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Executive Summary October 23, 2015

The Economy

It's been relatively calm fortnight on the economic front, with generally positive domestic data -- particularly the latest employment numbers -- being counterbalanced by fears of slowing growth overseas.

At home, new claims for unemployment have fallen slightly since our last newsletter, and are now about 9% below where they were a year ago. Even more impressively, the four-week average for new claims fell to its lowest level in almost 42 years. Continuing claims, the data for which lag new claims by a week, also moved lower since our last newsletter and are also 9% below year-ago levels..

Retail sales, meanwhile, edged higher by 0.1% in September, according to a new report from the Census Bureau, driven by a nice jump in automobile sales. That's about 2.5% higher than the year-ago level.

Housing starts rose 6.5%, in September, meanwhile, according to the Census Bureau, and are about 18% above year-ago levels. Permit issuance for new construction fell 5%, but is 4.4% above where it stood a year ago.

Inflation is, well, deflation. The Consumer Price Index slid 0.2% in September, according to the Labor Department. That put it even with its year-ago pace. But if you strip out volatile food and energy prices, so-called "core" inflation, which was up 0.2% in September, is 1.9% ahead of its year-ago pace. The difference between the overall inflation and core inflation numbers is, of course, a result of the huge decline we have seen in oil and other commodities over the past year.

And those oil and gas prices keep falling, though the declines have been moderating. As of October 21, a gallon of regular unleaded on average cost $2.24, down from $2.29 a month earlier. That's 27.5% below where it was one year ago.

Overseas, China announced that gross domestic product rose 6.9% for the third quarter, marking the first time since 2009 that the figure has been below 7%. That's no surprise -- it's been clear that China's growth has been slowing for several quarters now. While the slowing growth has meant less worldwide demand for commodities, 6.9% is nothing to sneeze at, but the fact that growth dropped below 7% for the first time in six years may provide more impetus for China's leaders to increase their efforts to reinvigorate growth. In the longer term, the relatively weak quarter could thus end up being a positive.

Since our last newsletter, the S&P 500 returned 1.9%, while the Hot List returned -2.3%. So far in 2015, the portfolio has returned -0.2% vs. -0.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 222.9% vs. the S&P's 105.2% gain.

A Quant's Journey

One of the reasons that I love investing is that it is a constant learning process. With so many factors impacting stocks day in and day out, no one -- not Peter Lynch, not Carl Icahn, not even Warren Buffett -- has learned all there is to know about the market, and I doubt anyone ever will. To succeed, you must constantly be looking at things from different angles, evaluating and re-evaluating your assumptions as the market tests you over and over again. Trying to wrap your arms around the enormous, dynamic machine that is the stock market is a fascinating, and sometimes humbling, endeavor.

But while the specifics of financial markets are constantly changing, that doesn't mean you can't extract some enduring lessons from the shifting landscape. Given that we recently hit the 12-year anniversary of running the Hot List and our other guru-inspired portfolios, I've been thinking a lot about just what lessons I've learned over these past dozen years, and there are plenty of them. In this week's newsletter and our next rebalancing newsletter, I'd like to share those lessons with you.

To start, this week I'll look at what I've learned from the copious amounts of data that we've compiled while monitoring these model portfolios. In Part Two, I will focus more on the psychological lessons I've taken away from the past dozen years.

Lesson 1: Quantitative Strategies Work: The ubiquity of the Internet has made stock market information available far and wide to the masses over the past 12 years. In theory, efficient market hypothesizers would say, that should make quantitative strategies lose their effectiveness. According to the EMH, the market digests all well-known information and factors it into stock prices. The advantages that one used to get from digging through newspapers and financial reports should largely disappear when just about anyone can instantaneously get access to that information through stock screening websites.

But our experience shows a much different scenario. Since their respective inception dates (most of which came in 2003), the 14 ten-stock portfolios we track (which include 12 individual guru-based portfolios and our 2 consensus portfolios) have returned an average of 8.32% annualized. Over the same timeframe, the S&P 500 has returned 5.69% annualized. Of the 14 portfolios, 11 have beaten the S&P, many by a wide margin.

It's not just the 10-stock portfolios. The 20-stock versions that we track have returned 8.16% annualized, compared to that 5.69% figure for the S&P. For the larger portfolios, 12 of the 14 have beaten the index.

How can this be? It's because markets are not completely efficient, and investors are far from completely rational. When times are tough, they expect the difficulties to go on forever, whether it applies to an individual company or the broader market. When the good times are rolling, they expect them to go on forever. Their frequent overreaction creates an environment in which disciplined investors can take advantage of mispricings, and quantitative strategies are a great means to do so because they can give you an almost instantaneous look at cold, hard financial data for thousands of stocks.

