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Improving Portfolio Management



February 20, 2013 – Comments (1)

 Board: Special Ops Strategy Room

Author: TMFDeej

[The following is from our premium service Motley Fool Special Ops. Click here to take a no-risk, free thirty-day trial of any of our services.]

Last week, I posted a detailed analysis of my real-world investment portfolio here. When I initially began writing that post, it was more for entertainment purposes. I love talking about investing and this was a chance for me to do so with people who are interested in the same subject. However, I ended up learning what I believe is some valuable lessons from the exercise.

I think that the best lesson so far is where my personal strengths are as an investor. I have always adhered to a "hit 'em where they ain't sort" of investment philosophy, meaning I will invest in any type of stock that fits my value with a catalyst mold, regardless of its market cap. What I found in evaluating my portfolio though is that my returns from investing in small cap stocks over the past four and change years are nearly three times as great as my returns from investing in large cap stocks. Who knew? This is definitely something that I would not have noticed the statistical significance of had I not taken a close look at my portfolio.

This may be a result of a number of factors, including the small investors' edge in investing in opportunities that are not large enough for the big boys to bother with, or investing in things that are under-followed (though this is somewhat similar), or that large cap stocks do not have nearly the long runway for gains that small cap stocks do. Whatever the reason, small cap value with catalyst investing significantly outperforms its large cap cousin.

As a result, I have started trimming my large cap holdings over the past week or so. This is actually a good thing because it forced me to sell out of a few positions where for the most part the catalysts that I was looking for have already played out and the "easy" gains are gone.

One old friend that I said goodbye to in real-life and here in CAPS last week was American Water Works (AWK). Back in April 2010 I went long the stock in real money and in CAPS, writing the following:

"To me, Monopoly is the greatest board game of all-time. When playing Monopoly, high-end properties that rake in huge sums of cash when opponents land on them, like Boardwalk, are the most sought after. However, there's always a place in one's Monopoly portfolio for the game's steady, lower-yielding utilities, like Water Works. The same goes for one's real-life portfolios. It's nice to have a few conservative investments mixed in with those that have more upside.

Publications have been all over water utilities lately. I have seen write-ups and recommendations on a number of different companies in the sector over the past several months. The thesis behind the sudden affinity for water companies is that many states and municipalities are having huge budget problems (that's an understatement - the pensions and free healthcare, etc... that the state workers get are nuts but that's a debate for another time that I don't want to get into now). These financial problems may increase the likelihood that state and local governments will sell their water-utility operations off to private companies. I personally would be all for my state selling off any water assets that it hasn't already. It could use the proceeds to pay down its massive wad of debt.

Currently approximately three quarters of all utilities are government-owned, so clearly there a lot potential for growth for publicly-traded companies in the sector.

I certainly can see the logic in this theory, however the privatization of public assets...particularly one as essential as easier said than done. Even if states and municipalities want to sell off their water assets, the public often freaks out and attempts to prevent the transaction (see Trenton, NJ for an example of this).

Even though I believe that the acquisition of public water assets will be more challenging than many believe, I still see some merit in this thesis. Many states are in big, big financial trouble and despite the public outcry they may not have a choice to sell off a number of assets.

Seeking to capitalize on this potential trend, I looked into companies in the sector. I ultimately decided to go with American Water Works (AWK). Some of the people who are familiar with the industry may find this choice surprising.

As the old saying goes, you pay a high price for perfection (or something like that). This is why I often look for companies that are a little dinged up when investing instead of the best-run organizations. The former often have more upside.

Looking at the numbers, a number of the other companies in the sector appear to be run better than AWK. American Water Works' operating margin of 25.5% pales in comparison to Aqua America's (WTR) 35.4% (perhaps the industry's best run company). Furthermore, AWK's actually reported a loss last quarter (as a result of a wetter and cooler than normal weather).

So why did I choose AWK? I went with it because it has all three elements that I look for in stocks.

It's cheap

The company's relatively weak margins and the fact that it actually reported a loss last quarter have made the stock cheap. It currently trades at only 1.55 times sales, versus 1.82 times sales for California Water Service Group (CWT) and 3.75 times sales for WTR. American Water's price-to-sales ratio is a surprising 54.68% below the average of the Water Utilities industry.

It pays a dividend

AWK pays a solid 3.9% dividend that its cash flow from operations easily covers. That's higher than many companies in the sector.

It has hidden catalysts

In addition to the aforementioned potential acquisitions from financially strapped states, AWK has another hidden catalyst that should help its performance down the road. American Water Works was taken private by a German company in 2003. In order to get regulatory approval for the purchase, the German company agreed not to raise prices at all for five years despite the fact that it was spending a lot of money on projects. The end of the five-year no rate hike time period is rapidly approaching. AWK's margins are worse than many of its competitors because it has been spending money on lots of projects yet getting no rate hikes in return. The logic here is that it will be allowed to raise its rates to the point that it receives the 10% return on capital that its competitors are getting on average. I have seen this sort of situation play out with power company rate hike decisions in the past. The companies that have terrible margins are allowed to raise rates, but the ones with awesome margins are not. It's illogical to punish well-run companies and reward poorly run ones, but that's the way the government works I guess. "

So how did the story play out? Well, the whole cash-strapped governments selling off assets thesis did not play out at all, neither here nor in another stock that I attempted to play that theory with, Government Properties (GOV). Having said that, my investment in AWK was a home run. The hypothesis that the company would be allowed to raise rates faster than its competitors after being barred from doing so for five years came true. AWK returned +104.25% for me here in CAPS versus a +27.14% gain in the S&P 500 for outperformance to the tune of +77.11. Why can't they all turn out like this :)?

AWK is still cheap relative to its competitors, which is the reason why I was holding it. However, A) there isn't a catalyst that I am aware of that will cause this to change in the immediate future and B) who's to say that its competitors aren't just overvalued and that their multiples might fall going forward causing the spread to normalize. There wasn't anything wrong with holding onto AWK and its 2.6% dividend, but the big gains are likely gone, so I sold.

Today I reinvested a portion of those funds in a new, smaller company that I will be allowed to talk about later this week. When possible, I plan on trying to focus my future investments on smaller companies, probably not too much of the micro-cap OTC stuff that some bloggers love, but you never know. Suffice to say that I am just looking for things that are smaller in general, smaller than some of the companies that I sold, like the $7 billion AWK. I won't place any rigid restrictions on market cap, other than to say that I'm looking for smaller companies in general.

I also sold off two other large cap positions today that do not appear to have any catalysts that will cause them to outperform in the near future, one that beat the market and one that didn't. Again, I will likely talk about them when I am allowed to later this week.

The cash in my portfolio now stands at a reasonably high (for me) 10% or so, up from the 5.7% that I reported in my previous post. This will give me new money to deploy in attractive investment opportunities that I believe have catalysts that will unlock value in the more immediate future. It also provides me with some fund that I can use if this whole fiscal cliff debate causes a sell-off in the markets as a whole.

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1 Comments – Post Your Own

#1) On February 20, 2013 at 11:15 AM, Teacherman1 (< 20) wrote:

Welcome to the "Dark Side" Deej.:)

Will be looking forward to seeing what you like in the Small Caps sector.

Hope to be able to "poach" from your future picks as you lay out your reasoning in coming blogs.

Good luck.

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