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Executive Summary July 18, 2014

The Economy

Another strong jobs report has highlighted a good fortnight for the economy, helping keep stocks near all-time highs.

The June jobs report showed that the private sector added 262,000 jobs during month, the fourth straight month the figure has topped 200,000. April and May's total nonfarm payrolls were also revised upward by a total of nearly 30,000. The unemployment rate fell to 6.1%, the lowest it has been since September 2008. The number of people not in the workforce did climb by 111,000, but the "U-6"unemployment rate, which unlike the headline rate takes into account those who have given up looking for a job, dipped slightly to 12.1%. That indicates that the increase in those out of the labor force wasn't due to discouraged workers giving up the job search.

Industrial production increased 0.2% in June, meanwhile, according to a new Federal Reserve report, with manufacturing output rising 0.1%. Mining output also rose, by 0.8%, while utility output, which tends to be seasonally driven, fell 0.3%. May's industrial production gain was revised downward slightly from 0.6% to 0.5%.

The service sector also expanded in June for the 53rd straight month, according tho the Institute for Supply Management, doing so at almost the same strong pace as it did in May. The New Orders sub-index continued to rise and is at an extremely strong level, while the Employment sub-index made a nice gain, indicating that employment conditions in the sector keep improving. Prices remained elevated, meaning inflation continues to be something to monitor.

Retail and food service sales increased 0.2% in June, according to the Commerce Department. They are now about 4.3% above where they stood a year ago, a fairly healthy year-over-year increase.

Housing market data was one of the only weak spots. Housing starts fell 9.3% in June, according to the Census Bureau, though they are still about 6% above where they were a year ago. Permit issuance for new construction fell 4.2%, but is 6.7% above year-ago levels.

Since our last newsletter, the S&P 500 returned -1.4%, while the Hot List returned -2.2%. So far in 2014, the portfolio has returned -14.3% vs. 5.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 211.6% vs. the S&P's 95.7% gain.

Portfolio Update

With optimism about solid economic data being tempered by fears of stretched valuations, stocks have ended up right around where they were at the time of our last newsletter, as of this writing. The Hot List has done the same, though the way it has gotten there has been a bit unusual.

For the fortnight, 7 of the portfolio's 10 holdings have been in the red (as of midmorning trading on July 17). But 2 of the 3 winners have been well in the black, helping buoy the overall portfolio's returns. One of the big winners has been Banco Macro, up 11.5%. The stock jumped sharply amid speculation that Argentina will finally reach a deal with creditors to address the country's debt woes. Shares of Argentine stocks in general rose, and a financial like Banco Macro really got a boost.

The other big gainer was Rex American Resources, which jumped 12%. The catalyst appeared to be reports of a very strong coming corn crop, which sent the price of corn tumbling -- prices fell below $4 per bushel for the first time in almost four years, the Financial Times reported. For ethanol firms like Rex, that means higher margins going forward.

On the down side, discount retailer Ross Stores is off more than 7% since our last newsletter. Part of the reason seemed to be that the stock was downgraded to "neutral" from "buy" by Sterne Agee on July 15. Stern Agee cited Ross's struggle to balance margins and traffic, TheStreet.com reported. My models still give Ross very good scores overall, though its scores have fallen a bit since it joined the portfolio two weeks ago; if the Hot List were rebalanced today, the stock would fall just short of remaining in the portfolio. We'll see if that changes by the time of our next rebalancing on Aug. 1.

Overall, the Hot List is still lagging market by quite a bit in 2014. But its long-term track record remains exceptional, making me confident that the recent troubles are the standard short-term rough patches that all good strategies go through. While such stretches certainly are difficult to deal with, we'll stay disciplined, and over the long haul I think we'll reap rewards for our patience.

Editor-in-Chief: John Reese

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Guru Spotlight: David Dreman

While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.

But while most of these gurus are contrarians, one in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.

Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).

How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.

Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)

But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."

This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.

But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P). It struggled in 2013 and is lagging this year again, showing how much volatility a contrarian-focused strategy can have. Still, since its July 2003 inception, the 10-stock Dreman-based portfolio is ahead of the S&P 500, returning 100.3%, or 6.5% annualized, vs. 96.7%, or 6.3%, for the S&P (through July 11).

As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Right now, its holdings include some very unloved firms, including several financials and emerging market stocks. Here's the full list of its current holdings:

Santander Mexico Financial Group SAB de CV (BSMX)
Mobile TeleSystems OAO (MBT)
Chimera Investment Corporation (CIM)
Ecopetrol SA (EC)
Companhia Energetica de Minas Gerais (CIG)
CNOOC Limited (CEO)
Annaly Capital Management, Inc.(NLY)
HSBC Holdings plc (HSBC)
Companhia Paranaense de Energia (ELP)
BCE Inc. (BCE)

News about Validea Hot List Stocks

Valero Energy (VLO): Valero said second-quarter income will be higher than a year ago but short of Wall Street estimates on seasonal weakness in its biggest Gulf Coast market, Reuters reported. Valero expects income from continuing operations of $1.10 to $1.25 per share for Q2, short of analysts expectations of $1.39 per share, according to Thomson Reuters I/B/E/S. Shares fell initially after the news, but recovered quickly.

Banco Macro SA (BMA): Shares of the Argentine bank jumped amid speculation that Argentina will finally reach a compromise with creditors to address its debt crisis, Investor's Business Daily reported. A court ruling has said Argentina must pay off holders of defaulted debt, IBD said, and Argentine Economy Minister Axel Kicillof has now said the country is ready to negotiate with them.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at hotlist@validea.com.

