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|Executive Summary||February 20, 2009|
While criticisms of the government's efforts to jumpstart this troubled economy may be many, a failure to take dramatic action certainly cannot be one of them. This week, Congress and the president passed a massive $787 billion stimulus package, which, combined with last fall's $700 billion bank bailout plan, means legislators have now allocated almost one and a half trillion dollars toward the economic recovery efforts. And that's not even including the hundreds of billions of dollars worth of loans and other debt that the feds have guaranteed.
The new plan involves tax cuts and rebates, major infrastructure spending designed to create jobs, funding to help streamline the healthcare system, and a number of other projects. In addition, President Obama has also unveiled a new $75 billion plan (with the funding to come from the original bank bailout money) to help homeowners struggling to pay their mortgages.
The efforts are sweeping and unprecedented. The question, of course, is, "Will they work?" Some critics say the plan doesn't do enough; others say any type of bailout will only compound the problems. (More on this in a bit.)
While it's unclear when -- or, some would say, if -- the stimulus plan will start producing results, what is clear is that the economy is continuing to languish. The housing market has yet to bottom -- in fact, January housing starts were down 17 percent from December, a new Commerce Department report showed, reaching their lowest level since the government started keeping track of the figure 50 years ago, CNNMoney reported.
The financial sector also continues to be a giant, painful mystery. There is still a lot of doubt as to how much bad debt the big banks are holding, and reports that nationalization of some of the big boys -- including Bank of America and Citigroup -- is on the table have kept fears elevated on Wall Street.
Industrial production, meanwhile, continues to slip, dropping 1.8 percent in January, with more than half the drop being caused by automobile and parts production dropoffs, the Federal Reserve reported.
And oil prices -- whose decline has served as a silver lining during the economic crisis --surged 14 percent yesterday after the government announced that, to the surprise of many analysts, inventories had declined last week as consumption increased.
Some good news also emerged over the past couple weeks, however. For starters, despite all of the talk of tapped out consumers and retailer Armageddon, retail sales made a surprising and significant jump in January, rising by 1.0 percent over December. It might not sound like a lot, but it is encouraging -- especially given that sales had dropped 3.0 percent just one month earlier.
That's not to say the retail picture is bright, however. There is no doubt more pain to be had for the industry -- consulting firm Davidowitz & Associates says to expect 220,000 more stores to close in the U.S. this year, with luxury retailers like Saks and Nieman Marcus being among the hardest hit.
Another piece of good news -- albeit one with another caveat -- involves the Conference Board's index of leading economic indicators. This index, which combines such economic stats as unemployment claims, building permit issues, and factory work levels to project where the economy will be in six to nine months, rose in January for the second straight month. That's a sign the recession will become less severe as 2009 wears on.
The catch: Some say the positive readings are a "false positive". Rex Nutting of MarketWatch says the indicators that track the "real economy" continue to weaken, while most of the indicators that track the financial system are improving -- and "no one believes the financial system is actually improving in any meaningful way".
With sentiment like that permeating Wall Street, it's no surprise that the markets have continued to scuffle. Since our last newsletter, the S&P 500 has fallen 7.9 percent, while the Hot List is down 7.5 percent. The portfolio remains well ahead of the market for the long term, having gained 47.7 percent since its July 2003 inception, while the S&P has tumbled 22.1 percent.
This rebalancing, the portfolio is adding four new stocks, and my model is continuing to focus on smaller firms. The four stocks I'm adding range from about $450 million to $1.75 billion in market cap, and the largest of the ten stocks now in the portfolio (American Eagle Outfitters) has a cap just under $2 billion. Small caps led the market's rally late last year (the Russell 2000 gained 31 percent from Nov. 20 to Jan. 2, compared with the Dow Jones Industrial Average's 20 percent gain, according to the Wall Street Journal). The Hot List seems to think small caps are primed for another gain.
Doom & Gloom, Meet Facts & Figures
Now, let's go back to the caveats I mentioned before when discussing the recent positive signs in the market and economy. I brought those up not to be a downer or sound like a Cassandra; I did so, rather, because I think the very fact that the retail sales, leading indicator index, and other pieces of good news are coming with caveats is an interesting sign.
Back in January, I wrote that one reason I was optimistic for stocks moving forward was the high levels of pessimism in the market. Because people are prone to overreaction, times of great pessimism are usually followed by periods of strong returns, as investors realize things aren't as bad as they feared.
