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Executive Summary September 3, 2010

The Economy

While individual investors continue to run from stocks, a good deal of recent economic data has been solid -- and in some cases, quite good.

A good example is the manufacturing sector. It expanded in August for the 13th straight month, according to the Institute for Supply Management. In fact, manufacturing growth actually accelerated, with ISM's manufacturing index rising to 56.3, up from 55.5 in July. (A reading above 50 indicates expansion.) The group's employment sub-index also grew at an accelerating rate, rising to 60.4 in August -- its highest level since December 1983.

Another good sign: Retail sales figures came in stronger than expected in August. Same-store sales (those at stores open more than a year) rose 3.3% for the month, exceeding July's 2.7% increase, according to The Wall Street Journal. New Commerce Department data also showed that consumer spending increased in July at its swiftest pace since March, though the 0.4% gain wasn't exactly eye-popping.

The manufacturing and consumer news was particularly encouraging giving that it came on the heels of a government report showing that gross domestic product grew in the first quarter at a slower pace (1.6%) than initially thought (2.5%).

There was also decent news on the employment front, as new claims for unemployment dipped slightly in the week ending Aug. 28, according to the Labor Department. But claims remain quite elevated by historical standards. Today's August unemployment report will offer a broader picture of whether the labor market is improving.

In the financial sector -- the epicenter of the 2008 crisis and market crash -- news has been mixed. Bank profits totaled $21.6 billion in the second quarter after being in the red a year earlier, the Journal reported, and the number of loans past due by at least three months fell for the first time since 2006. The number of loans that banks charged off also declined in most major categories, the Journal reported.

But while larger, government-aided banks are faring well, smaller banks are struggling. A new Federal Deposit Insurance Corporation report put more than 10% of U.S. banks on FDIC's "problem list", and smaller banks are increasingly making up a bigger portion of that list, according to the Journal. Lending also remains tight, with loan balances falling in the second quarter.

The housing market -- another area at the center of the 2008 crisis -- got good news this week, as it was announced that the S&P/Case-Shiller home price index rose in June. Pending home sales also increased, with a National Association of Realtors' index rising 5.2% for July. But the announcement of that minor increase follows a 27.2% plunge in existing home sales for July. All in all, the housing market's status is very hard to gauge. Many buyers pushed hard to get their deals done by the end of June to take advantage of the government's homebuyer tax credit program, which was supposed to expire at that point (though it has since been extended). The impact of the tax credit, as well as the two-month lag time in home price data reporting, makes it pretty futile to try to draw any major conclusions about the housing market's direction right now.

The stock market digested all of this with some major ups and downs over the past fortnight. The S&P 500 returned 1.3%, while the Hot List returned 3.1%. For the year, the portfolio stands at -7.0% vs. -2.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 124.1% vs. the S&P's 9.0% gain.

The Corrections

In the past couple newsletters, I've taken a look at how past economic recoveries have proceeded, examining how key indicators like GDP, unemployment, and manufacturing activity fared during some previous turnarounds. The main trend in those analyses was that recoveries don't occur in a straight line; there are ups and downs and plateaus along the way, so a slowdown in a recovery -- which we've seen over the past couple months -- is by no means a sure sign that a new downturn is imminent, or even likely.

This week, I thought we'd look in a similar way at how past bull markets have developed, to see what has happened historically after a bull run first hits trouble (as it has recently). To do so, I examined four bull markets (using the S&P 500) that cross a wide span: those that started in 1957, 1974, 1982, and 2002.

Let's take the earliest first. The 1957 bull began in October, running for nearly two years before hitting a rough patch. From August 1959 to late October of 1960 -- a span of more than 14 months -- it went into correction mode, losing 14.0% in a series of stops and starts. Then, however, the bull resumed, with the market gaining close to 40% over the next 13-and-a-half months before the bull ended in late 1961.

