|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||February 6, 2009|
As has been the case for the past few months, the economic news continues to be pretty dreary. Last week, the United States posted its worst quarterly gross domestic product results in 26 years. GDP fell by an inflation-adjusted 3.8 percent in the fourth quarter of last year, much worse than the 0.5 percent decline posted in the third quarter. The drop shouldn't have come as any surprise given all that's happened in the fall and winter -- in fact, economists actually expected the result to be significantly worse than it turned out to be -- but it hurts nonetheless.
Employment also continues to be at the top of the "bad news" list. New data shows that initial unemployment claims were up 6 percent last week from the previous week, and significantly higher than economists expected. Today, the January unemployment rate is scheduled to be released. Given all of the layoffs we saw last month, it certainly seems likely that the rate will increase from its 7.2 percent December level.
To keep things in perspective, we've seen worse. Back in the fall of 1982, the number of new jobless claims was greater than it was last week -- and that was when the U.S. was home to about 75 million fewer people than it is today.
That is by no means to dismiss the issue, however; employment is a real concern -- and not just because of all of the layoffs that are occurring. As CNNMoney's Chris Isidore noted recently, the job losses are being compounded by the fact that few employers are hiring new employees, meaning that those who lose their jobs have few places to turn to find new work. As of November (the most recently available data), layoffs were up 17 percent from the previous year, but the number of job openings had plunged 30 percent, Isidore writes. And since November, the amount of job listings tracked by The Conference Board has fallen another 23 percent. During the recession we endured earlier this decade, layoffs peaked in late 2001, but employment didn't turn around until 2003. And in the current recession, the hiring drop is much greater than it was back then, Isidore writes.
Not surprisingly, with more Americans out of work, and home and stock prices having been battered in recent months, businesses are continuing to struggle to bring in the profits. According to Thomson Reuters' monthly assessment of 35 retail firms, same-store sales fell almost 2 percent in January, the second-worst month since the group started tracking that data in 2000.
Manufacturing activity also remains weak -- though there are signs that it is getting better. In January, the Institute for Supply Management's manufacturing index was at 35.6. While the January figure reflects a continued contraction (readings below 50 indicate a contraction, while those above 50 indicate an expansion), the reading was up from 32.9 in December.
With the financial sector still reeling, consumers tightening their belts, and many firms posting losses this earnings season, corporations and Wall Street are looking to the government to pull us out of the mess. As you've no doubt seen, the Obama Administration's stimulus package is working its way through Capitol Hill, and it remains unclear exactly what the final product will look like. New Treasury Secretary Timothy Geithner is expected to unveil the plan -- estimated to cost another $700 billion -- Monday.
While I'm not an economic expert, there are a couple insightful points that I think we should keep our eyes on as the latest bailout plan unfolds, and they come from two of the brightest minds on Wall Street -- PIMCO's Bill Gross and GMO's Jeremy Grantham, both of whom saw the credit crisis coming.
In his latest market commentary, Gross notes that the government needs not only to keep its focus on banks, but also on the "shadow banking system" that has gotten us into this mess -- the hedge funds, investment banks, structured investment vehicles, and other non-bank financials that have contributed to the current over-leveraging.
Gross says that, contrary to popular belief, the big banks have started lending again. "While banks may have tightened their lending standards, fresh capital from the TARP has made it possible to make new loans," Gross said. "The shadow banks, however hedge funds, investment banks, and structured financial conduits have been forced to delever as government funds have been directed to more visible institutional lenders. Banks have been recapitalized yes and banks have cautiously started to lend. But shadow banks are still delevering due to disappearing and unavailable fresh capital and, as they do, they continue to drag asset prices with them."