Well, in the past few weeks the pessimism has kept on growing, so much so that it seems no good news can be mentioned without some sort of caveat. When retail sales go down, it's a sign of impending doom; when they go up, it's an aberration. When leading indicators are negative, it's a sign that we're headed for catastrophe; when they're up, it's a "false positive". Similarly, investors clamor for the government to take major actions to stem the crisis; when the government does indeed take unprecedented actions, those actions are viewed as insufficient, too much, or just flat-out wrong.
In fact, the mere fact that the term I used above -- "Cassandra" -- needs no explanation these days is a sign of just how gloomy things have become. Doomsday forecasters have become quite en vogue on Wall Street these days.
RealMoney columnist Doug Kass -- who has been pretty bearish over the past year -- does a great job summing up this current doom & gloom mood in a recent column (one in which he says he's beginning to see several positive signs in the market):
The headwinds working against an economic resolution this year seem cast in stone. Those few who still express confidence in a second-half recovery, similar to the characters Raoul Duke and Dr. Gonzo in Fear and Loathing in Las Vegas, are either taking too many drugs or are oblivious to the clogged transmission of credit, the steady drop in business and investor confidence and the general waning of business activity. Today, there is almost unanimity that neither an aggressive monetary policy nor a massive stimulus program nor an unprecedented and large bank rescue plan will have any possibility of success. And, with the exception of the few remaining permabulls, most now appreciate that the consumer is cooked and that the great unwind of credit will be a headwind measuring in years not months.
Kass sees all of this pessismism as a positive, and I do, too. That doesn't mean the market is going to turn around today, tomorrow, or next week, though. What it does mean is that, with investors expecting so little from the economy and the markets, there is a tremendous amount of fear and pessimism baked into stock prices right now, and times like that are usually a great time to buy.
The fundamentals back that up. In the March issue of Money magazine, Joe Light notes that the market's 10-year price/earnings ratio (which uses average earnings for the past 10 years, a model Yale professor Robert Shiller developed as a way to smooth out earnings fluctuations) is now about 14. That's exceptionally low compared to recent levels -- the 10-year P/E was 22 at the end of the 2000-2002 bear market, and almost 28 in 2007. But the 10-year P/E isn't just low compared to recent years (when high leverage was inflating profits); it's actually now below its long-term historic average of 16. That's the first time that has occurred since 1991 -- right around the time that a 10-year bull market began.
Could P/Es get lower? Of course. But the data shows that we're getting close to the point at which the risk involved in staying on the sidelines is becoming pretty high. When the 10-year P/E has been between 15 and 19.9, stock returns for the following decade have averaged 5.7 percent, according to Money (using Shiller's data); when P/Es have been between 10 and 14.9 (the category into which the current P/E falls), returns have been almost double that in the succeeding decade, at 10.3 percent. When P/Es fall to the 5 to 9.9 range, however, the ensuing ten-year return hasn't been that much more, at 10.8 percent. We are, of course, near the higher end of that 10 to 14.9 category, and presumably the lower the P/E gets within that range, the higher the returns will probably be. But the general trend seems to indicate that there is a diminishing returns phenomenon as P/Es get lower and lower than the levels at which they now sit.
Other fundamentals are also encouraging. For one thing, stocks are selling at cheap levels compared to their replacement book values. (The ratio is about 1.0 now, compared to the 1.4 historical average, notes Kass). And the spread between 10-year Treasuries and 10-year, highly-rated corporate bonds has come down significantly in the past month, with the 10-year T-bill yield jumping about half a point to about 2.86 percent and the muni yield down to about 3.1 percent. That's a sign investors are willing to take on more risk and aren't hiding in risk-free Treasuries as much.
Nevertheless, the economic situation is going to continue to be a slow, tough ride, which I've noted in many of my past newsletters. Recovery won't come overnight, even with the passage of a $787 billion stimulus plan. That's a reality that doesn't make for a good story in the hour-to-hour, minute-to-minute media of today, however; every hour that the market or economy don't show signs of a turnaround, the headlines and pundits sound more and more like the turnaround might never come. One column in a major financial magazine that I read two days before Congress's passage of the stimulus bill even asked, "We know that the stimulus bill will create jobs, but when, where and how? The market doesn't see any 'Hiring Now' signs yet." Apparently, the stimulus package was supposed to fix the current problems even before it was actually approved.
For the economy, the bottom line is that we're talking about trillion-dollar problems, and unfortunately we must rely in large part on far-from-perfect politicians to fix those trillion-dollar problems. That will take time.
For the stock market, however, the bottom line is this: Many stocks -- and, in fact, the market as a whole -- are now selling on the cheap, even by the most conservative of assessments. That's what the numbers tell us, and, as Hot List readers know, I believe in trusting the numbers far more than I believe in trusting the headlines or the pundits. Yes, sticking with the numbers hasn't spared the Hot List from pain over the past several months. But that's going to happen from time to time. History shows that investors who try to make their way in the market by relying on instinct or other nonquantitative methods will end up experiencing far more pain over the long run.
