|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||December 23, 2010|
The biggest economic news over the past couple weeks has come from Uncle Sam, with Congress giving a somewhat reluctant approval to the tax compromise forged by President Obama and Congressional Republicans.
The deal has major implications for the economy and investors. While adding significantly to the U.S. deficit, it keeps more money in American workers' pockets, keeps the dividend tax rate at 15%, and significantly extends benefits for the nation's unemployed. There will certainly be issues down the road as the government tries to get its deficits and debt under control. But the tax deal should provide substantial stimulus -- or, perhaps more accurately, prevent a substantial drag that could have occurred had the tax breaks not been continued -- to help keep the economic recovery moving forward.
And it is moving forward. While the government's moves have stolen most of the headlines, continued positive economic signs have popped up in the past two weeks. Manufacturing and industrial activity continues to improve, with industrial production rising 0.4% in November, new data from the Federal Reserve showed. A big chunk of the increase was driven by the utilities sector, as falling temperatures led to increased demand for heating, but the manufacturing sector also showed significant growth in the month. The overall gain in industrial production reversed a slight decline seen in October -- the only time in the past 17 months that production has declined.
Early indicators also show that manufacturing growth has continued at a very strong pace in December. Manufacturing activity in the mid-Atlantic region jumped to its highest level since April 2005, according to the Philadelphia Federal Reserve Bank's business activity index. And the New York Federal Reserve Bank's manufacturing index made a sharp turnaround from November, jumping well into positive territory after having been well in negative territory.
The U.S. consumer also continued to show that he isn't tapped out, as many have feared. Retail sales rose 0.8% in November, the Commerce Department reported, marking the fifth straight month of gains. Sales figures for October and September were also revised upward. The November figure was the highest level for retail sales since the start of the 2007-09 recession. With consumer spending making up about 70% of U.S. economic activity, that's great news.
The Federal Reserve, meanwhile, is continuing its latest round of quantitative easing -- the so-called "QE2" plan. Somewhat surprisingly, the Fed's latest bond-buying binge has corresponded with a rise in interest rates -- the opposite of what the Fed was expecting. In the past month, the yield on the 10-Year Treasury Bond has jumped nearly 20%, though it has started to come back down in the last week. What's unclear is why the yields are moving upward. Part of it seems to be the improving economy, which has heartened investors and stemmed the fear-induced rush into the perceived safety of Treasury bonds. But part also may be the so-called "bond vigilantes", who, perturbed by the climbing U.S. deficit and debt, are selling off bonds and demanding higher yields. The reality is that both the improving economy and bond vigilante-type activity are likely impacting yields.
Another big issue pertaining to the U.S. government's actions is the value of the dollar. The government's huge stimulus efforts and quantitative easing plans are expected to hurt the dollar in the long run, but, in recent weeks at least, the dollar has held its own against various foreign currencies. Part of that is likely because, while the U.S. is still recovering from the financial crisis and Great Recession, many other developed countries are experiencing greater troubles. And with fears about Europe's debt crisis again making headlines, the U.S., with its size and influence, is seen as a relative safe haven. What happens to the dollar over the longer term is a factor to keep an eye on, however.
Finally, some good news came from the housing market this week, with the National Association of Realtors reporting that its existing-home sales index rose 5.6% in November. Inventories of homes fell for the fourth straight month. Still, the housing market remains questionable, and it's difficult to ascertain the true strength or weakness of the market as it continues to adjust to a post-government-tax-credit environment.
Overall for the fortnight, the S&P returned 2.5%, while the Hot List returned 1.9%. For the year, the portfolio stands at 12.5% vs. 12.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 171.2% vs. the S&P's 25.8% gain.
One Final Shakeup
As we head into the final week of 2010, the Hot List today is performing its final scheduled rebalancing. And the theme seems to be, think "small". Two of the stocks the portfolio is adding (Cash America International and Tower Group) have market capitalizations of about $1.1 billion, while the third (Fossil, Inc.) has a market cap below $5 billion.
The two financial small-caps are a particularly interesting pair. While financial firms have been pounded in recent years, both Cash America and Tower Group have managed to continuously increase both earnings and revenues. Tower upped earnings per share by 25.6% in 2008 and 12.7% in 2009, and sales by 17.5% in '08 and a whopping 103% in '09. Cash America, meanwhile, upped EPS by 3.4% in a very tough '08 and 17.4% in '09, and upped revenues by 11% and 8.6%, respectively, in those two years.
