Adviser Q&A
Charles Dow Is Alive And Well
Missy Sullivan, 02.26.02, 1:14 PM ET

	Richard Moroney

Richard Moroney, editor of Dow Theory Forecasts, is an investment newsletter lifer. He began his career at Dow Theory Forecasts right out of college, as an analyst, working his way up to the editor's perch in 1994. Along the way, he received his MBA from the University of Chicago, and he recently took on the role of chief investment officer for Horizon Investments (Horizon Publishing is the newsletter's parent company), with $30 million currently under management. While it takes its name from the market theory developed by Charles Dow in the early 20th century, the letter, which has been published since 1946, uses Dow Theory as a starting point for stock-picking, employing a combination of market timing, technical screening and fundamental analysis. The Hulbert Financial Digest rates the Dow Theory Forecast's portfolio as 17% less risky than the market overall, accounting for its steady, but not eye-popping, gains. Over ten years, it has edged out the S&P 12.4% to 12.3%, on a risk-adjusted basis. The letter's Focus List portfolio, which represents its favored top 12-15 stocks, lost only 0.4% last year, versus a 9.2% dip in the S&P 500.

Can you give us a quick recap of the Dow Theory?

It's the original technical analysis developed by Charles Dow, the first editor of the Wall Street Journal, and William Hamilton, the Journal's second editor. The basic idea is this: You want to see the Dow Jones Industrial and Transport averages confirming each other to the upside. When both those averages are reaching important highs, the primary trend of the market is considered bullish. When both of those averages are reaching lows, the primary trend is considered bearish. When they diverge, that's a yellow flag and you should be alert to a possible change in trend.

So what do the averages tell us now?

We've been bearish since October 1999. We've had a bear market, reaching important lows on Sept. 21. For a change in the primary trend, what you need to see is a rally off the lows, then a correction and then a move above the rally highs. On the Industrials, we had the move down to 9389.48 on Sept. 21. Then on Jan. 4 we hit 10,259.74--that's our rally off of bear-market bottom. Then we reached the most recent low after that, 9618.24, in early February. We regard that as a significant correction. It retraced nearly one-third of the move up off the lows. Now the question is, if the Industrial and Transport averages are going to move up through the January highs, then the Dow Theory primary trend would shift to bullish. Until then, we're still taking a cautious stance. That means 33% of your equity portfolio in cash as a hedge.

We might miss a few points by waiting for the Industrials and Transports to clear those January highs, but we're also lowering our risk of the whole rally failing and going back for a retest of the September lows. With Dow Theory, you never get to the exact bottom or sell at the exact top. You're trying to get the big swing on those big moves and capture that vast majority of an advance. It's been a pretty choppy market and you can get whipsawed, but the theory has done a pretty good job over the past several years.

Burton Malkiel and others over the years have discredited the Dow Theory as less effective than a buy-and-hold strategy. But there were some finance professors at Yale and NYU who recently did a long-term study of the theory using artificial intelligence software, discovering that it has beaten buy-and-hold by 4.4% annualized from 1930-1997. Is that your best defense of the Dow Theory?

Our defense is that it works. We've been doing this letter since 1946, and our renewal rate is 80%, so obviously our subscribers aren't paying for bad advice. The long-term record of the Dow Theory is pretty good, not foolproof. Over the last century, 25 of last 27 bull market signals we've given have been profitable signals that got you out with a profit when the Dow Theory went bearish. But the theory does require some interpretation. I wouldn't rely entirely on it, but as a way to frame the market, it's a good thing for your toolbox.

How often do you make picks, and how long do you hold?

Every week we publish our buy list and our focus list, and we generally look 12 months out. Sure, we've had some stocks for decades; for instance, we've had Exxon on there since the 1950s. We try and reduce turnover and look toward the long term. But in terms of our top buys, we're generally looking at whether these stocks can beat the market for the next 12 months. The typical holding period tends to be longer than that, more like 18-24 months.

Do you mostly buy large cap stocks?

