The Economy
Despite a surprisingly weak fourth-quarter GDP report, it appears that overall, the U.S. economy is continuing to push forward.
The GDP report showed that the economy shrank 0.1% last quarter, significantly worse then the 1.1% average that economists had forecast, according to Bloomberg. But a couple big factors that led to the slight contractions appear to be one-time issues. For one thing, defense spending dropped sharply, perhaps in expectation that the U.S. would go of the "fiscal cliff", triggering dramatic budget cuts. For another, there was also a sharp decline in private inventory accumulation, which I am guessing had to do with businesses wanting to be as streamlined as possible in the event that we did go off the cliff. According to Bank of America/Merrill Lynch, the decline in defense spending and the decline in inventory accumulation lowered GDP by 2.6 percentage points during the quarter. Otherwise, several key parts of the report -- including consumer spending, business spending, and housing -- we're pretty strong , indicating that overall things are continuing to improve.
Bolstering that contention were some other economic reports. Home prices in 20 major U.S. cities rose an average of 0.6% in November, according to the latest data from the S&P/Case-Shiller Home Price Indices. The year-over-year increase was 5.5% -- the largest since August 2006, when the housing boom was in full effect (here and below, week-over-week or month-over-month data is seasonally adjusted; year-over-year data is not). The National Association of Realtors' Pending Home Sales Index, meanwhile, fell 4.3% in December, but the reason appeared to be a lack of inventory. The index was still about 5% higher than it was a year ago, the 20th straight month that the year-over-year change has been positive.
Another positive sign: Durable goods orders jumped 4.6% in December, according to a new Commerce Department report.
Job market data has been somewhat mixed, with the data suggesting that post-holiday seasonal effects may be causing some volatility. Prior to this week's report, new claims for unemployment had fallen sharply over the previous two weeks, reaching their lowest level in five years on a seasonally adjusted basis. On an adjusted basis, however, new claims were actually up from where they were the previous year in those two weeks. All of that changed with this week's report, though, as seasonally adjusted claims rose to 368,000, within the range we've seen for most of the past year, and unadjusted claims showed a sharp drop from the same week last year. Unadjusted new claims were down more than 13% from the year ago period. Continuing claims (the data for which lag new claims by a week) have fallen slightly over the past two weeks, and now sit about 10% below year ago levels.
As far as earnings, so far the fourth-quarter results have been good. As of January 30, with 133 of the S&P 500 companies having reported, about 67% had exceeded expectations, slightly above the 65% average for the past four quarters, according to Thomson Reuters.
Since our last newsletter, the S&P 500 returned 1.2%, while the Hot List returned -1.6%. So far in 2013, the portfolio has returned 4.8% vs. 5.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 184.2% vs. the S&P's 49.7% gain.
A (Non-random) Walk Through Graham-and-Doddsville
The results are in, and they show that 2012 was another tough year for mutual fund managers: About 65% of U.S. large-cap core stock funds lagged the S&P 500, according to Goldman Sachs and The Wall Street Journal. That was actually better than the past two years, when the figure was close to 80%. But it's still pretty dismal. So, too, is this: Of the nearly 2,000 U.S. stock funds tracked by Morningstar, only 10% beat their benchmark in both 2011 and 2012, the Journal reports.
Over the longer term, the results aren't much better. And those sort of results, some might argue, are evidence that it's just not possible to beat the market over the long haul. I disagree -- and if you want some good evidence that the market is not, as efficient market hypothesis proponents say, a "random walk", Warren Buffett has provided it. In a 1984 speech he gave at Columbia University entitled "The Superinvestors of Graham-and-Doddsville", Buffett examined the remarkable track records of a small group of investors who studied under Benjamin Graham, the man known as "The Father of Value Investing". He explained that from 1954 to 1956, there were four "peasant level" employees working under Graham at the Graham-Newman Corporation (David Dodd and Jerome Newman were among the firm's other directors). Three of those "peasants" (Walter Schloss, Tom Knapp, and Buffett himself) established easily traceable track records after leaving the firm, Buffett said -- and all of those track records were tremendous.
Schloss, who passed away last year at the age of 95, produced gains of 16.1% and 21.3% annualized at two partnerships over a 28-year period, while the S&P 500 gained just 8.4% per year, according to a revised version of Graham's The Intelligent Investor (which used Buffett's 1984 speech as its introduction). Another of the "peasants", Tom Knapp, produced annualized gains of 20% and 16% at two funds over a 15-year period, vs. 7.0% for the S&P. And Buffett, of course, may have the best investment track record of all-time. Prior to taking over Berkshire Hathaway, he produced annualized returns of 29.5% and 23.8% at two partnerships over a 13-year period, while the broader market was returning 7.4% per year. Then he moved on to Berkshire, where his track record is well known.
Those three weren't the only Graham/Dodd/Newman disciples who produced stellar long-term returns. Bill Ruane, Charlie Munger, John Templeton, John Neff -- all of these gurus and others worked under or learned from Graham and company. To Buffett, that was proof that the value investing tenets Graham espoused were a real way to beat the market over the long haul. "A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village," he said in his speech. In other words, the results show that Graham-style value investing works.
It's hard to argue the point, and my success with Graham's strategy only bolsters the already impressive case. Since its mid-2003 inception, my 10-stock Graham-based portfolio is up 242.6% (through Jan. 30), compared with 50.1% for the S&P 500. That's a 13.8% annualized gain vs. 4.3% for the index. My 20-stock Graham-inspired portfolio has been even better, returning 334.2% (16.6% annualized) over that period. All of the stocks in those portfolios were chosen using a strategy inspired by the "Defensive Investor" approach Graham laid out some 64 years ago in his book.