The bull market that followed the steep 1973-74 bear was much more eventful. It started in October 1974, and featured five corrections during its six-year run (and that's not including another big dip that wasn't quite a correction). Here's how it went:

1974-80 Bull Market
(Start: Oct. 3, 1974)

First Leg: +20.8% (13 months)
Correction: -13.6% (1 month)

Second Leg: +47.1% (7 months)
Correction: -14.1% (2 months)

Third Leg: +31.4% (12 months)
Correction -19.4% (5.5 months)

Fourth Leg: +28.0% (19 months)
Correction: -10.2% (1 month)

Fifth Leg: +18.6% (3 months)
Correction: -17.1% (1.5 months)

Sixth Leg: +43.1% (8 months)
Bull market ends, Nov. 28, 1980

A six-correction bull market certainly isn't the norm, but the '74-'80 bull shows just how topsy-turvy a bull can be. Many other bulls, however, are closer to the 1957-61 version, with just one correction (and several other 5%-10% dips). One example is the bull that followed the 1980-82 bear. It started in mid-August of '82, and ran for nearly 70% and 14 months before correcting. It then lost 14.4% over a nine-and-a-half-month span, before the second leg of the bull took hold. It took the market up another 127.8% over more than three years until the bull finally died.

Another one-correction bull is the most recent bull, which ran from 2002-2007. It started in October of 2002, with the S&P gaining 20.9% over its first month-and-a-half. The market then ran into a correction, falling 14.7% in a three-and-a-half-month span. Then came Leg #2 of the bull, which featured several minor dips but ended up taking the S&P up more than 95% over the next four-and-a-half years.

This is a lot of data, but it all boils down to this: Bull markets aren't smooth and easy. In fact, every bull market of the past 50 years has had at least one correction of at least 10%. And as you can see, some have multiple corrections, and sometimes the corrections can be long -- even over a year. In that context, the recent correction -- which, using the July 2 low, was a 16.0% decline in a little over two months -- certainly isn't unusual. In fact, Kenneth Fisher -- one of the gurus upon whom I base one of my best-performing strategies -- recently said this correction has been "textbook", and the numbers indicate he may well be right.

Many investors, however, continue to focus on more recent history, staying away from stocks in part because of the broader market's poor performance over the past decade. They see the correction as the start of another big, lengthy move downward. But in succumbing to this "recency bias", they are ignoring the fact that many of the market conditions that led to the poor decade of returns for stocks -- including bloated valuations and easy, bubble-forming credit for just about anyone -- aren't present right now.

What are present, however, are a number of strong, streamlined firms whose shares are trading at reasonable -- or cheap -- prices. And the Hot List is pouncing on some of them.

Consider the balance sheets of the companies in the portfolio right now. One of the tests that the late, great Benjamin Graham used while looking for good investments was the ratio of a firm's long-term debt to its net current assets (current assets minus current liabilities). Essentially, this tells you whether a company could pay off all its liabilities if it were liquidated today. It's a tough standard to meet, but currently, seven of the eight non-financial stocks in the Hot List do just that -- in fact, seven of the eight have more than double as much in net current assets as they do in long-term debt. (The lone stock not to pass this test is newcomer GameStop, which falls just short; it has $431 million in net current assets and $448 million in long-term debt.)

Financial firms, of course, tend to carry high debt levels because of the nature of their businesses. So for the two financial firms in the portfolio, let's look at two measures that the great Peter Lynch used on financials: the equity/assets ratio, which measures financial health, and the return on assets rate, which measures profitability. The model I base on Lynch's writings requires E/A ratios of at least 5% and ROAs of at least 1%. HealthSpring and Cash America both have E/As over 50% and ROAs of at least 8%, passing those tests with flying colors.

The firms in the portfolio have also been producing strong growth in earnings and sales, averaging long-term EPS growth rates of about 30% and long-term revenue growth rates close to 20% -- and only one trades for more than 15 times trailing 12-month earnings, despite their strong growth. (That's Dollar Tree, which trades for about 17.5 times TTM earnings, but still has a solid P/E/Growth ratio of 0.83.)

