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|Executive Summary||May 27, 2011|
If the economy were a boxer, this past fortnight wouldn't have been his best round. But he's showing he can take a punch or two, and overall he appears to be winning the fight.
One of the punches taken since our last newsletter came in the form of industrial production data. Industrial and manufacturing activity has been a strength during the post-Great-Recession recovery, but in April industrial production was flat, only the third time in the past 22 months it hadn't increased. March's increase was also revised slightly downward, and February's figure was changed from a 0.1% increase to a 0.3% decrease. The figures do not indicate a major slump, however, and slight monthly declines aren't out of the ordinary in the course of a lengthy economic expansion.
Regional manufacturing reports for May, meanwhile, have been decent, but activity was below that of previous months. The Philadelphia Federal Reserve Bank's business activity index fell substantially from April, but still indicated the manufacturing sector was expanding in the mid-Atlantic region. The New York Fed's Empire State Manufacturing Survey also fell, but remained well in expansion territory. The slowdown in industrial and manufacturing growth may be due in part -- perhaps in large part -- to the fallout from the Japan earthquake and tsunami, and its impact on the global economy.
On the employment front, the latest data was mixed. Over the past two weeks, new claims for unemployment have fallen slightly (by about 3%), but remain above levels associated with strong job growth. Continuing claims, however, neared their lowest point since September 2008 in the latest week for which data is available (ending May 14).
As for the housing market, it continues to struggle. Existing-home sales fell 0.8% in April, the National Association of Realtors said. Housing starts experienced a sharper decline, by 10.6%, according to the Commerce Department. Compared to a year ago, residential construction was down nearly 24%.
On the bright side, gas prices are waning a bit, giving consumers a bit of a reprieve. Unleaded regular prices were down about 9 cents as of yesterday vs. a week earlier, according to AAA, Wright Express, and the Oil Price Information Service. They're expected to fall further as lower oil prices work their way into gas prices.
Other good news came from Corporate America. With 468 of the S&P 500 companies reporting first-quarter earnings, 72% had beaten analysts' expectations, according to Bloomberg.
As for the markets, since our last newsletter, the S&P 500 returned -1.7%, while the Hot List returned -2.7%. So far in 2011, the portfolio is up 7.9% vs. 5.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 191.2% vs. the S&P's 32.5% gain.
Beware the 'Summer Blockbuster'
With the weather finally starting to warm, it's summer blockbuster time for the movie industry, the time of year when throngs of people line up to see the latest big-budget, big-hype films. Even if you're not a movie-goer, it's hard to escape the Hollywood blitz, what with the onslaught of television commercials touting the "most action-packed"/"funniest"/"can't-miss" hits of 2011.
If you're like me, you've probably had the experience of going to one of these types of overhyped movies and walking away less than thrilled. The movie might not have been bad -- in fact, it might have been quite good. But once the buzz surrounding a film reaches a certain level, it's just hard to live up to the hype.
Similarly, you may have been to a movie that didn't get much hype, or even one that critics had bashed. And a lot of the time you may walk away from such a movie being pleasantly surprised. The movie may not have been a great film, but it was better than you thought it would be, and that leaves you in a pretty good mood.
If you've ever had similar movie-going experiences, you know something about what it's like to be a value investor. That's because, just as they play a huge role in a movie you see or a restaurant you visit or a vacation you take, expectations play a huge role in how and why value investing works.
That's what Joel Greenblatt -- the hedge fund guru upon whose writings I base one of my best-performing strategies -- recently discussed in an interview with Barron's. "The way we make money as a group," Greenblatt explained, "is that we don't pay a lot for anything, and most of the stocks we buy have low expectations. So if the future is a little better or a lot better than the low expectations -- it doesn't have to be great -- you have the chance for asymmetric returns on the upside. And, hopefully, you don't lose much on the ones that don't do better than the low expectations, because you didn't pay much for them in the first place."
While Greenblatt has used this mindset to great success, he's not the first to embrace it. Benjamin Graham, the man known as the "Father of Value Investing" (and another of the gurus upon whom I base one of my best-performing strategies) recognized more than half a century ago that expectations were a big factor in stock returns. The "margin of safety" concept that guided his investment philosophy was based on the idea that stocks with high valuations (i.e., high expectations) would be hit much harder if something went wrong than would stocks with low valuations (i.e., low expectations).
The Wall Street Journal's Jason Zweig, who provided commentary in Graham's revised version of The Intelligent Investor, had this to say in discussing expectations and margin of safety: "Great expectations lead to great disappointment if they are not met; a failure to meet moderate expectations leads to a much milder reaction. Thus, one of the biggest risks in owning growth stocks is not that their growth will stop, but merely that it will slow down. And in the long run, that is not merely a risk, but a virtual certainty."
