The Economy

Economic news has continued to be mixed over the past two weeks. At the time of writing this newsletter the September jobs numbers was not yet published, but the ADP Employment Report showed an increase of 154,000 jobs in September. The Service sector was the main driver of the increase, contributing to 98% of the jobs added during the month.

Economic activity in the manufacturing sector expanded in September following a decrease in the month of August. The Institute for Supply Management's PMI index came in at 51.5%. Anything above 50% indicates that manufacturing business is expanding. Over the last 12 months, the PMI index has averaged a reading of 50.3%, so the current month number is stronger than the one year trailing trend.

Sales of cars in the US slowed during the past month with overall volume falling 0.7% to 1.4 million vehicles. Car sales, which have been increasing steadily over the last six years are showing signs of plateauing, according to analysts who follow the industry.

Oil prices continue to trend upward. Just a few months ago, the price of WTI Crude was trading below $27 a barrel, but as of today, the price of WTI is around $50 a barrel, representing an 88% increase off the low.

According to FactSet, corporate earnings for S&P 500 companies are expected to come in with a 2.1% decline for Q3 when all is said and done. This would make it the first time the index has recorded six consecutive quarters of year-over-year declines in earnings since FactSet began tracking the data in late 2008. You may have heard that US businesses are in an "earnings recession" and these numbers back it up. The silver lining is that the declines are small and eventually, at some point, estimates will be too pessimistic and companies will start beating bottom line estimates once again.

Lastly, it's worth commenting on one of the new acronyms that came to the forefront over the last month or two -- NIRP, which stands for Negative Interest Rates Policy. According to a Financial Times article in mid-August, $13.1 trillion worth of government and corporate bonds have negative interest rates. The level is approaching nearly one-third of total global debt. Negative rates, which have never been seen on such a widespread scale, have the potential to produce unintended consequences for borrowers, lenders, currencies and economies, and the markets are trying to understand the implications of negative yields.

Performance Update

Since our last issue, the Hot List has risen -0.4% while the S&P 500 is down 0.8%. On a YTD basis, the portfolio remains ahead of the market with a 7.5% gain compared to 5.7% for the S&P 500. Since inception, the Hot List up 203.0% vs. 116.0% for the S&P.

Portfolio Update & News about Hot List Stocks

Since our last issue of the Hot List we've had a few interesting stock moves to note. Our two international financial holdings - Banco Macro S.A. and Grupo Financiero Galicia - are both up around 7% over the past two weeks. Smith & Wesson, the gun manufacturer, was down about 5% during the two week session. Out of our three holdings tied to the housing market - Trex, American Woodmark & LGI Homes, Trex was the only position to squeak out a small gain over the period.

On October 5th, LGI Homes announced 363 homes closed in September 2016, up from 303 home closings in September 2015, representing year-over-year growth of 19.8%. In addition, the Company announced quarterly home closings of 1,052 for the third quarter of 2016, finishing out the first nine months of the year with 3,024 home closings, a 23.0% increase over 2,458 home closings during the first nine months of 2015.

In late September Tractor Supply announced the acquisition of Petsense, a leading specialty retailer of pet supplies and services with 136 stores in 25 states, for $116 million. Tractor Supply stated it plans to continue to grow the Petsense store base at a target rate of 15% to 20% annually and will convert its two existing HomeTown Pet stores to Petsense stores. The deal will not be material to 2016 earnings.

Smith & Wesson's stock came under pressure in late September after the The U.S. Army cut it from its competition to replace the Beretta M9 as its standard-issue sidearm. Smith & Wesson had partnered with General Dynamics in a bid for the contract.

Recommended Reading

There was a few recent blog posts that I found interesting and wanted to share. The first is from Morgan Housel. Housel, who was a long time columnist for The Motley Fool, recently moved over to the venture capital world, but he still writes and I like his viewpoints. In a recent piece, he offers up an impressive accountof our country's accomplishments over the last century.

The list covers everything from life span to medicine to auto fatalities and the number of cigarettes sold. Here are some interesting facts pertaining to economic issues:

  • The frequency of U.S. recessions has plunged. From 1860 to 1900 we were in recession 48% of the time. Since 1980, this has dropped to just over 12%.

  • Microsoft sold a computer mouse in 1985 for $179 ($401 when adjusted for inflation). Today, that would get you an iPhone 5, a Kindle and a Chromebook.

  • Median household income in 1929 (pre-crash) was about $16,000 (inflation-adjusted), according to Census Bureau data. Today it's more than $53,000 (which would have placed you in the top decile back then).

  • The average expense ratio for equity mutual/index funds has declined 34% since 1996, according to the Investment Company Institute. This has added an extra year of retirement income to the average saver's nest egg.

  • Bank failures in the early 1930s wiped out deposits equal to 2.2% of GDP, according to the FDIC. That's the equivalent of $396 billion today.

  • The United States uses less than half as much energy for every unit of GDP as it did in the 1970s, says energy analyst Daniel Yergin.


    • Housel concludes referencing a fascinating comment by marketing strategist Tom Goodwin: "The world's largest taxi firm, Uber, owns no cars. The world's most popular media company, Facebook, creates no content. The world's most valuable retailer, Alibaba, carries no stock. And the world's largest accommodation provider, Airbnb, owns no property."

    As investors we sometimes put too much attention on the "bad" news of the day and fail to recognize the progress that has been made over time. Great investors often take an optimistic view over the long term, and that has paid off for those investing in the markets.

    Switching gears a bit, I recently wrote a piece for CNBC about Buffett and one of the companies in Berkshire's portfolio, Verisk Analytics. Verisk scores very highly according to my Buffett model, and as I investigated it further I discovered it had an interesting back story. ( read it here ).

    In the article I describe how Verisk, a data analytics company for the insurance business, operated for years as a proprietary "lab" to support Buffett's and the other consortium members' ventures. The business grew nicely and, when the repeal of Glass Steagall in 1999 lifted restrictions between insurance and banking, the growth accelerated.

    After the financial crisis, when many insurance companies were cash poor, the group decided to spin off their number-crunching gem in an IPO. Buffett's deep pockets afforded him the opportunity to hang on to his Verisk stake (he owns 2.1 percent of the company), which has earned a hefty 207 percent return since October 2009.

