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While investors have been spooked by whispers of a credit crisis and continued fears about interest rate hikes, the US economy -- and the economy of one of its key trading partners -- have offered several positive signs over the past two weeks.
The labor market followed up its stellar October with a strong November, for example, with the economy adding 211,000 jobs, the Labor Department said. In addition, the September and October jobs-added figures were revised higher by a total of 35,000. Average hourly wages grew at a modest annual pace of 1.9% vs. October, though average weekly wages fell slightly as average hours worked dipped just a bit. Amid all this, the unemployment rate remained at 5.0%, the lowest it has been since April 2008. The "U-6" rate, which unlike the headline number takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job, inched up a tenth of a percentage point in November to 9.9%.
Retail sales, meanwhile, rose by 0.2% in November, according to a new report from the Census Bureau. That put sales about 1.5% higher than they were a year ago -- not a particularly good year-over-year increase, but gains are gains.
Housing starts continued a topsy-turvy few months, bouncing back from a weak October with a strong November in which starts increased 10.5%, according to the Census Bureau. They are now 18.5% above where they were a year ago. Permit issuance for new construction also surged, rising 11%, and is nearly 25% above where it stood a year ago.
Of course, the biggest headlines from the last two weeks have been generated by the Federal Reserve decision to at long last raise interest rates. While the issue has often dominated financial news, it is important to keep in mind that the initial hike is very minor, and the Fed seemed to stress that any subsequent rate hikes will be very gradual.
One of the reasons the Fed held off for so long on increasing rates is that inflation has been so low in recent years. And while the Fed is moving ahead, inflation remains tame -- non-existent, actually. The Consumer Price Index was flat in November, according to the Labor Department, meaning it is ahead of its year-ago level by just 0.5%. Stripping out volatile food and energy prices, so-called "core" inflation, which was up 0.2% in November, is 2.0% ahead of its year-ago pace. The gap between the core number and the overall number should start to decrease as we move into 2016, as the year-ago comparisons get further from the epicenter of the late-2014 commodity collapse.
That doesn't mean commodities, and oil and gas prices in particular, have bottomed. Gas prices keep on falling and have been on the verge of dipping below the $2 mark for the first time since 2009. As of December 14, a gallon of regular unleaded on average cost $2.01, down from $2.18 a month earlier. That's about 21% below where it was one year ago.
Overseas, good news came out of China. Factory output grew at a 6.2% pace in November, according to Chinese government data, significantly ahead of the 5.6% that analysts expected and the 5.6% from the previous month. It was the strongest pace in five months. Retail sales, meanwhile, grew at 11.2%, the strongest pace of the year, topping estimates of 11.0%. Fixed-asset investment also exceeded expectations, according to Reuters. The Chinese government has implemented a number of stimulus measures in recent months, and the November data shows that they appear to be working.
Then there's Third Avenue. The firm said last week that it was barring investors from redeeming money from its Focused Credit Fund, a high-yield offering. Third Avenue said that it didn't have enough cash to meet redemption demand, according to The Wall Street Journal, and that it would hurt fund investors if it were to sell illiquid holdings at what it says are unreasonably low prices. The move got many investors thinking that a credit crisis may be looming, and there has indeed been a lot of turmoil in high yield areas of the credit market. A big reason for that is likely the Fed; interest rate increases tend to hurt high-yield fixed income assets. Whether a full blown credit crisis is in the offing remains to be seen, but the notion is certainly one to keep in mind going forward. From the commodity price collapse to the incredible top-heaviness of the market to the years and years of ultra-low interest rates we have had, a number of unusual factors are influencing the market and economy. I wouldn't rule anything out going forward.
Amid all this, the S&P 500 has returned -0.4% since our last newsletter, while the Hot List has returned -4.2%. So far in 2015, the portfolio has returned -12.3% vs. -0.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 183.8% vs. the S&P's 104.1% gain.
Believing In Value
It has been a rough stretch for the broader market and, to a greater degree, the Hot List. Several of the portfolio's holdings have stumbled over the past few weeks, most notably Banco Macro, which is down about 20% since joining the portfolio a month ago, and Cal-Maine Foods, which is down about 17% over that span (through Dec. 15). Neither of these firms has had any significant deterioration in its fundamentals that would merit such a decline. In the case of Banco Macro, the US interest rate increase (and the preceding expectation of an increase), as well as Argentina's tumultuous political situation, may well have played a role. But in times of broader market turbulence, it can be particularly hard to pinpoint exactly what is driving a stock's day-to-day machinations.
With less than two weeks left in the year, the Hot List's recent struggles mean that the portfolio will almost assuredly lag the S&P 500 in 2015. That would mark the first time in its twelve-year history that the portfolio has underperformed the index in consecutive years.
