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Executive Summary December 23, 2010

The Economy

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.

Opportunistic Thinking

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.
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: Lululemon Athletica Inc. (LULU), China Mediaexpress Holdings Inc (CCME) and L&l Energy, Inc. (LLEN).

The Keepers

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).

The Newbies

We are adding 3 stocks to the portfolio. These include: Cash America International, Inc. (CSH), Fossil, Inc. (FOSL) and Tower Group, Inc. (TWGP).

Portfolio Changes

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 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

ARO   |   MICC   |   TEF   |   RTN   |   TWGP   |   CSH   |   FOSL   |   SNY   |   GME   |   DLTR   |  

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.

Millicom International Cellular S.A. (Millicom) is a global mobile telecommunications operator. The Company also operates fixed telephony, cable and broadband businesses in five countries in Central America. As of December 31, 2009, the Company had 14 mobile operations in 14 countries focusing on emerging markets in Central America, South America, Africa and Asia. Millicom operates its mobile businesses in El Salvador, Guatemala and Honduras in Central America; in Bolivia, Colombia and Paraguay in South America; in Chad, the Democratic Republic of Congo, Ghana, Mauritius, Rwanda, Senegal and Tanzania in Africa; and in Laos in Asia. In November 2009, the Company announced that it has completed the sale of its Cambodian operations to The Royal Group. In October 2009, the Company announced the sale of Tigo (Private) Limited, its Sri Lanka operation, to Etisalat.

Telefonica SA (Telefonica) together with its subsidiaries and investees operates in the telecommunications, media and contact center industries. Telefonica basic purpose is the provision of all manner of public or private telecommunications services, including ancillary or complementary telecommunications services or related services. The Company operates in three business areas: Telefonica Spain, Telefonica Latin America and Telefonica Europe. During the year ended December 31, 2009, Telefonica Moviles Espana, SAU, a wholly owned subsidiary of the Company completed the sale of its 32.18% stake in Medi Telecom, SA. In January 2010, the Telefonica Group, through its wholly owned subsidiary, Telefonica Europe plc completed the acquisition of JAJAH.

Raytheon Company, together with its subsidiaries, develops products, services and solutions in defense markets; sensing, effects, command, control, communications and intelligence (C3I), and mission support, as well as the cybersecurity and homeland security markets. The Company serves both domestic and international customers, principally as a prime contractor on a portfolio of defense and related programs for government customers. It operates in six business segments Integrated Defense Systems (IDS), Intelligence and Information Systems (IIS), Missile Systems (MS), Network Centric Systems (NCS), Space and Airborne Systems (SAS) and Technical Services (TS). In October 2009, the Company acquired BBN Technologies Corp. and related entities. In November 2010, the Company acquired Trusted Computer Solutions, a company that delivers a portfolio of cross-domain, operating system and network security solutions.

Tower Group, Inc. (Tower), through its subsidiaries, offers a range of commercial, personal and specialty property and casualty insurance products and services to businesses in various industries and to individuals. The Company operates in three segments: Brokerage Insurance, Specialty Business and Insurance Services. On February 5, 2009, Tower acquired CastlePoint Holdings, Ltd. (CastlePoint). On February 27, 2009, the Company and its subsidiary, CastlePoint, completed the acquisition of HIG, Inc. (Hermitage), a property and casualty insurance holding company. On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers compensation business of AequiCap Program Administrators, Inc. (AequiCap), an underwriting agency. On November 13, 2009, it acquired Specialty Underwriters Alliance, Inc. (SUA). In July 2010, Tower Group, Inc. acquired the Personal Lines Division of OneBeacon Insurance Group, Ltd.

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.

Fossil, Inc. is a global designer, marketer and distributer company that specializes in consumer fashion accessories. Its offerings include a line of men's and women's fashion watches and jewelry, handbags, small leather goods, belts, sunglasses, footwear, cold weather accessories and apparel. Its products are distributed globally through a range of distribution channels, including wholesale in countries where it has a physical presence, direct to the consumer through its retail stores and commercial Websites and through third-party distributors in countries, where it does not maintain a physical presence. Fossil, Inc. sells its products through a diversified distribution network that includes department stores, specialty retail locations, specialty watch and jewelry stores, owned retail and factory outlet stores, mass market stores, owned and affiliate Internet sites and through its FOSSIL catalogs.

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. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company.

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.

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.