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Executive Summary October 30, 2009

The Economy

New data confirmed this week what many strategists had been saying for some time -- that the U.S. economy returned to growth in the third quarter, with gross domestic product rising for the first time in more than a year, and by the largest margin since the third quarter of 2007.

The GDP gain was good news, with the figure coming in higher than many economists had expected. The increase was driven by consumers, as personal consumption expenditures jumped 3.4% in the period. Many have noted that a big chunk of the gains were the result of the government's now-completed "Cash for Clunkers" auto rebate plan, but other areas also showed improvement. Non-durable goods increased 2.0% for the quarter, services increased 1.2%, and gross private investment rose 11.5% -- all good signs.

The figures also showed that core inflation -- which excludes volatile food and energy prices -- was mild, and less than it was in the second quarter. That's a good sign in terms of the Federal Reserve keeping interest rates at historically low levels.

Good signs also continue to come in the industrial sector. Since our last newsletter, the Fed has reported that industrial production rose 0.7% in September, and also revised its August figure upward to a 1.2% gain. That's three straight months of growth in that sector, following about a year-and-a-half of declines (with the exception of one hurricane-rebound month last year). Just as importantly, capacity is increasing, rising for a third straight month. Capacity usage (70.5%) is still way off its historical average (80.9%), but it's up significantly from June's low of 68.3%. That's a sign of increasing demand, and increased demand -- not cost-cutting -- is what is needed to grow the economy over the long haul.

The housing market is also showing signs of continued recovery. Existing home sales jumped 9.4% in September, the National Association of Realtors said last week, putting sales activity at its highest level in more than two years. That's also the fifth increase in six months, but where housing goes from here is quite unclear. The NAR said much of the home-buying momentum is a result of the government's first-time homebuyer tax credit, a program which is set to expire soon. And even housing guru and Yale economist Robert Shiller -- who called the housing bust -- seems unsure about what to expect. The S&P Case-Shiller home price index rose in August for the third straight month, but Shiller told Bloomberg this week that there's a good chance it will correct downward at some point soon. But, he also says the recent rebound has been broad enough that it must be due to more than just the tax credit, and he says "animal spirits" could continue to push prices higher.

All in all, the economy is continuing to rebound, as demonstrated by several of the figures noted above. But it's important to remember where we're coming from -- that 3.5% gain in GDP came off a very low starting point, and GDP is still about 7.7% off its 2007 year-end level. Unemployment remains very high, and the housing market is a lingering question. Nevertheless, we seem headed in the right direction.

The lingering economic issues helped drive stocks lower over the past fortnight, though Thursday's big gain erased a chunk of the losses seen in the previous week-and-a-half. The Hot List fared worse than the broader market, losing 7.1% compared to the S&P 500's 2.8% loss. For the year, however, the portfolio remains well ahead of the market, up 38.1% in 2009 vs. 18.0% for the S&P. And since its inception in July 2003, the Hot List has gained 126.4%, while the S&P is up just 6.6%.

A Focused Approach

The Hot List is making a pretty major shakeup this week, dropping six of its ten holdings and replacing them with six higher-rated stocks. Three of the six newcomers -- Oil States International, Tidewater, and National-Oilwell Varco -- come from the energy sector, meaning that half of the 10-stock portfolio is now comprised of energy stocks.

These oil picks aren't the big integrated firms. In fact, the Hot List is this week selling its stake in Chevron, a pick that has gained almost 20% since the portfolio picked it up in mid-May. The energy firms in the Hot List are instead mostly smaller, more specialized oil equipment, services, or operations firms. Many of these companies were hit particularly hard right around the time that oil prices peaked in the summer of 2008; the SPDR S&P Oil & Gas Equipment Services exchange-traded fund plummeted about 70% from July 11 to Nov. 20 of last year, a much sharper decline than both the S&P 500 (which lost about 40%) and the broader energy sector SPDR (which fell about 50%).

The oil services/operations firms have surged since then. But as a group, they remain well behind the big oil names since last summer, and my strategies are seeing exceptional fundamentals and a lot of value in them. Take National-Oilwell Varco, for example. Varco is currently the only stock out of the thousands in my database that gets approval from both my strict Benjamin Graham-based value strategy, and my James O'Shaughnessy-based growth model.