While we are of course disappointed with the past two years' performance, we are not alarmed; all strategies, even those used by history's best investors, go through losing periods, and sometimes those periods can last two or even three years. We do think it's important to understand the reasons behind the underperformance, however, and in this case there seem to be a couple main factors.
First, while history has shown that smaller stocks tend to beat their larger peers by a significant margin over the long haul, we've seen a divergence from that trend over the past couple years. As of Dec. 11, US large-cap stocks were slightly in the black in 2015, posting average gains of 0.2%, according to Morningstar.com. US small-cap stocks, meanwhile, were down nearly 6% for the year.
Part of that wide spread may be due to the normal ebb and flow that occurs between different market segments. But we think that a big part of it may be the result of something else: the rise of index funds. Index-tracking funds have become so popular in recent years, and the majority of them are weighted by market capitalization. This creates a cycle in which investors load up on index funds, pushing prices of the market's biggest stocks higher, which in turn makes those stocks comprise an even greater portion of the index, which means investors are buying more of those stocks when they buy index funds, and on and on.
The results of that is a very top-heavy market, and the data bears that out: Through October, the 10 largest stocks (by market capitalization) in the S&P 500 were up 13.9%. The other 490? They were down 5.8%. That spread of nearly 20 percentage points has been higher only twice -- in 1998 and 1999, the height of the Internet bubble. The tremendous outperformance of large-cap stocks was not sustainable back then, of course, and we doubt that it is sustainable right now. As of December 15, five of the 10 largest US stocks traded at price/earnings ratios of 36 or higher; three of them at P/E ratios of 98 or higher. It will be nearly impossible for multi-hundred-billion-dollar companies like these to produce the sort of growth that would sustain those lofty valuations. And it's not just that handful of the largest stocks that look pricey; mega-capitalization stocks have been more expensive than small stocks only 4% of the time over the past 10 years, according to our data.
Which brings me to the second major reason for our underperformance: the struggles of value stocks. Over many, many decades, value investing has proven to be a winning strategy. That doesn't mean it always works, however, and 2015 has been one of those years. Through Dec. 11, US growth stocks were up 4.5% year-to-date; US value stocks, meanwhile, were down 4.4%, according to Morningstar. When you combine the underperformance of small stocks with the underperformance of value stocks, the results are much worse: US small value stocks are down close to 10% this year. On the opposite end of the spectrum, large US growth stocks are up nearly 7%. That gap of nearly 17% is completely antithetical to the long-term historical averages; according to the data of noted financial researcher Kenneth French, from 1927 through 2014, small value stocks outperformed large growth stocks by an average of 5.1 percentage points annually.
But the underperformance of value goes beyond 2015. Since February 2007, US value stocks have lagged the most expensive US stocks by 2.6 percentage points annually, according to Barron's. The eight-year, seven-month stretch of underperformance is the longest losing streak on record, going back to 1926.
So, are value stocks dead? We find that notion very unlikely. That's because we don't think the historical outperformance of value stocks is due to circumstance or coincidence. Value stocks have outperformed because of human nature and the very nature of business itself.
We humans are an emotional bunch, and we have a tendency to overreact to events. We also have an innate desire to follow the crowd, and a great ability (and need) to recognize patterns. Thousands of years ago, those instincts helped us avoid danger, find food, and survive. When our ancestors saw a group of people sprinting out of the jungle with looks of terror on their faces, those who had the instinct to follow the crowd increased their chances of survival, for example. Similarly, if every time it rained, a river overflowed into the surrounding area, those who recognized the pattern and avoided that area when it started to rain increased their chances of survival. These characteristics thus were passed down to us in our DNA.
The problem is that, in investing, those same instincts and abilities work against us. We see danger in stocks that have short-term problems and are falling. We see a pattern in a declining stock price, and instinctively think the pattern will go on forever. The danger and the apparent pattern cause us to sell, and run as fast as we can away from the stock -- likely into a far more popular, and pricey, stock. Investors do this even when the first stock is already trading levels well below what its underlying business fundamentals would suggest, and even when the second stock is trading well above what its underlying business fundamentals would suggest. That's how we get value stocks, on one hand, and growth (or, more accurately, "glamour") stocks, on the other.
That's what happens in the short term. But at some point, fundamentals of business and investing dictate that a company must justify its glamorous valuation. And it's incredibly hard to produce the sort of earnings growth that justifies an earnings multiple of 40 or 50, let alone 100 or more, over the long-term. That's why glamour stocks tend to eventually tumble. Value stocks, on the other hand, have such low expectations that even minor improvements can lead to major increases in share price.
So, what is more likely: that, after decades upon decades upon decades, human nature and the nature of business have changed and the valuation of something that you buy has forever ceased to be relevant; or, that something else has been happening to temporarily distort the natural way of things?
