BI > APRIL 2005

Can We Be Too Thorough?

Eagle Creek Women's Investment Club

Eagle Creek Women's Investment Club is a terrific example of the NAIC dictum "learn and earn." It was formed in 1996 by longtime friends who had relocated from Dover to Lewes, a small town in southern Delaware. They were joined by others they met in Lewes, and at one time the club had 18 members.

They have held steady at 10 members for many years, and each of them actively participates in managing the club's portfolio. Eagle Creek reports that only rarely is more than one member absent from the monthly meetings. Members encourage one another and have aided each other's development by taking NAIC courses back in Dover.

Eagle Creek Women's Investment Club. From left: Anne Ratledge, Betsy Baumeister, Barbara Brown, Natalie Loughran, Barbara Vaughan, Irene Robb, Retta Zimmerman, Barbara Rider, Nancy Wrede and Lee Weston.

The club asked for help in two areas: knowing when to sell and overcoming a tendency to overanalyze stocks. Members frequently engage in seemingly endless study of particular stocks, and often the best ones rise in value before the club reaches a conclusion. They suffer from "analysis paralysis." Make no mistake about it, careful study of a prospective holding is a virtue. It's possible to have too much of a good thing, though.

Fighting Paralysis

After watching in frustration as a prospective holding rose, members have sometimes given in, left a review unfinished and purchased the stock anyway. They bought Harley-Davidson, Inc., after a sustained rise, but buying at that higher price has reduced their return. Members also watched Bed Bath & Beyond Inc. and Johnson & Johnson rise steadily after their reviews. They chose not to chase these stocks, although both subsequently rose even higher.

One solution would be to allow a stock decision to be deferred only until the following meeting. The stock then should be voted up or down. If it's voted down, it can still be considered later. At least the club would be able to move on to other stocks rather than repeatedly analyze the same one. Inability to make a strong case for a particular stock provides cause to move on.

The club can afford to relax more than others when making purchase decisions because it has thorough, written sell criteria. This document reminds members to be on the alert for declining profit margins, adverse management changes and deteriorating financial conditions. Each member is assigned at least one stock to follow and must track trends in earnings and sales growth on her stocks. Faithfully doing this is a good way to spot operational problems early.

The club lists other reasons to sell including cyclicality, the competitive environment and dependence on a single product. Sometimes holdings simply become too large for the portfolio. The club's sell philosophy also cautions members not to overreact to temporary bad news and to refrain from selling when the stock has fallen so much that remaining downside risk appears minimal. (Bear in mind that the potential downside is always 100 percent, whether the stock is selling at $5 or $50.)

An Investing Art

Good portfolio management is the art of selling, and creating a comprehensive, written selling philosophy is a smart move. Although Eagle Creek members believe they can do a better job determining when to sell, they're actually ahead of most investors who lack written guidelines. Remember, the focus should be on the growth, quality and value of the security more than on analysis of its recent price.

The club applied its philosophy in deciding to sell American Power Conversion Corporation, a stock that has languished for five years since earnings peaked in 1999. The club also had concerns about the management of Swift Transportation Co., Inc., and sold the stock. Swift is under investigation over the safety records of its drivers and also over stock transactions by the company and its CEO in 2004. Rather than just hold and hope, the club concluded that it doesn't have to keep a stock when it's uncomfortable with the management.

Like all of us, members occasionally ignore their sell standards -- usually to their regret. The club delayed selling American Power Conversion, concluding that its problems were related to those of the broader tech sector and weren't an indication of poor judgment by management. It's reasonable to allow a company time to react to an adverse business climate, but management must present a clear game plan.

Investors should also look for evidence of the company's superiority versus competitors in areas such as brand leadership, innovation and cost control. Consider a loss of superiority or failure to reasonably execute the game plan as sell signals. The club held on to ADC Telecommunications, Inc., before finally selling, thinking further depreciation was unlikely since the stock had already declined so much. Again, the potential downside is always 100 percent.

The club is to be credited for maintaining high quality among its remaining holdings. While money can be made on lower-quality stocks, they require more monitoring than monthly club meetings allow. The club had an unfortunate foray into medium-quality companies such as ADC Telecommunications and American Power Conversion and seems to have rededicated itself to high-quality companies.

Click to enlarge.

Current Holdings

Most of the holdings are steady companies purchased at reasonable prices. Let's review Eagle Creek's holdings, giving special attention to its written sell criteria:

The club made a great decision to ride the homebuilding boom with Toll Brothers, Inc., a leading national builder of higher-end homes. Toll Brothers has experienced rapid share price gains and trades at a price-earnings ratio of 15, higher than its long-term average. The ratio is a more moderate 10.4 times earnings for the fiscal year ending Oct. 31, 2005.

Growth in earnings per share has averaged 30 percent annually over the past five years, but investors should be cautious about the cyclical nature of the homebuilding industry. At 14 percent of the total portfolio and given the volatility of the homebuilding business, Toll Brothers might warrant attention under the club's sell criteria regarding cyclicality and imbalance of a holding.

The club has also done well with Constellation Brands, Inc., a marketer of alcoholic beverages such as Corona and St. Pauli Girl beers and Almaden, Inglenook and Ravenswood wines. Perhaps because many investors shun its industry, Constellation trades at a P/E of 19 despite a 20-percent annual growth rate over the past five years.