I know I talk about "trusting the numbers" a lot, and, given the Hot List's loss last year, I think it's important to reiterate that this quantitative approach isn't one that we are sticking with simply out of stubbornness or blind faith. There is copious evidence and long-term data showing that "the numbers" are a far more reliable guide to stock-picking than our own brains are, and I go into a lot of this research in my new book. In fact, sticking to the numbers is one of the six "Guiding Guru Principles" I lay out in The Guru Investor. Given all the emotion driving the market right now, I thought it would be a good time to follow up last newsletter's book excerpt (which detailed Principle 1: Combining Strategies to Minimize Risk and Maximize Returns) with another excerpt from the book, this one dealing with why "the numbers" are an investor's best friend.
[Excerpted from The Guru Investor: How to Beat the Market Using History's Best Investment Strategies.]
Principle 2: Stick to the Numbers or the Market Will Stick It to You
Blending strategies can smooth returns and take some of the emotion out of your portfolio management, but not all of it. You can do more blending than a Bahamian bartender and you'll still have to deal with the urge to buy and sell based on emotional reactions. As we discussed earlier, investors often sell good stocks of good companies that are having short-term problems because they can't see the forest for the trees; they let fear get the best of them, and mistakenly think short-term hiccups will be long-term problems for a company or an industry when the long-term data indicates otherwise. In addition, when buying, people have the urge to jump on hot, trendy stocks that turn out to be overpriced and overhyped.
A key to limiting the impact emotions have on your buying and selling decisions is following a quantitative investing strategy, like the guru-based methods we've examined. If you do that, a big part of the task of removing emotion from your portfolio management is already done. That's because you'll be using an approach that sticks to the numbers - stock's fundamentals. You won't buy stocks because they're getting good press, because a magazine predicts that a stock's price will double, or because a friend tells you it's a sure thing; similarly, you won't sell when a stock gets bad press, or you hear rumors that it's on the way down. Instead, you'll buy and sell when the numbers are right and only when they're right. (We'll talk more specifically about how to use the numbers to determine when to sell a little later.) No hunches, no guesswork, just strategies that have long histories of producing strong results by using cold, hard facts and figures.
Why stick solely to the numbers? After all, we're intelligent people; surely using our own insights, whether alone or in tandem with the numbers, can work better than using such an impersonal, rigid, quantitative approach, right?
Wrong. As humans, there are a lot of things we do well. Unfortunately for investors, predicting and forecasting are not among them. Think back to Chapter 1, and the study that Philip Tetlock detailed in his book Expert Political Judgment: How Good Is It? How Can We Know? Tetlock's research found that even so-called "experts" couldn't explain more than 20 percent of the total variability in outcomes when trying to predict future events.
Statistical models, meanwhile, aren't perfect at forecasting the future, but they're a lot better than humans. If you'll recall, Tetlock found that sophisticated algorithms could explain 47 percent of outcomes in his study, more than twice as much as "expert" human forecasters.
James O'Shaughnessy, the growth-value guru we discussed in Chapter 10, gives some excellent insights into this phenomenon in What Works on Wall Street. In the book, O'Shaughnessy cites additional studies that all found that human prognosticators couldn't match statistical-actuLato forecasting models. In one study, for example, an actuLato model did better in predicting whether certain high school students would be successful in college than did admissions officers at many colleges. In another, a researcher named Jack Sawyer reviewed 45 different studies that compared human and actuLato predictive ability. In none [of the 45] was the clinical, intuitive method - the one favored by most people - found to be superior, O'Shaughnessy writes. What's more, Sawyer included instances in which the human judges had more information than the model and were given the results of the quantitative models before being asked for a prediction. The actuLato models still beat the human judges!
How can that be? It's because people are emotional creatures, and emotions lead to inconsistency in how we assess problems. Explains O'Shaughnessy: "Models beat human forecasters because they reliably and consistently apply the same criteria time after time. Models never vary. They are always consistent. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don't favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don't have egos. They're not out to prove anything."
We agree. No matter how objective you might try to be, you can't completely turn off your emotions. Once you read that article about "The Next Apple," or about an analyst's report on a particular stock, it's tough to get it out of your head. Even if you're conscious of the negative impact emotions can have on your decision-making, it might not help. They still may seep into your mind unconsciously, without you even realizing it. Or, you might try so hard not to succumb to your emotions that you end up simply doing the exact opposite of what they're telling you, which also might not necessarily be for the best.
