Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary August 16, 2013

The Economy

Improvement in the service sector, declining jobless claims, a normal level of inflation, continued strength in the housing sector -- the U.S. economy has delivered some pretty good news over the past couple weeks. And, ironically, it's been bad for the market in the short term, with short-sighted investors fretting that a better economy means less support from the Federal Reserve.

Of course, the long-term goal is for the economy to be able to stand on its own, and the past fortnight's data gave some signs that it's in position to do so. The service sector expanded for the 43rd straight month in July, for example, and it did so at its quickest pace since February, the Institute for Supply Management said. The group's new orders sub-index also made a big jump, indicating that production could be strong in coming months as well. The prices sub-index also made a big jump.

Other data showed that prices have been rising, with inflation picking up from the near-zero pace we've seen in recent months. Still, prices are hardly surging. A government report showed that the personal consumption expenditure price index rose 0.4% in June, putting it 1.3% above year-ago levels. Both figures were the highest since February. The Labor Department, meanwhile, said that the Consumer Price Index rose 0.2% in July, putting it 2.0% ahead of its year-ago level. Wall Street seemed to be troubled by the news, since rising inflation makes the Federal Reserve more likely to taper its quantitative easing efforts. But in reality coming back to a reasonable inflation level is good news.

Another piece of good news: New claims for unemployment fell since our last newsletter, reaching their lowest point since October 2007. They are 11.7% below their year-ago level. Continuing claims were more or less flat, and are more than 10% below where they were a year ago.

Industrial production was flat for July, a new Federal Reserve report showed. Manufacturing output slipped 0.1%, while mining output rose 2.1%. Utility output, which is usually weather-dependent, fell 2.1%.

The personal consumption expenditure report also showed that, while disposable personal income rose 0.3% in June, real DPI actually fell 0.1% because of price increases. Personal consumption expenditures rose 0.5%, but only 0.1% in real terms. The personal saving rate dipped slightly, to 4.4% from 4.6% a month earlier, but still remains at a healthy level. The Commerce Department, meanwhile, said that retail and food service sales increased by 0.2% in July, putting them a very solid 6.8% above their year-ago level.

Finally, the housing sector keeps on supplying good news. The National Association of Home Builders/Wells Fargo index of builder confidence rose to its highest level since 2005 in August, the group said this week.

Since our last newsletter, the S&P 500 returned -2.7%, while the Hot List returned -4.5%. So far in 2013, the portfolio has returned 25.9% vs. 16.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 241.5% vs. the S&P's 66.1% gain.

Editor-in-Chief: John Reese

Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

Are you looking for an alternative to your underperforming mutual funds or financial advisor? Click here to download Validea Capital's investment kit and learn more about the firm's guru-based portfolios.

Get More Information on Validea Capital!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

Portfolio Update

The Hot List and broader market have taken some hits in recent days, though the portfolio remains well ahead of the S&P 500 this year. As I noted above, a lot of the declines seem to be driven by fears that the Fed will begin tapering its QE efforts. It's thus a strange world we're living in -- one in which good economic data leads to trouble for the market because it means the Fed is more likely to taper. That probably had something to do with some of the down fortnights for some of the Hot List's holdings.

But other factors also were involved. Inter Parfums, for example, had a disappointing second-quarter earnings report, a big reason why its shares were down 12.9% since our last newsletter (all figures as of afternoon trading on August 15). USANA Health Sciences, meanwhile, was apparently the victim of a trading error that caused a mini "flash crash" that briefly sent its stock tumbling on August 8. It made up that ground, but had nonetheless lost about 8% since our last newsletter, likely because of the QE and broader market fears. (The stock has still gained over 130% since joining the portfolio back in December.) Overstock.com also had a rough two weeks, with shares down nearly 11%. There was no clear catalyst for the decline, but the broader QE/economic fears may have been partly responsible for the declines. Investors also may have been taking profits on the stock, which had made some very good gains last month after a strong earnings report.

There were some strong performers in the portfolio, however. Most notable was AmTrust Financial Services. In part because of a strong earnings report -- earnings about doubled from the year-ago quarter -- shares rose 5.5%.

While most of the portfolio's holdings were in the red over the past couple weeks, the catalysts for the declines seem to be emotional and/or short-term. Looking forward, most of these stocks still have very good prospects, and there are plenty of other very attractive, reasonably priced stocks in the market. We'll see which holdings the Hot List holds onto when we rebalance the portfolio in two weeks.

Guru Spotlight: David Dreman

While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.

But while most of these gurus are contrarians, one in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.

Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).

How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.

When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.

Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)

But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.

Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."

This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.

But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P). Since its July 2003 inception, the 10-stock Dreman-based portfolio is well ahead of the S&P 500, returning 100.8%, or 7.2% annualized, vs. 68.5%, or 5.3 %, for the S&P (through Aug. 14).

