector at 3.8% and a competitive price multiple of just 10.5 times trailing. Copper prices have rebounded lately and 2013 production should be stronger than the 3.7 billion lbs. reported in 2012. The planned acquisition of Plains Exploration & Production (PXP) and McMoran Exploration (MMR) may dilute the company's position as a strong copper miner. To fund the acquisitions, the company has become the latest to take advantage of historically low rates and issue one of the largest debt offers this year. Freeport McMoRan issued four tranches of debt for a total of $6.5 billion with spreads on the issuance ranging from 1.62% to 2.37% above the 10-year Treasury rate and at the narrow end of guidance. Though the rate on debt is exceptionally low, there is some fear that the company could have difficulty if energy and copper prices declined on slower global growth.
Investors looking for aggressive growth often underweight utilities in favor of cyclical stocks in their portfolio. This increases risk and can limit income yield which has been an important part of total return over the last decade. Rather than under- or over-weighting specific sectors, the core-satellite approach described in this series gives investors a chance to outperform without having to skew their holdings and time market cycles.
We will wrap up the series in the next article, which will cover the finance, healthcare and industrial products sectors.