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|Executive Summary||May 8, 2015|
Economic data remains mixed, with encouraging signs in the job market and service sector being counterbalanced by tepid growth in manufacturing and gross domestic product.
GDP rose just 0.2% in the first quarter, according to a report from the Commerce Department. That figure may be adjusted downward, many analysts say, in light of newer data showing that the US trade deficit reached a six-and-a-half year high in March. Some said the increase was the result of the end of the West Coast dockworkers strikes, which had created a backlog of imports that have flooded back in. But exports have also been trending down, and others worried that the strong dollar has made US goods too expensive abroad.
On the positive side, new claims for unemployment have fallen significantly since our last newsletter, and are 18.4% below year-ago levels. The four-week moving average of new claims is at its lowest level in 15 years Continuing claims, the data for which lag new claims by a week, also moved lower since our last newsletter and are 16.7% below year-ago levels.
Earnings season has been in full swing, and bottom-line results have been pretty solid. With 360 of the S&P 500 companies having reported, 71% had beaten earnings estimates, according to FactSet. Top-line results have been much weaker, with 46% of firms beating sales estimates. In late March, analysts had expected earnings to decline at a 4.7% pace in the quarter, but so far the decline stands at 0.4%, with eight sectors having higher-than-expected growth rates due to upside earnings surprises.
The manufacturing sector expanded in April for the 28th straight month, according to the Institute for Supply Management, though it did so at a fairly weak pace. New orders picked up and are at a pretty solid pace, which means manufacturing growth could pick up in coming months.
ISM's service sector index was more impressive. It showed that the service sector expanded in April for the 63nd straight month, doing so at the fastest pace since November. New orders rose and are at a very high level, while employment conditions remained at about the same strong level they were in March.
After several strong monthly gains, personal income was flat in March, according to the Commerce Department. Real disposable personal income, which also had jumped in recent months, fell 0.2%. The opposite was true of real personal consumption expenditures. Real PCE had been weak for several months, but jumped 0.3% in March, as consumers may be starting to spend the money they're saving on gas. The personal savings rate dipped from 5.7% to 5.3%, still a very healthy level.
Speaking of gas, however, prices are rising again. As of May 6, a gallon of regular unleaded on average cost $2.64, up from $2.39 a month earlier. That's still far below the year-ago level of $3.67, but we'll have to see how much higher prices go.
Since our last newsletter, the S&P 500 returned -1.2%, while the Hot List returned -2.2%. So far in 2015, the portfolio has returned 11.7% vs. 1.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 261.4% vs. the S&P's 108.7% gain.
The Importance Of A Plan
The investment research firm Dalbar recently released its annual Quantitative Analysis of Investor Behavior, and, as usual, the data was not encouraging for individual investors. In 2014, according to Dalbar, the S&P 500 returned 13.7%, but the average equity mutual fund investor gained a mere 5.5%. And while the Barclays Aggregate Bond Index was gaining nearly 6%, the average fixed income mutual fund investor was gaining just 1.2%.
While the 2014 results were particularly bad, they are merely part of a broader, long-term pattern of investors underperforming the broader market indices by wide margins. Over the past 30 years, the S&P 500 has returned 11.1% annualized, while the average equity mutual fund investor has gained just 3.8%, according to Dalbar. Returns for fixed income investors have been even worse. Over the past 3 decades, the Barclays index has averaged annualized returns of 7.4%; investors in fixed income funds gained an average of 0.7%.
While fees no doubt take a bite out of investor returns, Dalbar indicates that the main reason for individual investors' terrible collective performance is behavioral. "Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally," the group says. "That irrationality leads to the buying and selling at the wrong time which leads to underperformance."
I've often talked about the behavioral biases that hamper investors, and Dalbar offers its own list of nine specific behaviors that "tend to plague investors based on their personal experiences and unique personalities." They are:
Loss Aversion -- Expecting to find high returns with low risk
Narrow Framing -- Making decisions without considering all the implications
Anchoring -- Relating to familiar experiences, even when not appropriate
Mental Accounting -- Taking undue risk in one area and avoiding rational risk in others
Diversification -- Seeking to reduce risk, but simply using other sources
Herding -- Copying the behavior of others even in the face of unfavorable outcomes
Regret -- Treating errors of commission more seriously than errors of omission
Media Response -- Tendency to react to news without reasonable examination
Optimism -- Belief that good things happen to me and bad things happen to others
One of the particularly interesting pieces of data from this year's QAIB involves Dalbar's "guess right ratio". This measures the frequency that the average investor makes a correct call on the market's direction by looking at whether the market goes up or down the month after an investor has net inflows. While the average mutual fund investor greatly lagged the broader market in 2014, the average investor "guessed right" about the market's direction the following month in 8 of 12 months of the year. But some of the months when investors were wrong were months in which they made their largest bets. According to Dalbar, equity mutual fund inflows in December 2013 were the highest they'd been since December 2007, and the 4th highest they've ever been. The next month, January 2014, the S&P 500 lost 3.5%, its worst performance in more than 2 1/2 years. That's apparently not unique -- over the past 20 years, investors have "guessed right" at least 50% of the time in all but four years, but greatly lagged the market. The timing of when you guess right and guess wrong is critical.
Other data from Dalbar shows just how critical it can be. The firm looked at the 10 months over the past 30 years in which investors lagged the S&P by the greatest percentage. The gap for a single month was as high as 7.4 percentage points -- that was in October 2008, around the height of the financial crisis.
