Fully Invested, but Defensively So

by: Alan Brochstein, CFA

I first posted on Seeking Alpha 27 months and 227 articles ago. For those who have followed my submissions, you are aware that I combine top-down and bottom-up analysis and technicals to produce those 2 articles a week on average. You may not be aware that for the past year I have been running a model portfolio that reflects the views that I share here. While the past year has been tough, with the S&P 500 declining in value by approximately 1/3, I am celebrating my Top 20 Model Portfolio's first anniversary appreciating that it has declined only 8% despite being fully invested over the entire time-frame.

Two things have helped me to beat the market so soundly: active trading and a willingness to take concentrated sector bets. While I certainly expected lower turnover when I launched a year ago, only five names remain from the original twenty stock portfolio. We have bought and sold a few of the names on multiple occasions. The fact of the matter is that high market volatility, such as we have experienced, leads to many opportunities for those willing to take advantage.

The portfolio today is much different than the one I went with on the launch a year ago. At that time, I was optimistic that the bear market was nearing an end and positioned the portfolio aggressively. While it never really lagged the market despite its poor positioning, including a big zero in Fannie Mae (FNM), it has really done well since I repositioned it during Q4 for a more defensive environment. Here is what it looks like now:

TOP 20 5-27-08

Before I share further insight about the portfolio, it's worth considering what it looked like on inception. Below is a list of the 15 names besides the original five that remain in the portfolio (Catalyst Health (NASDAQ:CHSI), EZCORP (NASDAQ:EZPW) Stratasys (NASDAQ:SSYS) and Ladish (NASDAQ:LDSH) and Shoe Carnival (NASDAQ:SCVL) which we sold and then repurchased):

  • Americredit (ACF)
  • Allergan (NYSE:AGN)
  • Administaff (ASF)
  • Astec Industries (NASDAQ:ASTE)
  • Carpenter Technologies (NYSE:CRS)
  • Federated Investors (NYSE:FII)
  • Fannie Mae (FNM)
  • Lincare (NASDAQ:LNCR)
  • Lowes (NYSE:LOW)
  • Middleby (NASDAQ:MIDD)
  • Men's Wearhouse (MW)
  • National Instruments (NASDAQ:NATI)
  • NetApp (NASDAQ:NTAP)
  • Surmodics (NASDAQ:SRDX)
  • Timberland (NYSE:TBL)

Other names that were added later but have been subsequently removed include Advisory Board (NASDAQ:ABCO), BedBathBeyond (NASDAQ:BBBY), Biomed Realty (NYSE:BMR), Cisco (NASDAQ:CSCO), Cintas (NASDAQ:CTAS), Intuitive Surgical (NASDAQ:ISRG) and Thor Industries (NYSE:THO). So, there have been a total of 42 names over the past year.

Looking at the current portfolio, it is pretty clear that I like strong balance sheets. The highest net debt-to-cap names are rather average, while overall the portfolio has typically companies with net cash. Similarly, I have been focused on price-to-tangible book. While some of the names are quite distant from that metric, 13 of the 20 are below 2.5X.

Reviewing the list by sector, the Energy holdings represent a much larger portion of the Top 20 than they do of the S&P 500. Chevron (NYSE:CVX) is the only large-cap name, while the other three are small-cap. Contango (NYSEMKT:MCF) is a producer leveraged to natural gas. Carbo Ceramics (NYSE:CRR) is also leveraged to natural gas but land-based and is more of a technology play. Lufkin (NASDAQ:LUFK) is involved in both energy, where it competes with Weatherford (NYSE:WFT) as well as power transmission for industrial applications. In all cases, these are "value" stocks. Despite the big run recently, I am sticking with these names for now.

We are underweight Industrials, but our two names Ladish (LDSH), which we have trimmed significantly, and Met-Pro (NYSE:MPR), a recent addition, are both very tiny companies. LDSH is in a duopoly with Precision Castparts (NYSE:PCP) in the jet engine component market and trades at tangible book value. MPR is a company involved in green applications - water filtration and pollution control.

The portfolio was extremely heavy in small-cap retailers early in the year, but we have trimmed a lot of the exposure. What remains is a collection of small and rather inexpensive companies. Dorman Products (NASDAQ:DORM) and America's Car-Mart (NASDAQ:CRMT) are both plays on the slowdown in new car sales. Shoe Carnival (SCVL), which had a great report this morning, trades way too cheaply. They sell shoes to a lower-income demographic, and the decline in gasoline prices over the past year as well as pent-up demand should continue to help them to perform better than typical retailers. Columbia (NASDAQ:COLM) is just a plain old-fashioned value stock, with significant inside ownership. So, we are still overweight the sector, but in a defensive manner in my opinion.

We launched with no Consumer Staples stocks, but have picked up some gems over the past six months. We started with Hormel (NYSE:HRL) around Thanksgiving and remain pleased with this very inexpensive food manufacturer with one of the best balance sheets in the industry. We added Walgreen's (WAG) next, but have trimmed it after the nice run. Finally, we most recently added Sysco Foods (NYSE:SYY). It has lagged its restaurant customers significantly, though it should benefit from some of the same factors. The dividend is high and sustainable, a rarity these days.

Healthcare is our largest exposure. Volcano (NASDAQ:VOLC) is a recent add and truly a growth name with a very high percentage of its sales in consumables. It competes very well with its larger, less-focused rivals, and I really like the CEO and his vision. C.R. Bard (NYSE:BCR) is more of a value play that I appreciate because they don't sell any capital equipment. Catalyst (CHSI) is a small PBM with greater transparency than its rivals. While it did very well last year, it has been a disappointment in 2009. The valuation is compelling, but I am watching the 19 support level. We caught Zimmer (ZMH) at a great time and have trimmed a bit recently, though it remains very inexpensive. Investors are just too pessimistic on the ortho players. This one has the best balance sheet and valuation. Finally, we like the diversity and consistency of Johnson & Johnson (NYSE:JNJ), and the valuation is very attractive.

Our only exposure to Financials is through EZCORP (EZPW), which is primarily a pawn lender being weighed down by concerns over its payday lending (regulatory). The company has a fantastic balance sheet and should continue to be counter-cyclical. It is truly a defensive name in many respects. Our only Technology name is Stratasys (SSYS), which has been too cheap to sell but not particularly defensive except for its high cash and relatively low valuation compared to its book value. I think that Tech could disappoint over the next couple of quarters and remain underweight despite the sector having better balance sheets than others.

The model portfolio doesn't allow me to make short bets or to move to cash, so it's important to remember that these picks are relative to the market and not absolute. I happen to own 17 stocks currently, 15 of which are currently in the model. As always, I post my holdings on my website. I look forward to the days ahead, whenever they return, when I can invest with a longer time-horizon and not have to churn the portfolio so much. I wouldn't expect to beat the market in that environment by 25% a year again, but it sure would be a lot less work!