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Executive Summary July 20, 2012

The Economy

The economy continues to offer a very mixed bag, with a sluggish job market and consumer pullback being offset by signs of strength in a couple other key areas.

One of the bright spots comes from the industrial sector. Industrial production increased 0.7% in June (vs. May), according to a new report from the Federal Reserve (here and below all comparisons of successive weeks/months are seasonally adjusted; comparisons to year-ago periods are unadjusted). The gain came despite a decline of nearly 2% in utility output, which tends to be the most volatile of the three industry groups that make up the sector. The other two groups did more than pick up the slack, however, with manufacturing output increasing 0.7% -- reversing a 0.7% decline from the previous month -- and mining output also increasing 0.7%.

The other area of the economy offering good news was the housing market. Housing starts rose nearly 7% in June versus May, according to new data from the Commerce Department. The annualized figure of 760,000 starts represented the highest level seen since the fall of 2008. Housing starts are now about 25% above their year-ago level. Permit issuance for new housing fell, however, by 3.7% versus May, but is about 15% above year-ago levels. That, combined with the latest U.S. home price data, which showed that prices moved upward in April for the first time in several months, means we're continuing to see signs that the housing sector may at long last be ready to take part in the economic recovery that began in mid-2009.

If that is indeed what is happening, it comes at a good time. That's because U.S. consumers continue to pull back. Retail and food service sales declined in June, falling 0.5% vs. May, according to the Commerce Department. It was the third straight month that the figure has dropped, after nearly a year straight of monthly gains. Sales remain about 3.6% above their year-ago level, though the year-over-year increases have been shrinking rather rapidly in recent months.

The consumer pullback very likely has a lot to do with the jobs market, which remains soft. Since our last newsletter, new claims for unemployment have risen by about 2.7%, while continuing claims have stayed pretty much flat%. What's interesting to note, however, is that using unadjusted numbers, new claims were just 3.6% lower in the most recent week than they were in the corresponding week a year ago, a much lower spread than we've seen in recent months. That could just be an aberration. But given some of the questions that have arisen recently regarding the way the government makes seasonal adjustments to its data, most notably those raised by the highly regarded Economic Cycle Research Institute, it's something to keep an eye on.

On the macro front, the debt crisis news coming out of Europe has slowed over the past couple weeks, as policymakers try to hammer out the details of some of their recent compromises. Hopefully the relative quiet is a sign of the most contentious and potentially dangerous phase of the crisis has ended, though, to be sure, much work still needs to be done. Taking center stage in Europe's absence has been Ben Bernanke and talk of another round of quantitative easing by the Federal Reserve. So far, the Fed has seemed hesitant to implement such a plan, and frankly that may be a good thing, considering the diminishing returns we've seen on the Fed's previous easing efforts.

Since our last newsletter, the S&P 500 returned 0.6%, while the Hot List returned -4.0%. So far in 2012, the portfolio has returned 9.5% vs. 9.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 147.6% vs. the S&P's 37.6% gain.

Are We in a Recession?

As job growth, retail sales, and even (according to some reports) manufacturing activity have slowed in recent months, some notable strategists, including Lakshman Achuthan, who heads the ECRI, and fund manager John Hussman, have suggested that we have entered a new recession.

To be sure, the economy has slowed since the first quarter. But have we entered a new recession? Morningstar Director of Economic Analysis Robert Johnson recently provided some interesting data indicating that, while growth isn't gangbusters, we haven't fallen into recession. Johnson notes that, while many people think of a recession as simply being two quarters of negative growth, the official determination is made based on four factors: industrial production, retail sales adjusted for inflation, personal income less transfer payments (unemployment, disability, Social Security) adjusted for inflation, and employment. For each of the past 13 months, he looked at how the three-month average in each of those four categories compared to the same period a year earlier -- and how it compared to the levels in December 2007, when the U.S. entered the Great Recession.

What did the data show? Well, Johnson found that industrial production is actually increasing at a more rapid pace than it was a year ago, posting 4.9% growth as of June 1 vs. 3.6% a year earlier. (You should be aware that the June data uses Morningstar's estimates.) That 4.9% pace is nearly twice the 2.5% growth we were seeing heading into the Great Recession.

As for job growth, it was increasing at a 1.4% pace through June 1, ahead of the 1.0% rate from a year earlier. In December 2007, it was at 0.9%.

Retail sales, meanwhile, have been trending downward and were increasing at a 3.4% pace as of June 1, vs. 4.5% a year earlier. But they are well ahead of the December 2007 start-of-recession pace, which was a meager 0.2%. Only personal income is very close to the Great Recession starting level; it was at 1.7% entering the Great Recession, and was at 1.8% as of June 1 (vs. 2.7% a year earlier). But it has also been rising for three straight months since falling to 1.0% earlier this year.

