BI > DECEMBER 2004

Staying in Balance

Carousel Investment Club

The Carousel Investment Club is a terrific example of how a club should mature. The Philadelphia-area club was started 17 years ago with just $500, and the 20 current members now hold a portfolio worth $184,000. The members were realistic from the outset. They chose the name Carousel because the ups and downs of merry-go-round horses are reminiscent of the market's gyrations.

Carousel Investment Club. From left: Dolores Winsley; Donald Davidson, secretary; Geoffrey Cudd, treasurer; Dennis Rickards; Gordon Lang; David Lang; Daniel Maguire; Nancy Latch; David Lang, Jr.; Gerald Christie; Mark Matthews; and Fred Latch, agent. Not pictured: Jan Ceton, Fred DeLozier, Cynthia Garrison, Michael Gillin, Douglas Heisserman, William Manning, A.J. McAllister and Bradford Rice.

The club's longevity also suggests the members must enjoy one another. In addition to regular monthly club meetings, they get together for an annual dinner in February to which spouses are invited. All of this is well and good, but the purpose of the club still basically comes down to business.

Getting along socially and injecting fun into the process can help a club survive by maintaining members' interest when the market goes through an inevitable downturn. Carousel runs an annual contest in which each member invests a fictitious $10,000 starting at the annual dinner. The member who grows the portfolio the most doesn't have to contribute toward the next annual dinner. While there have been some repeat winners, the club reports that many different members have won over the years.

The club's maturity also shows up in its decision-making. David Lang says that in the past members flew by the seat of their pants. While even a blind squirrel will find a nut every once in a while, veteran investors will tell you that you won't have enough acorns saved up for winter if you don't do your homework.

Click to enlarge.

Now the club insists on going through the NAIC stock study process before buying or selling stocks. The club uses NAIC software for its financial reporting and investment decision-making. As is typical among successful clubs, individual stocks are assigned to specific members for follow-up and reporting at monthly meetings. Carousel looks at sales and earnings, trends and analyst reports for its holdings at each meeting.

Diversification Considerations

Some club members are concerned they either have too many stocks or are perhaps not diversified enough. Before discussing some of the individual stocks in the club's portfolio, let's address this key concern about portfolio structure.

How many stocks are enough? I once knew a very wealthy man with 200 stocks in his portfolio. This is certainly too many, and his investments had long ago started to resemble just a collection of stocks rather than a portfolio. A good portfolio can consist of as few as eight or 10 stocks if they're in different industries. By the time a portfolio reaches 40 or 50 stocks, it may have too much exposure to mediocre companies, unattractive industries or third- or fourth-best companies in their industries.

The simple answer to the question of how many stocks investors should hold is at least eight and preferably less than 30. The most important lesson is to remain invested in several industries and in individual companies that members believe have merit.

The Carousel portfolio consists of 15 stocks, a very appropriate number. They're spread across numerous industries, including health care, consumer products, retail, finance, technology, oil and raw materials.

Consumer Products Overweighted?

While exposure to these industries may seem to represent adequate diversification, I see an overreliance on the stocks of companies providing consumer products. Some industries such as utilities and capital goods aren't included in this list; these are industries that generally exhibit modest long-term growth and may not be appropriate for a growth portfolio.

Anheuser-Busch Companies, Inc., Hershey Foods Corporation, The Home Depot, Inc., and PepsiCo, Inc., together constitute more than 46 percent of the portfolio. There are many great consumer companies, but overall growth among the major food, beverage and retail companies is likely to be only moderate. Markets for the products offered by these companies exhibit moderate growth, and the companies that Carousel owns already have substantial market share.

Anheuser-Busch has more than 50 percent of the U.S. beer market, for example. Hershey is the largest candy maker. PepsiCo has more than 30 percent of the soft drink market and 58 percent of salty snacks. Home Depot is increasingly engaged in a duopoly with Lowe's Companies, Inc., in the home improvement market.

These are all wonderful companies, but their high shares of modest-growth markets call into question how fast they can grow in the future. While there's nothing wrong with any of them individually, 46-percent exposure to consumer products giants is too high and leaves less room for excellent companies in other industries.

Quality Is King

The club earns excellent marks for choosing quality. About 90 percent of the portfolio consists of blue chip or near blue chip companies. Unless shareholders are extremely sophisticated investors, blue chips should form the core of most investment portfolios, I believe.

Blue chips are prized for their quality, but two problems can come from owning them. First, blue chip companies have frequently reached a point of maturity from which rapid growth is no longer likely. The second problem is that without enough companies with substantial growth potential, portfolios can start to look stale and fail to cover the periodic losses from big losers.

About 58 percent of the value of Carousel's portfolio consists of five stocks that have been held since the end of 1991: Abbott Laboratories, Anheuser-Busch, Baxter International Inc., Hershey Foods and PepsiCo. These great performers are companies the club says it has never had any reason to sell. Since 1991 Anheuser-Busch and Hershey Foods have quadrupled in price, while the S&P 500 is up 170 percent. The other three of these original five are up more or less in line with the broader market.

Limits to Growth?

These high-quality stocks show some strain in terms of actual business growth, however. None of the original five has grown sales faster than 8 percent annually over the past five years (based on Dec. 31, 2004, sales estimates). While three of the five have increased profits at annualized rates in the low teens, earnings growth in each case has greatly outstripped sales growth. This is a problem because it isn't possible to cut costs and buy back stock forever -- the two primary ways to have earnings growth outstrip sales growth.