A history of growth during both good times and bad is a characteristic that many other Hot List holdings share, and that's a good position to be in as we head into 2011. I expect the economy to continue what has become a solid recovery, particularly with confidence starting to rise and the government continuing to do all in its power to stimulate the economy, both in terms of quantitative easing and the new tax deal. But in terms of how the recovery progresses, there are a number of big questions. Will the government's spending binge yield the inflation that many have been expecting for some time now? Or will continued deleveraging and cautiousness by consumers and businesses make for a period of low inflation? Will the dollar tumble, or will its status as a "safe haven" currency continue to bolster its value? And how will that impact U.S. exports and imports? At what point will the Federal Reserve start to tighten monetary conditions?
With all those questions in play, it makes sense to have a portfolio filled with stocks of companies that have excelled in a variety of different environments. Financials like Cash America and Tower Group that have fared well during a major financial crisis; retailers like Aeropostale that have kept on boosting profits and sales in a period in which the consumer was declared "dead"; healthcare firms like Sanofi-Aventis that have held up well despite concerns about the impending healthcare overhaul -- these are the types of strong, proven companies that should be able to deal with whatever 2011 deals us.
One thing I found interesting about this rebalancing is that the Hot List is adding three relatively small stocks while selling three other smaller stocks (lululemon athletica, China MediaExpress, and L&L Energy). The portfolio's movement within the small-cap sector comes at a time when that area of the market has had more "cross-sectional volatility" than other areas.
Cross-sectional volatility measures how differently stocks in a particular area of the market are performing, and Russell Investments and Parametric Portfolio Associates have developed indices that measure this type of volatility, The Wall Street Journalrecently noted. The Journal reported that "overall cross-sectional volatility is fairly low right now, but market segments such as U.S. small-cap growth stocks and emerging-market small caps look like better hunting grounds for active managers".
The key underlying idea here is that, while investors tend to dislike volatility, it is volatility that presents us with opportunity. More volatility usually makes for more chances that a stock will become mispriced. And investors who can identify those mispricings can may a lot of hay. That's particularly important to remember when times get rough and the market is making you want to jump ship.
The broader point of the Journal article was also interesting, and very relevant to the Hot List. The piece focused on a new study on "closet indexers" -- mutual funds that purport to have the goal of beating their benchmarks, but which really act merely as mirrors of those benchmarks. The study, performed by Antti Petajisto, a visiting assistant finance professor at New York University's Stern School of Business, found that about one-third of U.S. stock fund assets are managed by "closet indexers", meaning that investors are paying mutual fund fees and getting index-fund performance.
One metric Petajisto's study used was "active share", which measures how much of a particular fund's assets are invested in different holdings than the fund's benchmark. Many funds with active share between 20% and 60% "generally purport to be 'actively managed' but are actually closet indexing, according to Prof. Petajisto's study," the Journal states. (Funds with active share below 20% tend to be pure index funds.)
Closet indexing has been on the rise, Petajisto's study found. Back in 2006, about 19% of U.S. stock fund assets were in funds that had active share rates between 20% and 60%. By 2009, it had grown to 31%.
What's interesting is that Petajisto found that the most active stock-picking fund managers tend to beat their benchmarks by an average of 1.26% annually after fees. Those with low active share rates tend to lag their benchmarks.
The message is that you can't beat the market by owning it -- or by owning something very close to it. And the goal of the Hot List is to beat the market -- not to mirror it. That's why the portfolio often diverges significantly from its benchmark (the S&P 500). Currently, for example, only two of the portfolio's ten holdings (Raytheon and GameStop) are members of the S&P 500. At this time in 2009, the portfolio included just two S&P 500 members, and at this time in '08 it included just one.
The lack of correlation between the Hot List and its benchmark isn't simply an effort to be contrarian. It's really an indication, and reminder, that "the market" is much more than the "S&P 500". While the signature S&P index is very often used as a proxy for "the market", there are thousands of other stocks trading on U.S. exchanges; our Validea.com database includes about 7,700 U.S.-traded stocks.