    Today, Berkshire's piece of the Verisk pie ($128 million) represents a relatively small percentage of Berkshire's holdings, but has significantly outperformed not only Berkshire but also the S&P 500 and the core holdings in Berkshire's portfolio (such as American Express, Wells Fargo, Coca Cola and IBM). Validea's guru analysis gives high marks to Verisk for its competitive prowess as well as its modest capital expenditures, solid return-on-assets and stable, growing earnings.

    Guru Spotlight: Martin Zweig

    In today's Guru Spotlight, we take a look at the growth strategy of the late Martin Zweig. Zweig passed away in 2013, but his stock selection principles continue to endure. Our portfolio based on his book Winning on Wall Street has almost doubled the market's return since its inception in 2003.

    Zweig was an intriguing character known for putting his fortune to use in some pretty fun, flashy ways. He 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 was also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he 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. (Zweig also used his money for some very noble purposes -- in 2011, he and his wife, Barbara, pledged $5 million gift to Mount Sinai Hospital, which went toward the Zweig Family Center for Living Donation, a facility that focuses on providing medical, surgical, and psychological care to living organ donors.)

    Zweig became well known back in the 1980s as a frequent guest on PBS's Wall $treet Week with Louis Rukeyser, where he famously called the 1987 market crash. Just one trading day before the crash, he said he expected "a brief decline, but a vicious one" that would be similar to the 1929 crash. Stocks tumbled more than 20% on "Black Monday", but -- just as he predicted -- made a quick comeback, reaching pre-crash levels in just about a year.

    Zweig was a growth investor, and his methodology 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 he wanted their growth to be 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% annualized return during that time. Zweig 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.

    A Serious Strategy

    Zweig may have spent 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, and I've incorporated them into the Zweig-inspired model I base on his book, Winning on Wall Street. They include:

    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% over the long term; a growth rate over 30% 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 put 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% of EPS growth. If a stock fails that test but its revenues are growing by at least 30% 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 in recent years). 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, and the indicators he used are quite relevant given today's environment. Some 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 315.1%, while the S&P 500 has gained 199.2%. Here are the portfolio's current holdings:

    CUSTOMERS BANCORP INC (CUBI)
    WALKER & DUNLOP, INC. (WD)
    AMTRUST FINANCIAL SERVICES INC (AFSI)
    ENTERPRISE FINANCIAL SERVICES CORP (EFSC)
    HAIN CELESTIAL GROUP INC (HAIN)
    LGI HOMES INC (LGIH)
    FRANKLIN FINANCIAL NETWORK INC (FSB)
    SERVISFIRST BANCSHARES, INC. (SFBS)
    BANCO MACRO SA (ADR) (BMA)
    UNITEDHEALTH GROUP INC (UNH)

    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.

    Portfolio Holdings
    Ticker Date Added Return
    BMA 7/1/2016 7.2%
    GGAL 8/26/2016 5.2%
    IIIN 9/23/2016 -0.3%
    LGIH 7/1/2016 6.8%
    TSCO 9/23/2016 -0.3%
    VLO 6/3/2016 -0.5%
    AFSI 8/26/2016 2.1%
    AMWD 9/23/2016 1.3%
    SWHC 9/23/2016 -8.5%
    TREX 8/26/2016 -2.1%


    Guru 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

    BMA   |   GGAL   |   IIIN   |   LGIH   |   TSCO   |   VLO   |   AFSI   |   AMWD   |   SWHC   |   TREX   |  

    BANCO MACRO SA (ADR)

    Strategy: Small-Cap Growth Investor
    Based on: Motley Fool

    Banco Macro S.A. offers traditional bank products and services to companies, including those operating in regional economies, as well as to individuals. In addition, the Bank performs certain transactions through its subsidiaries, including mainly Banco del Tucuman, Macro Bank Limited, Macro Securities S.A., Macro Fiducia S.A. and Macro Fondos S.G.F.C.I. S.A. It has approximately two categories of customers, such as retail customers, including individuals and entrepreneurs and corporate customers, which include small, medium and large companies and major corporations. In addition, it provides services to over four provincial governments. It provides its corporate customers with traditional banking products and services, such as deposits, lending (including overdraft facilities), check cashing advances and factoring, guaranteed loans and credit lines for financing foreign trade and cash management services.


    PROFIT MARGIN: PASS

    This methodology seeks companies with a minimum trailing 12 month after tax profit margin of 7%. The companies that pass this criterion have strong positions within their respective industries and offer greater shareholder returns. A true test of the quality of a company is that they can sustain this margin. BMA's profit margin of 29.47% passes this test.


    RELATIVE STRENGTH: PASS

    The investor must look at the relative strength of the company in question. Companies whose relative strength is 90 or above (that is, the company outperforms 90% or more of the market for the past year), are considered attractive. Companies whose price has been rising much quicker than the market tend to keep rising. BMA, with a relative strength of 93, satisfies this test.


    COMPARE SALES AND EPS GROWTH TO THE SAME PERIOD LAST YEAR: PASS

    Companies must demonstrate both revenue and net income growth of at least 25% as compared to the prior year. These growth rates give you the dynamic companies that you are looking for. These rates for BMA (1,461.54% for EPS, and 44.69% for Sales) are good enough to pass.


    INSIDER HOLDINGS: FAIL

    BMA's insiders ownership is not available at the current time. Insiders of a company should own at least 15% of the outstanding shares. A high percentage typically indicates that the insiders are confident that the company will do well.


    CASH FLOW FROM OPERATIONS: PASS

    A positive cash flow is typically used for internal expansion, acquisitions, dividend payments, etc. A company that generates rather than consumes cash is in much better shape to fund such activities on their own, rather than needing to borrow funds to do so. BMA's free cash flow of $4.70 per share passes this test.


    PROFIT MARGIN CONSISTENCY: FAIL

    The profit margin in the past must be consistently increasing. The profit margin of BMA has been inconsistent in the past three years (Current year: 24.91%, Last year: 23.70%, Two years ago: 25.05%), which is unacceptable. This inconsistency will carryover directly to the company's bottom line, or earnings per share.


    R&D AS A PERCENTAGE OF SALES: NEUTRAL

    This criterion is not critically important for companies that are not high-tech or medical stocks because they are not as R&D dependant as companies within those sectors. Not much emphasis should be placed on this test in BMA's case.


