Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary March 1, 2013

The Economy

After months of faring better than expected, the economy appears to have slowed, or perhaps plateaued, in recent weeks, and policymakers' continuing failure to act on the country's budget issues is threatening to exacerbate the slowdown.

Signs of the economy plateauing have come from several sources since our last newsletter. The Federal Reserve, for example, reported that industrial production dipped 0.1% in January, thanks in large part to a 0.4% decrease in manufacturing production. On the bright side, however, the Fed revised its estimate of fourth-quarter industrial production growth much higher, from 0.2% to 1.9%.

Existing home sales, meanwhile, crept up 0.4% in January, according to the National Association of Realtors. The slight improvement meant that sales are now nearly 12% above their year-ago level. Pending home sales, a forward-looking indicator, made a nice jump, rising 4.5%, according to the Realtor group. They are now more than 10% above year-ago levels.

January's home-building data was mixed. Permit issuance for new construction rose about 2% during the month, while housing starts dipped 8.5%. Both figures are still far ahead of their year-ago levels, with permit issuance up more than 41%, and housing starts up about 24%.

Good news came on the home prices front. Prices in 20 major U.S. cities rose an average of 0.9% in December, according to the S&P/Case-Shiller Home Price Indices. For the fourth quarter, prices were up a full 2% versus the third quarter. The data also showed that for the full 2012 year, prices jumped 7.3%. Despite the nice gains, prices are still well below their housing bubble peaks; both the 10-and 20-city composite indices are about 30% below those 2006 levels.

Continuing claims for unemployment have stayed about the same over the past two weeks. The most recent week's numbers were, however, about 8% below the year-ago level, a nice improvement over the previous week, when claims were almost exactly equal to the year-ago level.

One area of concern: gas prices. The national average for a gallon of regular unleaded gas has jumped from $3.35 a month ago to $3.79, as of Feb. 27. Rising gas prices, of course, are a drag on the consumer, whose spending makes up about two-thirds of U.S. economic activity. It remains to be seen whether the recent spike is short-term, or a sign of things to come. The issue certainly bears watching.

As for the U.S. budget issues, legislators are continuing to steer the country ever closer to the sequestration that few seem to want, but even fewer seem willing to do anything about. With all the rhetoric, it's unclear just how much impact the budget cuts involved in the sequestration could have. If it does occur, there would certainly be some short-term impacts. But with Corporate America and the U.S. consumer having improved their financial situations dramatically in recent years, and the housing market continuing to improve, there should be several positive factors that will hopefully limit the budget cuts' impact on the economy.

Since our last newsletter, the S&P 500 has returned -0.4%, while the Hot List has returned -0.2%. So far in 2013, the portfolio has returned 6.9% vs. 6.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 190.0% vs. the S&P's 51.4% gain.
 
Editor-in-Chief: John Reese










Advertisement
Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

Are you looking for an alternative to your underperforming mutual funds or financial advisor? Click here to download Validea Capital's investment kit and learn more about the firm's guru-based portfolios.

Get More Information on Validea Capital!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.


Portfolio Update

It's continuing to be a solid year for the Hot List, which has been running slightly ahead of the broader market for much of the past couple weeks. Since our last newsletter, the portfolio has been helped by strong earnings announcements from both The TJX Companies and Questcor Pharmaceuticals. Questcor has had a particularly good fortnight, gaining about 20% since our last rebalancing two weeks ago (through Feb. 27). Questcor is a great example of a very unloved, very feared stock that the Hot List was able to find because of its quantitative nature. While fears about insurance reimbursement changes had been keeping many investors away from the stock, my models were focused on the firm's financials and fundamentals, which were quite attractive, and the pick has paid off quite nicely.(See the "News" section below for more on its earnings announcement.)

The same can be said of USANA Health Sciences, the portfolio's top current performer. Investors in recent months have begun to see the value in the stock, which had been a victim of guilt by association because of its similarities to Herbalife (which has taken some big hits over the past year). USANA is up about 30% since joining the portfolio back in December. As we move deeper into 2013, the Hot List will continue to look for fundamentally sound, attractively priced stocks like these, and over the long haul that should help the portfolio continue its strong performance.