Lesson 2: Blending Strategies Helps: While many of the individual guru-inspired strategies we track have fared quite well, we have found that using multiple strategies in a single portfolio -- like we do with the Hot List -- can further enhance returns. Both the Hot List, which looks for stocks that get consensus from multiple models, and the Top 5 Gurus portfolio, which selects the top 2 picks from 5 of our best strategies, are among our best 10-stock portfolios since their inceptions 12 years ago. The Top 5 Gurus portfolio has returned 13.8% annualized, while the Hot List is up 9.8% annualized. The 20-stock versions of these portfolios also both beating the S&P, with the Hot List up 9.1% and the Top 5 Gurus up 6.7%. The average annualized return for these 4 multi-strategy portfolios: 9.85%, topping both the average for our individual-guru portfolios and the S&P 500.

Lesson 3: Relative Strength Provides Consistency: One of the interesting things we found over the past dozen years is that strategies that include a 12-month relative strength component -- that is, those that look for stocks that have fared well over the past year compared to other stocks in the market -- have been more consistent than those that do not. The 10-stock Motley Fool-inspired portfolio has finished in the red in just one year since its 2003 inception; a 20-stock version of the portfolio has been in the red in just two years. The 10-stock Momentum Investor portfolio, meanwhile, has posted negative returns in just two years over that span, while its 20-stock version has done so just three times. And the James O'Shaughnessy-inspired 10- and 20-stock growth portfolios that we track internally have each been negative in just two of the years since their 2004 inceptions. In contrast, many of our other portfolios (including some of the top performers) have been in the red in 4 or more years.

Whether or not this trend continues to hold up remains to be seen. The relatively small number of down years for strategies with a RS component could, perhaps, be due to the lengthy stretch of outperformance that we've seen from growth and momentum stocks in the past 5 to 10 years. But it may also be because a relative strength component can act as a sort of stop-loss. When a stock declines, there's a good chance that its relative strength will also decline (unless the whole market is declining). So, if a strategy is looking for stocks with high relative strengths, a sharply declining holding will likely lose points on that criteria, and could find itself out of the portfolio before it declines much further. That doesn't mean using a relative strength component automatically leads to better returns -- such strategies will miss out on the strong rebounds that beaten-down value stocks can have. But it does appear that it can make for smoother returns and less of a downside in a given year.

Lesson 4: Concentrated Portfolios Can Provide All The Diversification You Need -- With One Big Caveat: "Don't put all your eggs in one basket" is timeless wisdom, and it certainly applies in the stock market. But our experience shows that to give yourself enough diversification, you can use far fewer baskets than you might think.

As I noted in a recent newsletter, many studies show that portfolios of 20 to 50 stocks provide sufficient diversification. But keep in mind that most of those studies are operating under the premise of randomly selected portfolios -- essentially, they are saying that if you were to randomly pick stocks, you should pick 20 to 50 to get proper diversification. It's not accidental that these studies focus on random picks - efficient market hypothesis thinking is prevalent in the academic world, and the EMH stipulates that the market is too efficient for any stock-picker to consistently do better than a randomly selected portfolio. I disagree, as I think that successful investors like Warren Buffett, Peter Lynch, Joel Greenblatt, and Benjamin Graham have proven that you can use careful stock analysis to beat the market. A good quantitative stock-picking strategy should screen out financially troubled stocks or those that are wildly overvalued -- the types of trouble stocks that would require you to hold more stocks in order to get proper diversification. Over the past 12 years, our 20-stock portfolios have on average not provided better returns than our 10-stock portfolios, nor have they come with less overall volatility or smaller maximum drawdowns.

The caveat is that, when you do get a big loser in a 10-stock portfolio (and it's inevitable that you will), it can have a significant impact on your short-term returns. It also just looks bad. Seeing that one of your 10 holdings is down, say 30%, can make your stomach churn in a way that it wouldn't if you held, say, 100 stocks -- and that is very likely going to make you want to jump ship and ditch your strategy. After a few big losers, you might also start wanting to veto some of your model's picks, fearing that some of the more unloved stocks that pop up on your "buy" list could end up driving down your entire portfolio.

If you want to succeed, however, overriding your strategy is a line you cannot cross. Why? For the answer to that, you'll have to wait until Part Two, when I look at the psychological lessons I've learned from my 12 years of quantitative investing.

Editor-in-Chief: John Reese

The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Zumiez Inc. (ZUMZ), Marcus & Millichap Inc (MMI), Travelers Companies Inc (TRV) and Bofi Holding, Inc. (BOFI).

The Keepers

6 stocks remain in the portfolio. They are: Sanderson Farms, Inc. (SAFM), Universal Insurance Holdings, Inc. (UVE), Foot Locker, Inc. (FL), Wisdomtree Investments, Inc. (WETF), Chart Industries, Inc. (GTLS) and Heritage Insurance Holdings Inc (HRTG).