If you stick closely to the 500 stocks in the S&P, you're thus ignoring literally thousands of other opportunities. And, because the stocks in the S&P tend to be the most visible and popular, you're ignoring numerous quality stocks that may be flying under the radar. Over the years, the ability of our guru-inspired models to scan through thousands of different stocks -- some well-known, many little-known -- has allowed the Hot List to find attractive stocks of excellent companies, even while the S&P 500 has struggled. By keeping the portfolio open to such a wide array of opportunities, I expect that it will continue to find more winners than losers over the long haul, and continue to post strong performance numbers regardless of what the S&P does.
Finally, since this is our last newsletter until 2011, I'd like to wish you all a happy and healthy holiday and New Year.
As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Lululemon Athletica Inc. (LULU), China Mediaexpress Holdings Inc (CCME) and L&l Energy, Inc. (LLEN).
7 stocks remain in the portfolio. They are: Telefonica S.a. (Adr) (TEF), Millicom International Cellular Sa (Usa) (MICC), Raytheon Company (RTN), Aeropostale, Inc. (ARO), Sanofi-aventis Sa (Adr) (SNY), Gamestop Corp. (GME) and Dollar Tree, Inc. (DLTR).
We are adding 3 stocks to the portfolio. These include: Cash America International, Inc. (CSH), Fossil, Inc. (FOSL) and Tower Group, Inc. (TWGP).
Newcomers to the Validea Hot List
Cash America International, Inc. (CSH): Based in Texas, Cash America operates in more than 1,000 locations in the U.S. and Mexico, providing secured non-recourse loans -- pawn loans. It also offers short-term cash advances and check cashing services. The firm has a market cap of about $1.1 billion.
Cash America, which gained 8.7% while in the Hot List from Aug. 6-Oct. 1, gets approval from my James O'Shaughnessy-based strategy. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
Tower Group, Inc. (TWGP): Based in New York City, this small-cap ($1.1 billion) offers specialized property and casualty insurance to businesses and individuals. It's upped EPS in eight straight years, and over the past year has taken in more than $1.3 billion in sales.
Tower gets approval from my Peter Lynch- and James O'Shaughnessy-based strategies. The "Detailed Stock Analysis" section below has more on the stock.
Fossil, Inc. (FOSL): Fossil designs and sells a variety of fashion accessories that are sold in more than 90 countries across the world. Its most notable product line is probably its extensive collection of watches, but the firm also makes small leather goods, belts, handbags, sunglasses, jewelry and apparel. Fossil's market cap is about $4.8 billion, and it has taken in almost $1.9 billion in sales over the past year.
The Hot List previously picked up Fossil in mid-March of 2009, when fear of retail stocks was very high, and the stock delivered, jumping 34% in a two-month stint in the portfolio. Now, two of my growth strategies -- those I base on the writings of Martin Zweig and Motley Fool creators Tom and David Gardner -- are again keen on the firm. See the "Detailed Stock Analysis" section below for more on Fossil's fundamentals.
News about Validea Hot List Stocks
Millicom International Cellular (MICC): Millicom announced this week that its subsidiary in the Democratic Republic of the Congo has reached a deal to sell 729 towers to Helios Towers, for at least $45 million of cash up front. Company officials said the move is expected to create savings in both capital and operating expenditures for the subsidiary. Millicom has outsourced other towers to Helios in Africa, as part of an effort to allow wireless operators to focus capital and management resources on higher quality service and be more cost-effective, Reuters reported.
L&L Energy (LLEN): Shares of L&L fell about 9% on Dec. 21 after CNBC reported that the Securities and Exchange Commission is investigating Chinese "reverse merger" companies that are trading in the U.S. L&L is not a reverse merger, but has "similar attributes", according to the report. There was no indication that L&L was part of the investigation, but the negative attention nonetheless drove shares lower. L&L's overall score on my Guru Strategies had been falling prior to the news, however, and because of that, the portfolio is selling the stock today for a nice profit. (Even with Tuesday's decline, shares were up over 20% since the Hot List picked up the stock on Oct. 1.) Another Hot List holding that does appear to have been a reverse merger, China MediaExpress (CCME), was impacted far less than L&L, losing 2.5% on Tuesday amid the news. As is the case with L&L, the portfolio today is selling its CCME shares because of deterioration in fundamentals.
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 email@example.com.
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