|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||March 19, 2010|
The economy keeps plugging along, continuing to show signs that the recovery is for real and that the Great Recession is in the rearview mirror.
Over the past fortnight, we've even seen some signs that the job market -- perhaps the most significant piece of the recovery puzzle yet to begin to fall into place -- is finally coming around. New claims for unemployment fell for the third straight week, according to a government report, and the Philadelphia Federal Reserve reported that its manufacturing index rose for the seventh straight month, largely due to improvements in its employment indicators. The group said the number of firms adding jobs outpaced the number of firms cutting jobs for the fourth straight month.
Overall, unemployment remains high, with the most recent figures showing that the unemployment rate held steady at 9.7% in February. But Gray & Christmas CEO John Challenger, whose firm conducts one of the more well known employment surveys, recently pointed out evidence indicating that that figure may be on the verge of substantial improvement. Challenger told Yahoo! TechTicker that we've had five straight months of "very light" layoffs, during a period (the fourth and first quarters) when layoffs are usually at higher levels. And employers have been steadily increasing the number of temporary employees they're hiring since September, he says; such increases are usually a leading indicator for permanent job growth. Challenger thinks we'll see more consistent job growth, and decreases in the unemployment rate, in the second half of 2010.
Elsewhere, data continues to show that the economy is stabilizing. The Commerce Department announced last week that retail sales -- which analysts had expected to decrease -- increased 0.3% in February. It was the second straight month they've risen, a sign that consumers aren't being as tight with their wallets as some had expected.
Industrial production also increased once again in February, though at a pace of just 0.1%, the Federal Reserve reported. That's a minor increase, but it still marked the eighth straight monthly increase -- and the gain came despite the fact that winter storms in the northeast likely held down production, according to the Fed. Capacity usage also rose for the eighth straight month.
Two of the big economic issues still involve the government. First, there's the issue of interest rates, which the Federal Reserve has been keeping extremely low, something that has likely been a major factor in the big stock market rally over the past year. What will happen when the Fed does raise rates remains to be seen, but inflation data released this week indicates that it may yet be a while before we find out. According to the Labor Department, the Consumer Price Index remained steady in February, and increased just 0.1% when food and energy prices, which tend to be volatile, were excluded. Wholesale prices fell 0.6%, meanwhile, as gas prices dropped. All of that means that inflation isn't yet rearing its head, which means the Fed will likely continue its low interest rate policy for some time.
The other key government-related issue involves the stimulus and bailout plans -- more specifically, what will happen when those training wheels are fully removed from the economy. No one knows for sure what the answer to that question is, but the continued growth in manufacturing, productivity, and other areas of the economy are good signs.
With the economic news continuing to lean to the positive side, the market has climbed over the past two weeks. The S&P 500 rose 3.8% since our last newsletter, while the Hot List is up 3.5%. The portfolio is now up 8.0% for the year vs. 4.5% for the S&P. Since its inception in July 2003, the Hot List has gained 160.3%, while the S&P is up 16.5%.
Shine Wears off of a Jeweler
While the Hot List had another strong fortnight and remains well ahead of the S&P for the year, one of its holdings had a dreadful performance this week that bears mentioning. Chinese jeweler FUQI International saw its stock plunge more than 37% Wednesday, after it announced that accounting mistakes had resulted in it overstating earnings for the first three quarters of 2009. (It also announced disappointing fourth-quarter results, which didn't help.)
The sharp decline triggered the Hot List's stop-loss rule, something that has happened very rarely throughout the portfolio's history. The stop-loss isn't set at one specific number, but instead is a function of the performance of a stock relative to the S&P 500. In periods where the market is up, like the period we are in now, our stop losses are tightened. During periods when the market is down, they are eased. We do this to ensure that stocks are removed due to their own individual problems and not something that is affecting the market as a whole. When a stock hits the stop-loss threshold, it is removed from the portfolio the next rebalancing, which is the case with FUQI today.
While such losses are never enjoyable, they do present a good opportunity to stress proper diversification. As you probably know, the Hot List is a fairly concentrated portfolio, but it still has enough holdings to cope with a big loss in one position, like the one FUQI sustained this week. Indeed, despite the FUQI loss, the Hot List still gained ground for the fortnight because FUQI's loss was dispersed over the broader portfolio, whose other holdings fared well.
It's also worth noting that the Hot List notched a 64.1% gain on Fuqi in 2009, so while FUQI's earnings revisions hurt the portfolio, the initially reported earnings had given the portfolio a big boost. Overall, last year's big gain and the big loss from earlier this week just about bring the stock's impact on the portfolio to zero since the start of 2009.
A (Re-)Balancing Act
This week, in addition to selling FUQI, the Hot List is cutting ties with five of its other holdings. Most have enjoyed solid performance, with Dresser-Rand, Oil States International, and NewMarket Corporation all up in the 15%-25% range (as of yesterday afternoon), GameStop in positive territory, and Telefonica slightly in the red. The six newcomers come from a variety of industries, including Aerospace & Defense (Raytheon); Retail Apparel (Jos. A. Bank Clothiers); Healthcare Facilities (Amedisys); Drugs (Sanofi-Aventis); Financial Services (Ares Capital); and Security Systems & Services (Brink's).