As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Right now, its holdings include some very unloved firms, including several financials, emerging market stocks, and much-maligned BP. Here's the full list of its current holdings:

Canadian Imperial Bank of Commerce (CM)
BP Plc (BP)
Telecom Argentina SA (TEO)
American Capital Agency Corp. (AGNC)
China Mobile Limited (CHL)
Vale SA (VALE)
Annaly Capital Management, Inc.(NLY)
Petroleo Brasileiro SA (PBR)
American Capital, Ltd. (ACAS)
Royal Dutch Shell Plc (RDS.A)

News about Validea Hot List Stocks

Inter Parfums (IPAR): On Aug. 7, Inter reported second-quarter net income of $3.8 million, or $0.12 per share, down from $6.0 million, or $0.20 per share, a year ago. Net sales of ongoing brands (excluding Burberry, with whom it terminated its agreement last year) increased 17% to $96.8 million from $82.7 million. Net sales including Burberry brand sales were down 19.3% to $117.5 million, compared to $145.6 million. Investors didn't take the news well, with shares dropping more than 10% over the next two days.

AmTrust Financial Services (AFSI): On Aug. 6, AmTrust reported second-quarter net income of $80.1 million or $1.14 per share, up sharply from $40.4 million or 59 cents a share in the year-ago quarter. Growth was primarily driven by significant improvement in top line and agency acquisitions implemented in the past one year, Zack's Equity Research said. Total revenue rose 66.4% to $716.5 million from $430.6 billion in the year-ago period. Earnings and revenue results both beat expectations, and the company announced that it will be paying a 10% stock dividend. Shares rose slightly the day of the announcement, and have continued to rise since then. They are up nearly 7% since before the announcement (as of early afternoon trading on August 15).

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 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

HCI   |   WSM   |   AFSI   |   OSTK   |   LEA   |   USNA   |   HFC   |   BPI   |   VLO   |   IPAR   |  

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The direct-to-customer segment of the Company's business sells its products through its six e-commerce Websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and rejuvenation.com) and seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed and Bath, PBteen, West Elm and Rejuvenation). Its e-commerce platform is available to customers in more than 75 countries, while its catalogs reach customers throughout the United States. The retail segment of its business sells products through its five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation). As of January 29, 2012, it operated 576 stores in 44 states, Washington, D.C., Canada and Puerto Rico. On November 1, 2011, the Company acquired Rejuvenation Inc.

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 segments: small commercial business, specialty program and personal lines reinsurance. In January 2013, the Company acquired First Nonprofit Companies, Inc. In February 2013, its subsidiary acquired Car Care Plan (Holdings) Limited from Ally Insurance Holdings, Inc. In April 2013, it acquired Sequoia Insurance Company and its subsidiaries, Sequoia Indemnity Company and Personal Express Insurance Company. In May 2013, the Company acquired Mutual Insurers Holding Company (MIHC) and MIHC's subsidiary, First Nonprofit Insurance Company.

Overstock.com, Inc. (Overstock) is an online retailer offering discount brand name, non-brand name and closeout merchandise, including bed-and-bath goods, home decor, kitchenware, furniture, watches and jewelry, apparel, electronics and computers, sporting goods, and designer accessories, among other products. The Company is also a channel through, which customers can purchase cars, insurance and travel products and services. Overstock sells advertising. The Company also sells books, magazines, compact discs (CDs), digital versatile discs (DVDs) and video games (BMMG). Overstock sells these products through its Internet Websites located at www.overstock.com, www.o.co and www.o.biz. Overstock operates in two segments: direct business and fulfillment partner business. As of December 31, 2011, the Company offered approximately 251,000 non-BMMG products and approximately 637,000 BMMG products.

Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.

USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.

HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's academic institutions include Ashford University and University of the Rockies. Its institutions deliver programs primarily online, as well as at their traditional campuses. As of December 31, 2011, the Company had 86,642 total students enrolled in its institutions. Bridgepoint's institutions conduct ongoing faculty and student assessment processes and provide a range of student services. The Company is also focused on developing new technologies, such as through Waypoint Outcomes, Constellation, and the development of its institutions' mobile learning platforms. The Company has developed Constellation to replace third party textbooks with digital course materials. Constellation materials are displayed in a browser-based platform. In January 2012, Bridgepoint introduced Thuze.

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.

Inter Parfums, Inc. operates in the fragrance business, and manufactures, markets and distributes an array of fragrances and fragrance related products. The Company operates in two segments: European based operations and United States based operations. Its prestige fragrance products are produced and marketed by its European operations through its 74% owned subsidiary in Paris, Interparfums SA. The Company's specialty retail and mass market fragrance and fragrance related products are marketed through its United States operations These fragrance products are sold under trademarks owned by the Company or pursuant to license or other agreements with the owners of brands which include the Gap, Banana Republic, Anna Sui, Brooks Brothers, bebe, Betsey Johnson, Nine West, Lane Bryant and Jordache.

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.

Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.

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.