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Executive Summary January 6, 2012

The Economy

Throughout much of the second half of 2011, the US economy defied the gloom and doom crowd, showing improvement in several key areas. And as 2012 begins, we're seeing more of the same, with a series of solid, if unspectacular, economic reports.

For starters, new claims for unemployment have for the past two weeks remained well below the 400,000 mark -- a level that proved difficult to break through throughout much of 2011. The four-week moving average of new claims has now fallen to levels not seen since the spring of 2008. Continuing claims remain around levels last seen in September 2008. Overall, unemployment remains far too high for the economy to be considered healthy, however. The Labor Department is scheduled to release its December jobs report today, and another significant decline in the unemployment rate would go a long way toward improving investor sentiment.

Solid data also came from the manufacturing sector, which expanded in December for the 29th straight month, according to the Institute for Supply Management. The expansion accelerated for the month, with the sector growing at its fastest pace since June of last year. The new orders subindex reached its highest point since April of last year, and the employment subindex rose significantly.

The service sector also expanded at an accelerating rate, according to ISM. It was the 25th straight month that it expanded, with the new orders and employment sub-indices also showing slight improvement.

The housing market, meanwhile, offered some mixed news. On the positive side the National Association of Realtors' Pending Home Sales Index rose 7.3% in November, according to new data. The index now stands at its highest point since April 2010, when buyers were rushing to try to meet the homebuyer tax credit deadline.

Home prices, however, continue to fall. The S&P/Case-Shiller Home Price Indices fell in the October, with the 10 city index falling 0.5% versus September on a seasonally adjusted basis, and the 20 city index falling 0.6%. The 10 city index is now 3% below where it was a year ago, and the 20 city index is 3.4% below the year-ago level.

Of course, the European debt crisis continues to hover over the markets. The situation remains in flux, with investors reacting -- and often overreacting -- to every new detail that emerges from across the pond.

Throughout the past fortnight, the European fears duked it out with the improving domestic economic numbers. Overall since our last newsletter, the S&P 500 returned 2.2%, while the Hot List returned 1.9%. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 129.2% vs. the S&P's 28.1% gain.

A Guru Year In Review

The past year was a difficult one for the Hot List, with the portfolio producing its worst performance relative to the S&P 500 since its 2003 inception. While the S&P was flat for the year (excluding dividends), the Hot List fell 16.2%.

For much of the year the portfolio was actually faring quite well. On July 22, it was up 7.8%, and beating the S&P. It had found big winners in stocks like GT Advanced Technologies, which gained 33.1% in just one month, GameStop Corp., which jumped more than 40% from September 2010 through early July, and Ancestry.com Inc., which rose 17% in a one-month stint in the portfolio.

But as European debt fears heightened, and political squabbling brought the US close to a historic default on its own debt, stocks tumbled, and the Hot List really suffered. In the two weeks between our July 22 and August 5 newsletters, the portfolio fell about 15%. Over the next two weeks it fell another 8% or so, and it never recovered.

Some of the declines were no doubt due to more economically sensitive value-type picks being hit harder amid all the fear. There were also some stock specific issues. Lincoln Educational Services lost 40% during a one-month stint in the portfolio, thanks in large part to the firm's announcement that it was significantly decreasing its 2011 earnings outlook. AmTech Systems, meanwhile, lost about 57% during the four-month stint in the portfolio -- much of which came during the month of August, when the firm announced very strong sales and earnings numbers, but a dramatic decline in orders.

Another firm that took a big hit around that time -- but not just because of the economic concerns -- was GT Advanced Technologies, which had been a big winner during its earlier stint in the Hot List. On its return to the portfolio in September, GT was impacted by a number of factors specific to the solar industry, including one -- the bankruptcy of fellow solar firm Solyndra -- that was more of "guilt by association" than any real problem with GT itself. Nevertheless, the stock tumbled close to 40% during its one-month stint in the portfolio.