Those asset prices -- in particular housing values -- are the key to solving the current crisis, Gross says. He does a much better job of explaining the reasons why than I could, so if you're interested I'd recommend reading his commentary (it's not too long). You can find it here
Grantham, meanwhile, recently explained to Forbes' Steve Forbes why he doesn't think tax cuts or rebates are going to help get us out of the current mess. It's tough advice to hear, given that all of us want Uncle Sam to be taking as little as possible from us, but his logic makes a good deal of sense. I'd recommend you check out his comments (You can find them under the "Stimulus" subhead here
As for the stock market, it's been an up and down fortnight since our last newsletter, and the broader market has ended up a bit higher than where it started, with the S&P 500 gaining 2.2 percent. The Hot List has fared much better, gaining 4.2 percent, led by some nice double-digit gains from Schnitzer Steel and Polo Ralph Lauren. For the year, the portfolio has lost 5.1 percent compared to the S&P's 6.4 percent loss; since its July 2003 inception, however, the portfolio is up 55.6 percent, while the index has fallen 15.5 percent.
Looking ahead, there continue to be some good signs for long-term investors. Fortune recently highlighted one of them, a metric that Warren Buffett uses to gauge the broader market's value. It compares the total value of the U.S. stock market to the nation's gross national product. Buffett assumes there should be a fairly "rational" relationship between these two factors, and has said that if stock values slip to 70 to 80 percent of GNP, it's good news for those buying stocks. Even with the fourth-quarter economic woes and production declines, this Buffett metric was signaling "buy" in late January, according to Fortune. At that point, stock market value was about 75 percent of GNP, right in that strike zone Buffett has cited.
Buffett has put his money where his mouth is lately, saying that he's been buying U.S. stocks for his own portfolio, which previously only held U.S. bonds. And he's not the only one of my gurus who's doing so. James O'Shaughnessy has been "pouring" his own cash into the market because he sees such great valuations, according to Reuters. "[I] will do so until [I'm] all in," O'Shaughnessy said. And that should probably be February or March. Other gurus who have been bullish include Kenneth Fisher, David Dreman, and John Neff, who was even tapping his bond portfolio in December for cash to put into stocks, according to Fortune.
A New Book -- and Some Enduring Principles
This week, my new book, The Guru Investor: How to Beat the Market Using History's Best Investment Strategies, arrived in bookstores. The book examines the strategies, lives, and track records of ten of the gurus I follow: Benjamin Graham, John Neff, Warren Buffett, David Dreman, Peter Lynch, Martin Zweig, Kenneth Fisher, James O'Shaughnessy, Joel Greenblatt, and Joseph Piotroski.
I thought it was important to include in the book not only the strategies these gurus have used, but also the lessons I've learned over the years in terms of implementing them. As I thought about those lessons while writing the book, I was able to break them down into six "Guiding Guru Principles". This week, I'd like to share with you an excerpt from The Guru Investor that details the first of those critical principles.
Principle 1: Combining Strategies to Minimize Risk and Maximize Returns
Over the long haul, there is no better or safer, when you consider inflation, investment class than stocks. But as we've seen, in the short term, Mr. Market (as the great Benjamin Graham called the stock market) can be extremely fickle. Sometimes he likes growth stocks; sometimes he likes value. Often he likes stocks with low price-sales ratios; other times, he thumbs his nose at them. There's no single strategy that will please him all of the time and if you try to predict his whims by jumping from strategy to strategy, as we've seen, you'll far more often than not end up buying high and selling low. The conundrum is thus how to even out those rough patches while sticking to your guns.
One of the best ways to do this, we've found, is to use a strategy that blends together different guru-based models that have a lower degree of correlation. What do we mean by "lower degree of correlation" It's simple, really. It means combining strategies that perform differently in the same kind of market conditions. The simplest example would be growth stocks and value stocks. When growth stocks are in favor, value stocks tend to be out of favor; when growth stocks are out of favor, value stocks tend to be in favor. If you use a two-pronged approach that includes a growth-focused strategy and a value-focused strategy, you'll see less volatility in your portfolio. Your highs might not be quite as high but, more importantly, your lows won't be as low during down times.