    CASH AND CASH EQUIVALENTS: FAIL

    BMA does not have a sufficiently large amount of cash, $82.87 million, on hand relative to its size. Although this criteria does not apply to companies of this size, we defined anything greater than $500 million in cash as having 'a lot of cash' to allow analysis of these companies. BMA will have more of a difficult time paying off debt (if it has any) or acquiring other companies than a company that passes this criterion.


    "THE FOOL RATIO" (P/E TO GROWTH): PASS

    The "Fool Ratio" is an extremely important aspect of this analysis. If the company has attractive fundamentals and its Fool Ratio is 0.5 or less (BMA's is 0.26), the shares are looked upon favorably. These high quality companies can often wind up as the biggest winners. BMA passes this test.

    The following criteria for BMA are less important which means you would place less emphasis on them when making your investment decision using this strategy:

    AVERAGE SHARES OUTSTANDING: PASS

    BMA has not been significantly increasing the number of shares outstanding within recent years which is a good sign. BMA currently has 58.0 million shares outstanding. This means the company is not taking any measures, with regards to the number of shares, that will dilute or devalue the stock.


    SALES: FAIL

    Companies with sales less than $500 million should be chosen. It is among these small-cap stocks that investors can find "an uncut gem", ones that institutions won't be able to buy yet. BMA's sales of $1,665.6 million based on trailing 12 month sales, are too high and would therefore fail the test. It is companies with $500 million or less in sales that are most likely to double or triple in size in the next few years.


    DAILY DOLLAR VOLUME: PASS

    BMA passes the Daily Dollar Volume (DDV of $7.9 million) test. It is required that this number be less than $25 million because these are the stocks that remain relatively undiscovered by institutions. "You'll be scoring touchdowns against the big guys on your turf."


    PRICE: PASS

    This is a very insignificant criterion for this methodology. But basically, low prices are chosen because "small numbers multiply more rapidly than large ones" and the potential for big returns expands. BMA with a price of $79.42 passes the price test, even though it doesn't fall in the preferred range. The price should be above $7 in order to eliminate penny stocks and below $20 since most stocks in this price range are undiscovered by the institutions.


    INCOME TAX PERCENTAGE: PASS

    BMA's income tax paid expressed as a percentage of pretax income this year was (33.17%) and last year (35.90%) are greater than 20% which is an acceptable level. If the tax rate is below 20% this could mean that the earnings that were reported were unrealistically inflated due to the lower level of income tax paid. This is a concern.

    GRUPO FINANCIERO GALICIA S.A. (ADR)

    Strategy: Contrarian Investor
    Based on: David Dreman

    Grupo Financiero Galicia S.A. (Grupo Financiero Galicia) is a financial services holding company. The Company's segments include Banking, Regional Credit Cards, CFA, Insurance and Other Grupo Galicia Businesses. Banco de Galicia y Buenos Aires S.A. (Banco Galicia) is a subsidiary of the Company. Its banking business segment represents Banco Galicia consolidated line by line with Banco Galicia Uruguay S.A. (Galicia Uruguay). It operates the regional credit cards segment through Tarjetas Regionales S.A. and its subsidiaries. Its CFA business segment extends unsecured personal loans to low and middle-income segments of the Argentine population. The Company operates the insurance segment through Sudamericana Holding S.A. and its subsidiaries. Its Other Grupo Galicia Businesses segment includes the results of Galicia Warrants S.A., Galicia Administradora de Fondos S.A. Sociedad Gerente de Fondos Comunes de Inversion and Net Investment S.A.

    MARKET CAP: PASS

    Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. GGAL has a market cap of $3,255 million, therefore passing the test.


    EARNINGS TREND: PASS

    A company should show a rising trend in the reported earnings for the most recent quarters. GGAL's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.07, 0.70 have been increasing, and therefore the company passes this test.


    EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: PASS

    This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. GGAL passes this test as its EPS growth rate over the past 6 months (900.00%) has beaten that of the S&P (11.73%). GGAL's estimated EPS growth for the current year is (1,227.27%), which indicates the company is expected to experience positive earnings growth. As a result, GGAL passes this test.


    This methodology would utilize four separate criteria to determine if GGAL is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


    P/E RATIO: PASS

    The P/E of a company should be in the bottom 20% of the overall market. GGAL's P/E of 12.18, based on trailing 12 month earnings, meets the bottom 20% criterion (below 12.58), and therefore passes this test.


    PRICE/CASH FLOW (P/CF) RATIO: FAIL

    The P/CF of a company should be in the bottom 20% of the overall market. GGAL's P/CF of 7.57 does not meet the bottom 20% criterion (below 7.22), and therefore fails this test.


    PRICE/BOOK (P/B) VALUE: FAIL

    The P/B value of a company should be in the bottom 20% of the overall market. GGAL's P/B is currently 3.68, which does not meet the bottom 20% criterion (below 0.98), and it therefore fails this test.


    PRICE/DIVIDEND (P/D) RATIO: FAIL

    The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). GGAL's P/D of 384.62 does not meet the bottom 20% criterion (below 20.24), and it therefore fails this test.


    This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


    PAYOUT RATIO: PASS

    A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for GGAL is 0.00%. Unfortunately, its historical payout ratio is not available. Nonetheless it passes the payout criterion, as this is a very low payout.


    RETURN ON EQUITY: PASS

    The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 16.11%, and would consider anything over 27% to be staggering. The ROE for GGAL of 35.42% is high enough to pass this criterion.


    PRE-TAX PROFIT MARGINS: PASS

    This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. GGAL's pre-tax profit margin is 25.66%, thus passing this criterion.


    YIELD: FAIL

    The company in question should have a yield that is high and that can be maintained or increased. GGAL's current yield is 0.26%, while the market yield is 2.72%. GGAL fails this test.

    INSTEEL INDUSTRIES INC

    Strategy: Growth Investor
    Based on: Martin Zweig

    Insteel Industries, Inc. (Insteel) is a manufacturer of steel wire reinforcing products for concrete construction applications. The Company manufactures and markets PC strand and welded wire reinforcement (WWR), including Engineered Structural Mesh (ESM), concrete pipe reinforcement (CPR) and standard welded wire reinforcement (SWWR). The Company's products are sold to manufacturers of concrete products that are used in nonresidential construction. Insteel has two wholly owned subsidiaries, Insteel Wire Products Company (IWP), an operating subsidiary, and Intercontinental Metals Corporation, an inactive subsidiary. The Company's concrete reinforcing products consist of PC strand and WWR. PC strand provides reinforcement for bridges, parking decks, buildings and other concrete structures. Welded Wire Reinforcement produces engineered reinforcing product for use in nonresidential and residential construction.


