|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||September 3, 2010|
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.
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.
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).
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).
We are adding 3 stocks to the portfolio. These include: Sanofi-aventis Sa (Adr) (SNY), Gamestop Corp. (GME) and Dollar Tree, Inc. (DLTR).
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
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