Why is it particularly important to smooth out those down times? The biggest reason is that downside volatility isn't just unpleasant it also costs you money. Let's see why. Consider a $10,000 portfolio (you could use any amount) that gains 25 percent one year, loses 30 percent the next, and gains 14 percent in the third. On the surface, it would seem like your average annual gain was 3 percent, because that's what you get when you average 25, 30, and 14 and divide by 3 years. But let's look at what you actually would gain.
The first year, your 25 percent gain on that $10,000 investment grows your portfolio to $12,500. The second year, you lose 30 percent on that new amount, dropping the $12,500 down to $8,750. Then, you gain 14 percent on that $8,750 in the third year. That leaves you with $9,975 after three years, $25 less than what you started with.
What happened to the 3 percent per year gain we were expecting? In a sense, it got washed away in the 30 percent drop in that second year, which significantly knocked down your capital. The 30 percent decline was 30 percent of $12,500 ($3,750); by comparison, the 14 percent gain the next year was 14 percent of just $8,750 (what you were left with after that bad second year). Because of that lower starting point, your 14 percent gain in the third year didn't get you back about half of the 30 percent you lost in year two, as you might expect; it instead recouped just $1,225 less than a third of what you lost in the second year.
The bottom line here is that in the stock market, your gains are compounded; that is, after your first year, you start earning money not on your initial investment, but on whatever you had at the end of the previous year, be it more or less than your initial investment. A bad down year thus doesn't just mean you lose a bunch of money one year; it's also limiting the potential money you can make next year, because any percentage gain will now be made on a lower base.
On the other hand, compound interest works for you if you're gaining ground, since you are generating returns off your principal and your gains from the previous year(s). The more you can smooth out the valleys and keep your portfolio growing in a steady upward trend, the better, even if it means you're smoothing out some of the peaks in big years.
There's another less tangible reason to limit your downside volatility: You'll feel less of an urge to ditch your approach when times get tough. Ideally, the data we've presented showing that sticking to a strategy is imperative has been so moving that you won't need this reassurance. But when investment dollars start disappearing in chunks, emotions can get so intense that even the best investors can lose their cool and jump ship. Anything that helps keep you stay the course and stick to your long-term strategy is thus a help, and combining strategies to limit losses during down times does just that.
If this type of blending sounds familiar, it's because you've seen it before. James O'Shaughnessy used such an approach in developing his United Cornerstone strategy, which we covered in Chapter 11. O'Shaughnessy's United Cornerstone approach didn't produce the best absolute returns in his study of more than four decades of stock market data; that distinction belonged to an approach in which he targeted stocks with price-sales ratios less than 1.0 and high relative strengths. But O'Shaughnessy settled on the United Cornerstone approach because it had the best risk-adjusted returns, as demonstrated by its Sharpe ratio, a risk-adjusted return measure developed by Nobel-laureate William Sharpe.
The Sharpe ratio takes into account not only returns, but also standard deviation. (If mathematical terms such as standard deviation make your head hurt, don't worry; it's basically just a measure of how volatile a strategy or a portfolio is). Notes O'Shaughnessy in What Works on Wall Street, "Generally, investors prefer a portfolio earning 15 percent a year with a standard deviation of 20 percent to one earning 16 percent a year with a standard deviation of 30 percent. A 1 percent absolute advantage doesn't compensate for the terror of the wild ride." The best combination of lower-risk, higher-return strategies, O'Shaughnessy found, was the blended United Cornerstone approach.
Our own findings support O'Shaughnessy's research. A Total Blend portfolio of stocks that used all 10 of the strategies detailed in this book, weighting each one equally, would have produced a better Sharpe ratio than any of the individual strategies from July 2003 through April 2008. That is, it would have had a better combination of high returns and low risk than any of our individual models. Its annualized return of 19.89 percent was better than all but three of our individual models, and it posted those returns while having a lower standard deviation than all of the individual models except the Greenblatt approach (and it trailed that by only 0.08 percentage points).
