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Executive Summary April 27, 2012

The Economy

It seems the economy remains plateaued following its impressive performance in the last two quarters, though the plateau on which it rests is a significantly higher perch than the one it sat on a year ago.

One sign of the flattening of growth came from the industrial and manufacturing sector. A new Federal Reserve report showed that industrial production was flat in March on a seasonally adjusted basis (vs. February) for the second month in a row, with manufacturing production actually declining 0.2%. The overall March industrial production figure was 3.6% higher than it was in the year-ago period, however. (Here and below, all week-over-week and month-over-month economic figures are seasonally adjusted, while year-over-year figures use unadjusted data since they are comparing like periods).

Also staying flat since our last newsletter were new claims for unemployment. Continuing claims, the data for which lags new claims by a week, have risen slightly. Still, new claims are more than 5% lower than they were last year at this time, while continuing claims are 10% lower, so the broader trend remains a good one.

A bright spot for the economy has been the continued strength in retail sales. They rose again in March, according to the Commerce Department, increasing a solid 0.8% (vs. February). They now stand 7.4% higher than they were a year ago, a very healthy increase. Overall, the data continues to show that the U.S. consumer is not tapped out, which is critical for our consumer-driven economy.

A good sign for consumers is that, while gas prices remain quite high, they have begun to fall. A gallon of regular unleaded averaged $3.84 as of April 25, according to AAA, down from $3.90 a month ago.

The housing sector, meanwhile, brought mixed news. Housing starts fell 5.8% in March (vs. February), according to the Census Bureau, though they remained more than 9% above year-ago levels. The amount of privately owned housing units authorized by building permits rose 4.5%, however, a sign that building may pick up. Permit authorizations are now more than 25% higher than they were a year ago.

The National Association of Realtors also reported that existing home sales declined 2.6% in March, though they remain 4% above their year ago level and the median sale price was 2.5% above the year ago level. Also, the realtor group said that it appeared in several markets across the country that a lack of inventory actually prevented more sales from being made. That's a very good sign -- since the housing bubble, the housing market has been working off some serious overcapacity. Until that happens, the homebuilding industry will struggle, and it's usually a big driver in economic expansions. Perhaps we're finally getting to the point where enough inventory has been worked off, and homebuilding will become a big driver in this expansion.

Since our last newsletter, the S&P 500 returned 0.9%, while the Hot List returned 3.2%. So far in 2012, the portfolio has returned 20.6% vs. 11.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 172.7% vs. the S&P's 39.9% gain.

Market Valuation Update

It's been a few months since we've taken an in-depth look at the broader market's valuation. In that time, stocks have made some big gains, so I think it's time to check in again and see where things stand.

For starters, the S&P 500 trades for about 14 times trailing 12-month operating earnings and 15 times as-reported earnings (both those figures include estimates for about two-thirds of companies for the first quarter), using Standard & Poor's data and the April 24 closing price. Back in December, the trailing P/Es were 13.1 for operating earnings and 14.3 for as-reported, so they've increased only slightly. Using projected earnings for the next year, the operating figure is about 12.6 and the as-reported is about 13.5.

The index's price/sales ratio, meanwhile, is a reasonable 1.3 (slightly above its 1.2 level from December) and its price/book ratio is about 2. And, its dividend yield is a solid 2.44% (just 0.09 percentage points below its December level), still well above the yield on 10-year Treasury bonds -- a rarity.

One figure that has increased significantly since I last looked in-depth at market valuation is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It has risen to 95.6% (from 86.4% in December) according to GuruFocus.com, which puts it in "modestly overvalued" range (90% to 115%), basd on the site's analysis of historical data.

The 10-year cyclically adjusted price/earnings ratio is also high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at 21.8 (through April 24), having risen slightly since mid-December when it was between 20 and 21. It's significantly higher than the 16.4 historical average (which dates back to 1871) but doesn't look as high when compared to the average of 18.2 since 1946 (which is a significant date because 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).

Bargains Abound

All in all, all of those metrics collectively indicate to me that the market is still pretty close to fair value. There are other issues that may be impacting the valuation picture, but it seems that for every negative the bears can point to, the bulls can point to an equally persuasive positive factor. For example, while bears have noted that profit margins are quite high compared to historical standards, which may be goosing earnings numbers, the bulls can point to the 10-year P/E ratio being skewed by the atrocious earnings of only a couple of big financial firms in 2008 and 2009 -- some of which aren't even in the S&P 500 index anymore. The fact that there are some persuasive arguments on both sides lends credence to the notion that we are somewhere in the fair value range.