To pass the Graham strategy, a stock needs to have a sterling balance sheet, and Varco does. Its current ratio is above 2.0 (it's 2.1), a sign of strong liquidity, and its net current assets ($5.4 billion) are far greater than its long-term debts ($875 million). In addition, it has the solid valuation ratios (11.7 price/earnings and 1.22 price/book) to get approval from the Graham model.

At the same time, however, Varco has upped earnings per share in each year of the past five-year period, and it has a solid relative strength of 77, catching the eye of the O'Shaughnessy growth approach. The strong interest ratings from two approaches that are quite different means Varco is attractive on a number of levels.

The Truth about Diversification

Of course, going 50% into energy stocks in a 10-stock portfolio may seem risky, given that diversification has long been touted as a critical part of portfolio management. But a lot of research (and my own experience) has taught me that overdiversification can sometimes be a greater problem than a lack of diversification, leading to watered-down returns, and high fees.

For example, take a study performed by investment research firm Morningstar earlier this year. The study examined the performance of "focused funds" -- those that hold no more than 40 stocks. (The average stock fund holds about 180 stocks, the group said.) "Among the findings:" wrote The Wall Street Journal's Larry Light. "As a group, these funds haven't consistently outperformed or underperformed funds with more diverse holdings. And based on recent performance and an earlier Morningstar study, concentrated funds aren't more volatile than more diversified funds, on average, and some are surprisingly steady, despite their small number of holdings."

In my most recent book, The Guru Investor, I looked at some other data that has similar implications. A 2003 study performed by California State University-Chico Professor H. Christine Hsu and H. Jeffrey Wei found, for example, that "the benefit of risk diversification is somewhat limited when the number of stocks in the portfolio goes beyond 50."

The Hot List has of course been somewhat riskier and more volatile than the broader market. But just how much more risk has it taken on? Consider these figures: From its inception date in July 2003 through July of this year, the Hot List has posted a monthly loss of 5% or more (using its 28-day rebalancing intervals) 11 times; the S&P 500 has lost 5% or more 7 times. The worst of those monthly intervals for the Hot List was a 22.89% decline last October; the worst for the S&P was a 16.83% decline in the same period. Given that the Hot List has returned about 28 times what the S&P has returned since its inception, those differences don't seem to represent an unreasonable amount of additional risk.

In producing those returns, the Hot List has many times gone heavy into a particular sector or industry -- look no further than earlier this year. Back in March and April, the portfolio included four oil firms and three retail-type stocks. Five of those seven went on to major gains -- between 28% and 79% each.

To be sure, there have been times when the Hot List has lost money while keying in on one or two particular industries. And, to be sure, you also need to have some limits on how concentrated a portfolio you should hold. (A six-stock portfolio that includes five retail stocks, for example, is probably not a good idea.) But over the long haul, I think the portfolio's ability to go heavy into certain sections of the market has been a key reason for its exceptional returns. Good values are good values, regardless of what sector they come from. And, if you're using rigorous fundamental-based strategies that do a good job of digging deep into a company's balance sheet, a 10- or 20-stock portfolio can give you all the diversification you need.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: Reliance Steel & Aluminum (RS), Credicorp Ltd. (Usa) (BAP), Brasil Telecom Participacoes Sa (Adr) (BRP), Chevron Corporation (CVX), Aeropostale, Inc. (ARO) and Mercadolibre, Inc. (MELI).

The Keepers

4 stocks remain in the portfolio. They are: Humana Inc. (HUM), Frontier Oil Corporation (FTO), World Fuel Services Corporation (INT) and Vanceinfo Technologies Inc. (VIT).

The Newbies

We are adding 6 stocks to the portfolio. These include: Itt Educational Services, Inc. (ESI), Tidewater Inc. (TDW), National-oilwell Varco, Inc. (NOV), Raytheon Company (RTN), Oil States International, Inc. (OIS) and Fuqi International, Inc. (FUQI).