Because the portfolio is changing more than half of its holdings, I thought it would be a good time to touch on the importance of rebalancing. In a recent Hot List, I talked about some studies that showed the virtues of rebalancing in terms of asset allocation -- i.e., periodically returning the amount of stocks, bonds, or any other asset you hold back to pre-determined target weights within a multi-asset portfolio.
For the Hot List, the rebalancing is of a different sort, since the portfolio is composed of only one asset. In this case, we're talking about rebalancing stocks to 1.) ensure that the portfolio includes only the stocks that best meet an underlying quantitative strategy, and 2.) bring them back to target weights in an all-equity portfolio.
As you might imagine, there's not a lot of research on this type of rebalancing, since the results can vary depending on the underlying strategy you are using. But we've compiled a good amount of our own research on the topic after nearly seven years of running our model portfolios.
What we've found is that, generally, a monthly rebalancing works best for our portfolios, particularly for the consensus-based Hot List. Using simple averages, the 14 ten-stock portfolios we track on Validea.com (12 individual guru portfolios, the Hot List, and our Top 5 Gurus portfolio) have returned an average of 9.79% per year since inception when rebalanced monthly (note: our "monthly" rebalancings are actually every 28 days). When rebalanced quarterly, the returns have been slightly lower, averaging 9.16% per year. And when rebalanced annually, the difference is much larger, with the average return being 6.04% per year. (All those figures, and those that follow, are through Wednesday.)
For our 20-stock portfolios, it's been a similar story. The monthly rebalanced portfolios have averaged 9.17% per year; the quarterly rebalanced versions have returned 9.06%; and the annually rebalanced portfolios have returned 5.19%.
For the Hot List, a 10-stock, monthly rebalancing approach -- what we use for our newsletter tracking -- has been particularly kind. It's resulted in 15.4% annualized returns for the portfolio since inception, compared to 11.9% for a quarterly rebalancing approach, and 9.7% for an annual rebalancing. For the 20-stock version of the Hot List, the monthly rebalancing has led to 13.4% annualized returns, while the quarterly and annual figures have been 10.7% and 9.1%, respectively.
Interestingly, the other consensus-based portfolio we track, the Top 5 Gurus portfolio (which picks an equal number of stocks using the five individual Guru Strategies with the best track records) has also had the most success with a monthly, 10-stock approach. That's resulted in an annualized return of 14.2%, doubling its quarterly rebalanced cousin and easily beating its annually rebalanced version (11.7%). The results for the Top 5 Gurus 20-stock portfolio, meanwhile, ranged from 5.6% to 9.9% for the different rebalancing periods.
Pick It -- and Stick with It
Now, the important question: What do all of those numbers mean for your portfolio? Do they mean you should definitely use a monthly rebalancing period?
Not necessarily. While I think there's value in examining the numbers I laid out above, it's important to realize that they cover a period of about six-and-a-half years, so there's certainly the chance that they could shift over longer periods.
In addition, different strategies may fare better with different rebalancing periods, and some of the gurus I follow even use different rebalancing periods. (Joel Greenblatt, for example, recommends an annual approach.) Even within my models, there's wide variation in terms of what has been most successful. For example, while the Hot List clearly has performed best with a 10-stock, monthly rebalancing approach, my Joseph Piotroski-inspired model has generated annualized returns of more than 10% using an annual rebalancing and 20-stock portfolio, but only 3.7% per year when using a 10-stock, monthly rebalancing approach. Some of these types of differences may be due to chance; some may be due to the specifics of the strategy.
There are other factors to consider, too. Transaction costs, tax implications, and even the simple issue of the time you have available to put into your rebalancing efforts can be key issues.
So, what's the bottom line, then? To me, the key is picking a rebalancing period -- whatever it may be -- and sticking with it. A regularly scheduled rebalancing period of any length (within reason) helps you do something that most investors can't do if left to their own devices: keep emotion out of buy and sell decisions. We humans are emotional creatures, and as such we're prone to a number of cognitive biases when it comes to stock investing. I've mentioned many of them -- hindsight bias, anchoring, over-optimism -- in past Hot Lists, and they will wreak havoc on your portfolio.
By following a disciplined rebalancing system of whatever length you choose, however, you keep those biases and your emotions at bay -- and as an investor, there may be no more important task. You buy and sell when your approach says it's time to buy or sell -- not when you read about a hot stock, or when your neighbor gives you a tip on a "sure thing", or when you get a feeling that the broader market is about to turn up or down. I believe that that sort of disciplined buying and selling at regular intervals has been a big reason that the Hot List has performed so well over the long haul, and I think it's an attribute of our system that will help us continue to outperform in years to come.
As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: Telefonica S.a. (Adr) (TEF), Oil States International, Inc. (OIS), Newmarket Corporation (NEU), Dresser-rand Group Inc. (DRC), Gamestop Corp. (GME) and Fuqi International, Inc. (FUQI).