    P/E RATIO: PASS

    The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. IIIN's P/E is 18.07, based on trailing 12 month earnings, while the current market PE is 14.00. Therefore, it passes the first test.


    REVENUE GROWTH IN RELATION TO EPS GROWTH: FAIL

    Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. IIIN's revenue growth is 11.64%, while it's earnings growth rate is 116.12%, based on the average of the 3 and 5 year historical eps growth rates. Therefore, IIIN fails this criterion.


    SALES GROWTH RATE: FAIL

    Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (-1.2%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (5.5%) of the current year. Sales growth for the prior must be greater than the latter. For IIIN this criterion has not been met and fails this test.


    The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


    CURRENT QUARTER EARNINGS: PASS

    The first of these criteria is that the current EPS be positive. IIIN's EPS ($0.71) pass this test.


    QUARTERLY EARNINGS ONE YEAR AGO: PASS

    The EPS for the quarter one year ago must be positive. IIIN's EPS for this quarter last year ($0.29) pass this test.


    POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

    The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. IIIN's growth rate of 144.83% passes this test.


    EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: PASS

    Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for IIIN is 58.06%. This should be less than the growth rates for the 3 previous quarters, which are 112.50%, 63.64%, and 171.43%. IIIN passes this test, which means that it has good, reasonably steady earnings.


    This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


    EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

    If the growth rate of the prior three quarter's earnings, 108.33%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 144.83%, (versus the same quarter one year ago) then the stock passes.


    EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: PASS

    The EPS growth rate for the current quarter, 144.83% must be greater than or equal to the historical growth which is 116.12%. IIIN would therefore pass this test.


    EARNINGS PERSISTENCE: PASS

    Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. IIIN, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were -0.02, 0.10, 0.64, 0.89 and 1.16, passes this test.


    LONG-TERM EPS GROWTH: PASS

    One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. IIIN's long-term growth rate of 116.12%, based on the average of the 3 and 5 year historical eps growth rates, passes this test.


    TOTAL DEBT/EQUITY RATIO: PASS

    A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. IIIN's Debt/Equity (0.00%) is not considered high relative to its industry (113.84%) and passes this test.


    INSIDER TRANSACTIONS: PASS

    A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For IIIN, this criterion has not been met (insider sell transactions are 171, while insiders buying number 160). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

    LGI HOMES INC

    Strategy: Growth Investor
    Based on: Martin Zweig

    LGI Homes, Inc. is a homebuilder. The Company is engaged in the design, construction, marketing and sale of new homes in markets in Texas, Arizona, Florida, Georgia, New Mexico, South Carolina, North Carolina, Colorado, Washington and Tennessee. The Company has five segments: the Texas division, the Southwest division, the Southeast division, the Florida division and the Northwest division. The Texas division includes homebuilding operations in Houston, Dallas/Fort Worth, San Antonio and Austin locations. The Southwest division includes homebuilding operations in Phoenix, Tucson, Albuquerque, Denver and Colorado Springs locations. The Southeast division includes homebuilding operations in Atlanta, Charlotte and Nashville locations. The Florida division includes homebuilding operations in Tampa, Orlando, Fort Myers and Jacksonville locations. The Northwest division includes homebuilding operations in Seattle location. Its product offerings include entry-level homes and move-up homes.


    P/E RATIO: PASS

    The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. LGIH's P/E is 11.66, based on trailing 12 month earnings, while the current market PE is 14.00. Therefore, it passes the first test.


    REVENUE GROWTH IN RELATION TO EPS GROWTH: PASS

    Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. LGIH's revenue growth is 94.39%, while it's earnings growth rate is 81.68%, based on the average of the 3 and 4 year historical eps growth rates. Therefore, LGIH passes this criterion.


    SALES GROWTH RATE: PASS

    Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (40.2%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (34.6%) of the current year. Sales growth for the prior must be greater than the latter. For LGIH this criterion has been met.


    The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


    CURRENT QUARTER EARNINGS: PASS

    The first of these criteria is that the current EPS be positive. LGIH's EPS ($0.96) pass this test.


    QUARTERLY EARNINGS ONE YEAR AGO: PASS

    The EPS for the quarter one year ago must be positive. LGIH's EPS for this quarter last year ($0.66) pass this test.


    POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

    The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. LGIH's growth rate of 45.45% passes this test.


    EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: PASS

    Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for LGIH is 40.84%. This should be less than the growth rates for the 3 previous quarters, which are 123.53%, 111.76%, and 72.73%. LGIH passes this test, which means that it has good, reasonably steady earnings.


    This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


    EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

    If the growth rate of the prior three quarter's earnings, 102.97%, (versus the same three quarters a year earlier) is greater than the growth rate of the current quarter earnings, 45.45%, (versus the same quarter one year ago) then the stock fails, with one exception: if the growth rate in earnings between the current quarter and the same quarter one year ago is greater than 30%, then the stock would pass. The growth rate over this period for LGIH is 45.5%, and it would therefore pass this test.


    EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: FAIL

    The EPS growth rate for the current quarter, 45.45% must be greater than or equal to the historical growth which is 81.68%. Since this is not the case LGIH would therefore fail this test.


    EARNINGS PERSISTENCE: PASS

    Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. LGIH, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 0.17, 0.50, 1.07, 1.33 and 2.44, passes this test.


    LONG-TERM EPS GROWTH: PASS

    One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. LGIH's long-term growth rate of 81.68%, based on the average of the 3 and 4 year historical eps growth rates, passes this test.


    TOTAL DEBT/EQUITY RATIO: FAIL

    A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. LGIH's Debt/Equity (111.05%) is considered high relative to its industry (49.21%) and fails this test.


    INSIDER TRANSACTIONS: PASS

    A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For LGIH, this criterion has not been met (insider sell transactions are 60, while insiders buying number 33). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.

    TRACTOR SUPPLY COMPANY

    Strategy: Contrarian Investor
    Based on: David Dreman

    Tractor Supply Company is an operator of rural lifestyle retail stores in the United States. The Company operates in the retail sale of products that support the rural lifestyle segment. The Company focuses on supplying the lifestyle needs of recreational farmers and ranchers, as well as tradesmen and small businesses. It operates over 1,490 retail stores in over 50 states under the names Tractor Supply Company, Del's Feed & Farm Supply and HomeTown Pet. It also operates a Website under the name TractorSupply.com. The Company's stores offer merchandise, which includes equine, livestock, pet and small animal products; hardware, truck, towing and tool products; seasonal products, including heating, lawn and garden items, power equipment, gifts and toys; work/recreational clothing and footwear, and maintenance products for agricultural and rural use. The Company's products are offered under various brands, which include 4health, Blue Mountain and Countyline.

