America's new president was sworn in this week amid a fervent atmosphere of hope, as citizens across the country -- and beyond -- awaited the leader who has promised to offer change for a nation in the grips of military conflicts and economic crisis. But while Barack Obama's inaugural address was filled with hopeful optimism, it was a hope tempered by realism, as the president said that -- while the problems facing the U.S. will be overcome -- it will not happen quickly or easily.
The past two weeks have made that abundantly clear in terms of the financial portion of the country's troubles. Data involving three of the factors key to the U.S. economy's woes -- and key to its eventual recovery -- all came in quite negative over the past fortnight.
Let's start with employment. The unemployment rate jumped again in December, rising from 6.7 percent to 7.2 percent, the highest level in almost 16 years. The pace doesn't seem to be slowing, either, and the cuts are coming across a variety of industries. Circuit City's recently announced bankruptcy is costing more than 30,000 jobs; aluminum king Alcoa is cutting 13,500 positions (more than an eighth of its workforce); drug giant Pfizer is cutting 2,500 -- or almost a third -- of its sales jobs, as well as 800 scientist posts; oil power ConocoPhillips is chopping 4 percent of its workforce; and Microsoft plans to cut about 5,000 workers.
To keep things in perspective, however, we still are a ways away from the type of unemployment we've seen in other rough periods. In 1975, unemployment peaked at 9 percent, and in late 1982, it came close to 11 percent.
As for the other two interlinked keys to the current crisis -- housing and the financial sector -- the news continues to be bad. Housing starts fell by 15.5 percent in December, according to the Commerce Department -- almost four times the drop expected by Wall Street. And building permits -- a sign of future home construction plans -- fell by more than 10 percent in December, The Wall Street Journal reported, far more than the 0.8 percent dip economists had expected.
Finally, the financials. What a mess. Bank of America, believed to be one of the stronger-positioned banks, needed an emergency injection of $20 billion from the federal government last week -- and the guaranteeing of $118 billion in mortgage-related and other debt -- as it became clear the firm's acquisition of troubled Merrill Lynch was going to be more problematic than initially thought. Many financial firms have been posting huge fourth-quarter losses in recent days, and there is now talk of the federal government creating a "bad bank" that would buy up and hold the bad debt now hamstringing U.S. banks. The idea of buying up bad debt was initially how Federal Reserve Chairman Ben Bernanke had pitched the financial sector bailout, before switching to a strategy based more on capital injections.
The bottom line here: The bailout binge is almost surely not over, even after the full usage of the initial $700 billion, and perhaps even after the coming Obama Administration stimulus plan.
The continued economic troubles are troubling, no doubt, but they shouldn't come as a surprise. Back in June, and again in September, I wrote that crises as large as the one we're dealing with take time -- sometimes a lot of time -- to sort themselves out. Wall Street spent years loading up on bad debt, and, while significant steps have been taken to unwind that debt, the process won't finish this week, this month, or, perhaps, even this year.
That doesn't mean investors should be avoiding the market, however. Even if the economic news continues to be rough, that's no guarantee that stocks will fall. Consider that in the two high-unemployment periods I mentioned above (1975 and late 1982), bull markets actually began about seven months and four months, respectively, before unemployment peaked, an example of how stocks usually turn around before the economy does.
The issue for stock investors is, as always, value. And, based on a variety of measures -- price/book ratios, forward price/earnings ratios, and even the ultra-conservative 10-year P/E ratio -- stocks are undervalued. That means it's a good time to be buying (or staying) in stocks, regardless of the short-term economic fallout.
A Smaller Shakeup
Amid all of the continued economic turmoil, the market has headed downward, with the Dow Jones Industrial Average re-testing the 8,000 level and the S&P 500 doing the same with the 800 mark. The market has shown some resiliency, however, remaining significantly above its Nov. 20 lows. Still, since our last Hot List, the S&P has fallen 9.0%, and the Hot List has fared worse, losing 10.5%. Since the portfolio's inception more than five-and-a-half years ago, it remains well ahead of the index, however, having gained 47.6 percent while the S&P has fallen 17.3 percent.
While the market continues to struggle to find direction, it has been significantly less volatile in the past few weeks. Probably because of that, this month's Hot List rebalancing involves the least amount of turnover we've seen since early September. The portfolio is selling four stocks -- taking profits on three of them (Baker Hughes, Lufkin Industries, and Jos. A. Bank).
The Hot List is putting the cash from those sales to work in some of the market's beaten-down areas. The additions include a financial (Net 1 U.E.P.S. Technologies), two retailers (The Dress Barn and Polo Ralph Lauren), and a steel producer (Schnitzer). All four of these stocks took a pounding from late September through Nov. 20, each falling at least 50 percent. But they've posted strong bounce-back gains since then, and the Hot List thinks all four remain substantially undervalued. Three of the four get approval from three of my best-performing Guru Strategies (those based on the writings of Peter Lynch, Kenneth Fisher, and Benjamin Graham), while the other gets double-guru approval. (For more on these firms, see the "New Stocks Added to The Validea Hot List" section below.
New Year, New Guru
While the portfolio is experiencing a smaller shakeup this rebalancing, I do have one big new change to report. Since our last newsletter, we've added a new Guru Strategy to our web site: my Joel Greenblatt-based model.
Greenblatt created quite a stir in the investment world in 2005, when he published "The Little Book that Beats The Market". In the book, Greenblatt explained how investors could produce outstanding long-term returns using his simple "Magic Formula". The 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.
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.