Using blended strategies in a single portfolio isn't just a way to smooth out returns. Done properly, it can also improve returns over the long haul. While the "Total Blend" approach we examined in the previous section puts the top picks of different individual strategies into a single, large portfolio, another type of blending involves looking for stocks with the most combined interest from different strategies. Most of our models examine a series of different variables when analyzing a stock, which means that using just one of these strategies ensures you're getting a stock that is financially strong on a number of different levels. But when you focus on stocks with multiguru approval, you're getting stocks that have really been put through the ringer.
A good case in point is the Validea Hot List portfolio that we track on our website. The Hot List looks for stocks that get the most combined interest from our strategies. It also gives greater weight to the strategies with the most historical success, meaning that the stocks it picks are fundamentally strong on a number of levels and get interest from strategies that have been very successful over the long term.
The results show what a multiguru blending approach can do. After five years of tracking, the Hot List had a higher annualized return than all but two of our guru-based models (our Kenneth Fisher- and Benjamin Graham-based approaches). From its July 15, 2003 inception through July 15, 2008, the portfolio gained 123.4 percent, more than five times the S&P 500s 21.4 percent gain during that time. What's more, the Hot List posted those impressive gains while having a standard deviation (remember, that's a measure of volatility) not much greater than most of our individual strategies. On a risk-adjusted basis (i.e. based on its Sharpe ratio), the only strategy that beat the Hot List by any significant amount was our Fisher model.
While an individual guru model may outperform the Hot List in a given period (as the Fisher model has done in recent years), we believe that over the longer term a blended approach will achieve the best results, because it limits downside risk when an individual strategy is going through a down period.
How does using a blended approach keep volatility in check and still beat out so many individual strategies in terms of absolute returns? A big part of it has to do with the thoroughness of our diverse group of individual models. For example, you can usually find a handful of stocks in the market that pass both our Peter Lynch-based fast-grower approach and our James O'Shaughnessy-based value model. These stocks must be growing earnings at a clip of at least 20 percent over a five-year span and have manageable debt to pass the Lynch fast-grower test, but they also must have the size and strong dividend yield and cash flow that the O'Shaughnessy value method requires. That combination of factors makes for a very, very complete stock, one that is growing earnings quickly, is conservatively financed, and is even paying a nice dividend. Over the long haul, it's hard to imagine many stocks with this kind of multiguru approval not improving.
Guru Spotlight: Kenneth Fisher
For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.
But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.
While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.
Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He made Forbes' list of "The 400 Richest Americans" again last fall, his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.
It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.
So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 55.8 percent, while the S&P 500 has lost 15.5 percent. That makes it one of my most successful long-term strategies.
Price-to-Sales and "The Glitch"
Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.
But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.
The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.
According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.
One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.
Beyond the PSR
While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.
Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year).
Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.
The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. A few newsletters back, we looked at the Guru Strategy I base on the writings of John Neff, who focused on the P/E ratio but used other fundamental measures to make sure that low P/E stocks weren't selling on the cheap because they were dogs. Much in the same way, the Fisher-based model identifies undervalued stocks using the PSR, but makes sure the firms behind those stocks have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach is why I think the strategy has yielded such strong results, and why I think it will continue to do so in the coming years.
News about Validea Hot List Stocks
Net 1 UEPS Technologies (UEPS): On Feb. 5, Net 1 UEPS reported second quarter GAAP net income of $27.76 million, or $0.49 per share, up from $20.32 million, or $0.36 per share, in the year-ago period. Revenues for the period ending Dec. 31 fell to $61.4 million from $68.5 million.
Polo Ralph Lauren (RL): The retailer's net income fell 6.6 percent for its fiscal third quarter, with earnings per share coming in at $1.05 (vs. $1.08 in the year-ago period), The Wall Street Journal reported on Feb. 5. The results still beat expectations, in part because of the firm's international business, the Journal reported, but Lauren did cut its fiscal year outlook.
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 email@example.com.
The use of the name of a financial analyst, identified as a "guru" represents the interpretation by Validea of that person's key investment analysis principles, as derived from published sources. The use of a guru's name does not mean that he personally endorses, or even agrees with any of the representations made with respect to specific securities as derived by Validea from its interpretation of his or her investment methodology.
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Fundamental data provided by Reuters