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Executive Summary August 29, 2014

The Economy

While the ongoing conflict in the Ukraine has at times overshadowed it, the US economy has continued its impressive run over the past couple weeks.

Industrial production increased 0.4% in July, for example, according to a new Federal Reserve report, with manufacturing output rising a stellar 1.0%. Mining output also rose, by 0.3%, while utility output, which tends to be seasonally driven, fell 3.4%. June's industrial production gain was also revised upward from 0.2% to 0.4%.

New claims for unemployment, meanwhile, fell back below the 300,000 mark in each of the past two weeks, and remain at levels not seen since before the Great Recession. That puts them more than 11% below where they stood a year earlier. Continuing claims, the data for which lag new claims by a week, have fallen slightly since our last newsletter, and are 15% below year-ago levels.

GDP growth for the second quarter was also revised to show that economic output rose at a 4.2% annualized pace. That was up from an initial estimate of 4.0%

The housing market has also shown signs of life. Housing starts jumped 15.7% in July, according to the Census Bureau, and are more than 20% above where they were a year ago. Permit issuance for new construction rose 8.1%, and is 7.6% above year-ago levels.

New home sales, meanwhile, fell 2.4%, according to a new government report, but are 12% above year-ago levels. And the National Association of Realtors reported its pending home sales index rose 3.3%.

While conflicts continue in the Middle East and Ukraine continue, the geopolitical turmoil hasn't sent gas prices upward. In fact, the price for a gallon of regular unleaded is down 9 cents from a month ago, according to AAA.

Not surprisingly, given gas prices, inflation slowed a bit in July, new data showed. The Consumer Price Index rose 0.1% for the month, according to the Labor Department. That put it 2.0% ahead of its year-ago pace. Core inflation, which strips out volatile food and energy prices, was up 1.9% year-over-year.

Overall since our last newsletter, the S&P 500 returned 2.1%, while the Hot List returned 1.5%. For the year, the portfolio stands at -10.0% vs. 8.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 227.3% vs. the S&P's 99.6% gain.

2000: A Valuation Odyssey

The S&P 500 topped 2,000 for the first time ever this week, a mark that is notable more for its psychological impact than any tangible factors. Some say the fact that we're climbing past that landmark is another sign that the market has risen too far, too fast. It's been about a full quarter since we last looked at broader market valuations, and given all of this I think it's a good time to check back in.

As always, let's start with earnings. Using the S&P 500's August 28 closing price of 1996.74, the index is trading for about 19.3 times trailing 12-month (TTM) as-reported earnings per share, right about where it was in early June, when last we checked in.

Using projected operating earnings for the next year, the P/E is about 15.6, again right about where it was in early June. P/Es are significantly higher than they were a year or two ago, but these earnings-related valuations are far from exuberant; they're within what I'd say is the "fair value" range, particularly in a low-interest-rate environment.

The S&P's price/sales ratio, meanwhile, is 1.66, up ever so slightly from 1.65 in early June, according to Morningstar.com. Its price/book ratio is 2.3, right where it was in June. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners, so that figure stacks up well. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Dividend yields, meanwhile, remain attractive, staying right where they were in June, at 2.3%.

One figure that continues to rise is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It is now 124.5%, up from 119.3% in June, according to GuruFocus.com. That puts it in the "Significantly Overvalued" range, based on the site's analysis of historical data. The current figure is higher than the 2007 peak, but still well short of the 2000 bull market peak.

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 26.2, using Yale Economist Robert Shiller's earnings data. That's up a bit from 25.8 in June. It's also well above the 16.5 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.3 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.

The Q ratio also indicates that the market is significantly overvalued. Based on a methodology developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. Using the most recent report, which came at the end of the first quarter, the Q ratio is about 1.17, up from 1.11 in June, according to an analysis done by Doug Short of Advisor Perspectives in early August. That was 72% higher than the historical average using the arithmetic mean and 85% higher than the geometric mean. As has been the case for some time, the current Q indicates the market is significantly overvalued, but it's not nearly as high as it has gotten at some market tops.

Overall, as you can see, there's a good deal of variation in the common metrics used to gauge market valuation. On the whole, I think these metrics continue to paint a picture of a market that is on the high side of the fair value range, or perhaps just a bit overvalued. After five-and-a-half years of bull market conditions, that's hardly surprising. I do not, however, think that valuations are so bloated that the bull can't continue for a good chunk of time more. Of course, no one can predict what will happen in the short term; what I'm saying is that, if the bull stops anytime soon, it won't be because of exorbitant valuation.

