t’s easy to get caught up in a company’s story– the latest and greatest product in the pipeline, a perceived positive change in management. Even when that story proves itself out in the data (as it tends to do, especially in Knowledge Leaders) all of the buzz may not translate into relative outperformance of a company’s stock. Take, for example, DM EMEA Health Care companies, a group that has performed very well over the last several years (second only to DM EMEA Information Technology companies):

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Narrowing the universe to only our Knowledge Leaders in the region, we see that Health Care has been the top performer on an absolute and relative basis over the last four years:

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When looking at the tables above, you’ll also note that only the Consumer Discretionary Knowledge Leaders in DM EMEA have performed worse than the constituents of the Health Care sector over the last three months. This only highlights that, in spite of continued qualification as a Knowledge Leader in our universe (details on the screening process here), a company with excellent fundamental characteristics does not necessarily equate with stock (out)performance.

An average, the DM EMEA Health Care Knowledge Leaders invest ~11% of sales on R&D and another ~7% of sales on advertising & firm-specific resources, generating a stock of intangible capital that is equivalent to nearly 20% of total assets.

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In addition to above average returns, this stock of intangibles results in the highest margins among any DM EMEA Knowledge Leaders:

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Finally, although average valuations have risen strongly over the last several years, one can make the case that Consumer Staples, Information Technology, and Materials Knowledge Leaders look more expensive–either relative to the MSCI Word or to their respective 10-year averages:

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So, we have a group of stocks that is not terribly overvalued and which exhibits desirable fundamental characteristics. Great–the portfolio selection process should be a snap! Except then we look at the companies’ relative performance in our point-and-figure charts:

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The topping and breakdown formations seen above indicate that investors are distributing or selling their interests in these companies. Typically, these distributive patterns tend to last for quite some time and are scenarios in which one should avoid any participation. After all, a portfolio of underperforming stocks tends to underperform. While the Health Care sector in DM EMEA doesn’t offer much in the way of good stocks for our portfolio, we are beginning to see opportunities in other (slightly more surprising) sectors. More on that soon!

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