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Executive Summary January 3, 2014

The Economy

While uncertainty reigned for the economy at the start of 2013, the year ended on what seemed to be much more stable footing.

After starting the year with an almost imperceptible expansion, for example, manufacturing activity was very strong in December, remaining right around its impressive November pace, according to the Institute for Supply Management. New orders, which were contracting slightly when the year started, edged higher in December and remain at an extremely strong level -- the highest in nearly four years -- a very good sign going forward.

The housing market, meanwhile, showed some signs of leveling off, in the short term at least. New home sales fell slightly in November (by 2.1%), but remain up about 18% this year, according to the Census Bureau. The median sales price jumped about 5% to hit its highest level since April. Pending home sales inched up 0.2% in November, according to the National Association of Realtors. They were about 4% lower than they were in the same period a year earlier, however, in part a reflection of increasingly difficult-to-match year-ago comps as the housing recovery stretches on. The index is still well above where it stood in 2011 and 2010. Existing home sales fell 4.3% during the month, the Realtor group said, as rising mortgage rates and inventory constraints squeezed the market. They are 3.6% below year-ago levels. The mean sales price was 9.4% above November 2012's pace, however, and the amount of sales remains well above 2010 and 2011 levels.

Personal income rose 0.2% in November after having fallen in October, the Commerce Department said. In real, after-inflation terms, disposable income inched higher by 0.1%. Consumers increased their spending more sharply than that though, as real personal consumption expenditures jumped 0.5%. After several months in which disposable income gains outpaced consumer spending increases, November marked the second straight month in which that trend reversed. Still, the personal savings rate was a healthy 4.2%.

Overseas, Chinese manufacturing growth slowed slightly in December, according to a couple new reports. The sector did grow a bit, however; as it was throughout 2013, the growth (or lack thereof) in the Asian giant will be a big story in 2014.

Since our last newsletter, the S&P 500 returned 1.2%, while the Hot List returned 2.1%. So far in a very young 2014, the portfolio has returned -1.2% vs. -0.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 259.5% vs. the S&P's 83.1% gain.

Portfolio Update

Following our final rebalancing of the year, the Hot List closed out 2013 in good form. Since our last newsletter, eight of the portfolio's 10 holdings were in the black (all performance figures as of about 1 p.m. on Thursday), and the solid recent performance helped the Hot List finish up 2013 with a 34.2% return, outpacing the S&P 500 (29.6% return) by a solid margin. It was the eighth time in 11 years that the portfolio has beaten the index, and its since-inception return through 2013 of 263.8% (13.1% annualized) more than tripled the S&P's 84.8% return (6.0% annualized) over that time.

Since our last newsletter, the top performer has been HollyFrontier Corp., which gained nearly 5%. Alliance Fiber Optic Products, meanwhile, was up about 3.7%, and HCI Group was up about 2.7%. There frankly did not seem to be a lot of stock-specific catalysts for the portfolio over the past two weeks. It seemed, rather, that stocks were moving along with the broader market or their industries. These three gainers may have reaped more benefits than the broader market since all three have been bouncing back from some short-term dips.

The fortnight's laggards were Lear Corporation and CNOOC, which were down 0.49% and 0.15%, respectively -- hardly alarming declines.

As we head into 2014, the Hot List is finding a lot of value in the energy sector, with four of its holdings -- Lukoil, HollyFrontier, Chevron, and CNOOC -- coming from that part of the market. But it's also finding value in a number of other places, with its other six holdings each coming from a different sector. Overall, the portfolio's fundamentals are extremely strong. Its holdings on average have a trailing 12 month P/E ratio of 11.0; five-year earnings-per-share growth of nearly 24%; a decent 2.0% dividend yield, and a solid relative strength of 63. With those types of stocks, the portfolio should be well-positioned to continue to produce strong gains over the long term.