Current Portfolio

Detailed Stock Analysis

Disclaimer: The analysis is from Validea's selection and interpretation of content from the guru's book or published writings, and is not from nor endorsed by the guru. See Full Disclaimer

ANIK   |   VLO   |   AGCO   |   REX   |   BMA   |   XRS   |   ROST   |   COH   |   TJX   |   TECD   |  

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

Rex American Resources Corporation (REX) is a holding company to succeed to the entire ownership of three affiliated corporations, Rex Radio and Television, Inc., Stereo Town, Inc. and Kelly & Cohen Appliances, Inc. As of January 31, 2012, the Company had lease agreements, as landlord, for six owned former retail stores and had 16 vacant former retail properties. The Company also owns one former distribution center that is partially leased, partially occupied by its corporate office personnel and partially vacant. As of January 31, 2012, the Company invested in five ethanol production entities, two of which the Company has a majority ownership interest in. These properties include One Earth Energy, LLC, NuGen Energy, LLC, Patriot Renewable Fuels, LLC, Levelland Hockley County Ethanol, LLC, and one group consisting of Big River Resources, LLC-W Burlington, Big River Resources, LLC-Galva and Big River United Energy, LLC.

Banco Macro SA is an Argentina-based financial institution. The Bank offers traditional banking products and services to businesses and individuals nationwide. It divides its operations into personal banking, which provides services for individuals and microenterprises; and corporate baking, which covers small, medium and large companies, as well as major corporations and agribusinesses. The Bank's products and services portfolio includes loans, insurance, debit and credit cards, investment advice and fixed-term deposits, among others. As of December 31, 2012, the Bank owned fully consolidated subsidiaries Banco del Tucuman SA, Banco Privado de Inversiones SA, Macro Bank Limited, Macro Securities SA Sociedad de Bolsa, Macro Fiducia SA and Banco del Tucuman SA.

TAL Education Group is a holding company for a group of companies engaged in provision of after-school tutoring programs for primary and secondary school students in the People's Republic of China (the PRC). The Company is a K-12 after-school tutoring services provider in the PRC. The Company offers tutoring services to K-12 students covering core academic subjects, including mathematics, English, Chinese, physics, chemistry and biology , history, political science and geography as well as preschool classes. It delivers its tutoring services through small classes, personalized premium services (such as one-on-one tutoring) and online course offerings. As of February 28, 2013, it network consisted of 255 learning centers and 237 service centers in 15 cities throughout China, with most of these learning centers and service centers located in Beijing and Shanghai, as well as its online platform.

Ross Stores, Inc. is an off-price apparel and home fashion chain in the United States. The Company operates two brands of off-price retail apparel and home fashion stores: Ross Dress for Less (Ross) and dd's DISCOUNTS. Ross offers designer apparel, accessories, footwear, and home fashions for the entire family at everyday savings of 20% to 60% off department and specialty store regular prices. Its merchandise offerings also include, but are not limited to, small furniture and furniture accents, educational toys and games, luggage, gourmet food and cookware, watches, and sporting goods. As of February 1, 2014, it operated 130 dd's DISCOUNTS stores in 10 states that features brand apparel, accessories, footwear, and home fashions for the entire family at everyday savings of 20% to 70% off moderate department and discount store regular prices. At February 1, 2014, it operated a total of 1,276 stores, of which 1,146 were Ross locations in 33 states, the District of Columbia and Guam.

Coach, Inc. (Coach) is a marketer of accessories and gifts for women and men. The Company offers a range of modern, fashionable handbags and accessories. Its product offerings include women's and men's bags, accessories, footwear, wearables, jewelry, travel bags, sunwear, watches and fragrance. The Company operates in two segments: North America, which includes sales to North American consumers through Company-operated stores, including the Internet, and sales to wholesale customers and distributors and International, which includes sales to consumers through Company-operated stores in Japan and mainland China, including the Internet, Hong Kong, Macau, Singapore, Taiwan, Malaysia and Korea and sales to wholesale customers and distributors in 25 countries.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office. In December 2012, the Company acquired Sierra Trading Post, an off-price Internet retailer.

Tech Data Corporation (Tech Data) is a wholesale distributor of technology products. The Company's customers include more than 125,000 value-added resellers (VARs), direct marketers, retailers and corporate resellers. The Company sells to customers in more than 100 countries throughout North America, South America, Europe, the Middle East and Africa. Tech Data distributes and markets more than 150,000 products from more than 500 computer hardware suppliers, networking equipment suppliers, software publishers, and other suppliers of computer peripherals, physical security, consumer electronics, digital signage and mobility hardware. In September 2012, it acquired Brightstar Corp.'s 50% ownership interest in Brightstar Europe Limited. In November 2013, Tech Data announced that it had completed the acquisition of joint venture partner Brightstar Corp.'s 50% ownership interest in TDMobility.

Watch List

The Watch List contains the highest scoring stocks according to our guru consensus system that are not currently in the Hot List portfolio. We provide this list both for informational purposes and for investors who are not comfortable with a portfolio of ten stocks.


The names of individuals (i.e., the 'gurus') appearing in this report are for identification purposes of his methodology only, as derived by Validea.com from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this report personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and tradenames appearing in this report are the property of their respective owners, and are likewise used for identification purposes only.

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