The bulk of stocks that we monitor are large cap. But our buy and focus lists are roughly 40% mid cap, 5% small cap and maybe 50%-60% large cap. But our subscribers also receive a small cap letter, which has gained 11% annualized since Hulbert started tracking it. With still more money coming into the small cap area, the letter's had a lot of success recently.

So what would you recommend among your recent small cap picks?

One recent addition to our small cap list is a generic drug company called Sicor. We had a great deal of success with it last year; it went from around $10 to almost $27, and we ended up with a double on it, getting out before it dropped back down to around $15. We put it back on the list in January since it started going sideways. Last week the company came out with an interesting earning report, declaring fourth-quarter profits of $47.5 million, or 41 cents a share, compared with profits of $9.8 million, or 9 cents a share, a year earlier. It has a lot of generics, but they're interesting, niche generics; they're biologicals, so the company won't have a lot of competition. It generally commands better profit margins than your typical generic maker.

What's your sell discipline?

Whenever we put a stock on the list, we write down clearly why we have it on the list and what our objective is for the stock. As soon as it is no longer valid, we'll sell it. If it was a value stock recommendation, and it stops being a value, and we don't see any reason to reconsider how high we think it will go, we'll sell. If it was a stock where we liked its earnings momentum and new products, and then the new products falter and the earnings momentum looks like it's going to fall through, then we'll sell. We do have a proprietary rating system called Quadrix that rates stocks on a percentile basis over a hundred different variables in seven different categories: momentum, quality, value, financial strength, earnings estimates, performance and volume metrics. We use that as a first screen for both buying and selling. We look at earnings revisions and performance of the stock as leading indicators that might raise a yellow flag that something is not fundamentally right. All the other fundamental factors: the earnings momentum, the cash-flow changes. As soon as we get a feeling that it's not acting fundamentally or technically as we expected, we'll get out.

What role does Quadrix serve in interpreting the Dow Theory for your subscribers?

It's basically a first screen. Subscribers can access it themselves and use it how they want. If someone is a pure value guy, they can go and just sort on value. We use it in a more balanced way, looking for as many confirming indicators as possible. Generally, the higher the near-term momentum (and by this, I mean near-term operating momentum) score, the lower the value score. Those are kind of a balancing act. What we're looking for is stocks in the sweet spot, where growth is accelerating and value is still reasonable, all adding up to a conclusion that this is a company that can exceed expectations. We're willing to pay a premium multiple if we think the company is going to deliver premium performance.

What are some of the recommended companies on your Focus List?

Waters Corporation is a company that supplies analytical and lab instruments to industrial, pharmaceutical and food companies. It holds a dominant market position in liquid chromatography and leading positions in mass spectrometry and thermal analysis. The stock got crushed last year due to overproduction and the deflation of genomic hype, but Waters just posted a strong December quarter, and growth should accelerate next year. It ranks a 97 overall out of 100 on our Quadrix ratings, scoring especially well in financial strength and quality. The average Quadrix score for companies in its industry is 32. We added it to the Focus List in the low 30s.

Another one is generic drugmaker Mylan Laboratories. It also scores very well in Quadrix (99 in financial strength, 93 overall), had gangbuster earnings growth last year. It has had a track record for inconsistency, which is part of the game in generic drugmaking. But historically those hiccups for Mylan have been pretty good buying opportunities. The Street is only looking for 2%-3% earnings growth, but we see more potential there. It has some 20 drugs in the pipeline, with seven tentatively approved, including generic versions of Prozac, diabetes drug Glucophage and anti-anxiety drug Buspirone. It is showing strong growth in this quarter, especially due to Buspirone, but it will need to maintain momentum in the June and September quarters.

SunGard Data Systems, which has a really good long-term track record, posted a 15% gain in net income in the fourth quarter. Wall Street has been penalizing acquisitive companies like SunGard, which completed seven acquisitions in 2001. I like its acquisition of disaster-recovery firm Comdisco, and as the financial markets stabilize, I like its investment-support business. This is potentially another double-digit grower. It offers an attractive play on rebounds in both technology and financial services.