    MARKET CAP: PASS

    Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. TSCO has a market cap of $9,111 million, therefore passing the test.


    EARNINGS TREND: PASS

    A company should show a rising trend in the reported earnings for the most recent quarters. TSCO's EPS for the past 2 quarters, (from earliest to most recent quarter) 0.50, 1.16 have been increasing, and therefore the company passes this test.


    EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: PASS

    This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. TSCO passes this test as its EPS growth rate over the past 6 months (41.46%) has beaten that of the S&P (11.73%). TSCO's estimated EPS growth for the current year is (8.00%), which indicates the company is expected to experience positive earnings growth. As a result, TSCO passes this test.


    This methodology would utilize four separate criteria to determine if TSCO is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


    P/E RATIO: FAIL

    The P/E of a company should be in the bottom 20% of the overall market. TSCO's P/E of 21.78, based on trailing 12 month earnings, is higher than the bottom 20% criterion (below 12.58), and therefore fails this test.


    PRICE/CASH FLOW (P/CF) RATIO: FAIL

    The P/CF of a company should be in the bottom 20% of the overall market. TSCO's P/CF of 16.45 does not meet the bottom 20% criterion (below 7.22), and therefore fails this test.


    PRICE/BOOK (P/B) VALUE: FAIL

    The P/B value of a company should be in the bottom 20% of the overall market. TSCO's P/B is currently 6.07, which does not meet the bottom 20% criterion (below 0.98), and it therefore fails this test.


    PRICE/DIVIDEND (P/D) RATIO: FAIL

    The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). TSCO's P/D of 70.92 does not meet the bottom 20% criterion (below 20.24), and it therefore fails this test.


    This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


    CURRENT RATIO: PASS

    A prospective company must have a strong Current Ratio (greater than or equal to the average of it's industry [1.41] or greater than 2). This is one identifier of financially strong companies, according to this methodology. TSCO's current ratio of 2.19 passes the test.


    PAYOUT RATIO: PASS

    A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for TSCO is 12.77%, while its historical payout ratio has been 20.19%. Therefore, it passes the payout criterion.


    RETURN ON EQUITY: PASS

    The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 large cap stocks, which is 16.11%, and would consider anything over 27% to be staggering. The ROE for TSCO of 29.33% is high enough to pass this criterion.


    PRE-TAX PROFIT MARGINS: PASS

    This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. TSCO's pre-tax profit margin is 10.33%, thus passing this criterion.


    YIELD: FAIL

    The company in question should have a yield that is high and that can be maintained or increased. TSCO's current yield is 1.41%, while the market yield is 2.72%. TSCO fails this test.


    LOOK AT THE TOTAL DEBT/EQUITY: PASS

    The company must have a low Debt/Equity ratio, which indicates a strong balance sheet. The Debt/Equity ratio should not be greater than 20% or should be less than the average Debt/Equity for its industry of 631.92%. TSCO's Total Debt/Equity of 14.57% is considered acceptable.

    VALERO ENERGY CORPORATION

    Strategy: Contrarian Investor
    Based on: David Dreman

    Valero Energy Corporation (Valero), through Valero Energy Partners LP (VLP), owns, operates, develops and acquires crude oil and refined petroleum products pipelines, terminals, and other transportation and logistics assets. The Company operates in two segments: refining and ethanol. Its refining segment includes refining and marketing operations in the United States, Canada, the United Kingdom, Aruba and Ireland. Its ethanol segment includes ethanol and marketing operations in the United States. VLP's assets include crude oil and refined petroleum products pipeline and terminal systems in the United States Gulf Coast and the United States Mid-Continent regions. Its refineries can produce conventional gasolines, premium gasolines, gasoline meeting the specifications of the California Air Resources Board (CARB), diesel, low-sulfur diesel, ultra-low-sulfur diesel, CARB diesel, other distillates, jet fuel, asphalt, petrochemicals, lubricants and other refined products.

    MARKET CAP: PASS

    Medium to large-sized companies (the largest 1500 companies) should be chosen, because they are more in the public eye. Furthermore, the investor is exposed to less risk of "accounting gimmickry", and companies of this size have more staying power. VLO has a market cap of $25,328 million, therefore passing the test.


    EARNINGS TREND: PASS

    A company should show a rising trend in the reported earnings for the most recent quarters. VLO's EPS for the past 2 quarters, (from earliest to most recent quarter) 1.06, 1.73 have been increasing, and therefore the company passes this test.


    EPS GROWTH RATE IN THE IMMEDIATE PAST AND FUTURE: FAIL

    This methodology likes to see companies with an EPS growth rate higher than the S&P in the immediate past and a likelihood that this trend will continue in the near future. VLO's EPS growth rate over the past 6 months (183.60%) has beaten that of the S&P (11.73%), but VLO's estimated EPS growth for the current year is (-58.34%) while that of the S&P is (-23.35%), therefore failing this test.


    This methodology would utilize four separate criteria to determine if VLO is a contrarian stock. In order to eliminate weak companies we have stipulated that the stock should pass at least two of the following four major criteria in order to receive "Some Interest".


    P/E RATIO: PASS

    The P/E of a company should be in the bottom 20% of the overall market. VLO's P/E of 8.87, based on trailing 12 month earnings, meets the bottom 20% criterion (below 12.58), and therefore passes this test.


    PRICE/CASH FLOW (P/CF) RATIO: PASS

    The P/CF of a company should be in the bottom 20% of the overall market. VLO's P/CF of 5.01 meets the bottom 20% criterion (below 7.22) and therefore passes this test.


    PRICE/BOOK (P/B) VALUE: FAIL

    The P/B value of a company should be in the bottom 20% of the overall market. VLO's P/B is currently 1.23, which does not meet the bottom 20% criterion (below 0.98), and it therefore fails this test.


    PRICE/DIVIDEND (P/D) RATIO: FAIL

    The P/D ratio for a company should be in the bottom 20% of the overall market (that is the yield should be in the top 20%). VLO's P/D of 22.88 does not meet the bottom 20% criterion (below 20.24), and it therefore fails this test.