More importantly to me, a myriad of quality stocks are trading at very attractive prices, offering lots of opportunities for stockpicking systems like the Hot List. For example, The TJX Companies, which is the parent of discount retailers TJ Maxx and Marshalls, has a return on equity of 47%, and nearly thre times as much net current assets as long-term debt. The firm has increased earnings-per-share in every year of the past decade, and has been growing EPS at a 21.5% annual pace over the long-term (that's using an average of the 3, 4, and 5 year EPS growth rates). Yet it trades for about 1.3 times sales -- a very reasonable figure -- and has a P/E-to-growth ratio just under 1.0, a sign that it's a good value.

Then there's Bridgepoint Education. Many investors have dumped for-profit education stocks as they've come under increased regulatory scrutiny over the past year or two. But Bridgepoint has kept on performing. It increased earnings-per-share by 41% last year, and revenue by 31%. The firm has a return on equity of 58%, no long-term debt, and a free cash flow yield of 15.4%. All of that, and it trades for just 7 times trailing 12 month earnings, about 1.2 times sales, and has a PEG ratio of about 0.2.

Finally, consider the lone financial in the portfolio right now, Cash America International. While the past decade has been a rough one for many financial firms, this Texas-based pawn loan firm has excelled, increasing EPS every year, and posting long-term EPS and sales growth rates of about 15% (again, based on an average of the respective 3, 4, and 5 year rates). It has an equity/assets ratio of 54%, and a return on assets rate of 8.7%. To give you an idea of how good that is, my Peter Lynch-based method uses targets of 5% for the equity/assets ratio and 1% for return on assets. But despite all that, Cash America is very cheap. It trades for 10.1 times trailing 12 month earnings and 0.82 times sales. That's the sort of high-quality, bargain-priced stock that the Hot List loves.

Overall, the 10 Hot List positions average a 32% return on equity and on average have increased earnings in all but two years of the past decade. The non-financials have a very solid 2.0 current ratio and very reasonable 21.9% debt/equity ratio, while the one financial has those stellar equity/assets and return on assets figures I mentioned above. Despite all that, these stocks are collectively quite cheap. On average, they have a trailing 12 month P/E ratio of 13.7; a PEG ratio of 0.59; and a price/sales ratio of 1.14.

Bottom line: While the broader market seems to be reasonably valued, there are plenty of very attractive, bargain-priced individual stocks out there, and the Hot List should benefit greatly over the long haul by scooping them up now.

Editor-in-Chief: John Reese

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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."

Solid Performer

My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned 62.1%, more than twice what the S&P 500 has gained (28.8%; all figures through April 23).

The portfolio has been a very strong performer over the past few years. In 2009, it had a banner year, gaining 50.3% and more than doubling the S&P. It lagged the index in 2010, gaining just 6.3%, but bounced back strong in 2011, gaining 10.2% while the broader market was flat. This year, it's outperforming again, having gained 11.7% thus far vs. 8.7% for the S&P.

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)
Oracle Corporation (ORCL)
PetMed Express, Inc. (PETS)
Monster Beverage Corp. (MNST)
Raven Industries (RAVN)
Bio-Reference Laboratories Inc. (BRLI)
Rollins Inc. (ROL)
World Acceptance Corp. (WRLD)
Coach, Inc. (COH)
Infosys Ltd (INFY)

News about Validea Hot List Stocks

Northrop Grumman (NOC): Grumman reported first-quarter income from continuing operations of $506 million, or $1.96 per diluted share, up from $496 million, or $1.67 a share, a year ago. The firm cited company-wide cost-cutting and a buyback of 4.4 million shares as reasons for the increase, according to Reuters. Grumman also raised its guidance for the full year nearly 30 cents, to $6.70-$6.95 per diluted share.

Apollo Group (APOL): Apollo said last week that the Securities and Exchange Commission was probing share sales by company insiders, Reuters reported. The SEC contacted Apollo seeking information about the stock sales and a Feb. 28 regulatory filing that disclosed the company's second-quarter outlook, the firm said in a regulatory filing, according to Reuters. An analyst noted that given the recent scrutiny of for-profit education firms, however, Apollo has "relatively robust insider trading controls," Reuters stated. Shares were down about 3.4% since our last newsletter (through April 26).