A key part of the analysis for a couple of those categories seems to involve inflation, something that many pundits don't look at when examining such numbers. That's something to keep in mind when looking at the consumer-related figures -- it's about real purchasing power, not a simple headline number. "Most of the metrics are currently improving after hitting lower growth rates earlier in 2012. Only retail sales are in a clear downward trend, and that is largely because of falling gasoline prices, which is actually a good thing for the economy," Johnson writes. "It certainly doesn't seem like we are about to fall into a recession, especially with falling prices and an improving housing market. In addition, at the end of 2007, inflation peaked at 4.6%, helping to push us into a recession; it is now a much more subdued 2.2% and still improving."

"Cliff" Notes

Of course, this certainly doesn't mean all's well with the economy. As I noted above, retail sales growth has been falling fairly quickly, and personal income and job growth are far from stellar. But a big factor behind the consumer pullback and tough labor market seems to be the uncertainty surrounding the U.S.'s "fiscal cliff" -- that is, the fact that a number of tax cuts are set to expire at the end of 2012, and a number of major automatic budget cuts are set to go into effect as a result of Congress' inability to reach a deficit deal last year. The "cliff" seems to be having a big impact on businesses -- or, perhaps more accurately, the uncertainty surrounding what will happen is having a big impact. A recent Investment News article titled "Uncertainty Scarier than Precipice Itself" looked at how the uncertainty is leading to a sort of paralysis among many companies, and investors. Unsure whether Congress will finally do something to extend the tax breaks -- which include taxing dividend income at just 15% rather than as normal income -- many are choosing to stand pat and wait for the ground rules to be laid out.

In fact, Charles Schwab's Liz Ann Sonders, whose economic calls over the past several years have been very good (she was one of the few who called both the start and end of the Great Recession), told Investment News that the uncertainty over the fiscal cliff is holding back both hiring and the stock market. "It is probably having the biggest impact on business psychology right now," she said. "We're seeing that the business is there, but business leaders are hesitant. That's been one of the main reasons for the slowdown in hiring." She added, "The market's poised for rallies, but you'd be crazy to play them aggressively at this point. We're in kind of a dead zone for the near term."

The key phrase there, I think, is "the business is there". Sure, it's disturbing that Congress has allowed partisan bickering to get in the way of real deficit solutions. But it seems that a big part of the hiring slowdown and accompanying consumer pullback is due to the lack of a plan -- any plan -- from Congress on how to address the deficit and tax cut issues. And that, believe it or not, is probably a better problem to have than a lack of demand. We don't necessarily need a plan that will miraculously solve all of our budgetary problems -- it's highly doubtful that such a plan exists. What is needed is simply clarity as to what the rules of the game are. Once those are known, we may well see a hiring pick-up as businesses are able to better plan for the future.

And while a chunk of the labor market and consumer slowdown are related to the short-term lack or clarity, signs continue to emerge that a big long-term driver of growth is waking from its long slumber: the housing market. As I noted earlier, housing starts reached a nearly-four-year high last month, though the pace remains relatively slow. Prices have also started to move upward a bit, and homebuilder confidence is at five-year highs, according to the National Association of Home Builders/Wells Fargo Housing Market Index.

In addition, while existing-home sales fell in June, according to the National Association of Realtors, inventory also fell, continuing a recent trend. Total housing inventory for existing homes fell to a 6.6-month supply, NAR said, down sharply from a 9.1-month supply at the same time last year. The group said the number of seriously delinquent mortgages has been falling, too, and short sales and foreclosures are down some 30% from a year ago. All of this is helping boost home prices, and indicating that the glut of homes creating during the housing bubble is getting worked off. The housing sector has been largely absent from the economic recovery, but the stage may well be getting set for it to begin adding significantly to growth.

So, getting back to the original question, given all of this, are we in a new recession? A slowing expansion? A standstill economy? In the end, it doesn't really matter how you spin the semantics. The bottom line is that the economy has cooled in recent months, but that a decent amount of the cooling is the result of the lack of short-term regulatory clarity. There are no doubt a myriad of issues the U.S. and world economies have to work through. But with just a bit of help from legislators -- again, clarity (not a perfect plan) is what is needed -- we may find that economically things aren't as bad as many are making them out to be.