    This methodology maintains that investors should look for as many healthy financial ratios as possible to ascertain the financial strength of the company. These criteria are detailed below.


    CURRENT RATIO: PASS

    A prospective company must have a strong Current Ratio (greater than or equal to the average of it's industry [1.28] or greater than 2). This is one identifier of financially strong companies, according to this methodology. VLO's current ratio of 1.87 passes the test.


    PAYOUT RATIO: FAIL

    A good indicator that a company has the ability to raise its dividend is a low payout ratio. The payout ratio for VLO is 33.65%, while its historical payout ratio has been 15.73%. Therefore, it fails the payout criterion.


    RETURN ON EQUITY: FAIL

    The company should have a high ROE, as this helps to ensure that there are no structural flaws in the company. This methodology feels that the ROE should be greater than the top one third of ROE from among the top 1500 largest cap stocks, which is 16.11%, and would consider anything over 27% to be staggering. The ROE for VLO of 14.18% is not high enough to pass this criterion.


    PRE-TAX PROFIT MARGINS: FAIL

    This methodology looks for pre-tax profit margins of at least 8%, and considers anything over 22% to be phenomenal. VLO's pre-tax profit margin is 5.80%, thus failing this criterion.


    YIELD: PASS

    The company in question should have a yield that is high and that can be maintained or increased. VLO's current yield is 4.37%, while the market yield is 2.72%. VLO passes this test.


    LOOK AT THE TOTAL DEBT/EQUITY: PASS

    The company must have a low Debt/Equity ratio, which indicates a strong balance sheet. The Debt/Equity ratio should not be greater than 20% or should be less than the average Debt/Equity for its industry of 59.00%. VLO's Total Debt/Equity of 36.50% is considered acceptable.

    AMTRUST FINANCIAL SERVICES INC

    Strategy: Patient Investor
    Based on: Warren Buffett

    Amtrust Financial Services, Inc. (AmTrust) is an insurance holding company. The Company, through its subsidiaries, provides specialty property and casualty insurance focusing on workers' compensation and commercial package coverage for small business, specialty risk and extended warranty coverage, and property and casualty coverage for middle market business. Its segments include Small Commercial Business, Specialty Risk and Extended Warranty, and Specialty Program. The Small Commercial Business segment is engaged in providing workers' compensation, commercial package and other commercial insurance lines produced by wholesale agents, retail agents and brokers in the United States. The Specialty Risk and Extended Warranty segment is engaged in providing coverage for consumer and commercial goods and custom designed coverages. The Specialty Program segment is engaged in writing commercial insurance for defined classes of insureds through general and other wholesale agents.

    STAGE 1: "Is this a Buffett type company?"

    A bedrock principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers. While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.


    LOOK FOR EARNINGS PREDICTABILITY: PASS

    Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 0.39, 0.68, 0.62, 0.78, 0.97, 1.14, 1.17, 1.78, 2.72, 2.80. Buffett would consider AFSI's earnings predictable, although earnings have declined 1 time(s) in the past seven years, with the most recent decline 8 years ago. The dips have totaled 8.8%. AFSI's long term historical EPS growth rate is 22.8%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 12.0% per year in the future, based on the analysts' consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.


    LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY: PASS

    Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for AFSI, over the last ten years, is 18.3%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 15.2%, 22.8%, 20.9%, 17.9%, 17.8%, 17.0%, 15.1%, 18.5%, 20.8%, 16.9%, and the average ROE over the last 3 years is 18.7%, thus passing this criterion.


    LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON ASSETS: PASS

    Buffett also requires, for financial companies, that the average Return On Assets (ROA) be at least 1% and consistent. Return On Assets is defined as the net earnings of the business divided by the total assets of the business. The average ROA for AFSI, over the last ten years, is 3.0%, which is high enough to pass. It is not enough that the average be at least 1%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROA must be at least 1% for Buffett to feel comfortable that the ROA is consistent. The ROA for the last 10 years, from earliest to latest, is 4.2%, 3.8%, 2.6%, 3.0%, 3.1%, 2.6%, 2.3%, 2.4%, 3.1%, 2.9%, thus passing this criterion.


    LOOK AT CAPITAL EXPENDITURES: PASS

    Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. AFSI's free cash flow per share of $4.20 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.


    LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS: PASS

    Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $11.11 and compares it to the gain in EPS over the same period of $2.41. AFSI's management has proven it can earn shareholders a 21.7% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.


    HAS THE COMPANY BEEN BUYING BACK SHARES: BONUS PASS

    Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. AFSI's shares outstanding have fallen in the current year from 175,919,998 to 173,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.

    The preceding concludes Buffett's qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate AFSI quantitatively.

    STAGE 2: "Should I buy at this price?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.


    CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]

    Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $2.80 and divide it by the current market price of $26.46. An investor, purchasing AFSI, could expect to receive a 10.58% initial rate of return. Furthermore, he or she could expect the rate to increase 12.0% per year, based on the analysts' consensus estimated long term growth rate, as this is how fast earnings are growing.


    COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: PASS

    Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 2.25%. Compare this with AFSI's initial yield of 10.58%, which will expand at an annual rate of 12.0%, based on the analysts' consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.


    CALCULATE THE FUTURE EPS: [No Pass/Fail]

    AFSI currently has a book value of $15.12. It is safe to say that if AFSI can preserve its average rate of return on equity of 18.3% and continues to retain 83.82% of its earnings, it will be able to sustain an earnings growth rate of 15.3% and it will have a book value of $62.95 in ten years. If it can still earn 18.3% on equity in ten years, then expected EPS will be $11.51.


    CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

    Now take the expected future EPS of $11.51 and multiply them by the lower of the 5 year average P/E ratio (10.2) or current P/E ratio (current P/E in this case), which is 9.4 and you get AFSI's projected future stock price of $108.68.


    CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

    Now add in the total expected dividend pool to be paid over the next ten years, which is $8.90. This gives you a total dollar amount of $117.58. These numbers indicate that one could expect to make a 16.1% average annual return on AFSI's stock at the present time. Buffett would consider this a great return.


    CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]

    If you take the EPS growth of 12.0%, based on the analysts' consensus estimated long term growth rate, you can project EPS in ten years to be $8.70. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio (10.2) or current P/E ratio (current P/E in this case), which is 9.4. This equals the future stock price of $82.09. Add in the total expected dividend pool of $8.90 to get a total dollar amount of $91.00.


    CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]

    Now you can figure out your expected return based on a current price of $26.46 and the future expected stock price, including the dividend pool, of $91.00. If you were to invest in AFSI at this time, you could expect a 13.15% average annual return on your money. Buffett likes to see a 15% return, but nonetheless would accept this return.


    LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: PASS

    Based on the two different methods, you could expect an annual compounding rate of return somewhere between 13.1% and 16.1%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 14.6% on AFSI stock for the next ten years, based on the current fundamentals. Buffett likes to see a 15% return, but nonetheless would accept this return, thus passing the criterion.

    AMERICAN WOODMARK CORPORATION

    Strategy: P/E/Growth Investor
    Based on: Peter Lynch

    American Woodmark Corporation manufactures and distributes kitchen cabinets and vanities for the remodeling and new home construction markets. The Company offers framed stock cabinets in approximately 500 different cabinet lines, ranging in price from relatively inexpensive to medium-priced styles. Styles vary by design and color from natural wood finishes to low-pressure laminate surfaces. The product offering of stock cabinets includes approximately 90 door designs in over 20 colors. Stock cabinets consist of cabinet interiors of varying dimensions and construction options, and a maple, oak, cherry, or hickory front frame, door and/or drawer front. The Company's products are sold under the brand names of American Woodmark, Simply Woodmark, Timberlake, Shenandoah Cabinetry, Shenandoah Value Series and Waypoint Living Spaces. The Company's primary raw materials used include hard maple, soft maple, oak, cherry, and hickory lumber and plywood.


    DETERMINE THE CLASSIFICATION:

    This methodology would consider AMWD a "fast-grower".


    P/E/GROWTH RATIO: PASS

    The investor should examine the P/E (20.60) relative to the growth rate (55.23%), based on the average of the 3 and 4 year historical eps growth rates using the current fiscal year eps estimate, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for AMWD (0.37) is very favorable.


    SALES AND P/E RATIO: NEUTRAL

    For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth rate high enough to support a P/E above this threshold. AMWD, whose sales are $974.0 million, is not considered large enough to apply the P/E ratio analysis. However, an investor can analyze the P/E ratio relative to the EPS growth rate.


    INVENTORY TO SALES: PASS

    When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for AMWD was 4.36% last year, while for this year it is 4.15%. Since inventory to sales has decreased from last year by -0.21%, AMWD passes this test.


    EPS GROWTH RATE: FAIL

    This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for AMWD is 55.2%, based on the average of the 3 and 4 year historical eps growth rates using the current fiscal year eps estimate, which is considered too fast.


    TOTAL DEBT/EQUITY RATIO: PASS

    This methodology would consider the Debt/Equity ratio for AMWD (8.08%) to be exceptionally low (equity is at least ten times debt). This ratio is one quick way to determine the financial strength of the company.


    FREE CASH FLOW: NEUTRAL

    The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for AMWD (3.20%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


    NET CASH POSITION: NEUTRAL

    Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for AMWD (13.56%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

    SMITH & WESSON HOLDING CORP

    Strategy: P/E/Growth Investor
    Based on: Peter Lynch

    Smith & Wesson Holding Corporation is a manufacturer of firearms and a provider of accessory products for the shooting, hunting and rugged outdoor enthusiast. The Company operates through two segments: firearms and accessories. The firearm segment includes firearms, handcuffs and other related products sold through a distribution chain and direct sales to consumers and international, state and federal governments. The accessories segment consists of shooting, hunting and outdoor accessories. It manufactures an array of handguns, including revolvers and pistols; long guns, including modern sporting rifles, bolt action rifles and single shot rifles; handcuffs, and firearm-related products and accessories. It also provides shooting, hunting and outdoor accessories, including reloading, gunsmithing, gun cleaning supplies, tree saws and vault accessories. The Company sells its products under the Smith & Wesson, M&P, Thompson/Center Arms and Wheeler Engineering, among other brands.


    DETERMINE THE CLASSIFICATION:

    This methodology would consider SWHC a "fast-grower".


    P/E/GROWTH RATIO: PASS

    The investor should examine the P/E (12.59) relative to the growth rate (40.37%), based on the average of the 3, 4 and 5 year historical eps growth rates, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for SWHC (0.31) is very favorable.


    SALES AND P/E RATIO: NEUTRAL

    For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth rate high enough to support a P/E above this threshold. SWHC, whose sales are $782.1 million, is not considered large enough to apply the P/E ratio analysis. However, an investor can analyze the P/E ratio relative to the EPS growth rate.


    INVENTORY TO SALES: PASS

    When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for SWHC was 13.93% last year, while for this year it is 10.76%. Since inventory to sales has decreased from last year by -3.17%, SWHC passes this test.


    EPS GROWTH RATE: PASS

    This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for SWHC is 40.4%, based on the average of the 3, 4 and 5 year historical eps growth rates, which is considered 'OK'. However, it may be difficult to sustain such a high growth rate.


    TOTAL DEBT/EQUITY RATIO: PASS

    This methodology would consider the Debt/Equity ratio for SWHC (50.39%) to be mediocre. If the Debt/Equity ratio is this high, the other ratios and financial statistics for SWHC should be good enough to compensate.


    FREE CASH FLOW: NEUTRAL

    The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for SWHC (9.84%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


    NET CASH POSITION: NEUTRAL

    Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for SWHC (1.81%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.

    TREX COMPANY INC

    Strategy: Small-Cap Growth Investor
    Based on: Motley Fool

    Trex Company, Inc. is a manufacturer of wood-alternative decking and railing products. The Company markets its products under the brand name Trex. The Company offers a set of outdoor living products in the decking, railing, porch, fencing, trim, steel deck framing and outdoor lighting categories. Its decking products include Trex Transcend, Trex Enhance and Trex Select. The Company's railing products include Trex Transcend Railing, Trex Select Railing and Trex Reveal aluminum railing. It offers Trex Transcend Porch Flooring and Railing System, a porch product, and a fencing product called Trex Seclusions. The Company offers TrexTrim product, which is a cellular polyvinyl chloride residential exterior trim product. It offers a triple-coated steel deck framing system called Trex Elevations. The Company offers outdoor lighting systems, including Trex DeckLighting and Trex Landscape Lighting. It also offers Trex Hideaway, which a hidden fastening system for grooved boards.