Obviously, we believe it to be the latter. It is likely that several factors have combined to create this extended stretch of underperformance by value stocks. First, as I've discussed several times before, many investors are still feeling the trauma of the 2008-09 financial crisis. The events of that jarring period have caused many to become extra sensitive to any sign of danger in the market. This risk aversion has likely led many investors to avoid -- more than usual -- value plays, which tend to have short-term problems hanging over them. Instead, they are following the crowd into glamour stocks that everyone seems to love.
Second, in recent years, US growth has been so-so, Europe has been in great turmoil, and growth in China and other emerging markets has slowed. With growth hard to come by, it is likely that investors are reaching for growth wherever they can find it -- even if it is in overpriced glamour stocks.
Thirdly, the basic materials and energy sectors tend to be laden with value stocks -- these unglamorous firms don't often demand particularly high valuations. Both of these sectors have been pummeled by the commodity collapse of the past year and a half, meaning that value stocks have taken the brunt of the commodity blow. The short-term pounding isn't a result of value investing failing; it is not as though investors suddenly found low valuations to be undesirable. Instead, it is a case of businesses being revalued in light of dramatic changes in commodity supply.
Finally, don't underestimate the role of the Federal Reserve in all this. When you tinker with markets, there are repercussions, and one of the repercussions of the Fed's extended period of ultra-low rates may well be a distortion of the growth/value cycle. Growth stocks are valued on future earnings -- when rates are on the rise, investors are less willing to pay high multiples. Value stocks, meanwhile, are the bird in hand, with strong existing cash flows. Given the recent underperformance of value stocks and strategies and the rate-hiking cycle that is about to begin, one would expect value to start to demonstrate better performance -- increasing rates are, in fact, typically good for value stocks.
The Gurus and Discipline
Above, I said that even the best strategies and strategists goes through losing periods. At times like these, it is important to remember that that's not just lip service. The gurus upon whom I base my strategies are some of history's most successful investors. But each of the 10 strategists about whom I wrote in The Guru Investor had multiyear stretches in which they significantly lagged the broader market.
What all of these gurus knew, however, was that ditching a proven, fundamentally sound strategy after a couple years of poor performance only compounds your trouble. Mean reversion is a powerful force, and good strategies rebound -- very often, the worse the underperformance, the bigger the rebound. Give up on a solid strategy after a bad year or two, and you are likely to miss the rebound. You end up with the pain of the bad year or two, and the pain of missing out when the worm turns.
The gurus didn't bail. They knew that value and fundamentals win over the long haul, so they stuck to their guns. Here are three examples of gurus who roared back from rough periods, along with an accompanying quote from each guru about the importance of sticking with a solid, fundamental-focused strategy:
The Rough Patch: While the S&P 500 lost 26.4% in 1974, Buffett was down 43.7%. The following year, when the S&P bounced back with a 37.2% gain, Buffett remained in the red, losing 5%.
The Rebound: In 1976, the S&P continued higher, gaining 23.6%. Buffett blew that away, posting gains of 134.2%. The following year, when the S&P lost 7.4%, Buffett gained another 55.1%. The rebound didn't end there. In 1978 and 1979, the S&P gained 6.4% and 18.2%, respectively. Buffett? He posted gains of 10.1% and 110.5%.
The Quote: "Successful Investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can't produce a baby in one month by getting nine women pregnant."
The Rough Patch: In 1971 in 1972, the S&P 500 gained 14.6% and 18.9%, respectively, as the "Nifty Fifty" -- a group of popular large-caps -- grew to bloated valuations. Neff's Windsor fund wasn't keen on the overvalued giants, and gained just 7.5% and 10.2%, however. Then in 1973, when the S&P fell 14.7%, Windsor was hit much harder, tumbling 25%.
The Rebound: After that three-year stretch of underperformance, Windsor beat the S&P by 9.6 percentage points, 18.3 percentage points, 22.8 percentage points, 8.4 percentage points, and 2.4 percentage points over the next five years.
The Quote: "I watched in amazement as investors clamored for Nifty Fifty stocks at the expense of dozens, if not hundreds, of sturdy growth stocks of lesser renown. My report to shareholders in November 1973 reflected the dismal course of events and, even more forcefully, my resilient faith in Windsor's low P/E strategy: '[We] view the current devastation in the marketplace, not as a reason for alarm, but rather as one of opportunity,' [I wrote]." -- from John Neff on Investing
The Rough Patch: In 1981, the S&P lost 5%, but Lynch's fund tumbled 22.6%. The next year, the S&P surged 21.4%, but Lynch lost 1.3%.
The Rebound: Lynch followed up those two years with his best year ever, posting a whopping 82.8% gain in 1983.