Editor-in-Chief: John Reese

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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 been my most volatile strategy. It has a beta of 1.35, meaning it has been 35% more volatile than the broader market. At times, it has been far ahead of the S&P 500, but right now it's coming off a tough stretch and is almost exactly in line with the index over the long haul. Since inception, it has returned 60.9% versus 61.2% for the S&P. It has lagged the index in each of the last three years, but I don't think that means it's time to quit on the strategy. Back in 2010, after a couple of mediocre years, the deep value approach roared back, gaining more than 55% -- quadrupling the S&P and more than doubling the gains of my next best individual guru portfolio. Volatility is to be expected from a deep value strategy that often focuses on small caps, so I really wouldn't be surprised if the Piotroski model puts up some big bounce-back numbers over the next couple years.

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 2013 results.

LG Display Co. Ltd. (LPL)
Benchmark Electronics (BHE)
Xinyuan Real Estate Co. (XIN)
Nam Tai Electronics (NTE)
Fresh Del Monte Produce (FDP)
Republic Airways Holdings (RJET)
Dominion Diamond Corp. (DDC)
Sears Hometown and Outlet Stores (SHOS)
Companhia Paranaense de Energia (ELP)
Orthofix International N.V. (OFIX)

News about Validea Hot List Stocks

HollyFrontier Corp. (HFC): A well being drilled at the firm's Cheyenne refinery will assess whether HollyFrontier will be able to dispose of selenium-tainted wastewater by injecting it deep underground, the Associated Press reported. HollyFrontier has been discharging wastewater into a small stream that flows into Colorado, but selenium levels have been measured to be several times higher than the state standard for surface water, AP reports. The selenium concentrations are below the level considered hazardous but too high for the creek.

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

HCI   |   LUKOY   |   LEA   |   HFC   |   AFOP   |   CEO   |   TJX   |   CVX   |   AGCO   |   USNA   |  

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

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, as well as Africa. 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. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO and completed acquisition of CJSC Kama-Oil. In June 2013, it sold a 99.57% stake in Lukoil Odes'kyi NPZ PAT. The Company's major shareholder is NKO ZAO NRD with a stake of 91.60%.

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.

HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.

Alliance Fiber Optic Products Inc. (AFOP) designs, manufactures and markets a range of fiber optic components, and integrated modules incorporating these components, for communications equipment manufacturers and service providers. The Company offers a range of products, including interconnect devices that are used to connect optical fibers and components, couplers and splitters that are used to divide and combine optical power, and dense wavelength division multiplexing (DWDM) devices that separate and combine multiple specific wavelengths. The Company's optical passive products include wavelength division multiplexing (WDM), coarse wavelength division multiplexers (CWDM) and DWDM components and modules that utilize thin film filter technologies to separate optical signals, variable attenuators, optical switches and other optical devices utilizing micro optic lensing technology including integrated electro-optical modules incorporating these products.

CNOOC Limited is an investment holding company. The Company, along with its subsidiaries, is a producer of offshore crude oil and natural gas and an independent oil and gas exploration and production company. Its subsidiaries are engaged in exploration, development, production and sales of oil and natural gas. It has three segments: independent operations, operations under joint arrangement and trading business. The Company has four producing areas in offshore China, which include the Bohai Bay, Western South China Sea, Eastern South China Sea and East China Sea. It also has oil and gas assets in Indonesia, Iraq, Australia, Africa, North America and South America. As of December 31, 2012, its subsidiaries included CNOOC China Limited, CNOOC International Limited, China Offshore Oil (Singapore) International Pte Ltd and others.

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.

Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates and provides administrative, financial, management and technology support to the United States and international subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining activities, power generation and energy services. Upstream operations consist primarily of exploring for, developing and producing crude oil and natural gas; processing, transportation and regasification associated with liquefied natural gas; transporting crude oil by international oil export pipelines; transporting, storage and marketing of natural gas, and a gas-to-liquids project. Downstream operations consist primarily of refining crude oil into petroleum products; transporting crude oil and refined products by pipeline, marine vessel, motor equipment and rail car, and manufacturing and marketing of commodity petrochemicals, plastics for industrial uses and fuel and lubricant additives.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

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.

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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