History does indeed show that value stocks -- which usually have low expectations -- as a group have outperformed growth stocks -- which usually have higher expectations -- over the long haul. From 1927 through 2009, U.S. large-cap growth stocks averaged a 9.08% annual compound return, according to the data of Dartmouth College Professor and noted stock researcher Kenneth French. Small-cap growth stocks, meanwhile, averaged 9.23%. On the value side, large-cap value plays averaged 11.21%, and well ahead of the pack were small-cap value stocks, which returned an average of 14.17% per year. (For the breakpoint between small and large stocks, French and colleague Eugene Fama use the mean market equity of New York Stock Exchange stocks. Growth stocks are defined as those in the bottom 30% of the market based on book/market ratios; value stocks are those in the top 30%.)
Perhaps more than any of the gurus I follow, David Dreman put great emphasis on investor expectations, and their impact on investment strategy. Dreman believed that investors' penchant for overreaction often makes popular stocks overpriced and unpopular stocks underpriced. Because of that, popular stocks have a long way to fall if they don't meet expectations, and little room to climb in the event they meet or exceed expectations. Because unpopular stocks are often already undervalued, however, they have a lot of room to climb if the company meets or exceeds expectations, and not much room to fall if the company disappoints.
"Negative surprises are like water off a duck's back for [stocks with the lowest valuations]," Dreman wrote in Contrarian Investment Strategies. "Investors have low expectations for what they consider lackluster or bad stocks, and when they do disappoint, few eyebrows are raised. Consider the 'best' companies, however. Investors expect only glowing prospects for these stocks. After all, they confidently -- overconfidently -- believe that they can divine the future of a 'good' stock with precision. These stocks are not supposed to disappoint; people pay top dollar for them for exactly this reason. So when the negative surprise arrives, the results are devastating."
Dreman believed, moreover, that surprises occurred a lot in the stock market, in part because analysts so often miss the mark with their earnings estimates. "There is only a 1 in 130 change that the analysts' consensus forecast will be within 5 percent for any four consecutive quarters," he wrote. "To put this in perspective, your odds are ten times greater of being the big winner of the New York State Lottery than of pinpointing earnings five years ahead. "Because of the frequent surprises in the market, focusing on unloved stocks could net you big rewards over the long run", his extensive research on historical stock returns found.
Having the conviction to buy stocks when expectations are low is how Dreman and other value-focused gurus I follow fared so well coming out of bear markets. The bear of 1973-74 ended in October of 1974. In 1975, when the S&P bounced back 37.2%, John Neff's Windsor Fund returned 54.5%, and James O'Shaughnessy produced back-tested returns of 47.9%. Neff and O'Shaughnessy again handily beat the market in 1976, as did the back-tested book/market method Joseph Piotroski used (1976 was the first year his study covered). Warren Buffett was the only one of our gurus to underperform in one of those two years -- and he followed his 5% loss in 1975 with a whopping 134.2% gain in 1976.
The gurus also performed exceptionally after the bear market that ended in August of 1982. While the S&P gained 22.4% in 1983, the gurus' returns for the year were as follows: Neff, 30.1%; Buffett, 69%; Peter Lynch, 82.8%; O'Shaughnessy, 35.6%; Piotroski, 32.4%. Only Martin Zweig lagged the S&P, producing returns of 17.4%.
The Guru Strategies I base on the writings of these investment greats also performed exceptionally well coming off the last two recessions and bear markets. The eight individual ten-stock portfolios we began tracking in July 2003 (shortly after the market began its post-bear market turnaround) each gained between 20% and 52% for the remainder of that year, while the S&P rose 11.1%. In 2004, seven of those eight portfolios more than doubled the S&P's return. In 2009, meanwhile, 11 of my 14 10-stock portfolios beat the market, and they did so handily, by between 6.7 and 39.6 percentage points.
These gurus and portfolios beat the market by so much because they did what few investors can do: buy solid stocks when expectations are very low, which they always are as bear markets wear on. Similarly, those investors who jump onto hot stocks with high expectations -- or who jump into the market when broader expectations for stocks are high, as they were in early 2000 and 2007 -- usually end up getting hit hard.