Whatever happens to the economy and the market in the short term, strategies that focus on stocks and businesses like these are a good bet to do well over the long haul. That's how the gurus achieved such outstanding success, and it's how the Hot List continues to stay far ahead of the market over the long run.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Ezcorp, Inc. (EZPW), Chevron Corporation (CVX) and Lululemon Athletica Inc. (LULU).

The Keepers

7 stocks remain in the portfolio. They are: Ross Stores, Inc. (ROST), Western Digital Corp. (WDC), Cash America International, Inc. (CSH), Jos. A. Bank Clothiers, Inc. (JOSB), Aeropostale, Inc. (ARO), China Automotive Systems, Inc. (CAAS) and Healthspring, Inc (HS).

The Newbies

We are adding 3 stocks to the portfolio. These include: Sanofi-aventis Sa (Adr) (SNY), Gamestop Corp. (GME) and Dollar Tree, Inc. (DLTR).

Portfolio Changes

Newcomers to the Validea Hot List

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 $78 billion market cap firm -- which is attempting to take over biotech firm Genzyme -- has taken in more than $40 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 read more about the stock, check out the "Detailed Stock Analysis" section below.

GameStop Corp. (GME): The world's largest video game retailer, GameStop sells all sorts of Nintendo, Xbox, and PlayStation games and game units, as well as a variety of computer games. The Texas-based company has more than 6,000 stores in the U.S. and 17 other countries, operating under the GameStop, EB Games, and Electronics Boutique names. The firm has a $2.7 billion market cap, and has taken in more than $9 billion in sales over the past 12 months.

GameStop gets approval from my Peter Lynch- and Joel Greenblatt-based strategies. To find out more about the stock's fundamentals, see the "Detailed Stock Analysis" section below.

Dollar Tree, Inc. (DLTR): Based in Virginia, Dollar Tree's stores offer a wide variety of discount merchandise, ranging from food items to household goods to toys to lawn- and garden-related items. It has a market cap of about $5.8 billion, and has taken in more than $5.5 billion in sales in the past year.

Dollar Tree gets approval from my Peter Lynch- and James O'Shaughnessy-based models. To read more about it, check out the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Jos. A. Bank Clothiers (JOSB): On Sept. 1, Bank said second-quarter earnings rose almost 32% vs. the year-ago quarter, the Baltimore Business Journal reported. Revenues increased by 12% over the same period a year earlier, and both profit and revenue results beat analysts' expectations, according to the BBJ.

HealthSpring, Inc. (HS): HealthSpring will acquire Baltimore-based Medicare Advantage plan operator Bravo Health Inc. for $545 million, the Associated Press reported on Aug. 27. Bravo has 100,000 Medicare Advantage members in the mid-Atlantic region and Texas, as well as stand-alone Medicare prescription drug plans in 43 states that serve close to 300,000 customers, AP reported. HealthSpring says the deal will help it expand into new markets, and says if the deal closes before year-end, it should add $0.45 to $0.55 to its 2011 earnings per share.

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

JOSB   |   ARO   |   HS   |   WDC   |   ROST   |   CAAS   |   SNY   |   GME   |   DLTR   |   CSH   |  

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer (through stores, catalog and Internet) of men's tailored and casual clothing and accessories. The Company sells substantially all of its products exclusively under the Jos. A. Bank label through its 473 retail stores (as of January 30, 2010, which includes seven outlet stores and 13 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. Jos. A. Bank operates through two segments: Stores and Direct Marketing. The Company's Stores segment consists of its 453 Full-line Stores. The Company opened 14 stores (and closed one store) during the fiscal year ended January 30, 2010 (fiscal 2009). The Company's Direct Marketing segment consists of its Internet and catalog channels.

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aropostale merchandise through its e-commerce Website, www.aeropostale.com. During the fiscal year ended January 30, 2010 (fiscal 2009), the Company launched P.S. from Aeropostale, which offers casual clothing and accessories focused on elementary school children between the ages of 7 and 12. During fiscal 2009, the Company completed the closure of its 14 store Jimmy'Z concept. Jimmy'Z Surf Co., Inc., a wholly owned subsidiary of Aeropostale, Inc., was a contemporary lifestyle brand targeting young women and men aged 18 to 25.