The Newbies

We are adding 4 stocks to the portfolio. These include: Apple Inc. (AAPL), Polaris Industries Inc. (PII), Eagle Bancorp, Inc. (EGBN) and Pinnacle Financial Partners (PNFP).

Portfolio Changes

Newcomers to the Validea Hot List

Apple, Inc. (AAPL): The tech behemoth is back, rejoining the Hot List this week. The iGiant has taken in nearly $225 billion in sales over the past year, and has a $650 billion market cap. Its fundamentals are still impeccable: a 41% return on equity, 23% profit margins, 27% long-term revenue growth, and a 0.45 PE-to-Growth ratio.

Apple gets strong interest from my Warren Buffett- and Peter Lynch-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Polaris Industries (PII): This Minnesota-based company makes off-road vehicles (including all-terrain and side-by-side vehicles and snowmobiles) and on-road vehicles (including motorcycles and small electric vehicles). The $7-billion-market-cap firm has taken in close to $5 billion in sales over the past year.

Polaris' fundamentals earn it strong interest from my Peter Lynch- and Warren Buffett-based models. For details about its impressive balance sheet and growth numbers, scroll down to the "Detailed Stock Analysis" section.

Pinnacle Financial Partners (PNFP): Pinnacle provides a full range of banking, investment, trust, mortgage and insurance products and services designed for businesses and their owners and individuals. The 15-year-old firm has about $6.5 billion in assets and is the second-largest bank holding company headquartered in Tennessee. It operates in Middle Tennessee, Memphis, East Tennessee and Chattanooga.

Pinnacle gets strong interest from my Peter Lynch-based model, and high scores from my Martin Zweig-based model and Momentum Investor approach. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

Eagle Bancorp, Inc. (EGBN): This $1.5 billion market cap firm is the parent of EagleBank, a local community business bank with twenty-two offices in Maryland, Northern Virginia and Washington, DC. It also offers a complete line of personal banking products and services.

Eagle is a favorite of my Peter Lynch-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

The Travelers Companies (TRV): Helped by higher underwriting gains, Travelers announced solid quarterly earnings results. Travelers' net income rose to $928 million, or $2.97 per share, up from $919 million, or $2.69 per share, a year earlier, Reuters reported. Operating income was $2.93 per share, beating the average analyst estimate of $2.27, according to Thomson Reuters I/B/E/S. Underwriting gains rose about 35% to $759 million in the third quarter.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. If you have any questions, please feel free to contact us at hotlist@validea.com.

Current Portfolio

Detailed Stock Analysis

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

GTLS   |   UVE   |   SAFM   |   FL   |   HRTG   |   PNFP   |   WETF   |   PII   |   AAPL   |   EGBN   |  

Chart Industries, Inc. (Chart) is a diversified manufacturer of engineered equipment engineered equipment for the industrial gas, energy, and biomedical industries. The Company's equipment and engineered systems are used for low-temperature and cryogenic applications. It operates through three segments: Energy & Chemicals (E&C), Distribution & Storage (D&S) and BioMedical. Its products include vacuum insulated containment vessels, heat exchangers, cold boxes and other cryogenic components. Its E&C and D&S segments manufacture products used in energy-related and industrial applications, such as the separation, liquefaction, distribution and storage of hydrocarbon and industrial gases. Through its BioMedical segment, it supplies cryogenic and other equipment used in the medical, biological research and animal breeding industries. The Company, through Thermax, Inc., provides cryogenic fluid vaporizers utilized in industrial gas, petro-chemical and liquefied natural gas applications.

Universal Insurance Holdings, Inc. (UIH), with its wholly owned subsidiaries, is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. The Company's offers homeowners' insurance through the Insurance Entities, Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC). Substantially all aspects of insurance underwriting, distribution and claims processing are performed by the Company's subsidiaries. UPCIC, a wholly owned subsidiary of the Company, is a writer of homeowners insurance in Florida and has commenced its operations in North Carolina, South Carolina, Hawaii, Georgia, Massachusetts, Maryland, Delaware, and Indiana. APPCIC, also a wholly owned subsidiary, writes homeowners multi-peril insurance on Florida homes valued in excess of $1 million, which are limits and coverages currently not targeted through its affiliate UPCIC.

Sanderson Farms, Inc. is a poultry processing company which is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared chicken items. In addition, the Company is engaged in the processing, marketing and distribution of prepared chicken through its wholly owned subsidiary, Sanderson Farms, Inc. (Foods Division). It produces a range of processed chicken products and prepared chicken items. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, and casual dining operators in the south-eastern, south-western, north-eastern and western United States and to customers who resell frozen chicken into export markets. During the fiscal year ended October 31, 2013 (fiscal 2013), it processed 452 million chickens, or over 3.0 billion dressed pounds.

Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailer whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction and SIX:02, as well as the retail stores of Runners Point Group, including Runners Point and Sidestep. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., and the direct-to-customer subsidiary of Runners Point Group, which sell to customers through their Internet and mobile sites and catalogs. As of January 31, 2015, the Company operated 3,423 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand. As of January 31, 2015, the Company operated a total of 78 franchised stores, of which 31 are in the Middle East, 27 in Germany and Switzerland, and 20 in the Republic of Korea.

Heritage Insurance Holdings, Inc. (Heritage Insurance), formerly Heritage Insurance Holdings, LLC, is a property and casualty insurance holding company. The Company is engaged in providing personal and commercial residential insurance. Through Its subsidiary, Heritage Property & Casualty Insurance Company (Heritage P&C), it provides personal residential insurance for single-family homeowners and condominium owners, rental property insurance and commercial residential insurance in the state of Florida. The Company is vertically integrated and control or manage all aspects of insurance underwriting, actulato analysis, distribution and claims processing, and adjusting. It has approximately 207,000 personal residential policies in force and approximately 2,400 commercial residential policies in force.

Pinnacle Financial Partners, Inc. (Pinnacle) is a bank holding company. Pinnacle operates through its wholly owned subsidiary, Pinnacle Bank. The Company operates as a community bank primarily in the urban markets of Nashville and Knoxville, Tennessee. As an urban community bank, Pinnacle provides the personalized service associated with small community banks, while seeking to offer the products and services, such as investments and treasury management, offered by large regional and national banks. Pinnacle Bank offers an array of convenience-centered products and services, including 24-hour telephone and internet banking, mobile banking, debit and credit cards, direct deposit, remote deposit and cash management services for small- to medium-sized businesses. In addition, Pinnacle Bank is associated with a network of automated teller machines of other financial institutions that its clients are able to use throughout Tennessee and other regions across the nation.

WisdomTree Investments, Inc. is an asset management company that focuses on exchange-traded funds (ETFs). The Company's family of ETFs includes fundamentally weighted funds that track its own indexes, funds that track third party indexes and actively managed funds. The Company distributes its ETFs through all major channels within the asset management industry, including brokerage firms, registered investment advisers, institutional investors, private wealth managers and discount brokers. Most of its index-based funds employ a fundamental weighted investment methodology, which weights securities on the basis of factors, such as dividends or earnings, whereas most other ETF industry indexes use a capitalization weighted methodology. In addition, it also offers actively managed ETFs, which are ETFs that are not-based on a particular index but rather are actively managed with complete transparency into the ETF's portfolio on a daily basis.

Polaris Industries Inc. (Polaris) designs, engineers and manufactures off-road vehicles (ORV), including all-terrain vehicles (ATV) and side-by-side vehicles for recreational and utility use, snowmobiles, motorcycles and small vehicles (SV). These products are sold through dealers and distributors located in the United States, Canada and Europe. The Company's ORVs include core ATVs, and RANGER and RZR side-by-side vehicles. The Company produces a range of snowmobiles, consisting of 32 models, ranging from youth models to utility and economy models to performance and competition models. Polaris' Motorcycles division consists of Victory, Indian motorcycles and three-wheel roadster motorcycle, Slingshot. The Company offer products in the light-duty hauling, people mover and urban/suburban commuting sub-sectors of the small vehicles industry. The Company produces or supplies a range of replacement parts and accessories for its product lines.

Apple Inc. designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players and sells a variety of related software, services, peripherals, networking solutions and third-party digital content and applications. The Company's products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud and a variety of accessory, service and support offerings. The Company offers a range of mobile communication and media devices, personal computing products and portable digital music players, as well as a variety of related software, services, peripherals, networking solutions and third-party hardware and software products. The Company's primary products include iPhone, iPad, Mac, iPod, iTunes, Mac App Store, iCloud, Operating System Software, Application Software and Other Application Software.

Eagle Bancorp, Inc. is a bank holding company for EagleBank (the Bank). The Bank is the Company's principal operating subsidiary. The Bank is a chartered commercial bank. The Bank operates twenty two banking offices: seven in Montgomery County, Maryland; five located in the District of Columbia, and ten in Northern Virginia. The Bank offers a range of commercial banking services to its business and professional clients, as well as consumer banking services to individuals living or working in the service area. The Bank also provides commercial banking services to sole proprietorships, small, medium and large-sized businesses, partnerships, corporations, non-profit organizations and associations, and investors. The Bank offers a range of retail banking services to accommodate the individual needs of both corporate customers as well as the community the Bank serves. The Bank also offers online banking, mobile banking and a remote deposit service.

Watch List

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


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

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

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