Portfolio Changes

Newcomers to the Validea Hot List

Fuqi International (FUQI): Based in Shenzhen, China, Fuqi designs and sells a range of high-quality jewelry. The firm, which has about a thousand employees, makes products from gold, diamonds, platinum, and other gemstones. It has increased earnings per share in seven straight years, including 2008, and has a market cap of about $530 million.

Fuqi was a standout in the Hot List portfolio earlier this year, gaining 64% from mid-June through early September. Now it's back, with two of my models -- those I base on the writings of Peter Lynch and James O'Shaughnessy -- giving it approval. Check out the "Detailed Stock Analysis" section below to find out why.

ITT Educational Services, Inc. (ESI): This private education firm offers a variety of post-secondary degree programs, most of which focus on technology-related fields. Based in Indiana, it operates more than 100 technical institutes in 37 states, teaching more than 60,000 students. ITT has taken in more than $1.2 billion in sales in the past 12 months, and has a market cap of about $3.4 billion. ITT gets approval from my Warren Buffett-, Peter Lynch-, and Joel Greenblatt-based models. The "Detailed Stock Analysis" section below explains why.

Oil States International (OIS): Based in Houston, this $1.7-billion-market-cap oil services company makes products used in deepwater oil production facilities and sub-sea pipelines. It also provides several types of services and products to the oil and gas industry, including production-related rental tools, work force accommodations and logistics, and land drilling services. It gets approval from three of my models, those I base on the writings of Peter Lynch, Kenneth Fisher, and James O'Shaughnessy. To see why, scroll down to the "Detailed Stock Analysis" section below.

Tidewater Inc. (TDW): This New Orleans-based firm provides a variety of services to oil companies. It has close to 400 vessels that work all over the world, transporting crews and supplies, towing and anchoring mobile rigs, and assisting in offshore construction. The firm has a market cap of about $2.2 billion, and it has taken in $1.38 billion in sales over the past 12 months.

Tidewater gets approval from the strategy I base on the writings of Benjamin Graham, as well as my Peter Lynch-based strategy. To see why, check out the "Detailed Stock Analysis" section below.

National-Oilwell Varco, Inc. (NOV): Based in Houston, Varco designs, manufactures and sells equipment, components, and services used in oil and gas drilling and production. More than 160 years old, the company's products include major mechanical components for land and offshore drilling rigs, complete land drilling and well servicing rigs, extensive lifting and handling equipment, and downhole drilling motors, bits and tools. It has a market cap of about $17.3 billion, and has raked in more than $13 billion in sales in the past 12 months.

Varco gets approval from two of my models, those I base on the writings of Benjamin Graham and James O'Shaughnessy. Scroll down to the "Detailed Stock Analysis" section below to find out why.

Raytheon Company (RTN): This Massachusetts-based aerospace & defense firm provides state-of-the-art electronics, products, and services in a variety of areas, including integrated defense systems, missile systems, space and airborne systems, and intelligence and information systems. It also provides a variety of mission support services. It has a market cap of about $17.8 billion, and has taken in more than $24 billion in sales in the past year.

Raytheon gets approval from my Joel Greenblatt-, Peter Lynch- and Kenneth Fisher-based models. The "Detailed Stock Analysis" section below explains why.

News about Validea Hot List Stocks

Humana Inc. (HUM): The U.S. Government Accountability Office upheld Humana Military Healthcare Services' protest about a government contract it lost that could be worth as much as $21.8 billion, according to Business First of Louisville. The contract involved providing health benefits for soldiers and their families under the U.S. Defense Department's TRICARE program. It is still unclear whether the contract will be rebid or awarded to a specific group, however. In an SEC filing Thursday, Louisville-based Humana said that "neither the grounds for the decision nor the nature of the relief recommended by the GAO have yet been disclosed to Humana", according to Business First.

Tidewater Inc. (TDW): Tidewater on Thursday announced fiscal-second-quarter (ending Sept. 30) profit of $98.2 million, or $1.90 per share, up from $95.4 million, or $1.85 per share, a year earlier. The results included a $34.3 million benefit from a tax settlement that increased per-share earnings 66 cents, according to the Associated Press. Excluding the benefit, earnings were $1.24 per share, which was short of analysts' $1.37 per share forecast. Revenue fell about 15% to $295.5 million, AP reported, adding that analysts had expected $308.9 million.