News about Validea Hot List Stocks

The TJX Companies (TJX): TJX said on Feb. 27 that fiscal fourth-quarter earnings came in at $604.8 million, or $0.82 per share, up more than 30% from the year-ago period. Sales were up 15% to $7.7 billion. Both figures beat analysts' expectations. TJX also said it will buy back $1.3 billion to $1.4 billion of its stock this fiscal year, which began on Feb. 2. And it said it will raise its dividend payout by 26%. Shares rose about 2.5% the day of the announcement.

Questcor Pharmaceuticals (QCOR): Questcor announced big jumps in earnings and revenues for the fourth quarter, beating analysts' expectations. Net income was $61.9 million, or $1.03 per share, more than doubling the year-ago period's per-share earnings of 48 cents. Revenue more than doubled to $160.5 million from $75.5 million. The results were well ahead of analysts' projections of 93 cents in net income per share and $142.2 million in revenue. Questcor also announced that it would be raising its dividend from $0.20 per share to $0.25. The gains in revenue and earnings were largely due to an 88% increase in shipments of the firm's main product, H.P. Acthar gel. Since our last newsletter, the stock is up about 20%.



Guru Spotlight: Joseph Piotroski

If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge -- just a straightforward assessment of a company's balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.

Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percentage points annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23% average annual return from 1976 and 1996.

Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market, returning 48.5% (4.5% annualized) vs. 32.2% (3.1% annualized) for the S&P 500 (through Feb. 27). But it's not for the faint of heart, as it can be very volatile -- in fact, its beta of 1.36 is the highest of any of my 10-stock portfolios. It fared very well in 2004, 2005, and 2006, before struggling in 2007, 2008, and 2009. Then it roared back in 2010, gaining 55.9% -- more than four times the S&P 500's 12.8% gain. Over the past couple years, it has lagged the market. The big swings are likely a result of the strategy keying on smaller, beaten-down stocks at a time when investors have been prone to bouts of fear -- primarily about macroeconomic issues. When those macro issues spark anxiety, investors dump smaller unloved stocks; then, when the fears subside, they dive back into the smaller value plays. So while you can make some nice profits over the long haul following a strategy like this, you have to have discipline -- or else you'll end up buying high, like after 2010, and selling low, like after 2011.

Let's take a look at how Piotroski's approach, and the model I base on it, work.

Diving into The Balance Sheet

Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.

The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use.

That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business -- not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski's other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting. Looking at how a company's fundamentals had been changing allowed him to not only get an idea of the firm's financial position, but also of whether that position was improving or declining.

Among the other "change" criteria Piotroski examined were the long-term debt/assets ratio, which he wanted to be steady or declining; the current ratio (current assets/current liabilities), which he wanted to be steady or increasing; gross margin, which should be steady or rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are the stocks currently in its 10-stock portfolio. Keep in mind that some of these companies could see changes in their ratings soon because they haven't yet reported full-year 2012 results.

Monster Worldwide (MWW)
Lukoil (LUKOY)
Harmony Gold Mining Co. (HMY)
Resolute Forest Products (RFP)
Ecopetrol S.A. (EC)
Norwegian Cruise Line Holdings (NCLH)
Iamgold Corporation (IAG)
Diana Containerships (DCIX)
Digitial River Inc. (DRIV)
Starz (STRZA)



Think Small -- And Boring

One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks.

For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products, though it will go into more "interesting" areas when valuations are right. But while they're not the flashiest firms, they're quite often the type of stocks that can pay excellent returns over the long haul.



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.


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

USNA   |   LUKOY   |   TJX   |   WDC   |   LEA   |   WRLD   |   MAIN   |   QCOR   |   ROST   |   STRZA   |  



USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.





NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. As of December 31, 2011, the Company's major shareholder was ING Bank (Eurasia) ZAO with a stake of 75.93%.





The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office. In December 2012, the Company acquired Sierra Trading Post, an off-price Internet retailer.





