How to follow Jubak's 50

The method is simple. At the beginning of the year, I pick five stocks to drop from the portfolio because the companies haven't run their businesses in the way that I want in a long-term portfolio holding, because they no longer can take advantage of the original long-term trend or because the trend has evaporated.

(That last one hasn't happened yet with any of the 10 trends I described in my book in 2008, although the environmental trend sure looks tattered at the moment. The book is out of print, by the way, but you can still order a used copy.)

I replace those five companies with shares of five companies that I think have what it takes to profit from one of these trends over the next five years.

In these buys and sells, I'm not trying to reinvent the wheel. I'm using the rules that were developed by long-term investors over the years and that have worked well.

The buying rules involve looking for companies with:

  • A lasting competitive edge. Morningstar calls this a "wide moat." Peter Lynch famously advised looking for businesses that even an idiot could run because one day an idiot will. Other long-term investors such as Warren Buffett look for companies that have built up the value of a brand name that assures their continued dominance in a market.
  • A return on invested capital that's higher than those of competitors. This is insurance, since it means that a company will have lots of profits to reinvest (at a higher-than-average rate of return) in staying a step or more ahead of competitors.
  • A history of research and development (or acquisition and development) that demonstrates a company doesn't fall asleep at the switch, knows how to press its advantage over competitors and can manage the change that sweeps through all parts of the global economy with increasing power these days.
  • A conservative management style that balances risk -- since companies don't survive long term unless they take risk -- with safety. Things can still go wrong at companies like these, but conservative management avoids bet-the-company gambles. An ability to recognize long-term global economic trends and to ride them even at the cost of disrupting the company's existing business is critical.

And the simple selling rules include:

  • Sell when the reason you bought the company in the first place no longer applies.
  • Sell when the long-term trend that the company is riding turns in a direction the company didn't expect or dissipates entirely. No use investing in even the world's best buggy whip company when cars are replacing horses.
  • And sell when a stock looks so overvalued that it has taken up a lot of the room to run in the larger trend.

At the same time that I pick five stocks to add and five to drop, I name five more already in the portfolio I think are especially appropriate that year for any portfolio -- buy-and-hold, buy-and-review, whatever.

The result is an annual list of 10 stocks to buy now for the next 10 years.

I'd add one other rule to these, one that wasn't so important to stress when stocks were headed up and up. The other part of selling high has always been buying low. After a year like 2011 in my annual revision, I'm looking to add long-term picks that play long-term trends but that are currently trading at very beaten-down prices.

The 5 to dump

So what companies get the ax as we start 2011?

That's not as easy a question as it might seem after a big down year in the portfolio. Just as in a bull market, when some pretty shaky companies look like winners, in a bear market some very good companies look like losers.

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Let me stress that I'm not looking to jettison a stock from this list just because it lost big money in 2011. That's a sure way to buy high and sell low. What I want to do is get rid of those companies that, on a fundamental level, look like they've lost their ability to profit from the long-term trends I've identified.

  • Central European Distribution (CEDC, news). The company's strategy of building market share in the distribution of vodka and other liquors in Poland, Russia and the rest of Eastern Europe by acquisitions went haywire during the past year. The company wound up acquiring brands for the sake of acquiring brands, and the result was a stable of labels that often competed with one another. Unfortunately for the company's ability to recover from this misstep, its early success has validated the attractiveness of this market to the extent that bigger liquor producers and distributors are moving in. I think Central European Distribution can sell out to a bigger competitor, but I don't think it can recover to take advantage of rising incomes and rising consumption in Eastern Europe. The pick lost 80.9% in 2011.
  • Deltic Timber (DEL, news). Deltic Timber was one of the portfolio's better-performing stocks in 2011. So why am I taking it out of the portfolio now? Because I think the trend that makes Deltic valuable -- the conversion of timber-producing land into real estate -- will be more profitable in the years ahead if you own more land than Deltic's 439,000 acres and if you own it in what are likely to be, once the housing market returns, higher-demand areas than Arkansas and Louisiana. (Remember that this is a long-term portfolio, so I'm willing to look ahead five years or so.) I'll also add a timber-to-real-estate play to the portfolio to replace Deltic. This pick gained 7.7% for 2011.
  • Encana (ECA, news). The company's December 2009 split into two companies was supposed to highlight the value of the U.S. and Canadian natural gas assets that Encana kept. The new company, Cenovus (CVE, news), got the Canadian oil sands and refining assets. Instead, the split has served to emphasize Encana's exposure to a glut in North American natural gas that could keep prices depressed for years. Encana still has a huge number of acres under lease, but there are North American energy companies with a more attractive asset mixes. The pick lost 33.6% in 2011.
  • First Solar (FSLR, news). This thin-film solar energy company saw the competitive ground shift against it in 2011 -- and the shift doesn't seem likely to reverse in quick order. First Solar's strategy has been built upon the superiority of its technology: Thin films aren't yet as efficient at turning sunlight into electricity as crystalline silicon technology is, but they are a whole lot cheaper. Make them cheap enough and improve efficiency as well, and at some point the technology leaves crystalline silicon solar cells in the dust. But this year, the key competitive advantage in the solar sector shifted to financing. You could also provide cheap financing to utilities to build projects that used your solar product. If you had access to cheap money, you could continue to build production capacity, even if the industry was awash in capacity that no one needed, and then cut prices to gobble up market share even if you lost money on what you produced and sold. That gave the big edge to Chinese solar manufacturers Yingli Green Energy (YGE, news) and Trina Solar (TSL, news), for example, and manufacturers in other countries, such as SunPower (SPWRA, news), that benefit from parents with deep pockets. This pick lost 74.1% in 2011.
  • Kinross Gold (KGC, news). Kinross got so deeply involved in adding new gold reserves that the company lost its focus on costs. Gold production indeed climbed in 2011, rising 13% year over year in the fourth quarter, for example. But cash costs soared to $634 per gold equivalent ounce in the fourth quarter of 2011 from $517 in the fourth quarter of 2010. Some of these costs came from higher fuel, labor and royalty costs, but the increase that will be hardest to do anything about stems from rising production in Kinross' higher-cost West African mines. Add in a huge backlog of projects under development, and I don't see management having the bandwidth to effectively tackle rising costs. This pick lost 39.3% in 2011.

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