From an investment point of view, that makes this an intriguing time. Short-term fears about the fiscal cliff are having sort of a double-impact on equities: Not only are they creating a general climate of fear that keeps prices of many stocks down, but they are also creating uncertainty among businesses that seems to be impacting hiring and growth numbers -- and many investors may be mistaking those weak numbers for broader, deeper problems, further depressesing stock prices. At the same time, some positive longer-term forces like housing are improving. To me, this combination of short-term fear, low expectations, and fundamentals that may not be as bad as they seem make this an attractive climate to be investing in stocks.
 
Editor-in-Chief: John Reese










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Guru Spotlight: Benjamin Graham

Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world's richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as "The Father of Value Investing", Graham inspired a number of famous "sons" -- Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation -- and fortune -- by using an extremely conservative, low-risk approach to investing. To him, preserving one's original capital was every bit as important as netting big gains, and two factors from his early years may show why. The first was Graham's own family's fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived. Graham's clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe, and Graham worked without compensation for five years until his clients' fortunes were fully restored.

Having lived through both his own family's financial troubles and the market crash, it's no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn't something that could be turned into quick, easy profits; anything that offers such "easy" rewards also comes with substantial risk, and Graham abhorred risk. True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."

In terms of specifics, Graham's "Defensive Investor" approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm's current ratio -- that is, the ratio of its current assets to its current liabilities -- is at least two, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed net current assets. Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he looked not only at trailing 12-month earnings but also at three-year average earnings, to ensure that one-year anomalies didn't skew the P/E ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.

My Graham-inspired strategy tends to find bargains across a variety of areas of the market. Here are the current holdings of the 10-stock Graham portfolio:

Forest Laboratories, Inc. (FRX)
Curtiss-Wright Corp. (CW)
Helmerich & Payne, Inc. (HP)
NTT DoCoMo, Inc. (DCM)
United Stationers Inc. (USTR)
GameStop Corp. (GME)
General Dynamics Corporation (GD)
USANA Health Sciences, Inc. (USNA)
DeVry, Inc. (DV)
Walgreen Company (WAG)

Two types of stocks that you won't find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they're not as risky today, I do the same. Financial stocks, meanwhile, aren't explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it's nearly impossible for a financial firm to garner approval.
Since I started tracking my Guru Strategies more than nine years ago, the performance of my Graham-based model has been rather remarkable. Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through July17, the 10-stock Graham-based portfolio was up 179.2% since its July 2003 inception, making it my second-best performer. That's a 12.1% annualized return in a period in which the S&P 500 has gained just 3.5% per year. The model's strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it rebounded big in 2009 and 2010, gaining 31.4% in '09 and 22.6% in '10. In 2011, it had its worst year, however, falling 19.0% while the broader market was flat. It's rebounded nicely in 2012, though, having risen 10.7% vs. 8.4% for the S&P, indicating that last year was an aberration.
It's also worth noting that the 20-stock Graham-based portfolio I track has been even better. In fact, it's the best performer of any of my 10- or 20-stock portfolios, having returned 259.7% since its July 2003 inception -- that's 15.3% per year.
The Graham portfolios' long-term results are a great demonstration of how successful stock investing doesn't need to be incredibly complex or cutting-edge. You don't need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Do that, and you should produce some strong results of your own.



News about Validea Hot List Stocks

Apollo Group Inc. (APOL): Apollo Group agreed to sell U.K.-based college prep school Mander Portman Woodward Ltd. to MPW Holdco Ltd. for $85.3 million, according to the Phoenix Business Journal. Apollo said the sale reflects its strategy to focus on the post-secondary education market, and said it expects the deal will add a gain of about $25 million during its fourth quarter of 2012.

Northrop Grumman Corp. (NOC): Grumman has been awarded a $782 million sole source contract from the Air Force to continue operating an airborne communications relay system in Afghanistan through September 2015, Nextgov.com recently reported. The move lifts the project's total value to $1.7 billion.



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

TJX   |   CSTR   |   SWI   |   LKQ   |   ASPS   |   APOL   |   TSCO   |   STMP   |   NOC   |   MWIV   |  



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.





Coinstar, Inc. (Coinstar) is a provider of automated retail solutions, which offers convenient products and services. the Company's offerings in automated retail include its Redbox business, where consumers can rent or purchase movies and video games from self-service kiosks (Redbox segment), and its Coin business, where consumers can convert their coin to cash or stored value products at self-service coin counting kiosks (Coin segment). Its New Ventures business (New Ventures segment) is focused on identifying, evaluating, building, and developing self-service concepts in the marketplace. On June 9, 2011, the Company completed the sale transaction of the Money Transfer Business to Sigue Corporation (Sigue). In June 2012, the Company's wholly owned subsidiary, Redbox Automated Retail, LLC, acquired certain assets of NCR Corp's self-service entertainment DVD kiosk business.