Western Digital Corporation (WD) is a provider of solutions for the collection, storage, management, protection and use of digital content, including audio and video. Its principal products are hard drives, which are devices that use one or more rotating magnetic disks (magnetic media) to store and allow access to data. Its hard drives are used in desktop and notebook computers, corporate and cloud computing data centers, home entertainment equipment and stand-alone consumer storage devices. In addition to hard drives, its other products include solid-state drives and home entertainment and networking products. Effective March 8, 2012, it acquired Viviti Technologies Ltd. In May 2012, the Company completed the divestiture of certain 3.5-inch hard drive assets to Toshiba Corporation. As part of its deal with Toshiba, WD also completed its purchase of Toshiba Storage Device (Thailand) Company Limited (TSDT), which manufactured hard drives.





Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.





World Acceptance Corporation operates a small-loan consumer finance business in 12 states and Mexico. The Company is engaged in the small-loan consumer finance business, offering short-term small loans, medium-term larger loans, related credit insurance and ancillary products and services to individuals. As of March 31, 2012, the Company offered standardized installment loans through 1,137 offices in South Carolina, Georgia, Texas, Oklahoma, Louisiana, Tennessee, Illinois, Missouri, New Mexico, Kentucky, Alabama, Wisconsin, and Mexico. The Company serves individuals with limited access to consumer credit from banks, credit unions, other consumer finance businesses and credit card lenders. In the United States offices, the Company also offers income tax return preparation services to its customers and others.





Main Street Capital Corporation is a United States-based principal investment firm that primarily provides long-term debt and equity capital to lower middle market companies. The Firm targets investments associated with ownership transitions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives for later stage businesses. In addition to providing companies with necessary capital, Main Street provides management with expertise in corporate finance, operations and growth strategy implementation.





Questcor Pharmaceuticals, Inc. (Questcor) is a biopharmaceutical company. The Company's primary product is H.P. Acthar Gel (repository corticotropin injection) (Acthar), an injectable drug that is approved by the United States Food and Drug Administration, for the treatment of 19 indications. As of December 31, 2011, H.P. Acthar Gel was approved for the treatment of acute exacerbations of multiple sclerosis in adults, and as monotherapy for the treatment of infantile spasms in infants and children under two years of age. It is also indicated to induce a diuresis or a remission of proteinuria in the nephrotic syndrome without uremia of the idiopathic type or that due to lupus erythematosus, as well as indicated for the treatment of a number of other diseases and disorders. Its other product is Doral (quazepam), which is indicated for the treatment of insomnia.





Ross Stores, Inc., along with its subsidiaries, operates two brands of off-price retail apparel and home fashion stores. As of January 28, 2012, the Company operated a total of 1,125 stores, of which 1,037 were Ross Dress for Less (Ross) locations in 29 states, the District of Columbia, and Guam, and 88 were dd's DISCOUNTS stores in seven states: 48 in California, 19 in Texas, 12 in Florida, four in Arizona, two in Georgia, two in Nevada, and one in Maryland. Ross focuses on customers primarily from middle income households, while dd's DISCOUNTS focuses on customers from more moderate income households. During the fiscal year ended January 28, 2012 (fiscal 2012), it opened 59 new Ross stores and closed ten existing stores. During fiscal 2011, it opened 21 new dd's DISCOUNTS stores. The average approximate dd's DISCOUNTS store size is 23,900 square feet. In April 2011, it purchased a 449,000 square foot warehouse for packaway storage in Riverside, California.





Starz, formerly Liberty Media Corporation, is an integrated global media and entertainment company with operating units that provide subscription video programming on domestic United States pay television channels (Starz Channels), global content distribution (Starz Distribution) and animated television and movie production (Starz Animation). As of January 14, 2013, its network included Starz, Encore, and Movieplex, Retroplex and Indieplex. Its businesses included Anchor Bay Entertainment, Starz Worldwide Distribution, and Starz Digital Media. Starz Animation produces animated television (TV) and movie content for studios and networks. Starz Distribution develops, produces and acquires entertainment content, distributing it to consumers globally on digital versatile disk (DVD). On January 11, 2013, Liberty Media Corporation (Liberty) and Starz announced the completion of the spin-off of Liberty from Starz.





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.





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.