But if the strength of the market over the past five-plus years -- we're up nearly 200% since the March 2009 low, or more than 20% annualized -- has you thinking that we've come too far, too fast and gotten ahead of fundamentals, look at it a different way: In the 12 years or so since the 2002 bottom, the S&P is averaging annualized returns of just over 8%. As a thought exercise, imagine that the index had gained 8% a year since that bottom a dozen years ago to reach its current level. Would that seem like a market that had gotten way ahead of itself? I sure don't think so. The point here is that the gains of the last five-plus years have been so large in part because the losses that preceded them were so large. For most of this bull, the market was catching up to fair value -- not streaking past it.

Most importantly, my models are continuing to find good buys in individual stocks. On today's rebalancing, we're adding five stocks to the portfolio, and their fundamentals are excellent. AmTrust Financial, for example, has been growing earnings and revenues at a 24% pace over the long term and revenues at a 38% clip, has a return on equity that is 14 percentage points higher than its industry average, and yet trades for 10.7 times trailing 12-month EPS, 0.99 times trailing 12-month sales, and at a 0.45 P/E-to-Growth ratio.

Whatever happens in the short term with the broader market, stocks with those type of fundamentals and financials are always offering good opportunities for investors. We'll continue to focus on just those sort of companies, and over the long-term it should pay off.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Bbva Banco Frances S.a. (Adr) (BFR), Silicon Motion Technology Corp. (Adr) (SIMO), Usana Health Sciences, Inc. (USNA), Williams-sonoma, Inc. (WSM) and Rex American Resources Corp (REX).

The Keepers

5 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Valero Energy Corporation (VLO), Anika Therapeutics, Inc. (ANIK), Piper Jaffray Companies (PJC) and Liquidity Services, Inc. (LQDT).

The Newbies

We are adding 5 stocks to the portfolio. These include: Bed Bath & Beyond Inc. (BBBY), Sturm, Ruger & Company (RGR), Foot Locker, Inc. (FL), Amtrust Financial Services, Inc. (AFSI) and Monster Beverage Corp (MNST).

Portfolio Changes

Newcomers to the Validea Hot List

Bed Bath & Beyond Inc. (BBBY): This New Jersey-based home goods and furnishings retailer ($13 billion market cap) has stores in the U.S., Canada, and Mexico, and has taken in about $11.5 billion in sales in the past 12 months. It gets some interest from my Warren Buffett-inspired strategy, in part because it has upped EPS in all but one year of the past decade. Bed Bath & Beyond also gets strong interest from my Peter Lynch-based model. To read more about it, check out the "Detailed Stock Analysis" section below.

Foot Locker (FL): This specialty athletic retailer operates nearly 3,500 stores in 23 countries in North America, Europe, Australia, and New Zealand, offering athletic footwear and apparel.

Foot Locker ($8 billion market cap) gets strong interest from my James O'Shaughnessy-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

Monster Beverage Corporation (MNST): This California-based firm makes energy drinks and alternative beverages under such names as Monster Energy, Java Monster, X-Presso Monster, M-3, Worx Energy and Hansen's natural sodas and juices. It gets a 100% score from my Warren Buffett-based model, thanks in part to its having upped EPS in all but one year of the past decade. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

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 gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.

Sturm Ruger & Co. Inc. (RGR ): This firearms manufacturer makes rifles, pistols, revolvers, and shotguns principally for a select number of licensed independent wholesale distributors primarily located in the United States. It has a $1 billion market cap.

Sturm Ruger gets strong interest from my Joel Greenblatt-based model. To find out more about the stock, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Rex American Resources (REX): Rex shares surged after the firm announced second quarter net income rose to $21.9 million, or $2.68 per share, compared to $5.8 million, or 71 cents per share for the 2013 second quarter. The firm attributed its record second quarter profit to "favorable market dynamics combined with the efficiency of our plants," TheStreet reported. Net sales declined to $150.2 million, vs. $175.4 million for the year ago quarter, due to reduced ethanol and distillers grains pricing. Shares rose more than 19% in the two trading days after the announcement.