You recently highlighted companies with expanding profit margins. Which do you like?

Henry Schein is a company we put on the Focus List at the end of December. It's the leading distributor of health care products to dental and medical private practices in North America and Europe. It's done a good job accelerating its sales growth both internally and through acquisitions. It's also done a good job holding down expenses, boosting its operating margin to 5.6% in the first nine months of last year. We could rank it a 'buy,' but have it as 'accumulate' now. If there's a chance to buy in the $35-$39 area, at that price it would be reasonably valued. It's a good solid company.

ADP is a company that is suffering in the short term due to problems in the labor market and in the securities industry, which it services. Those two things have slowed down sales growth, yet the company has still been able to boost its profit margins through cutting expenses. We feel as sales growth accelerates, the margins should continue to expand, and the company's long record of sustainable growth should continue. It's a more richly valued stock than you'd typically see on our Focus List, but we felt that at these prices that it still had upside given the company's track record of posting record sales and earnings for 162 consecutive quarters. And in this kind of environment, it's a company people will pay up for.

I see that a company called Rent-a-Center scored a 98 out of 100 on your Quadrix scale. Is that a hidden opportunity?

I'm not really familiar with that company. I should reiterate that our Quadrix tool is just a first screen. Like any quantitative tool, it's backward looking. Enron scored high when it was trading at $4, even though things were in the process of getting crushed. Until the profit comparisons start to show up as negative, Quadrix can let you down with some of those high scores. It's true that if you had bought all the companies that scored 80+ on Quadrix over the last seven quarters, you would have gained almost 20%. But I would caution anyone using it as a singular tool, because you need to look past the score. In the case of Rent-a-Center, there are reasons to be wary of renters and leasers in general--especially because the way they can count for depreciation can lead to aggressive accounting.

What do you like in your mutual fund portfolio?

We recommend quite a few, with a balance between growth and value and different cap spectrums as well. One that we like among large cap value: Excelsior Value and Restructuring. They've done a good job. If you're looking for a place to put some of that 33% cash allocation, we like two Vanguard bond funds: Vanguard Total Bond Market and Vanguard Short-term Corporate. There is an interest-rate risk, but it's small and the costs are low. If you're looking to play a tech rebound, one fund we're sticking with is Turner Mid-Cap Growth. It's going to be volatile, have big swings, because it's in fast-growing companies. This is for the more aggressive end of your portfolio.

Any specific sectors look particularly interesting as we emerge from this bear market?

We do have a fondness for pharmaceutical companies. We've always been market weight or overweight in that area. But right now, I'd say that we're warming to energy. If the economy is coming back, people will be surprised at how energy prices and the energy industry will bounce back. I'm still looking for high quality ways to play that. In the integrated camp, it would be Conoco, strong in natural gas, which is merging with Phillips, which is particularly strong in oil refining. A defensive way to play natural gas is Questar. It's a diversified play, 60% exploration and production. The stock has been bouncing around; it's around $23, but could trade close to $30 in 12-18 months.

What's the biggest mistake you see investors making?

Seeing things as values. A lot of investors assume that just because something is down substantially, it will come back as soon as the economy comes back. An example would be Cisco. Sometimes we put a stock on the sell list and we'll get a call from subscribers wondering why, if we bought a stock at $40, would we want to sell it when it's such a bargain at $30? You have to remember: If your original rational for buying is not valid, the best thing is to sell and look at it later.

Where have you learned your most painful lessons?

We got hurt his year with NRG Energy, the world's third-largest independent power company, which is 75% owned by Xcel Energy. (Xcel said it plans to buy back the 24% of NRG that it doesn't own.) The stock corrected severely last year, first during the California power crisis and then again in the fall when there were worries about a nationwide power glut. And we think the company has been unfairly tarnished by the whole Enron thing. As it turns out, it won't be a disaster. NRG is poised for growth, and I think there will be participation in the power plant market when it comes back. But looking back, we learned that perception sometimes becomes reality--the fact that everyone is so scared has real impact.

Thanks.

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