Market weakness offers a chance to upgrade portfolio

Consider selling losers, taking the tax loss and buying winners cheap

Dollars & Sense

August 04, 2002|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

When Wall Street is plunging, many folks ask themselves, "Why am I in stocks?"

The answer is actually pretty simple: You're in stocks because you won't need the money over the next few years, and because equities are still likely to perform pretty well or better than other asset classes over the long haul.

(And when I say "equities," I'm speaking broadly. Small caps, international stocks and that sort of thing all have their place in a diversified portfolio.)

So, let's ask a harder question: "Which stocks should I be in?"

You'd think the answer to this one would still be pretty easy - companies with strong competitive advantages that are likely to increase their economic value over time. Unfortunately, I've talked with way too many investors who are still clinging to dot-com detritus, waiting for the shares to "get back to break-even."

Folks, when Mr. Market is offering you irrationally low prices on so many high-quality companies, waiting for a bounce in your Yahoo (YHOO) shares is sheer folly. Blow out the bad stuff, take the tax loss, and upgrade the quality of your portfolio with some companies that you'd actually be proud to own in three or four years.

Some stocks that have plunged deserved to get whacked, and a lot of them aren't coming back. But more than a few companies with durable competitive advantages look reasonably priced, and these are the ones that should come back eventually.

So, I looked through our coverage universe to see what looks especially attractive at the moment. Some of these I've written about before, and needless to say those are generally even better deals than they were previously:

Automatic Data Processing (ADP): All good things must come to an end, and ADP's 41-year history of double-digit earnings per share will likely end this year. However, with the stock trading at its lowest P/E since 1990, you don't need heroic assumptions to reach a fair value estimate that's a fair amount higher than the current stock price. The company's competitive position is still quite strong, and a resumption of 11 percent top-line growth a few years out seems pretty doable.

Paychex (PAYX): Strong management plus a small share of a large and growing market plus tremendous free cash flow and shares that are trading at a 40 percent discount to our fair value estimate all add up to a solid buying opportunity. This one's riskier than ADP, though, so bear that in mind when finding a place for it in your portfolio.

J.P. Morgan Chase (JPM): Even if you assume much higher charge-off levels this year and next, the company's dividend looks pretty secure - which makes that 6.2 percent yield awfully enticing. (For what it's worth, the firm's capital position improved even in the weak second quarter.) Every few years, some panic or other gives you a chance to buy many financial firms on the cheap, and they all blow over eventually. This one's unlikely to be any different.

Washington Mutual (WM): After a big runup earlier this year, WaMu's shares have retreated back to the low $30s, where they trade at a 35 percent discount to our $50 fair value estimate and a P/E of just 8. (Yes, eight.) The thrift's exposure to rising interest rates isn't nearly as bad as the market seems to think - WaMu originates a lot of adjustable-rate mortgages when rates rise - and the firm's push into consumer banking is going very well so far.

Costco (COST) and Wal-Mart (WMT): The story on both of these companies is largely the same: Well-managed category killers that have so far steamrolled over everything in their paths. As a result, neither company's shares have been affordable until the recent market downturn. Both focus exclusively on discounting - the most consistently growing area of retail - and both should weather any weakness in consumer spending better than their peers.

Pepsi (PEP): Here's another wide-moat, low-risk stock that's substantially undervalued. Pepsi's management did a great job in its recent conference call of addressing investor concerns up front. Rather than rehashing the press release, they spent the first half-hour addressing the questions they expected most people were wondering about, then spent another hour answering questions. They're starting an aggressive buyback program this week, and one of the analysts on the call said that buying back their own stock at these prices is the best investment Pepsi could make right now. We agree.

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