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

ANIK   |   VLO   |   PJC   |   FL   |   BBBY   |   AFSI   |   MNST   |   RGR   |   LQDT   |   AGCO   |  

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

Piper Jaffray Companies is an investment bank and asset management firm, serving the needs of corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The Company operates in two segments: Capital Markets and Asset Management. The Capital Markets segment provides investment banking and institutional sales, trading and research services for various equity and fixed income products. The Asset Management segment includes traditional asset management activities and related services. The Company markets the investment banking and institutional securities business under Piper Jaffray name. Its asset management business is marketed under Advisory Research, Inc. In July 2013, Piper Jaffray Companies announced that it has completed its purchase of Seattle-Northwest Securities Corporation. In July 2013, the Company announced that it has completed its purchase of Edgeview Partners L.P.

Foot Locker, Inc. is a global retailer of shoes and apparel, operating 3,473 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand as of February 1, 2014. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailers whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction, SIX:02, as well as the retail stores of Runners Point Group, including Runners Point, Sidestep and Run2. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., CCS, and Tredex, which sells to customers through Internet Websites, mobile devices, and catalogs.

Bed Bath & Beyond Inc. is a chain of retail stores, operating under the names Bed Bath & Beyond (BBB), Christmas Tree Shops (CTS), Harmon and Harmon Face Values (Harmon), buybuy BABY and World Market or Cost Plus World Market (World Market). In addition, it is a partner in a joint venture, which operates three stores in the Mexico City market under the name Bed Bath & Beyond. The Company sells a range of domestics merchandise and home furnishings. Domestics merchandise includes categories, such as bed linens and related items, bath items and kitchen textiles. Home furnishings include categories, such as kitchen and tabletop items, fine tabletop, basic housewares and general home. During fiscal year ended March 2, 2013 (fiscal 2012), the Company opened a total of 38 stores, including 12 BBB stores throughout the United States and Canada, five CTS stores, one Harmon store and 18 buybuy BABY stores, and six World Market stores throughout the United States and closed one BBB store.

Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four business segments: small commercial business, specialty program and personal lines reinsurance. The Company transacts business through 11 insurance company subsidiaries: Technology Insurance Company, Inc. (TIC), Rochdale Insurance Company (RIC), Wesco Insurance Company (WIC), Associated Industries Insurance Company, Inc. (AIIC), Milwaukee Casualty Insurance Company (MCIC), Security National Insurance Company (SNIC), AmTrust Insurance Company of Kansas, Inc. (AICK) and AmTrust Lloyd's Insurance Company of Texas (ALIC). In December 2013, the Company announced that it its wholly owned subsidiary completed the acquisition of Sagicor Europe Limited. In January 2014, the Company acquired Insco Dico Group.

Monster Beverage Corporation is a holding company. The Company develops, markets, sells and distributes alternative beverage, such as non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, single-serve juices and fruit beverages, ready-to-drink dairy and coffee drinks, energy drinks, sports drinks, and single-serve still water (flavored and unflavored) with beverages, including sodas that are considered natural, sparkling juices and flavored sparkling beverages. It has two reportable segments, namely Direct Store Delivery (DSD), whose principal products comprise energy drinks, and Warehouse (Warehouse), whose principal products comprise juice-based and soda beverages. The DSD segment develops, markets and sells products primarily through an exclusive distributor network. The Warehouse segment develops, markets and sells products directly to retailers.

Sturm Ruger & Co Inc, formerly Sturm, Ruger & Company, Inc., is engaged in the design, manufacture, and sale of firearms to domestic customers. The Company operates in two segments: firearms and investment castings. The firearms segment manufactures and sells rifles, pistols, revolvers, and shotguns principally to a select number of licensed independent wholesale distributors primarily located in the United States. The investment castings segment manufactures and sells steel investment castings. The Company offers products in four industry product categories, which include rifles, shotguns, pistols, and revolvers. The Company's firearms are sold through independent wholesale distributors, principally to the commercial sporting market. The Company's customers include Jerry's/Ellett Brothers, Davidson's, Sports South and Lipsey's.

Liquidity Services, Inc. is an auction marketplace for surplus and salvage assets. The Company enables buyers and sellers to transact in an automated online auction environment offering over 500 product categories. The Company's marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with digital images and other relevant product information. It organizes its products into categories across industry verticals, such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware and specialty equipment. It's online auction marketplaces are www.liquidation.com, www.govliquidation.com, www.govdeals.com and www.liquibiz.com. It also operates a wholesale industry portal www.goWholesale.com. In July 2012, the Company acquired GoIndustry-DoveBid plc. In November 2012, the Company acquired National Electronics Service Association.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

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.


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