6 Stocks That Need Replacing

10/03/2011 10:00 am EST

Focus: STOCKS

Richard Moroney

Editor, Dow Theory Forecasts

It’s just as important to know what to sell as it is what to buy, and it’s also just as important to remember why you bought your long-term stocks, writes Richard Moroney of Dow Theory Forecasts.

For my money, there are two ways to manage a stock portfolio:

  1. Relentlessly strive to limit your portfolio to your very best ideas, selling current holdings whenever you need to make room for a better name.
  2. Assemble a diversified portfolio of attractively valued shares of high-quality companies, limiting portfolio turnover, and selling when the original rationale for owning a stock is no longer valid.

In hindsight, we’ve allowed the differences between the Buy List and Long-Term Buy List to blur somewhat in recent years. We’ve held a few Buys too long, partly because we felt some high-quality names were due for a rebound. And we’ve been too quick to sell a few Long-Term Buys, partly because the stocks seemed likely to move lower in the near term.

Going forward, we plan to run the Buy List and Long-Term Buy List in stricter accordance with their mission statements, even if that means the lists have fewer names in common and the Buy List sees higher turnover. As part of this plan, we’re making several rank changes this week.

We’re dropping four stocks from our Buy List that no longer rank among our best year-ahead picks, even though all four qualify as Long-Term Buys based on their 24- to 48-month potential. We’re adding five stocks to the Buy List, including Microsoft (MSFT) .

Microsoft’s decision to raise its quarterly dividend 25% to 20 cents, payable December 8, disappointed some who were looking for a bigger hike. But the increase lifts the stock’s yield to 3%, and the share price seems capable of reaching $33 over the next 12 months.

Also, we’re replacing IBM (IBM) with Intel (INTC). We continue to like IBM, but we now prefer Intel for year-ahead returns.

Apache (APA) is being dropped from the Buy List but retained as a Long-Term Buy. In each of the last five quarters, Apache delivered growth of at least 31% in sales and 27% in operating profits. The August dip in oil prices weighed on many energy stocks, but Apache suffered more than most.

Apache shares have slumped 21% from their July highs, third worst among independent producers in the S&P 500 Index. We still like Apache’s prospects, but we are not as confident it will outperform over the next year. Chevron (CVX), with a cheaper valuation, seems like a better bet for the next 12 months.

BASF (BASFY) is being dropped from the Long-Term Buy List. The stock has slumped since the German chemical giant reported weaker-than-expected earnings for the June quarter.

Consensus estimates project per-share profits will be up 2% this year and down 5% next year. Just two months ago, Wall Street expected profits to jump 20% next year.

The company’s balance sheet is solid, but continuing problems in European debt markets could lead to higher funding costs. Considering all the uncertainty, BASF should be sold.

Dover (DOV) is being dropped from the Buy List but kept as a Long-Term Buy. We had hoped the stock would bounce after the early September sell-off. But the maker of industrial equipment can’t seem to gain traction.

Dover does look cheap, trading at less than 13 times trailing earnings. Couple that valuation with a diversified mix of businesses and the potential for long-term double-digit profit growth, and you have a textbook Long-Term Buy. But a near-term breakdown below $49 would not be surprising if industrials continue to weaken.

Hewlett-Packard (HPQ) is being dropped from the Buy List but retained as a Long-Term Buy. The stock bounced September 21 on reports the board is considering replacing CEO Leo Apotheker, who has presided over three revenue warnings in less than 11 months on the job.

While we would not be surprised by a near-term move to $27 or $28, we prefer other tech names for 12-month returns.

JPMorgan Chase (JPM) is being dropped from the Buy List, but the stock remains a Long-Term Buy based on its modest valuation and financial strength relative to its banking peers.

The stock, yielding 3.1% and trading at seven times trailing earnings, seems likely to deliver attractive returns over the next 24 to 48 months. But profit estimates are under pressure, and an earnings shortfall in the September or December quarters would not be surprising.

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