HealthSpring, Inc. (HealthSpring) is a managed care organization with a primary focus on Medicare, the federal government-sponsored health insurance program for United States citizens aged 65 and older, qualifying disabled persons and persons suffering from end-stage renal disease. As of December 31, 2009, the Company operated coordinated care Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas. As of January 1, 2010, it also commenced operations of Medicare Advantage plans in three counties in Northern Georgia. As of December 31, 2009, the Company's Medicare Advantage plans had over 189,000 members. The Company also offers prescription drug benefits in accordance with Medicare Part D to its Medicare Advantage plan members, in addition to providing other medical benefits (MA-PD) plans. It also offers prescription drug benefits nationally on a stand-alone basis in accordance with Medicare Part D (PDP).

Western Digital Corporation (WD) designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufacturers (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. Its hard drives are used in desktop computers, notebook computers, and enterprise applications such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Its hard drives are used in CE applications, such as digital video recorders (DVRs), and satellite and cable set-top boxes (STBs). It also sells its hard drives as stand-alone storage products by integrating them into finished enclosures, embedding application software and offering the products as WD-branded external storage appliances for personal data backup and portable or expanded storage of digital music, video and other digital data.

Ross Stores, Inc. operates two chains of off-price retail apparel and home accessories stores. As of January 30, 2010, the Company operated a total of 1,005 stores, of which 953 were Ross Dress for Less (Ross) locations in 27 states and Guam and 52 were dd's DISCOUNTS stores in four states. Both chains target women and men between the ages of 18 and 54. Ross target customers are primarily from middle income households, while the dd's DISCOUNTS target customer is from more moderate income households. Ross offers name brand and designer apparel, accessories, footwear, and home fashions for the entire family at everyday savings of 20% to 60% off department and specialty store regular prices. dd's DISCOUNTS features a moderately-priced assortment of name brand apparel, accessories, footwear, and home fashions for the entire family at everyday savings of 20% to 70% off moderate department and discount store regular prices.

China Automotive Systems, Inc. (China Automotive) is a holding company and has no significant business operations or assets other than its interest in Great Genesis Holdings Limited (Genesis). Through Genesis, the Company manufactures power steering systems and other component parts for automobiles. All operations are conducted through eight Sino-foreign joint ventures in China and a wholly owned subsidiary in the United States. The Company has business relations with more than 60 vehicle manufacturers, including FAW Group and Dongfeng Auto Group, automobile manufacturers in China; Shenyang Brilliance Jinbei Co., Ltd., light vehicle manufacturer in China; Chery Automobile Co., Ltd, state-owned car manufacturer in China, and Xi'an BYD Auto Co., Ltd and Zhejiang Geely Automobile Co., Ltd., car manufacturers.

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. The Company is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, the Company specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

Dollar Tree, Inc. (Dollar Tree) is an operator of discount variety stores offering merchandise at the fixed price of one dollar. At January 30, 2010, the Company operated 3,806 discount variety retail stores. Approximately 3,650 of these stores sell substantially all items for one dollar or less. The remaining stores, operating as Deal$, sell items for one dollar or less but also sell items for more than one dollar. Dollar Tree's stores operate under the names of Dollar Tree, Deal$ and Dollar Bills.

Cash America International, Inc. provides specialty financial services to individuals through its Company-owned and franchised lending locations, and check cashing centers and via the Internet. These services include secured non-recourse loans (pawn loans), short-term unsecured cash advances and related financial services. It operates in three segments. As of December 31, 2009, the pawn lending segment offered pawn loans through 676 total pawn lending locations operating under the names of Cash America Pawn, SuperPawn and Prenda Facil. As of December 31, 2009, the cash advance operating segment included 246 cash advance storefront locations in six states in the United States operating under the names Cash America Payday Advance and Cashland. As of December 31, 2009, the check cashing operating segment consisted of 120 unconsolidated franchised and six consolidated Company-owned check cashing locations operating in 16 states in the United States under the name Mr. Payroll.

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.

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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.