ITT Educational Services (ESI): ITT said on Oct. 22 that third quarter profit was $75.4 million, or $2 per share, up from $50.2 million, or $1.28 per share, in the same period last year, the Associated Press reported. Analysts expected net income of $1.97 per share, on average. Sales jumped 33% to $339.6 million, beating analysts' expectations of $335.3 million as new student enrollment rose 27%, AP stated. Bad debt expenses did rise to 6.8% of sales, however, up from 5% a year ago.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will examine one of my individual Guru Strategies in greater depth. 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

FUQI   |   INT   |   VIT   |   FTO   |   OIS   |   NOV   |   ESI   |   HUM   |   RTN   |   TDW   |  

Fuqi International, Inc. (Fuqi) is a designer of precious metal jewelry in China, developing, promoting, and selling a range of products in the Chinese luxury goods market. The Company's products consist of a range of styles and designs made from gold and other precious metals, such as platinum and Karat gold (K-gold). The Company also produce jewelry items that contain diamonds and other precious stones on a custom-order basis. Its design database contains over 30,000 products. The Company operates through its wholly owned subsidiary Fuqi International Holdings Co., Ltd. (Fuqi BVI) and its wholly owned subsidiary, Shenzhen Fuqi Jewelry Co., Ltd. (Fuqi China). As of December 31, 2008, the Company had 69 jewelry retail counters and stores in China.

World Fuel Services Corporation is engaged in the marketing and sale of marine, aviation and land fuel products and related services on a worldwide basis. The Company operates in three segments: marine, aviation and land. In its marine segment it offers fuel and related services to maritime customers, including international container and tanker fleets, commercial cruise lines and time-charter operators. In its aviation segment, it offers fuel and related services to major commercial airlines, second and third-tier airlines, cargo carriers, regional and low-cost carriers, corporate fleets, fractional operators, private aircraft, military fleets. In its land segment, it offers fuel and related services to petroleum distributors operating in the land transportation market. In June 2008, it acquired certain assets of Texor Petroleum Company, Inc. In April 2009, the Company acquired the Henty Oil Group of Companies.

VanceInfo Technologies Inc. is an information technology (IT) service provider and one of the offshore software development companies in China. The Company's range of IT services includes research and development services (R&D services), enterprise solutions, application development and maintenance (ADM), quality assurance and testing, as well as globalization and localization. It provides these services primarily to corporations headquartered in the United States, Europe, Japan and China, targeting industries, such as technology, telecommunications, financial services, manufacturing, retail and distribution. The Company operates a range of offshore development centers in China (CDCs). Its major clients include Microsoft, IBM, Huawei, TIBCO, and a European mobile handset manufacturer. In July 2009, the Company acquired the operating subsidiaries of TP Corporation Limited (TP), a provider of customer relationship management (CRM) solutions and call center services.

Frontier Oil Corporation (Frontier) is an independent energy company engaged in crude oil refining and the wholesale marketing of refined petroleum products. The Company operates refineries (the Refineries) in Cheyenne, Wyoming and El Dorado, Kansas with a total annual average crude oil capacity of approximately 182,000 barrels per day (bpd). Frontier's Cheyenne Refinery has a permitted crude oil capacity of 52,000 bpd on a 12-month average. The Company markets its refined products primarily in the eastern slope of the Rocky Mountain region, which encompasses eastern Colorado (including the Denver metropolitan area), eastern Wyoming and western Nebraska (the Eastern Slope). The Cheyenne Refinery has a coking unit, which allows the refinery to process amounts of heavy crude oil for use as a feedstock. During the year ended December 31, 2008, heavy crude oil constituted approximately 76% of the Cheyenne Refinery's total crude oil charge.

