Reboot Your Portfolio

New year, new president, same ol' jittery stock market.

Yesterday, as the nation's 44th president was being sworn in, Wall Street was swearing off stocks yet again. Media reports blamed it on renewed worries over the banking industry and/or what Obama didn't say in his inaugural address -- as if that occasion was the proper forum for doling out an economic to-do list.

The result? At the close of the yesterday's market business, the Nasdaq-tracking PowerShares QQQ (QQQQ) had declined by roughly 5%, with such relatively racy heavyweights as Adobe Systems (Nasdaq: ADBE  ) , Oracle (Nasdaq: ORCL  ) , and Cisco Systems (Nasdaq: CSCO  ) all posting big declines.

The less growth-oriented SPDRs (AMEX: SPY  ) suffered a similar fate, with Chevron (NYSE: CVX  ) , Microsoft (Nasdaq: MSFT  ) , and GE (NYSE: GE  ) -- top-ten positions all -- mired deep in the red.

We didn't start the fire
In other words, the fire sale continues -- and the song therefore remains the same: With so many high-quality companies trading for, um, a song, how should savvy types choose among them?

Also complicating matters is this fact of financial life: Like the banks, apparently, many of us are "shoring up our cash positions," otherwise known as hoarding.

How to proceed? Here's a suggestion: Reboot your portfolio. Your lineup may benefit from a jolt of out-with-the-old, in-with-the-new energy.

Selling your duds, after all, could line your brokerage account with cash, giving you moolah you can put to work behind new names that have greater upside potential than your current holdings.

Even if, like Warren Buffett, your favorite holding period is forever -- and it should be -- sometimes cutting your losses is a good strategy. So how can you determine which stocks to cut loose and which to keep?

Turn me loose
For my money (literally), there are three main factors to consider when zeroing in on your portfolio's potential sell candidates -- and returns aren't one of them.

First, whatever value the market has, for the moment, placed on a company's shares, that company's real worth is a function of its profitability, as gauged via a metric like return on equity. If it's not profitable -- and if its prospects in that department seem like a pipedream -- you should let the company dream on while you move on to financially healthier alternatives.

Second, ROE reveals how effectively management has put its shareholder's capital to work, and so it offers something of an analytic twofer: In addition to assessing profitability, you can use ROE to judge the quality of the honchos who run the company. Conference call eloquence is all well and good, after all, but when it comes to investing, I'm after companies that can show me the money, not just talk about it.

Additional items on my managerial checklist: Healthy levels of inside ownership, candid and forthcoming shareholder communications, and a willingness to spend judiciously (as measured by capital expenditures) in order to promote the company's future growth.

Finally, another item I like to focus on when vetting potential buys -- or sells -- is free cash flow. FCF (as the cool kids like to call it) is the number that remains after subtracting a firm's capital investments (e.g., plant and equipment purchases) from the cash it has raked in from operations. The bigger the better, and if a firm's FCF isn't growing, you'll want to find out why.

Frankly, these days I wouldn't spend a moment's time researching -- or holding -- companies that are cash flow negative, unless there are painfully obvious reasons to believe that that condition is going to be temporary -- very temporary. After a downturn that's lasted over a year, there are just too many financially healthy, cash-flow positive contenders.

If a company isn't profitable, isn't being well run, and is cash flow negative, getting out is a no-brainer.

The price you pay
Once your selling has given you some funds to work with, those same three criteria can help you narrow in on companies to buy.

But once you've put your prospects through their profitability and cash-flow paces, you'll need to determine one more thing: whether the market has priced them appropriately.

Valuation work can be tricky (and risky) business: As the market's recent history attests, stocks that look like stone-cold bargains can get colder still, often for reasons that have nothing to do with fundamentals.

The valuation approach I've taken at the Fool service I head up (Ready-Made Millionaire) is known in investment parlance as a "discounted cash flow" analysis. After screening picks for the metrics called out above (among other things), I do the following three things:

  1. Plug in the rate of return I require in light of a company's risk profile.
  2. Make very conservative forecasts about future earnings growth.
  3. Find out whether, at its current price, the firm is trading well below (i.e., 30% or more) its actual value.

If it is? I've just added a company to my buy list.

The result? A clutch of contenders that, based on their fundamental profiles and current stock prices, look poised for long-term outperformance -- regardless of Mr. Market's day-over-day mood swings.

The Foolish bottom line
At Ready-Made, we've identified four companies that fit that profile, and we've combined them with a power trio of world-class mutual funds (and one ETF) into a set-and-forget portfolio that's backed by a million bucks from the Motley Fool. We've taken our lumps out of the gates, but because our holdings continue to fire on all fundamental cylinders, that means just one thing to me: They're even better bargains than when we launched last July.

If you're looking to reboot your portfolio -- perhaps by shedding holdings that don't meet the criteria I've outlined above -- consider taking RMM for a spin. We'll soon reopen to new members, and to tide you over until then, just click here to snag our free special report, The 11-Minute Millionaire. The report provides the inside scoop on our service and outlines three things you need to know before investing another dime in this market. Download it now, and we'll be sure to let you know when RMM reopens.

Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire service. At the time of publication, he didn't own any of the companies mentioned. Microsoft is a Motley Fool Inside Value recommendation. You can check out the Fool's strict disclosure policy by clicking right here.


Read/Post Comments (3) | Recommend This Article (20)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 21, 2009, at 4:02 PM, pthomsen40906 wrote:

    Advertorial! How can i trust it_

  • Report this Comment On January 21, 2009, at 4:13 PM, jakeisme wrote:

    Nothing new about this. Would have cost you about 50% during last 4 months. Better get used to new world; understand balance sheets first. Which of these companies has no cds exposure, and how do you know?

  • Report this Comment On January 21, 2009, at 6:48 PM, Rasbold wrote:

    Even though we probably haven't seen the bottom quite yet, the riverbanks are well exposed. Pick some up gold nuggets before the water returns, anything with a cash flow. They are so cheap, can we expect at least fifty percent? I think so, and sooner than we think!

    Good luck rebuilding and May your Dow never Jones.

    http://www.whatwouldwarrendo.com

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