These types of losses are certainly disappointing and frustrating. But when you're running a focused portfolio, occasional painful losses on individual positions are inevitable. And for a fundamental-based system like ours, which removes emotion from the equation and focuses purely on cold hard facts, the portfolio can be particularly vulnerable at times when investors are letting fear get the best of them. This summer, between the broader market fears and some of the stock-specific issues we encountered, the market gave us a fairly painful one-two punch. But the portfolio is still far, far outperforming the market over the long haul, having generated annualized returns of more than 10% since its 2003 inception (through Jan. 4), vs. just 2.9% for the S&P 500.

The Hot List's 2011 struggles didn't mean that some of my individual 10-stock guru-based portfolios didn't have strong years, however. My Momentum Investor portfolio, for example, returned more than 20% for the year. My James O'Shaughnessy-based growth/value model returned 13.3%, mostly on the strength of its growth picks. And my Warren Buffett-based portfolio posted a strong 10.2% return, despite the market turbulence. Other individual models to beat the market were my Martin Zweig-based growth model, and my Motley Fool-based small-cap growth strategy. The Fool-inspired portfolio has now beaten the broader market in each of the nine years since its inception, a remarkable feat, and it is now my top performer over the long haul. It has returned more than 200% since its 2003 inception, vs. just 27.7% for the S&P (through Jan. 4).

On the other side of the coin, there were some major laggards among my individual 10-stock portfolios. My Joseph Piotroski-based portfolio lost 24.4%; my Peter Lynch-inspired portfolio fell 21.4%; and my Benjamin Graham-based portfolio lost 19%. All three of those strategies still have excellent long-term track records, however, with the Piotroski-based model more than tripling the market since its inception, the Lynch portfolio more than doubling the market, and the Graham-based model more than quadrupling it.

All in all, the strategies that go into the Hot List are still very good strategies. Eleven of the twelve individual strategies are beating the S&P over the long term, and the one that isn't (the John Neff-based portfolio) was in a virtual dead heat through Wednesday. In fact, most of the individual 10-stock portfolios have more than doubled the index's returns over the long haul, with several tripling or even quadrupling it.

The silver lining in this year's subpar performance for the Hot List is that some of the big losses we took on specific positions appear to be anomalous. I do not, for example, expect to see too many more instances of stocks gaining 26% between the time my models identify it and the time it gets locked into the portfolio, as Stamps.com did. So while some of these poor performers caused short-term pain, I don't believe that they are indications that the models that go into the Hot List have stopped working. Far from it. These approaches focus on fundamentals that get to the core of good business and good investing. Fundamentals like return on equity, debt/equity ratios, price/earnings ratios, and dividend yields always been good ways to evaluate companies and their stocks, and they will continue to be going forward.

In addition, the US economy not only weathered the storm in the second half of 2011, it showed significant improvement in a number of areas. And, ever so slowly, the European debt crisis is getting closer to a resolution. So as we head into 2012, I'm confident that the Hot List is very well positioned to rebound and add to its exceptional long-term track record.

Editor-in-Chief: John Reese

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Guru Spotlight: Martin Zweig

Generally, my Guru Strategies have a distinct value bias. The majority of these models -- ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy -- are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.

But that doesn't mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we'll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock's earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently -- and that their growth was coming from the right sources.

Zweig's thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.

Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotlights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls.

A Serious Strategy

Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:

Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not cost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).

Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

Macro Issues

There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).

Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 89.8%, or 7.9% per year, while the S&P 500 has gained just 27.7%, or 2.9% per year.

Last year, the Zweig portfolio posted positive returns (+1.7%) while the S&P was flat. The model tends to choose stocks from a variety of areas. Here are the portfolio's current holdings:

Quality Systems Inc. (QSII)
SolarWinds, Inc. (SWI)
IntercontinentalExchange, Inc. (ICE)
Intuitive Surgical, Inc. (ISRG)
Buffalo Wild Wings (BWLD)
Cash America International, Inc. (CSH)
Discover Financial Services (DFS)
Synovis Life Technologies, Inc. (SYNO)
Altisource Portfolio Solutions S.A. (ASPS)
American Public Education, Inc. (APEI)

As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.