Oil States International, Inc. (Oil States) through its subsidiaries, is a provider of specialty products and services to oil and gas drilling and production companies worldwide. The Company operates in a number of oil and gas producing regions, including the Gulf of Mexico, United States onshore, West Africa, the North Sea, Canada, South America and Southeast and Central Asia. Its customers include many of the national oil companies, major and independent oil and gas companies and other oilfield service companies. Oil States operates in three principal business segments: offshore products, tubular services and well site services. The Company's well site services segment includes the accommodations, rental tools and drilling services businesses. On February 1, 2008, Oil States purchased all of Christina Lake Enterprises Ltd., the owners of an accommodations lodge (Christina Lake Lodge) in the Conklin area of Alberta, Canada.

National Oilwell Varco, Inc. (NOV) is a provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates in three segments. The Rig Technology segment designs, manufactures, sells and services systems for the drilling, completion and servicing of oil and gas wells. The Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells, service pipelines, flowlines and other oilfield tubular goods. The Distribution Services segment provides maintenance, repair and operating (MRO) supplies, and spare parts to drill site and production locations worldwide.On April 21, 2008, NOV acquired Grant Prideco, Inc. In December 2008, it acquired Sakhalin Outfitters LLC and Mid-South Machine, Inc. In April 2009, NOV acquired ASEP Group Holding B.V. and Anson Limited.

ITT Educational Services, Inc. (ITT/ESI), is a provider of postsecondary degree programs in the United States based on revenue and student enrollment. As of December 31, 2008, the Company offered master, bachelor and associate degree programs to approximately 62,000 students. As of December 31, 2008, it had 105 institutes and nine learning sites located in 37 states. All of its institutes are authorized by the applicable education authorities of the states, in which they operate, and are accredited by an accrediting commission recognized by the United States Department of Education (ED). During the year ended December 31, 2008, the Company began its operations at eight new institutes. As of December 31, 2008, the Company offered 33 degree programs in various fields schools of study: information technology (IT); electronics technology; drafting and design; business; criminal justice, and health sciences.

Humana Inc. (Humana) is a health and supplemental benefits company. The Company is a full-service benefits solutions company, offering an array of health and supplemental benefit plans for employer groups, government benefit programs and individuals. The Company operates in two segments: Government and Commercial. The Government segment consists of beneficiaries of government benefit programs, and includes three lines of business: Medicare, Military and Medicaid. The Commercial segment consists of members enrolled in its medical and specialty products marketed to employer groups and individuals. On October 31, 2008, the Company acquired PHP Companies, Inc. (doing business as Cariten Healthcare). On August 29, 2008, the Company acquired Metcare Health Plans, Inc. On May 22, 2008, it acquired OSF Health Plans, Inc. On April 30, 2008, the Company acquired UnitedHealth Group's Las Vegas, Nevada individual SecureHorizons Medicare Advantage health maintenance organization (HMO) business.

Raytheon Company designs, develops, manufactures, integrates, supports and provides a range of products, services and solutions for principally governmental customers in the United States and worldwide. The Company operates in six business segments: Integrated Defense Systems (IDS), Intelligence and Information Systems (ibis'), Missile Systems (MS), Network Centric Systems (NCS), Space and Airborne Systems (SAS) and Technical Services (TS). In April 2008, the Company acquired SI Government Solutions. In July 2008, Raytheon Company acquired Telemus Solutions, Inc., a provider of information security, intelligence and technical services to defense, intelligence and other federal customers.In October 2009, the Company acquired BBN Technologies.

Tidewater Inc. provides offshore supply vessels and marine support services to the offshore energy industry through the operation of offshore marine service vessels. As of March 31, 2008, the Company had a total of 430 vessels, of which 10 were operated through joint ventures, 61 were stacked and 11 vessels withdrawn from service. The Company provides services supporting all phases of offshore exploration, development and production, including towing of and anchor handling of mobile drilling rigs and equipment; transporting supplies and personnel necessary to sustain drilling, workover and production activities; assisting in offshore construction activities, and a variety of specialized services, including pipe laying, cable laying and three-dimensional (3-D) seismic work. The Company operates in two segments: United States and International.

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.


The names of individuals (i.e., the 'gurus') appearing in this report are for identification purposes of his methodology only, as derived by Validea.com from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this report personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and tradenames appearing in this report are the property of their respective owners, and are likewise used for identification purposes only.

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Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.