|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||August 15, 2014|
While stock market gains greatly outpaced economic improvement last year, we continue to see a touch of a reversal in 2014, with moderate stock gains underpinned by some of the best economic data the US has posted in years.
The July jobs report, for example, showed that the private sector added 198,000 jobs during month, with overall nonfarm payrolls rising by 209,000 -- the fifth straight month the figure has topped 200,000. May and June's total nonfarm payrolls were also revised upward by a total of 15,000. The unemployment rate did rise slightly to 6.2%, but that appears to have been because more people were looking for jobs -- the number of people not in the workforce fell by 119,000. The "U-6"unemployment rate, which unlike the headline rate takes into account those who have given up looking for a job, ticked up slightly to 12.2%.
New claims for unemployment, meanwhile, remain lower than they've been for some time. The four-week moving average is at levels not seen since early 2006, while continuing claims are 14% below where they stood a year ago.
The service sector also expanded in July for the 54th straight month, according to the Institute for Supply Management, doing so at the fastest pace since its 2008 inception. The New Orders sub-index continued to rise and is at an extremely strong level, while the Employment sub-index made a nice gain, indicating that employment conditions in the sector keep improving.
Manufacturing activity also expanded at an accelerating pace in July, ISM said -- its fastest pace since April 2011. It was the 14th straight month the sector expanded. New orders also jumped, as did ISM's employment sub-index for the sector.
Retail and food service sales were unchanged in July according to the Commerce Department. They are now about 4.2% above where they stood a year ago, a pretty healthy year-over-year increase.
In the housing market, prices are moderating, which probably good given the rapid rise we'd experienced in recent years. Home prices across 20 US cities rose an average of 1.1% in May, according to the latest S&P/Case-Shiller Home Price indices. But when seasonally adjusted, they actually fell 0.3%.
Since our last newsletter, the S&P 500 returned 1.3%, while the Hot List returned 3.0%. So far in 2014, the portfolio has returned -11.4% vs. 5.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 222.4% vs. the S&P's 95.4% gain.
It's been a fairly tame two weeks for the stock market, but a few big winners have helped the Hot List gain some ground over the fortnight.
Overall, 7 of the portfolio's 10 holdings were in the black since our last newsletter. Leading the way was Rex Natural Resources, which was up nearly 15% (all performance data as of mid-afternoon trading on Aug. 14). Rex seems to be continuing to ride the wave that has been pushing ethanol firms higher since excellent corn crop data was announced a few weeks ago.
Not far behind Rex was Silicon Motion Technology Corp., up 14.4%. SIMO has had a couple of upward earnings revisions over the past month or so, and it looks like that has investors turning bullish on the stock.
USANA Health Sciences was another big winner, gaining 9.7%. Its shares had fallen sharply in late July after an earnings announcement that fell short of expectations, so its strong performance since then may be a bounce-back gain as investors respond to the initial overreaction.
On the downside, BBVA Banco Frances SA was off 14.6%. The Argentina-based bank, like many of the country's stocks, was hit hard when Argentina defaulted on its debt late last month. The situation remains uncertain, though the latest reports indicate that chances of a quick resolution to the crisis are fading. BBVA's fundamentals and financials continue to earn it pretty strong scores from my strategies, however. In two weeks, we'll rebalance the Hot List, at which time we will see whether the stock has what it takes to remain in the portfolio.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples. In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned 107.5%, vs. 83.4% for the S&P 500 (figures through Aug. 13). That's 7.1% annualized, vs. just 5.8% for the S&P.
The portfolio has been a very strong performer over the last few years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. In 2012, it gained more than 15%, again topping the index. Last year, it gained 34.8% vs. the S&P's 29.6%. It's down in 2014, but I suspect that's a short-term hiccup.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings. It's an interesting group, and some of the holdings might not seem like "Buffett-type" plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
The TJX Companies, Inc. (TJX)
Monster Beverage Corp. (MNST)
Ross Stores, Inc. (ROST)
NetEase Inc. (NTES)
Credit Acceptance Corporation (CACC)
Polaris Industries Inc. (PII)
Dollar Tree, Inc. (DLTR)
World Acceptance Corporation (WRLD)
Accenture plc (ACN)
Syntel, Inc. (SYNT)
News about Validea Hot List Stocks
Liquidity Services, Inc. (LQDT): The firm reported fiscal Q3 earnings per share of $0.31, $0.04 better than the analyst estimate of $0.27, StreetInsider.com reported. Revenue came in at $127 million versus the consensus estimate of $122.9 million. Liquidity Services expects Q4 2014 EPS of $0.13-$0.19, well below the consensus of $0.27, however. It expects FY2014 EPS of $1.00-$1.06, versus prior guidance of $1.1-$1.27 and the consensus of $1.12. Investors all in all seemed pleased with the news, as shares jumped nearly 10% on August 11, the first full trading day after the firm filed its quarterly report with regulators.
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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