SolarWinds, Inc. (SolarWinds) designs, develops, markets, sells and supports enterprise information technology (IT), infrastructure management software to IT professionals in organizations of all sizes. The Company's product offerings range from individual software tools to more comprehensive software products that solve problems encountered by IT professionals. Its products are designed to help management of their infrastructure, including networks, applications, storage and physical and virtual servers, as well as products for log and event management. It offers a portfolio of products for IT infrastructure management. Its products operate in three categories: Free Tools, Transactional Products and Core Products. In January 2011, it acquired Hyper9, Inc. (Hyper9). In July 2011, it acquired TriGeo Network Security, Inc. (TriGeo). In October 2011, it acquired DNS Enterprise, Inc. (DNS). In December 2011, it acquired certain assets of DameWare Development LLC (DameWare).





LKQ Corporation (LKQ) provides replacement parts, components and systems needed to repair vehicles (cars and trucks). The Company operates in four segments: Wholesale-North America Wholesale-Europe, Self Service and Heavy-Duty Truck. Buyers of vehicle replacement products have the option to purchase from primarily five sources: new products produced by original equipment manufacturers (OEMs), which are known as OEM products; new products produced by companies other than the OEMs, which are sometimes referred to as aftermarket products; recycled products originally produced by OEMs, which it refers to as recycled products; used products that have been refurbished; and used products that have been remanufactured. October 1, 2011, it acquired Euro Car Parts Holdings Limited (ECP). On May 27, 2011, it acquired AkzoNobel Coatings Inc.'s paint distribution business. In February 2012, the Company announced that it had acquired Pieces Automobiles Lecavalier Inc.





Altisource Portfolio Solutions S.A.( Altisource), together with its subsidiaries, is a provider of services focused on technology-enabled, knowledge-based functions related to real estate and mortgage portfolio management, asset recovery and customer relationship management. The Company operates in three segments: Mortgage Services, Financial Services and Technology Services. In April 2011, the Company acquired Springhouse, LLC (Springhouse). In July 2011, the Company acquired the assembled workforce of a sub-contractor (Tracmail) in India.





Apollo Group, Inc. (Apollo Group) is a private education provider. The Company offers educational programs and services both online and on-campus at the undergraduate, master's and doctoral levels through its wholly owned subsidiaries, The University of Phoenix, Inc. (University of Phoenix); Institute for Professional Development (IPD); The College for Financial Planning Institutes Corporation (CFFP), and Meritus University, Inc. (Meritus). Apollo Group also formed a joint venture with The Carlyle Group (Carlyle), called Apollo Global, Inc. (Apollo Global), to pursue investments primarily in the international education services industry. As of August 31, 2011, Apollo Group owned 85.6% of Apollo Global, with Carlyle owning the remaining 14.4%. During the year ended December 31, 2011, the Other Schools segment includes IPD and CFFP, as well as Meritus University, Inc. (Meritus), which ceased operations.





Tractor Supply Company is an operator of retail farm and ranch stores in the United States. The Company operates retail stores under the names Tractor Supply Company and Del's Farm Supply and operate a Website under the name TractorSupply.com. The Company's stores are located in towns outlying metropolitan markets and in rural communities, and offer a selection of merchandise, which include equine, pet and small animal products, including items necessary for their health, care, growth and containment; hardware, truck, towing and tool products; seasonal products, including lawn and garden items, power equipment, gifts and toys; maintenance products for agricultural and rural use, and work/recreational clothing and footwear. The Company operates at farm and ranch retail sales segment, both at its retail locations and online.





Stamps.com Inc. is a provider of Internet-based postage solutions. The Company's customers use its service to mail and ship a variety of mail pieces, including postcards, envelopes, flats and packages, using a range of United States Postal Service (the USPS) mail classes, including First Class Mail, Priority Mail, Express Mail, Media Mail, Parcel Post, and others. Its customers include individuals, small businesses, home offices, medium-size businesses and enterprises.





Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business.





MWI Veterinary Supply, Inc. (MWI) is a distributor animal health products to veterinarians across the United States and United Kingdom. The Company's products include pharmaceuticals, vaccines, parasiticides, diagnostics, capital equipment, supplies, specialty products, veterinary pet food and nutritional products. MWI markets the products to veterinarians in both the companion animal and production animal markets. The Company also offers its customers a variety of value-added services, including e-commerce platform, pharmacy fulfillment, inventory management system, equipment procurement consultation, special order fulfillment, educational seminars and pet cremation. On March 21, 2011, The Company acquired Nelson Laboratories Limited Partnership (Nelson). On October 31, 2011, the Company acquired substantially all of the assets of Micro Beef Technologies, Ltd. (Micro).





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


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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.