Top Underperforming Stocks JPMorgan Is Selling

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Includes: AAPL, FE, IBM, KO, LO, LRCX, PEP
by: The Analyst Hub

JPMorgan Chase and Co. (NYSE:JPM) manages around $200 billion in equity assets, primarily through its asset management subsidiary, J.P. Morgan Asset Management. The firm caters to high-net-worth individuals, corporations, pension and profit sharing plans, charitable organizations and institutions.

Investment Strategy

J.P. Morgan Asset Management offers various strategies, including active extension, behavioral, core, enhanced, growth, long/short, quantitative and value. Investments are carried out through U.S., international and global portfolios. Emphasis is placed on identifying and monitoring key valuation and risk metrics. For the domestic investments, the firm primarily employs fundamental research to identify favorable investments. A three-step process is applied, combining research, valuation and stock selection. JPMorgan purchases companies that are undervalued and considers selling them when they appear to be overvalued. In addition to valuation, the firm looks for a catalyst that could prompt a rise in a stock's price, a high potential reward compared to potential risk, or temporary mispricings due to market overreactions.

I discussed JPMorgan's best performing top buys in a previous article. In addition to its best performing buys, it is also interesting to have a look at top underperforming companies which JPMorgan is selling. The following is a list of top seven sells by JPMorgan Chase and Co. that have underperformed the S&P 500's 9.05% gain since Sept. 30, 2011:

Stock

Symbol

Shares Held 06/30/2011

Shares Held 09/30/2011

Shares Sold Last Quarter

% change in Share Price since 09/30/2011

Pepsico Inc.

PEP

15769884

8760602

7009282

6.07%

International Business Machines

IBM

12612984

10257993

2354991

3.23%

Apple Inc.

AAPL

13123363

12283377

839986

4.08%

The Coca-Cola Company

KO

24420428

20167265

4253163

1.19%

Lorillard Inc.

LO

3639208

1102246

2536962

3.58%

Firstenergy Corp.

FE

6156510

768005

5388505

-1.28%

Lam Research Corporation

LRCX

14682333

8993229

5689104

-3.16%

Source: 13F filing

My favorite short candidate among above stocks is Pepsi Inc. However, I don't agree with JPMorgan on IBM, Apple and Coca Cola and believe they are a buy instead of sell.

Pepsi has invested almost $7 billion in acquisitions in last 24 months in its attempts to diversify beyond its core soft drinks business. This is more money than it had spent in total in the prior decade. This spending has come at a cost of ad expense, which has badly underpaced its #1 global competitor Coca-Cola.

Pepsi's ad spend has been ~3% of sales vs. 8% for Coca-Cola. This has led to market share losses in Pepsi's core business and has hurt brand development and innovation. The acquisition deals haven't yielded great results either as is evident from Pepsi's EBIT margin decline (-240 bps) since 2008. On the other hand, Pepsi's debt/EBITDA ratio has increased to 1.85x now from 0.65x three years ago.

Going forward, the weak fundamentals trends are expected to continue in the near term, given weak U.S. consumer spending, commodity cost pressures, market share losses and unfavorable y/y forex trends. Consensus estimates remain too high for Q4 and 2012 and analysts are assuming an underlying profit growth in Q4 2012, which is unrealistic.

The company is trading at comparable valuations with other consumer stocks like the Hershey Co. (HSY), Kraft Foods (KFT), Coca-Cola, Procter & Gamble (PG) and Colgate-Palmolive (CL) which are growing volume as fast and have better cash usage. I see a further downside in Pepsi as investors shift to better avenues.

The only upside risk I see to my short thesis is Pepsico's business review, which it will discuss with analysts and stockholders early next year. The company has recently extended this review, which was earlier scheduled to be completed by December. In my opinion, this delay only signifies that fundamentals are becoming incrementally worse, and it is not easy to change the direction of the trend.

I won't be worrying if the company comes up with any superficial discussion or optical value creators, like spin-offs, etc., after the review. However, any major cost-cutting initiative will be a slight positive for the stock. I won't change my negative thesis in the near term unless there are some major management changes in the company and to be honest, I don't see much likelihood of that happening.

On the long side, I like Apple, despite last quarter's earnings miss, which was largely due to customers holding back on new iPhone purchases before the iPhone 4S launch in October. iPhone 4S is currently seeing very strong demand, with over 4 million units sold in just three days after the launch in early October. Earnings calls of AT&T (T),Verizon (VZ) and Sprint (S) have also indicated strong trends for iPhone 4S. The carriers have witnessed a slowdown in sales of Android and BlackBerry phones, in addition to iPhone sales, from Q2 to Q3. There is a good chance that a number of Android / BlackBerry customers also waited to switch to the iPhone 4S in October, and that's why they delayed purchases.

Going forward, Apple will likely continue to see strong near term demand, on the back of holiday sales and anticipated iPad3 and iPhone5 launches next year. From a medium- to long-term perspective, Apple's secular growth and market share gains in the smartphone and tablet space is likely to continue for the next several years. Apple's strategy of customer-centric innovation and launching products with potential to create whole new markets is still intact. If one goes by Steve Job's biography, Apple TV is likely the next such product in the line. At a valuation of just 8.25x forward earnings (adjusted for cash), Apple is trading at very attractive levels. I believe it is a good opportunity to go long the stock.

IBM is another good long candidate in the above list. IBM's stock has been a consistent performer in the past few years, outperforming S&P 500 in 5 of the past 6 years. I like the defensive nature of the business, given that its high visibility annuity business accounts for more than 50% of revenue and 70% of profits which will support the company during downturn. Trading at around 13x forward earnings, the stock does not look pricey.

I also like Coca Cola despite of its relative underperformance. Coca Cola is one of the best defensive bets in the current uncertain times, with its stable business. Growth trends in emerging markets, focus on cost savings and strong cash generation, all add up to an attractive long term growth story for investors in Coca-Cola. Its innovative marketing programs have continued to push and drive the growth of the brand. Trading at ~15x forward PE with 2.8% dividend yield, I believe Coca Cola makes a good buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.