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

CSTR   |   APOL   |   AAP   |   FINL   |   TJX   |   BPI   |   NOC   |   CSH   |   FRX   |   BODY   |  

Coinstar, Inc. (Coinstar) is a provider of automated retail solutions, which offers convenient products and services. the Company's offerings in automated retail include its Redbox business, where consumers can rent or purchase movies and video games from self-service kiosks (Redbox segment), and its Coin business, where consumers can convert their coin to cash or stored value products at self-service coin counting kiosks (Coin segment). Its New Ventures business (New Ventures segment) is focused on identifying, evaluating, building, and developing self-service concepts in the marketplace. On June 9, 2011, the Company completed the sale transaction of the Money Transfer Business to Sigue Corporation (Sigue).

Apollo Group, Inc. (Apollo Group) is a private education provider. The Company offers educational programs and services both online and on-campus at the undergraduate, master's and doctoral levels through its wholly owned subsidiaries, The University of Phoenix, Inc. (University of Phoenix); Institute for Professional Development (IPD); The College for Financial Planning Institutes Corporation (CFFP), and Meritus University, Inc. (Meritus). Apollo Group also formed a joint venture with The Carlyle Group (Carlyle), called Apollo Global, Inc. (Apollo Global), to pursue investments primarily in the international education services industry. As of August 31, 2011, Apollo Group owned 85.6% of Apollo Global, with Carlyle owning the remaining 14.4%. During the year ended December 31, 2011, the Other Schools segment includes IPD and CFFP, as well as Meritus University, Inc. (Meritus), which ceased operations.

Advance Auto Parts, Inc. (Advance) is a specialty retailer of automotive aftermarket parts, accessories, batteries and maintenance items primarily operating within the United States. The Company operates in two segments: Advance Auto Parts (AAP), and Autopart International (AI). Its stores carry an extensive product line for cars, vans, sport utility vehicles and light trucks. The Company serves both do-it-yourself (DIY), and do-it-for-me (Commercial), customers. Its Commercial customers consist primarily of delivery customers for whom the Company delivers product from its store locations to it Commercial customers' places of business, including independent garages, service stations and auto dealers.

The Finish Line, Inc. (Finish Line) is a mall-based specialty retailer in the United States. Finish Line is a retailer of athletic shoes, apparel and accessories. As of April 15, 2011, the Company operated 660 Finish Line stores averaging approximately 5,400 square feet in 47 states. The Company's stores are primarily located in enclosed shopping malls. The typical Finish Line store format has a sales floor, which includes a try-on area, and a display area where each style of footwear carried in the store is displayed by category In addition, the Company operates an e-commerce site, www.finishline.com, as well as mobile commerce via m.finishline.com. Finish Line stores generally carry a selection of men's, women's and kids' performance and athletic casual shoes, as well as an assortment of apparel and accessories. Brand names offered by Finish Line include Nike, Brand Jordan, Reebok, Puma, adidas, Under Armour, Asics, Brooks, New Balance, Mizuno, Lacoste, The North Face and others.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office.

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.

Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business.

Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. The Company offers secured non-recourse loans, commonly referred to as pawn loans. The Company also offers unsecured consumer loans. Its consumer loan portfolio includes short-term loans, which include single payment loans (that are commonly referred to as payday loans) and line of credit products; longer-term multi-payment installment loans; and credit services and participation interests in receivables acquired from a third-party lender through the micro line of credit (MLOC) channel. It operates in two segments: retail services and e-commerce. Through the credit services organization programs (the CSO programs), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization or credit access business on behalf of consumers.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Body Central Corp. is a specialty retailer of young women's apparel and accessories operating retail stores in the South, Mid-Atlantic and Midwest regions of the United States. In addition, the Company operates a direct business through its e-commerce Website, www.bodyc.com, and Body Central catalog. It operates specialty apparel stores under the Body Central and Body Shop banners. It targets women in their late teens and twenties from diverse cultural backgrounds who seek the latest fashions and a flattering fit. Its stores feature a variety of tops, dresses, bottoms, jewellery, accessories and shoes sold primarily under Body Central and Lipstick labels. As of January 1, 2011, it had 209 stores located in fashion retail venues across 23 states in the South, Mid-Atlantic and Midwest. Its average store size is 4,300 square feet. During the fiscal year ended January 2, 2010 (fiscal 2010), the Company opened 27 stores. From fiscal year 2009 through January 1, 2011, it closed 13 stores.

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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