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Executive Summary January 20, 2012

The Economy

So far in 2012, the economic story is playing out much in the same way it did for most of the second half of 2011 -- with improving U.S. economic data slugging it out with European debt crisis fears for control of the markets. And, this week, the U.S. economy landed some solid body blows.

The biggest shot came in the new unemployment claims data. New claims tumbled more than 12%, reaching their lowest point since April 2008. Continuing claims dropped about 6%, falling to levels not seen since before Lehman Brothers' collapse triggered the financial crisis in 2008. Following on the heels of four straight months in which the unemployment rate has dropped -- falling from 9.1% in August to 8.5% in December -- that's very good news.

Improving employment has a multitude of positive effects on the economy. Of course, it means money and stability for more Americans, which should let them spend more, which leads to a cycle of increasing demand and increased hiring. Another key issue is that it can help a good deal with national deficit problems. Deficit problems get exacerbated during tough times -- tax revenues decline because many people's incomes decline (or they just can't pay their tax bills), and expenses increase because more people receive unemployment benefits, food stamps, and other government-sponsored benefits. It's not surprising then that as the employment picture has improved over the past several months, so too has the U.S.'s deficit situation. In the first three months of fiscal 2012 (October, November, and December), revenues were up 4.3% while spending is down 3.3% (vs. the year-ago months); all in all, the deficit for the first quarter was 13% lower than it was for the same period in 2011, according to Yahoo! Finance's Daniel Gross. Growth alone won't get the U.S. out of its enormous deficit, but it certainly is helping -- a lot more than our political leaders seem to be.

Retail sales, meanwhile, continued to climb, but a significantly slower pace than they had in past months. According to the Commerce Department, retail and food service sales increased 0.1% in December, the 7th straight month that they have increased. Sales for the full 2011 year were 7.7% higher than they were in 2010, showing that the US consumer is not as tapped out as many have claimed.

As for the housing market, after some impressive gains a month ago, housing starts dipped 4.1% in December, according to new data from the Commerce Department. Building permit issuance for privately owned homes was just about flat. Still, the bigger picture shows that things are much better than they were a year ago, with housing starts nearly 25% higher than their year ago levels and building permit issuance nearly 8% above year ago levels.

Companies have also begun reporting fourth-quarter earnings, with solid results. Some of the big financial firms, like Bank of America and Morgan Stanley, have surprised on the upside, a great sign. And, while Google disappointed, some other big tech bellwethers like Microsoft and Intel have beaten expectations.

Of course, Europe continues to weigh on investors minds. The debt crisis there is ever so slowly working its way towards resolution, and certainly needs to be monitored going forward.

All in all, the positive economic news at home has overshadowed the Europe fears for much of the past fortnight. Since our last newsletter, the S&P 500 returned 2.6%, while the Hot List returned 6.7%. So far in 2012, the portfolio has returned 8.1% vs. 4.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 144.4% vs. the S&P's 31.4% gain.

The Contrarian Case

Over the past decade-and-a-half, some very powerful emotions have been at work in the stock market. In the late 1990s, the rise of the Internet sent stocks -- particularly tech stocks -- soaring, and many investors were swept up in the euphoria. But the bursting of that bubble in 2000 turned visions of endless profits into the reality of devastated portfolios. Then the real estate bubble began to inflate, and buyers across the country were consumed with visions of homeownership, and/or quick, easy profits. But, of course, those dreams turned to nightmares when the housing bubble burst. Panic set in in the fall of 2008, with unemployment spiking, lending seizing up, and the "D"-word -- Depression -- swirling.

Those scars still haunt many investors today, more than three years later. As the European debt crisis and America's own inability to deal with its deficit flared up in the second half of last year, markets swung wildly; every negative story, it seemed, confirmed that we were headed for another crisis, while every positive story seemed to generate huge sighs of relief. Some companies saw their market values rise or fall 10% or 15% from day to day during the height of the volatility -- without having announced any changes to earnings or revenues or debt.