That's why I actually find the copious amount of negative news stories swirling around the stock market to be a good sign. Yesterday afternoon, for example, the top stories on CNBC.com included one about banking giant UBS "falling apart"; one on the FDIC chief saying a U.S. debt default would be "calamitous"; and one on how foreclosures are becoming a bigger part of the U.S. housing market. That's not to mention the lingering EuroZone debt crisis, the continued fallout from the Japan earthquake and tsunami, and fears about what will happen when the Federal Reserve's latest round of quantitative easing ends.
To be sure, all of those issues are legitimate and must be dealt with. But while these problems may inspire fear, they also lower expectations -- and investors' tendency to be myopic often leads those expectations to become unrealistically low. And, for disciplined investors, that signals opportunity.
Don't Forget Quality
Of course, low expectations -- whether it's for the market or individual stocks -- aren't inherently a bullish sign. Sometimes, for example, expectations are low for a stock for good reason -- the company is a dog, and everyone knows it. That's why my models look not only for attractively valued shares, but also for companies that meet a variety of quality tests. My Buffett-based model, for example, looks back ten years into a firm's historical returns on equity and total capital. Several of my models look at how much free cash a firm is generating per share. And the most popular variable my models examine -- more than earnings growth, more than price/earnings ratios -- is the level of a company's debt.
Right now, I see a lot of quality in the U.S. market. And despite the market's two-year bull run, I also see a lot of lingering fears and low expectations, which are holding down the valuations of some quality investments. Through Wednesday, the ten holdings in the Hot List were trading for an average of 9.8 times trailing 12-month earnings, and yielding almost 4%. The nine non-financials also had average debt/equity ratios of just 12.7%. Those are the types of shares the Hot List will continue to focus on as we move deeper into 2011.
Guru Spotlight: Joseph Piotroski
If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.
In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge -- just a straightforward assessment of a company's balance sheet.
His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.
Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.
Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percentage points annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23% average annual return from 1976 and 1996.
Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market, though with some big ups and downs. It fared very well in 2004, 2005, and 2006, before being hit hard in 2008 and 2009. But it roared back in 2010, gaining 55.9% -- more than four times the S&P 500's 12.8% gain. In the seven-plus years since its inception, it has returned 76.6%, or 8.2% annualized, during a period in which the S&P has gained just 15.2%, or 2.0% annually.
Let's take a look at how Piotroski's approach, and the model I base on it, work.
Diving into The Balance Sheet
Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.
The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use.
That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.
Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business -- not because of accounting changes, lawsuits, or other one-time gains.
Several of Piotroski' other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting. Looking at how a company's fundamentals had been changing allowed him to not only get an idea of the firm's financial position, but also of whether that position was improving or declining.
Among the other "change" criteria Piotroski examined were the long-term debt/assets ratio, which he wanted to be steady or declining; the current ratio (current assets/current liabilities), which he wanted to be steady or increasing; gross margin, which should be steady or rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be steady or increasing).
As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks currently in its 10-stock portfolio:
SkyWest, Inc. (SKYW)
Smith Micro Software Inc. (SMSI)
Benchmark Electronics, Inc. (BHE)
AU Optronics Corp. (AUO)
Iridium Communications Inc. (IRDM)
Xyratex Ltd. (XRTX)
Hanwha SolarOne Co. Ltd. (HSOL)
Fushi Copperweld, Inc. (FSIN)
SunTech Power Holdings Co., Ltd. (STP)
The E.W. Scripps Company (SSP)
Think Small -- And Boring
One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks. Of the 10 current holdings in my Piotroski portfolio, only one (AU Optronics) has a market cap above $1.4 billion.
For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products, though it will go into more "interesting" areas when valuations are right (as it is right now, with a few tech stocks among its holdings). But while they're not the flashiest firms, they're quite often the type of stocks that can pay excellent returns over the long haul.
News about Validea Hot List Stocks
Bridgepoint Education Inc. (BPI): Bridgepoint shares jumped this week after the stock was upgraded by a Piper Jaffray analyst. As of Wednesday afternoon, shares were up more than 11% for the day and more than 27% since the Hot List picked up the stock in mid-March.
Aeropostale (ARO): On May 19, Aeropostale announced first-quarter earnings in line with analysts' estimates, but second-quarter guidance well below estimates. Earnings per share were $0.20 for the first quarter, down 64% from the year-ago period, while sales rose 1%. For the second quarter, the company expects to earn 11 to 16 cents per share, compared with analysts' expectations of 27 cents a share, according to Thomson Reuters I/B/E/S. The firm said the second quarter guidance reflects plans to aggressively clear through spring inventories to position itself for the important back to school selling season. It also said costs have been increasing across the industry. Shares of Aeropostale tumbled on the news, falling 14% from May 19-20.
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 email@example.com.
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