C. R. Bard, Inc., might appear pricey now, but it was a very reasonable purchase when Eagle Creek bought the stock. Bard manufactures medical devices such as catheters, vascular grafts and specialty products used in oncology, gastroenterology and laparoscopy. The Eagle Creek sell criteria don't list a high P/E ratio as a reason to sell, and a high P/E alone is rarely a reason to sell. Investors should, however, be less tolerant of even minor deterioration, such as a slight decline in profit margin, among high-P/E stocks.

Staples, Inc., has performed well but is also the holding with the lowest initial investment. The well-known office supplies retailer has returned to solid growth over the past two years after three subpar years. While the company isn't opening stores at its historical rate, same-store sales growth remains strong. It has expanded internationally with more than 200 stores in Canada and another 200 in Europe. Profit margins have expanded steadily, helping to produce substantial earnings increases.

The portfolio has experienced solid growth from AFLAC Incorporated and PepsiCo, Inc., with good gains recently from Oracle Corporation. The Home Depot, Inc., and Pfizer Inc. appear reasonably valued with decent growth, but the market hasn't really embraced them yet; the club is holding them at an unrealized loss.

Pfizer is a difficult holding for many investors. Its growth appears acceptable, but the world's largest pharmaceuticals company continues to be dogged by questions about the safety of certain medicines, patent expirations and how fast it can grow. Of the many studies performed on Pfizer's Celebrex anti-inflammatory drug, only one has suggested any safety flaws. And that study involved the administration of doses four to eight times the standard level.

The club's frustration from watching stocks rise while being evaluated shows up in certain holdings. Despite rapid earnings growth of Apollo Group, Inc., and Stryker Corporation, Eagle Creek has little profit to show on them. These are clearly high-growth businesses and can be reasonable investments -- at the right price.

Apollo is handicapped by belonging to the same industry -- for-profit higher education -- as a couple of companies accused of wrongdoing. While Apollo hasn't been accused, a cloud will hang over the sector until these matters are resolved.

Among the Fallen?

The portfolio also appears to contain a few fallen angels that are resting on past glory rather than current merit. Paychex, Inc., was a wonderful holding throughout the 1980s and 1990s, providing payroll services to small and medium-sized companies and growing through downturns. Paychex was tripped up, however, by the 2000-2001 recession.

Annual EPS growth has averaged less than 6 percent over the past three years, compared with 37-percent annual growth over the preceding decade. There are good reasons for the slowdown -- the weak labor market, for example -- and Paychex's primary competitors have suffered, too. Valuation questions come into play here because Paychex's business performance has slowed while the P/E remains high. Should investors pay a P/E of 36 times trailing earnings for a company struggling to grow faster than a single-digit rate, even if the slower growth is because of economic conditions seemingly beyond the control of management?

Another possible fallen angel is General Electric Company. The year 2004 represented GE's fourth straight year of single-digit EPS growth, including negligible growth over the past two years. While the manufacturing recession is partially to blame, more than half GE's profits come from financial services rather than manufacturing. GE is forecasting profit growth of 10 percent to 15 percent for 2005 and seems optimistic about 2006 as well.

This is a powerful company in several ways. How much price appreciation, though, can be expected from a company that has a P/E of 23 and might grow earnings by 8 percent to 10 percent a year on a long-term basis? GE doesn't meet any of Eagle Creek's sell criteria, but its moderate growth and high P/E suggest watching for any deterioration. (Editor's note: As shown in a separate entry in the chart above, Eagle Creek bought a large portion of its GE shares through GE Stock Direct, the company's direct stock purchase plan.)

Harley-Davidson, Inc., is starting to look a little long in the tooth. Despite improving economic conditions, its growth slowed in 2004. Comparisons were difficult because of strong demand for the company's motorcycles during its centennial celebration in 2003. Revenues rose 8.5 percent for all of 2004, aided by strong sales of accessories.

Fourth-quarter sales grew just 5.4 percent. The company lost domestic market share for the first time in recent memory, with a 6.7-percent rise in U.S. motorcycle sales compared with an estimated 9.3 percent for the industry. The stock has a P/E of 20 times 2004 earnings and 17.6 times 2005 estimated earnings. The stock doesn't appear grossly overpriced and doesn't meet Eagle Creek's sell criteria. It bears watching, however, if sales growth doesn't return to double-digit levels.

Contrast the club's modest 7-percent appreciation from these last five stocks with the 52-percent appreciation it has experienced from its remaining holdings (excluding cash). While the club believes it could do a better job knowing when to sell, members have to realize that selling is the most difficult task investors face. Good judgment when buying reduces the need to be concerned about selling.

If I have one concern about the club's portfolio, it's the proportion of large-company stocks. Investors can choose from some 2,000 to 3,000 profitable, publicly traded companies, so they shouldn't feel limited to just those in the S&P 500 index. Read Better Investing and look at Value Line (including the Small- and Mid-Cap Edition). Look for interesting, well-run companies of many sizes to add diversification to the portfolio. The availability of such appealing companies also serves as an adjunct to the sell philosophy: Sometimes the best way out of a mediocre situation is just to trade up to a better opportunity.

Scott D. Horsburgh, Chartered Financial Analyst, is president of the investment management firm Seger-Elvekrog Inc., Bloomfield Hills, Mich. The author and clients of his business may own stocks mentioned in this article. Views expressed in this feature are those of the author and don't necessarily reflect positions of either this magazine or BetterInvesting. No investment recommendations are intended.