The "Superinvestors" aren't the only evidence that value investing works over the long haul. Other value-focused strategists, like Joel Greenblatt, Donald Yacktman, and David Herro, have also put up very strong long-term track records. And, in past newsletters I've examined studies done by the Brandes Institute and by Elroy Dimson, Paul Marsh, Mike Staunton, and Jay Ritter, both of which showed that value stocks (identified using a number of different valuation metrics) have outperformed the broader market for decades and decades.
While there are different value-focused approaches one can take to beat the market over the long haul, I have found that the best value investors generally share two key similarities: They focus on numbers -- that is, a company's financials and fundamentals -- rather than hype, and they stayed disciplined over the long haul. That's how they distinguish themselves "in kind -- not in a fancied superior degree," from the rest, as Graham said one needed to do in order to succeed in investing. In his day, just as today, most investors weren't investors at all -- they were speculators, buying and selling stocks based on rumor, hunches, and emotions. Succeeding in the market, Graham believed, wasn't a matter of being a better speculator than others. It was a matter of using a different tactic altogether -- that is, being analytical, rational, and disciplined. To invest well, one needed to analyze the numbers on the company's balance sheet and in its fundamentals, determine what its shares were worth, and pay less for them. That meant going against the crowd, buying stocks that were unloved, and avoiding the popular, overpriced shares that everyone seemed to be buying. It also meant sticking with that mindset, even during very rough short-term periods -- no small task. "Successful investment," Graham wrote, "may become substantially a matter of techniques and criteria that are learnable, rather than the product of unique and incommunicable mental powers. The intelligence here presupposed is a trait more of the character than of the brain."
Today, one might think that our high-tech world has made it harder for value investing to work, because information is now so easily accessible. In Graham's day, it took a lot of legwork and effort to analyze even one company's financials and fundamentals. But those who had the time, desire, and initiative to find and crunch the numbers could get a huge leg up on others. Today, the Internet gives us financial and fundamental information on thousands of stocks with just a few mouse clicks. Finding a company with a strong return on equity, low debt, and dirt-cheap shares is something that just about anyone can do, and do quite easily.
Why then, is a value strategy like Graham's continuing to work today? After all, when a metric or strategy becomes known, it can become endangered -- if too many people start following it, the prices of the stocks it targets will shoot up to overvalued levels, essentially killing the usefulness of the metric or strategy. Why hasn't that happened with Graham's approach and other value-focused strategies? I think it's because the technological forces that have helped level the playing field in terms of timely access to financial and fundamental data have also made it much harder for people to focus on the long-term. As easy as it is to get financial and fundamental data that can help you identify strong value stocks, it's even easier to get another piece of data: stock prices -- get them anywhere, anytime. Turn on the TV, pop open your laptop, click on your phone -- all of them give you a front row seat to every up and down of every stock in your portfolio, and the rest of the market. And your computer and your smartphone give you the ability to act on any one of those ups or downs in a matter of seconds. Because we humans are emotional creatures, many, if not most, investors end up acting far more than they should, selling goods stocks that have had a bad day, or buying hot stocks that have had a good day, without regard to what truly matters: what those shares are really worth.
So, while it is far easier for average investors to find good value stocks today than it was in Graham's day, it's also far more difficult to hold onto them. And that's a good thing for disciplined value investors. Since many investors will dump shares of good companies when they see one negative Tweet or get an alert telling them that the stock is down a few percent today, those investors who are rational and disciplined can swoop in and snatch up the bargains left behind. It's a difficult task, of course, because the whims and emotions of the market can take those bargain-priced shares any which way in the short term. But eventually, more often than not, the market recognizes the value in a bargain, something Graham knew well. If you have the stomach for those short-term gyrations, and the discipline to stick with a good value-focused approach over the long term, you can thus still generate some very nice returns over the long haul. That's how my Graham-based portfolios have fared so well, and how the Hot List has produced some exceptional long-term returns of its own. If you focus on the fundamentals and stay disciplined over the long haul, you can do the same.
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Editor-in-Chief: John Reese
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Guru Spotlight: Joel Greenblatt
Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.
Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.
Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.
Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.
In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.
The Details
To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.
The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.
In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.
In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.
We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past five years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 18.8%; the Greenblatt-based portfolio has gained 58.2% -- that's 6.6% annualized, vs. 2.4% annualized for the S&P. The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009, vs. 23.5% for the S&P. After beating the market again in 2010, it has struggled the past two years, however. But Greenblatt stresses that the strategy won't beat the market every month or even every year, which is important to remember. In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisiplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.
One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.
So far in 2013, the Greenblatt-based portfolio has bounced back strong, returning more than 10% already. Here's a look at its current holdings.
USANA Health Sciences Inc. (USNA)
Express Inc. (EXPR)
Strayer Education Inc. (STRA)
C&J Energy Services Inc. (CJES)
CACI International Inc. (CACI)
InterDigital, Inc. (IDCC)
CA, Inc. (CA)
Belo Corp. (BLC)
AmSurg Corp (AMSG)
PDL BioPharma, Inc. (PDLI)
News about Validea Hot List Stocks
Jos. A. Bank Clothiers (JOSB): Bank shares tumbled on Jan. 28 after the firm announced that its fiscal year 2012 net income is likely to be about 20% lower than its fiscal year 2011 net income. The firm says sales will be up for the year, but that they won't be up enough to offset higher marketing expenses and lower gross margin. Bank shares fell 15% the first trading day after the announcement. The stock had been a good performer before then, gaining 8.5% after joining the Hot List on Dec. 21.
Ross Stores (ROST): Ross shares made a nice jump on Jan. 24 after Credit Suisse upgraded the stock to outperform, from neutral, Investor's Business Daily reported. Credit Suisse raised Ross' target price to 68 from 60. Ross, which joined the Hot List in October, has gained nearly 12% so far in 2013.
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.
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