While we've only recently added the Greenblatt portfolio to our site, we have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past year or so. So far, the model has been a strong outperformer. Since we began tracking the 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has fallen 33.6 percent, but the portfolio has lost less than half of that, 14.6 percent. It beat the S&P in 2006 (+14.4 percent to +13.6 percent), 2007 (+9.1 percent to +3.5 percent), and 2008 (-26.3 percent to -38.5 percent).
Part of the reason the model significantly outperformed the S&P this year is that it doesn't invest in financial stocks. Because of the way they 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.
Quantitative Formula, Mental Approach
While Greenblatt's methodology is completely quantitative, one of the most important aspects of his approach is psychological -- and it's something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn't in the specifics of the variables; it's having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn't always work -- a notion that is true for any good strategy.
Why is that so critical to keep in mind now? Because, given that the economy has a ways to go before stabilizing, it's likely that we'll see continued market volatility in the coming weeks or months -- even if Nov. 20 turns out to have been the bear bottom. And, those stops and starts could be significant in magnitude. (Remember, the six-year-long bull market that followed the terrible 1973-74 bear featured six 10-percent corrections.)
Times of short-term ups and downs can mean big trouble for those who don't stick to their strategies. Consider the five-week period that started on Dec. 5. During that period, the Dow moved a total of 0.4 percent (downward). But in between, it crossed back and forth over that Dec. 5 starting point price level eight times. Those investors who ditched their strategy and simply gambled that each upward move signaled a bull run, or that each downward move was a precursor to another plummet, likely got burned as the market flip-flopped.
As for the coming weeks and months, I don't know just how big the ups and downs will be. But they will come in some form, to be sure, and, given the severity of the current crisis, they'll probably be significant. Ditch your long-term strategy and try to time the market amid that kind of see-sawing, and you can lose a lot of money, even if the market ends up right back where it started. Whether you use Greenblatt's strategy or not, you should thus definitely heed his broader point as we wade through the economic muck: If you have a good strategy, stick with it; it may cause you some pain in the short-term, but you're likely to have a lot more pain if you fail to stay disciplined.
|Editor-in-Chief: John Reese
As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include:
Baker Hughes Incorporated (BHI), Gardner Denver, Inc. (GDI), Jos. A. Bank Clothiers, Inc. (JOSB)
Lufkin Industries, Inc. (LUFK).
6 stocks remain in the portfolio. They are:
American Eagle Outfitters (AEO), Ameron International Corporation (AMN), Esterline Technologies Corporation (ESL), Kennametal Inc. (KMT), Jakks Pacific, Inc. (JAKK)
Skechers Usa, Inc. (SKX).
We are adding 4 stocks to the portfolio. These include:
The Dress Barn, Inc. (DBRN), Schnitzer Steel Industries, Inc. (SCHN), Polo Ralph Lauren Corporation (RL)
Net17 1 Ueps Technologies Inc (UEPS).
New Stocks Added to The Validea Hot List
Net 1 U.E.P.S. Technologies, Inc. (UEPS): With profits plunging and the future outlook unclear, the Hot List has been avoiding the financial sector lately. But this South Africa-based firm isn't your typical financial. It makes card technologies and systems that allow for transactions between formal businesses and people in developing countries who have no or limited access to traditional banking facilities. Governments and businesses use the firm's cards to make social security or wage payments to beneficiaries or employees, who can in turn use their cards for such things as making purchases, paying bills, or withdrawing cash. Users get charged monthly fees or transaction fees. Net 1 has a market cap of about $700 million.
Net 1 gets approval from two of my Guru Strategies, those that I base on the writings of Peter Lynch and Joel Greenblatt. To find out exactly why, see the "Detailed Stock Analysis" section below.
Schnitzer Steel Industries, Inc. (SCHN): Based in Oregon, Schnitzer is one of the nation's largest recyclers of scrap metal. It also is a leading provider of used and recycled auto parts, and it manufactures finished steel products. The 100-plus-year-old firm has a market cap of $1.02 billion, and it has taken in more than $3.5 billion in sales in the last 12 months.
The steel industry has taken some big hits lately as the global economy has weakened. But Schnitzer has taken too much of a hit, according to three of my Guru Strategies. The models I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher all have strong interesting in the stock. See the "Detailed Stock Analysis" section below to find out why.
The Dress Barn, Inc. (DBRN): This New York state-based clothing retailer operates more than 800 stores in 46 states under the "dressbarn" name, as well as close to 700 more stores under the "maurices" name. It specializes in apparel for women age 35 to 55, and, while it's a small-cap ($550 million market cap), it has taken in $1.5 billion in sales over the past 12 months. It's a favorite of my Peter Lynch-, Benjamin Graham-, and Kenneth Fisher-based strategies. To find out why, see the "Detailed Stock Analysis" section below.
Polo Ralph Lauren Corporation (RL): Keeping with its beaten-down-sector theme, the Hot List is also adding this clothing giant to the portfolio this rebalancing. Based in New York City, Polo is know for its signature shirts that bear its polo player logo, but the firm's reach goes beyond its stylish clothes. The company also has a home goods branch, and it sells accessories and various fragrances. Polo has a market cap of $3.8 billion, and has taken in more than $5 billion in sales in the past year.
Like Schnitzer and Dress Barn, Polo is getting approval from my Peter Lynch-, Kenneth Fisher-, and Benjamin Graham-based approaches. To see why, check the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Kennametal Inc (KMT): On Jan. 12, Kennametal announced that it expects earnings of $0.34 per share, excluding a 14-cent restructuring charge, for the most recent quarter, Reuters reported. That was below analysts' expectations of $0.48 per share. The firm also announced it plans to cut 1,200 jobs because of the deepening global recession, according to Reuters.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will examine our Kenneth Fisher-based Guru Strategy in greater detail. If you have any questions, please feel free to contact us at email@example.com.