Long-term earnings growth (and therefore share price growth) depends on rising sales. For example, PepsiCo increased its sales by 8 percent annually over the past five years, but earnings per share grew at a 13-percent rate. If these trends continued for 37 years, without considering share repurchases, pre-tax profit would then equal sales. Employees, suppliers and creditors all need to be paid, so it isn't possible for pre-tax profits to ever equal sales.

To maintain earnings growth, sales growth at these companies would have to rise. With the maturity of their markets and their large market shares, however, it's more likely that future EPS growth will slip in the direction of sales growth. Should this prove the case, it's unlikely the companies' future price gains from current lofty price-earnings ratio levels will match what they've achieved in the past. These five companies have P/Es in the range of 18 to 25, based on the last 12 months' earnings.

Financial Services Option

The club has also ventured into some lesser-known companies. The inclusion of market leaders like Commerce Bancorp, Inc., and MBNA Corporation is a good step in the direction of looking at strong companies outside the consumer products area.

Commerce Bancorp is an interesting emerging bank headquartered in New Jersey. The company has proven extremely adept at attracting low-cost deposits from customers who are fleeing the poor service reputation of big banks. It conservatively invests this money in loans and high-quality securities.

Commerce is not without its risks, however, as there have been some controversies surrounding the company. For this reason it may be a more aggressive situation than many investors realize (see March 2004 Stock to Study).

MBNA is a leading credit card issuer. It's best-known for linking up with various groups (including NAIC) that allow MBNA to market credit cards issued under the names of those organizations. Annual earnings growth has averaged 20 percent over the past five years with no hiccups along the way.

Carousel members may want to consider emerging blue chips like Commerce and MBNA as possible replacements for some of their highly priced original five holdings that may not be as appealing in the future as they were in the past. Where does one find these gems? The club says most of its buy ideas come from members themselves, perhaps from well-run companies they have encountered at work.

This is like the Peter Lynch way -- invest in what you know. It works, but it does tend to limit the possibilities. For other NAIC ideas, evaluate stocks mentioned in BI. Skim through Value Line reports -- including those in its Small- and Mid-Cap Expanded edition -- found at many libraries.

Volatility Issues

Two companies in the portfolio appear to experience severe cyclical trends -- Plum Creek Timber Company, Inc., and Vishay Intertechnology, Inc. The club reports that Vishay is a local company and that Carousel has had some good runs with it.

Although the company has indeed had a good run here and there, it's in a very difficult business with intense competition. Profits in 2002 and 2003 were the lowest they've been since the 1980s. At the recent price, Vishay is up 4 percent annually from its cost in 1992, hardly a rewarding investment.

Plum Creek Timber has benefited from better volume and higher lumber prices in 2004. Its profits are closely tied to the price of lumber and are still well below where they were at the peak in 1990.

The stock price has moved in a narrow range for many years, but it does generate reasonable current income. At the recent price, Plum Creek Timber trades at 26 times profits for the last 12 months. This seems a very generous valuation for a company that hasn't grown profits in 10 years.

With Vishay, Plum Creek Timber or any other cyclical company, it's difficult to profit from a long-term, buy-and-hold approach. These types of stocks are best left to traders who can try to profit from the timing of business-cycle swings. For long-term investors, profits in these stocks appear and then disappear, paralleling swings in the business cycle. This up-and-down movement with little progress may not be the type of ride that long-term investors want to be on.

An interesting smaller company is Edwards Lifesciences Corporation. The company has experienced dramatic growth since going public in 2000. Even in recent years, results were not as strong as they may first appear, however. Excluding a change in accounting for sales in Japan and the effect of the weaker U.S. dollar, sales increased less than 3 percent in 2003 and declined 2 percent in 2002.

The company is engaged in a number of activities related to cardiac health, but it's up against some giants. Growth has slowed thus far in 2004, and this is a matter of some concern. This appears to be a stock requiring careful evaluation.

Plotting a Solution

To further monitor the progress of each holding, Carousel members can use Portfolio Evaluation Review Technique, part of the Investor's Toolkit software program. With PERT, investors can monitor quarterly sales, pre-tax profits and EPS trends to understand the sources of earnings growth.

Ideally, rising profits should result from higher sales and stable to slightly improving profit margins. Rising sales together with falling profit margins can indicate future trouble and necessitate additional investigation. Likewise, as we've already noted, profits can't go up faster than sales forever.

Investment education is a never-ending process, an odyssey of self- improvement. The Carousel Investment Club's insistence on doing proper homework, conducting monthly follow-ups and staying with high quality are signs of its maturity. Members' next step is to become better portfolio managers. It's also important to keep things light and fun. The Carousel Investment Club can take home a blue ribbon for that one.

The opinions expressed in this article are those of the author and do not necessarily reflect positions of either Better Investing or NAIC.

Portfolios are reviewed only in "Repair Shop." Send portfolio, current valuation statement and description of club challenges to "Repair Shop," c/o NAIC, 711 W. 13 Mile Rd., Madison Heights, MI 48071.

If a sharp photograph is available, send it along with the members' names, in order, and preferably in the form of a JPEG (RGB) electronic image set up as a high-resolution (300 dpi) or large (72 dpi) file. Include the names of those not pictured.

Scott D. Horsburgh, CFA, is president of the investment management firm Seger-Elvekrog Inc. (www.seger-elvekrog.com), Bloomfield Hills, Mich.