Aug. 16 (Bloomberg) -- For eight years, from 1999 through 2006, I wrote an annual column about my “Sane Portfolio.” With investors in a cautious mood, it’s time to bring it back.
This selection process for stocks is designed for slightly conservative investors and is intended to have low turnover from year to year. To qualify for inclusion, a stock must pass seven tests:
-- Market value of more than $1 billion.
-- Debt that is less than stockholders’ equity.
-- Earnings growth averaging at least 5 percent a year for the past five years.
-- Return on stockholders’ equity of at least 10 percent in the latest fiscal year.
-- Stock price that is less than 18 times earnings.
-- Stock price that is less than three times revenue.
-- Stock price that is less than three times book value.
No single hurdle is particularly hard to clear. But as of Aug. 11, only 170 U.S. stocks surmounted all seven.
I sift through the qualifiers and select a dozen. Once a stock is in the portfolio, it remains there unless it violates one of the seven criteria.
From the 2006 list, nary a stock remains. Two of the 12 were acquired by other companies. The remaining 10 rose in valuation, fell in profitability or took on too much debt.
The two longest-tenured stocks on the list were Occidental Petroleum Corp., based in Los Angeles, and Ryland Group Inc. of Calabasas, California. Each was on the list for five years. Occidental’s price/sales ratio is now too high. Ryland lost money in 2007, 2008 and 2009 as the homebuilding industry was flattened by an economic steamroller.
So, we start fresh.
My first pick for the new Sane Portfolio is Exxon Mobil Corp. of Irving, Texas, the largest U.S. oil company. In the oil industry, it is said that Exxon has the pick of the best geologists, and often the first crack at the best drilling sites. Yet Exxon’s stock sells for a comfortable 11 times earnings.
In the pharmaceutical industry, Merck & Co. is my pick. I loved its 33 percent return on stockholders’ equity last year. The stock sells for 10 times earnings and offers a 4 percent dividend yield.
Even with dire predictions that the recession would keep people away from Disneyland and Disney World theme parks, Walt Disney Co. averaged a 12 percent annual earnings gain during the past five years. I like the way the Burbank, California, company’s divisions -- movies, television, theme parks and merchandise -- reinforce each other.
Another company that has shown admirable consistency is Gap Inc., the clothing chain. The San Francisco-based company has made a profit every year since losing one penny per share in 2002.
A 148 percent jump in profits in fiscal 2009 helped put Lancaster Colony Corp. on my list. It makes specialty foods as well as glassware and candles. For fiscal 2010, which ended in June, the Columbus, Ohio, company is expected to show a 34 percent earnings gain.
Harris Corp., based in Melbourne, Florida, makes communication systems for governments and businesses. Its products are used by military personnel and by air traffic controllers, oil producers and commercial broadcasters. The stock has tripled in the past 10 years but sells for a reasonable multiple of 10 times earnings.
San Diego-based Cubic Corp. gets about 70 percent of its revenue from defense products and about 30 percent from transportation systems. The defense operations include simulation equipment for training, as well as military electronics. I like its business mix.
The most prosaic stock on the list is Greif Inc., a maker of industrial packaging. I have included this Delaware, Ohio, company as a play on an economic recovery -- something I expect, though few folks seem to agree with me lately.
Representing the financial sector is Chubb Corp. of Warren, New Jersey. A property and casualty insurer, Chubb is quite disciplined in the way it writes and prices its policies. It usually makes a profit on its insurance operations, rather than depending on investment income to make a profit. Last year it paid out 86 percent of premiums in claims and expenses.
Cliffs Natural Resources Inc., with headquarters in Cleveland, is a global mining and natural resources company. About 30 percent of its sales are to China. I’m in the camp that expects China to keep growing substantially.
Demand for Computers
Western Digital Corp., with headquarters in Lake Forest, California, is the world’s second-biggest maker of hard disks for personal computers. I think both businesses and consumers have pent-up demand for new computers. The stock looks like a major bargain at four times earnings, the lowest P/E ratio among qualifying companies.
Given my fondness for the energy industry, I’ll close with another energy pick -- Diamond Offshore Drilling Inc., based in Houston. The entire offshore drilling industry is in disfavor because of the Gulf of Mexico oil spill, but in my view that will change within a year or so.
Disclosure note: For clients and personally, I own shares of Cliffs Natural Resources, Merck and Western Digital. I have no long or short positions in the other stocks discussed in this week’s column.
(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)
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