4 stocks remain in the portfolio. They are: Itt Educational Services, Inc. (ESI), Triumph Group, Inc. (TGI), Emcor Group, Inc. (EME) and Aeropostale, Inc. (ARO).
We are adding 6 stocks to the portfolio. These include: Amedisys, Inc. (AMED), Jos. A. Bank Clothiers, Inc. (JOSB), Raytheon Company (RTN), Sanofi-aventis Sa (Adr) (SNY), The Brink's Company (BCO) and Ares Capital Corporation (ARCC).
Newcomers to the Validea Hot List
Ares Capital Corporation (ARCC): Based in New York, Ares is a closed-end, non-diversified specialty finance company that focuses on underserved financing needs of private middle market companies across a variety industries. Its portfolio was valued at about $2.2 billion at the end of 2009, and was invested in 95 companies and backed by 67 private equity sponsors. About a third of its portfolio involves first lien senior debt, and substantial portions are invested in mezzanine and high-yield areas, second lien senior debt, and equity holdings.
Ares, which has a $1.85 billion market cap, currently gets some interest from an interesting trio of my strategies: my Martin Zweig-based Growth Investor model, my David Dreman-inspired Contrarian Investor approach, and my Peter Lynch-based P/E/Growth Investor model. To see why, check out the "Detailed Stock Analysis" section below.
Jos. A. Bank Clothiers (JOSB): Based in Hampstead, Maryland, this prior Hot List favorite is once again catching the portfolio's eye. The 100-plus-year-old retailer sells a variety of men's tailored, casual, and sports clothing, as well as shoes and accessories such as hats and belts. The small-cap ($900 million market cap), has more than 475 stores across the U.S.
Bank, which gained 78.2% while in the Hot List from Feb. 20 to Oct. 2 of 2009, gets strong interest from my James O'Shaughnessy growth model and my Peter Lynch-based strategy. To see why they like Bank, see the "Detailed Stock Analysis" section below.
Amedisys, Inc. (AMED): This Baton Rouge-based home healthcare and hospice services provider owned and operated 521 Medicare-certified home health agencies and 65 Medicare-certified hospice agencies as of the end of 2009, with operations in 40 states, the District of Columbia and Puerto Rico. It has a $1.7 billion market cap.
Amedisys is a favorite of my Joel Greenblatt- and James O'Shaughnessy-based models. The "Detailed Stock Analysis" section below explains why.
Raytheon Company (RTN): This Massachusetts-based aerospace & defense firm provides state-of-the-art electronics, products, and services in a variety of areas, including integrated defense systems, missile systems, space and airborne systems, and intelligence and information systems. It also provides a variety of mission support services. It has a market cap of about $21.5 billion, and has taken in more than $24 billion in sales in the past year.
Raytheon, which gained 14% while in the Hot List for a one-month stint last fall, gets approval from my Joel Greenblatt-, Peter Lynch- and James O'Shaughnessy-based models. The "Detailed Stock Analysis" section below explains why.
Sanofi-Aventis SA (SNY): Headquartered in Paris with operations in more than 100 countries, Sanofi makes a wide array of drugs, including Allegra (allergies), Ambien CR (a prescription sleeping aid), and Plavix (used to prevent blood clots). The $103 billion market cap firm has taken in more than $42 billion in sales in the past year.
Sanofi-Aventis gets strong interest from my Benjamin Graham-, Peter Lynch-, and James O'Shaughnessy-based models. To see why, check out the "Detailed Stock Analysis" section below.
The Brink's Company (BCO): This Virginia-based security firm operates in over 50 countries around the globe. Known for its armored car transportation services, it also provides ATM servicing, currency and coin processing, and other value-added services to banks, retailers and other businesses and governmental agencies.
Brink's, which has a $1.3 billion market cap and has taken in more than twice that in sales in the past year, gets approval from my Peter Lynch- and Kenneth Fisher-based models. The "Detailed Stock Analysis" section below explains why.
News about Validea Hot List Stocks
EMCOR Group, Inc. (EME): Fortune magazine has named EMCOR the 2009 World's Most Admired Company in the Engineering and Construction Industry, the second straight year EMCOR has been given the honor. The rankings are based on survey scores involving factors like Innovation, People Management, Use of Corporate Assets, Social Responsibility, Quality of Management, Long-Term Investment, and Quality of Service.
Fuqi International, Inc. (FUQI): On March 16, Fuqi announced that it had found accounting errors that caused it to overstate profit for the first nine months of 2009, and that revenue and profit came in below the company's expectations in the fourth quarter. The firm said an internal investigation found that its cost of sales was understated in 2009's first three quarters, causing the company to overstate the $1.66 in earnings per share it had reported for that period by an estimated $0.15 to $0.19, the Associated Press reported. FUQI is delaying the filing of its annual report because of the mistakes.
The worse-than-expected fourth-quarter results were due to customers buying cheaper products, the company said. Profit was between $0.24 and $0.28 per share for the quarter, as opposed to the previous forecast of $0.55 to $0.60, AP reported. Shares of FUQI fell more than 37% Tuesday.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take an in-depth look at one of my individual guru-based strategies. If you have any questions, please feel free to contact us at email@example.com.
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