    PROFIT MARGIN: PASS

    This methodology seeks companies with a minimum trailing 12 month after tax profit margin of 7%. The companies that pass this criterion have strong positions within their respective industries and offer greater shareholder returns. A true test of the quality of a company is that they can sustain this margin. TREX's profit margin of 12.68% passes this test.


    RELATIVE STRENGTH: FAIL

    The investor must look at the relative strength of the company in question. Companies whose relative strength is 90 or above (that is, the company outperforms 90% or more of the market for the past year), are considered attractive. Companies whose price has been rising much quicker than the market tend to keep rising. Although TREX's relative strength of 87 is below the acceptable level, yet it is very close. Keep an eye on the stock as it could move into the acceptable range.


    COMPARE SALES AND EPS GROWTH TO THE SAME PERIOD LAST YEAR: FAIL

    Companies must demonstrate both revenue and net income growth of at least 25% as compared to the prior year. These growth rates give you the dynamic companies that you are looking for. These rates for TREX (36.21% for EPS, and 7.07% for Sales) are not good enough to pass.


    INSIDER HOLDINGS: FAIL

    TREX's insiders should own at least 10% (they own 0.32%) of the company's outstanding shares. This does not satisfy the minimum requirement, and companies that do not pass this criteria are less attractive.


    CASH FLOW FROM OPERATIONS: PASS

    A positive cash flow is typically used for internal expansion, acquisitions, dividend payments, etc. A company that generates rather than consumes cash is in much better shape to fund such activities on their own, rather than needing to borrow funds to do so. TREX's free cash flow of $1.24 per share passes this test.


    PROFIT MARGIN CONSISTENCY: PASS

    TREX's profit margin has been consistent or even increasing over the past three years (Current year: 10.91%, Last year: 10.60%, Two years ago: 10.10%), passing the requirement. It is a sign of good management and a healthy and competitive enterprise.


    R&D AS A PERCENTAGE OF SALES: NEUTRAL

    This criterion is not critically important for companies that are not high-tech or medical stocks because they are not as R&D dependant as companies within those sectors. Not much emphasis should be placed on this test in TREX's case.


    CASH AND CASH EQUIVALENTS: FAIL

    TREX does not have a sufficiently large amount of cash, $6.00 million, on hand relative to its size. Although this criteria does not apply to companies of this size, we defined anything greater than $500 million in cash as having 'a lot of cash' to allow analysis of these companies. TREX will have more of a difficult time paying off debt (if it has any) or acquiring other companies than a company that passes this criterion.


    INVENTORY TO SALES: PASS

    This methodology strongly believes that companies, especially small ones, should have tight control over inventory. It's a warning sign if a company's inventory relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more. Inventory to Sales for TREX was 6.06% last year, while for this year it is 5.24%. Since the inventory to sales is decreasing by -0.82% the stock passes this criterion.


    ACCOUNT RECEIVABLE TO SALES: PASS

    This methodology wants to make sure that a company's accounts receivable do not get significantly out of line with sales. It's a warning sign if a company's accounts receivable relative to sales increases significantly when compared to the previous year. Up to a 30% increase is allowed, but no more. Accounts Receivable to Sales for TREX was 9.29% last year, while for this year it is 11.91%. Although the AR to sales is rising, it is below the max 30% that is allowed. The investor can still consider the stock if all other criteria appear very attractive.


    LONG TERM DEBT/EQUITY RATIO: PASS

    TREX's trailing twelve-month Debt/Equity ratio (0.00%) is at a great level according to this methodology because the superior companies that you are looking for don't need to borrow money in order to grow.


    "THE FOOL RATIO" (P/E TO GROWTH): PASS

    The "Fool Ratio" is an extremely important aspect of this analysis. If the company has attractive fundamentals and its Fool Ratio is 0.5 or less (TREX's is 0.38), the shares are looked upon favorably. These high quality companies can often wind up as the biggest winners. TREX passes this test.

    The following criteria for TREX are less important which means you would place less emphasis on them when making your investment decision using this strategy:

    AVERAGE SHARES OUTSTANDING: PASS

    TREX has not been significantly increasing the number of shares outstanding within recent years which is a good sign. TREX currently has 29.0 million shares outstanding. This means the company is not taking any measures, with regards to the number of shares, that will dilute or devalue the stock.


    SALES: PASS

    Companies with sales less than $500 million should be chosen. It is among these small-cap stocks that investors can find "an uncut gem", ones that institutions won't be able to buy yet. TREX's sales of $461.4 million based on trailing 12 month sales, are fine, making this company one such "prospective gem". TREX passes the sales test.


    DAILY DOLLAR VOLUME: PASS

    TREX passes the Daily Dollar Volume (DDV of $15.9 million) test. It is required that this number be less than $25 million because these are the stocks that remain relatively undiscovered by institutions. "You'll be scoring touchdowns against the big guys on your turf."


    PRICE: PASS

    This is a very insignificant criterion for this methodology. But basically, low prices are chosen because "small numbers multiply more rapidly than large ones" and the potential for big returns expands. TREX with a price of $60.51 passes the price test, even though it doesn't fall in the preferred range. The price should be above $7 in order to eliminate penny stocks and below $20 since most stocks in this price range are undiscovered by the institutions.


    INCOME TAX PERCENTAGE: PASS

    TREX's income tax paid expressed as a percentage of pretax income this year was (37.36%) and last year (37.98%) are greater than 20% which is an acceptable level. If the tax rate is below 20% this could mean that the earnings that were reported were unrealistically inflated due to the lower level of income tax paid. This is a concern.


    Watch List

    The top scoring stocks not currently in the Hot List portfolio.

    Ticker Company Name Current
    Score
    AGX ARGAN, INC. 40%
    HA HAWAIIAN HOLDINGS, INC. 40%
    WDR WADDELL & REED FINANCIAL, INC. 40%
    WAL WESTERN ALLIANCE BANCORPORATION 39%
    UFPI UNIVERSAL FOREST PRODUCTS, INC. 39%
    FIZZ NATIONAL BEVERAGE CORP. 39%
    JBSS JOHN B. SANFILIPPO & SON, INC. 38%
    UTHR UNITED THERAPEUTICS CORPORATION 38%
    SUPN SUPERNUS PHARMACEUTICALS INC 37%
    SYNT SYNTEL, INC. 37%



    Disclaimer

    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.