Even if you just try to modify a proven, quantitative strategy with your own additions, you're asking for trouble. Your modifications may work for a while, but over the long term, you have no idea how they will impact your returns. By sticking to a proven, purely quantitative buying and selling system, you neutralize your brain, and you put your faith in strategies that are supported by years and years of data, not by hunches or fleeting emotions.
As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Jakks Pacific, Inc. (JAKK), Polo Ralph Lauren Corporation (RL), Skechers Usa, Inc. (SKX) and Net17 1 Ueps Technologies Inc (UEPS).
6 stocks remain in the portfolio. They are: The Dress Barn, Inc. (DBRN), American Eagle Outfitters (AEO), Ameron International Corporation (AMN), Esterline Technologies Corporation (ESL), Kennametal Inc. (KMT) and Schnitzer Steel Industries, Inc. (SCHN).
We are adding 4 stocks to the portfolio. These include: Jos. A. Bank Clothiers, Inc. (JOSB), Lincoln Electric Holdings, Inc. (LECO), Gildan Activewear Inc. (Usa) (GIL) and Logitech International Sa (Usa) (LOGI).
New Stocks Added to the Validea Hot List
Gildan Activewear Inc. (GIL): You might never have heard of this Montreal-based clothing manufacturer, but you may well have worn its products. Gildan sells T-shirts, sport shirts and fleece to wholesale distributors as "blanks" -- that is, without logos or decorating. Screen printers then decorate the items with various designs and logos. The final products are sold at sporting, entertainment, and corporate events and travel and tourism destinations, and are also used as work uniforms. Gildan, which also is a major supplier of socks, has a major presence in the U.S., Canada, and Europe, and has been growing in Mexico and the Asia-Pacific region. It employs more than 20,000 people around the globe, and has a market cap of $878 million.
Gildan gets approval from three of my Guru Strategies -- those I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher. To find out why, see the "Detailed Stock Analysis" section below.
Jos. A. Bank Clothiers (JOSB): Based in Hampstead, Maryland, this prior Hot List favorite has seen its price come down over the past couple weeks, and my models think it's time to bring it back into the fold. The 100-plus-year-old retailer sells a variety of men's tailored, casual, and sports clothing, as well as shoes and accessories such as hats and belts. The small-cap ($450 million market cap), has about 450 stores in 42 states and the District of Columbia, and has taken in more than $650 million in sales in the past 12 months.
Bank is one of the rare stocks that gets approval from four of my Guru Strategies. My Peter Lynch-, Benjamin Graham-, James O'Shaughnessy-, and Kenneth Fisher-based models are all very high on the stock. To see why they like Bank so much, see the "Detailed Stock Analysis" section below.
Lincoln Electric Holdings, Inc. (LECO): This 114-year-old welding specialist makes a variety of industrial-type products, including arc welding tools, robotic welding systems, and plasma and oxyfuel cutting equipments. The Cleveland-based firm has a presence in more than 160 countries, more than 9,000 employees, and has taken in more than $2.5 billion in sales in the past year. It has a market cap of about $1.75 billion.
Lincoln gets approval from three of my Guru Strategies -- those I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher. For more on why, see the "Detailed Stock Analysis" section below.
Logitech International S.A. (LOGI): Now based in California, Logitech was founded in 1981 in Switzerland as a computer mouse specialist. It since has branched out into a number of different areas, and now makes all sorts of computer-related products, including mice, keyboards, webcams, video game controllers and accessories, PC headsets, and much more. Its products are distributed in more than 100 countries, and the firm has taken in more than $2.4 billion in sales in the past year. It's a smaller-sized mid-cap ($1.58 billion market cap).
Logitech scores very high on both my Peter Lynch- and Kenneth Fisher-based models. See the "Detailed Stock Analysis" section below to find out why these strategies like the stock.
News about Validea Hot List Stocks
The Dress Barn (DBRN): The women's clothing retailer announced a fiscal second-quarter loss this week, but reiterated its guidance for the full 2009 year and said same-store sales have been up in January and February, the Associated Press reported. That helped shares jump 11 percent Thursday.
Gildan Activewear (GIL): Gildan's shares fell more than 25 percent after the firm posted an 85 percent decline in quarterly profit last week. The decline came before the Hot List purchased the stock.
Jos. A. Bank Clothiers (JOSB): Investor's Business Daily reports that the retailer's discount-driven promotional strategy has "worked like a charm" recently, with sales growing by double digits the past three quarters amid a terrible retail climate.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will examine one of my Guru Strategies in greater depth. If you have any questions, please feel free to contact us at email@example.com.
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Fundamental data provided by Reuters