The Quote: "When people say, 'Look, in two months it's up 20%, so I really picked a winner,' or 'Terrible, in two months it's down 20%, so I really picked a loser,' they're confusing prices with prospects. Unless they are short-term traders who are looking for 20% gains, the short-term fanfare means absolutely nothing. A stock's going up or down after you buy it only tells you that there was somebody who was willing to pay more -- or less -- for the identical merchandise." -- from One Up On Wall Street
The Power of Mean Reversion
Having faith in their fundamental-focused approaches during times when fundamentals were being overlooked was a key to these gurus' long-term successes. They knew that, sooner or later, the market would come back to fundamentals and value, and that their results would revert to their very successful means.
We have seen a similar mean-reversion with our Guru Strategies. We recently tested how these approaches have performed following one-year stretches of underperformance. We calculated results on a rolling, daily basis (i.e., we looked at subsequent performance starting on any day that followed a 365-day period of underperformance), meaning that our study covers about 2,500 one-year periods.
The results showed that some of our most heavily weighted strategies have demonstrated tremendous mean-reversion. For example, following one-year periods in which it has lagged the S&P 500, the Motley Fool-based portfolio has, on average, gone on to outperform the index by 17.2 percentage points over the next year. The Joel Greenblatt-based portfolio has outperformed by an average of 9.4 percentage points in similar circumstances, while the Benjamin Graham-based portfolio has outperformed by 7.2 percentage points.
The exceptional performance of these and other models that drive the Hot List, along with the performances and advice of the gurus who inspired them, have me very optimistic as we look ahead to 2016. I'm not saying things will turn around immediately. But what I am saying is that history has shown that investing always comes back to fundamentals and value. That means that, over the long term, fundamental-focused, value-centric strategies like ours are the best way to invest. To give up on these approaches after a couple down years would be shortsighted.
The hardest part about investing is staying disciplined through periods of underperformance. But, as the gurus have demonstrated, if you can do so, you should reap the rewards down the line. We believe that the rewards are coming, and we will continue to be patient and disciplined so that we do not miss out on them.
As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Trueblue Inc (TBI), Silicon Motion Technology Corp. (Adr) (SIMO) and Apple Inc. (AAPL).
7 stocks remain in the portfolio. They are: Valero Energy Corporation (VLO), Polaris Industries Inc. (PII), Sanderson Farms, Inc. (SAFM), Tesoro Corporation (TSO), Cal-maine Foods Inc (CALM), Syntel, Inc. (SYNT) and Banco Macro Sa (Adr) (BMA).
The New Additions
We are adding 3 stocks to the portfolio. These include: Thor Industries, Inc. (THO), National-oilwell Varco, Inc. (NOV) and Eplus Inc. (PLUS).
Newcomers to the Validea Hot List
Thor Industries, Inc. (THO): Thor ($3 billion market cap) manufactures and sells a wide variety of recreational vehicles throughout the US and Canada, including the Airstream line of campers and trailers. They include conventional travel trailers, fifth wheels and park models. In addition, it also produces truck and folding campers and equestrian and other specialty towable vehicles.
Thor gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about its fundamentals, scroll down to 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 serves commercial, state, municipal, and education customers nationally.
ePlus ($750 million market cap) gets strong interest from my James O'Shaughnessy- and Peter Lynch-based models. To read more about it, check out the "Detailed Stock Analysis" section below.
National Oilwell Varco, Inc. (NOV): Varco is engaged in providing design, manufacture and sale of equipment and components used in oil and gas drilling, completion and production operations. The company also provides oilfield services to the upstream oil and gas industry.
Varco ($13 billion market cap) has taken in $18 billion in sales over the past year. It's a favorite of my Peter Lynch- and Benjamin Graham-based models. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
TrueBlue Inc. (TBI): TrueBlue announced that it has acquired workforce efficiency specialist SIMOS Insourcing Solutions, which provides on-premise staffing solutions for several Fortune 500 companies. Atlanta-based SIMOS will join TrueBlue's workforce management group, which includes Staff Management SMX, Centerline and PlaneTechs. It will continue to be managed by President and CEO Kelly Carlson.
Tesoro Corporation (TSO) Tesoro has agreed to acquire Great Northern Midstream, a crude oil logistics provider which owns and operates a recently constructed crude oil pipeline, gathering system, and transportation, storage and rail loading facilities in the Williston Basin of North Dakota. The deal includes the 97-mile BakkenLink crude oil pipeline, which connects to several third-party gathering systems, as well as a proprietary 28-mile gathering system in the core of the Bakken and a rail loading operation and storage facility that can provide outbound deliveries to the West, East and Gulf Coasts. The acquisition price represents 5 to 6 times Tesoro-estimated future EBITDA for the Great Northern Midstream business and is expected to be immediately accretive. The deal is expected to close in the first quarter of 2016.
The Next Issue
Have a wonderful holiday and a happy New Year. 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 firstname.lastname@example.org.
The top scoring stocks not currently in the Hot List portfolio.
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