Not coincidentally, many of those 10 worst performing months came at major inflection points for the market -- September and October 2008, October 1987 (Black Monday), November 1997 (when markets rebounded after the October mini-crash associated with the "Asian Contagion" financial crisis), August 1998 (the Russian financial crisis), March 2000 (the end of the bull market/start of the tech crash), and November 2000 (during the indecision surrounding the US's Presidential election) are all on the list. All of these were highly emotional times, and it's when emotions are high that we humans make mistakes and let those pesky biases worm their way into our decision-making processes -- just when our potential returns are really on the line.
Dalbar says that "no amount of prior education can adequately prevent the enveloping fear that exists when the [emotion-triggering] event is actually taking place," and to an extent that's true -- you will feel fear when markets are swinging wildly no matter what. But I believe that you can mitigate the impacts of fear and other emotions on your behavior (and your portfolio) through preparation. In a recent piece for Kiplinger magazine, Anne Kates Smith talked about the biases that impact investors and how you can combat them. "Crafting an investment policy statement -- and an exit strategy -- before the going gets rough helps take the emotion out of buying, selling and rebalancing decisions," she said, and I agree with that sentiment. As is the case with just about anything in life, the more you prepare for difficult times, the less likely you are to panic when difficult times do hit.
With the Hot List, we've thought a great deal about how to handle market declines and turbulent times. In fact, our entire portfolio management system is designed to overcome the biases that dog investors. By using a purely quantitative system and buying and selling only at fixed intervals, we've created a system in which emotion has no place. When times get tough and the market starts falling, rules like these help us focus on the long-term and not get swayed by stress or emotion. If you set rules with the intent of keeping your emotions at bay, you feel as though you've failed if you break the rules; that's a good incentive to help keep you on track.
I also think it's very important to familiarize yourself with market history. If you have researched past market cycles, you become familiar with several important notions -- that stocks have always rebounded from terrible economic, political, and social crises; that times when fears are high and the market is tumbling tend to be the best times to invest; that overly exuberant periods are often followed by market declines. Knowing all of that can offer comfort when things get tough. Those who aren't familiar with the market's resilience and behavioral finance, on the other hand, are likely to get overwhelmed when the market gets volatile.
When and how the next market crisis hits is anyone's guess. But at some point, trouble will occur -- it's just the nature of the beast. Instead of trying to predict when it will happen -- which few, if any, people can do -- I'd advise that you think about what you will do when things get rough. Have a plan that will best serve your needs. Write down how you want to react when big declines hit, and what your rationale is. Then return back to that document when the going gets tough. Ready yourself while the skies are relatively clear, because when thunderstorms hit, most people are too busy worrying about the rain and lightning to think clearly.
As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Pilgrim's Pride Corporation (PPC), Sasol Limited (Adr) (SSL), Fossil Group Inc (FOSL) and Apple Inc. (AAPL).
6 stocks remain in the portfolio. They are: Credit Acceptance Corp. (CACC), Sanderson Farms, Inc. (SAFM), Jones Lang Lasalle Inc (JLL), Universal Insurance Holdings, Inc. (UVE), Lannett Company, Inc. (LCI) and Chart Industries, Inc. (GTLS).
We are adding 4 stocks to the portfolio. These include: World Acceptance Corp. (WRLD), Eplus Inc. (PLUS), Amtrust Financial Services Inc (AFSI) and Trueblue Inc (TBI).
Newcomers to the Validea Hot List
AmTrust Financial Services (AFSI): Founded as a workers' compensation insurance firm, this New York City-based company has expanded into a multi-national property and casualty insurer. It specializes in coverage for small businesses.
AmTrust ($4.9 billion market cap) gets strong interest from my Peter Lynch-, Warren Buffett, and James O'Shaughnessy-based models and my Momentum Investor strategy. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
ePlus Inc. (PLUS): Virginia-based ePlus helps organizations optimize their IT infrastructure and supply chain processes by delivering complex information technology solutions, which include managed and professional services and products from top manufacturers, flexible financing, and proprietary software. The 24-year-old firm has more than 950 associates serving commercial, state, municipal, and education customers nationally.
ePlus ($615 million market cap) gets strong interest from my James O'Shaughnessy- and Peter Lynch-based models and my Momentum Investor approach. To read more about it, scroll down to the "Detailed Stock Analysis" section.
World Acceptance Corp. (WRLD): This South Carolina-based small-cap ($880 million) specializes in making small, short-term loans in the southern and central U.S. and Mexico. It has taken in about $630 million in sales over the past year.
World Acceptance gets strong interest from my James O'Shaughnessy-, Warren Buffett- and Peter Lynch-based models. For more on the stock, see the "Detailed Stock Analysis" section below.
TrueBlue Inc. (TBI): Tacoma, Wash.-based TrueBlue provides temporary blue-collar staffing services to a variety of industries, including construction, manufacturing, transportation, aviation, waste, hospitality, retail, and renewable energy. It operates about 700 branches in all 50 states, Puerto Rico and Canada, and has taken in about $2.4 billion in sales over the past 12 months.
TrueBlue ($1.2 billion market cap) gets strong interest from my Peter Lynch-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Lannett Company (LCI): Lannett posted strong fiscal third-quarter profit results and improved guidance on May 6, but shares tumbled. Lannett posted net income of $36.2 million, or 97 cents per share, up sharply from $23.0 million, or 63 cents a share, in the year-ago period. The profit results beat analysts estimates of 95 cents per share, the Associated Press reported. Revenue was $99.4 million in the period, which was well above year-ago levels of $80 million but missed estimates of $100.7 million. Perhaps because of the revenue miss, Lannett shares tumbled more than 12% the day after the announcement. Still, Lannett increased its full-year revenue guidance to $403 million to $408 million, up from previous guidance of $395 million to $405 million. Given all of that, the stock seems like it may be a very good candidate for a strong bounce back.
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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