What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

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

TX   |   FRX   |   JOSB   |   BPI   |   CSH   |   CPLA   |   ARO   |   BIG   |   DV   |   PBR   |  

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. It sells substantially all of its products exclusively under the Jos. A. Bank label through its 506 retail stores (as of January 29, 2011, which includes 12 outlet and factory stores and 14 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. It sources substantially all of its merchandise from suppliers and manufacturers or through buying agents using Jos. A. Bank designs and specifications. The Company operates in two segments: Stores and Direct Marketing. The Stores segment consists of all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment consists of its Internet and catalog operations.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. These services include secured non-recourse loans, commonly referred to as pawn loans and unsecured consumer loans. The Company's consumer loan portfolio includes short-term single payment loans, longer-term multi-payment installment loans, credit services and participation interests purchased from third parties in the micro line of credit (MLOC) services channel. Through the Credit Services Organization program (the CSO program), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization on behalf of consumers. As of December 31, 2010, it operated in two segments: retail services and e-commerce. During the year ended December 31, 2010, the Company renamed its Internet Services Division as the E-Commerce Division.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

Aeropostale, Inc. is a mall-based, specialty retailer of casual apparel and accessories, principally targeting 14 to 17 year-old young women and men through its Aeropostale stores and 7 to 12 year-old kids through its P.S. from Aeropostale stores. The Company designs, sources, markets and sells all of its own merchandise. P.S. from Aeropostale products can be purchased in P.S. from Aeropostale stores, in certain Aeropostale stores, including its new Times Square store in New York City and online at www.ps4u.com. As of January 29, 2011, it operated 965 Aeropostale stores, consisting of 906 stores in 49 states and Puerto Rico, 59 stores in Canada, as well as 47 P.S. from Aeropostale stores in 13 states. In addition, pursuant to a Licensing Agreement, one of its international licensees operated 10 Aeropostale stores in the United Arab Emirates as of January 29, 2011. During March 2011, it announced that it had signed a second licensing agreement.

Big Lots, Inc. is a closeout retailer. The Company's merchandising categories include Consumables, Furniture, Home, Hardlines, Seasonal, and Other. The Consumables category includes the food, health and beauty, plastics, paper, chemical, and pet departments. The Furniture category includes the upholstery, mattresses, ready-to-assemble, and case goods departments. Case goods consist of bedroom, dining room, and occasional furniture. The Home category includes the domestics, stationery, and home decorative departments. The Hardlines category includes the electronics, appliances, tools, and home maintenance departments. The Seasonal category includes the lawn and garden, Christmas, summer, and other holiday departments. The Other category includes the toy, jewelry, infant accessories, and apparel departments. At January 29, 2011, it operated a total of 1,398 stores in 48 states. In July 2011, the Company acquired Liquidation World Inc.

DeVry Inc. (DeVry) is a provider of educational services and the parent organization of Advanced Academics, Becker Professional Education, Carrington College and Carrington College California, Chamberlain College of Nursing, DeVry Brasil, DeVry University, and Ross University. These institutions offer a range of programs in business, healthcare and technology and serve students in middle school through postsecondary education, as well as accounting and finance professionals. In August 2011, the Company acquired the business operations of privately held American University of the Caribbean.

Petroleo Brasileiro SA Petrobras (Petrobras) is a Brazilian integrated oil and gas company. It operates in five segments: exploration and production; refining, commercialization and transport of oil and natural gas; petrochemicals; distribution of derivatives, electrical energy, biofuels and other renewable energy sources. Directly or through its subsidiaries, Petrobras is engaged in the research, extraction, refining, processing, commercialization and transport of oil from wells, shales and other rocks, its derivatives, natural gas and other liquid hydrocarbons, as well as in activities related to energy, promoting research, development, production, transport, distribution and commercialization of all forms of energy. As of December 31, 2010, it had 132 production platforms, 16 refineries, 291 vessels, 29,398 kilometers of pipelines, six biofuel plants and 16 thermoelectric plants. On December 27, 2011, the Company acquired remaining 80% capital of CPDU to own the company completely.

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.

Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.

Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.