How can emotions shift so suddenly, and what can investors do in the face of such swings? Those are among several of the key questions that noted contrarian investor David Dreman tackles in his new book, Contrarian Investment Strategies: The Psychological Edge. As you probably know, Dreman's work forms the basis of one of my better-performing Guru Strategies. He's been a pioneer in the field of behavioral finance, and in the past I've touched on many of his key points and findings. His new work includes a number of very interesting, and very relevant, pieces of data and research, many of which I'm sure I'll be sharing with you in the coming weeks in one form or another. For this newsletter, I'd like to focus on two key issues Dreman addresses: the notion of "Affect" and its impact on investors, and the performance of contrarian strategies over the past tumultuous decade.

Let's start with "Affect". Dreman writes that psychologists have begun to recognize and understand the critical role Affect plays in people's decision-making, whether in the financial world or otherwise. It essentially is the way that our minds tag representations of objects or events with positive or negative feelings. "A rabid sports fan, for example, will have positive representations for a favored sports team and negative ones for an archrival team," Dreman writes.

That may seem obvious. But what's important is how Affect works within the "dual-process" dynamic our minds use to make decisions. One part of that process is the "rational-analytic system", which is deliberative and analytical and evidence-based, Dreman notes. The other part of the process is where Affect comes into play -- the "experiential system", which draws on "information derived from experience and emotional recall and encodes reality into images, metaphors, and narratives to which affective feelings have been attached," Dreman writes.

And here's a crucial point: The emotion-based experiential system functions much faster than the rational-analytic system -- though it often is a far worse investment decision-maker than its rational counterpart. "Although analysis is critical to many decision-making circumstances, reliance on Affect and emotions is a quicker, easier, and more efficient way to navigate in a complex, uncertain, and sometimes dangerous world," says Dreman. "In periods of great anxiety and uncertainty, it is quite natural for the experiential system, often dominated by Affect, to take over." That's just what happened in late 2008, and it's what happened last summer when the debt ceiling debacle and European debt crisis dominated the headlines. During such times, fundamentals and facts fall by the wayside; emotions take over. Often, Affect leads investors to abandon their strategies and simply follow the herd, which can have disastrous results. Dreman says it's critical not to let emotion and Affect overtake your investment decisions in those periods. "Do not abandon the prices projected by careful security analysis," he writes, "even if they are temporarily far removed from market prices. Over time the market prices will regress to levels similar to those originally projected."

Before you can combat the impact Affect has on your decision-making processes, of course, you first have to be able to recognize it. It comes in four key forms, Dreman says. They are:

Insensitivity to probability: Dreman cites several studies showing that once people attach a positive Affect to something, they don't care how expensive it is -- they become convinced it will only continue to gain in value. One study, for example, "demonstrated that if the potential outcome of a gamble is emotionally powerful, its attractiveness (or unattractiveness) is relatively insensitive to changes in probability as great as from .99 to .01, or 100 fold," he says, adding that the way tech stocks became overvalued during the Internet bubble is a perfect example.

Judgments of risk and benefit are negatively correlated: Studies also show that people tend to let their personal feelings about the nature of an activity or technology color their judgments of the risk and benefits involved. When we view something as "good", i.e., with positive Affect, we tend to think it entails less risk. When we view something as "bad", i.e., with negative Affect, we tend to think it involves more risk -- regardless of the facts and data. So, for example, when the tech stock bubble formed, the positive emotional response people had when they thought of tech stocks actually caused their brain to underestimate the amount of risk associated with those stocks, which was of course quite substantial.

The Durability Bias: Investors overestimate how long a positive or negative event will impact a company, its stock, its industry, or the market itself, Dreman says. "To take one example, oil exploration and development companies plummeted sharply in the spring of 2010, after the BP rig blew up and a major oil spill ensued in the Gulf of Mexico," he notes. Many assumed these firms would struggle for a lengthy period. But deepwater drilling resumed again within a year and many offshore drilling companies' stocks rebounded strongly.

Temporal Construal: Studies also show that when people look at a company's short-term prospects, they are more detail- and fact-oriented. But when the look at the longer term, they let vague feelings drive their decisions. This, for example, pertains to the plight of Yahoo investors during the tech bubble, Dreman says. They somewhat ignored weak short-term earnings results, instead focusing on the broader idea that the company had incredible, if not unlimited, potential to grow over the longer term. By continuing to focus on these vague beliefs rather than short-term facts and data, many investors continued to pour money into the stock even after there were plenty of signs that it was far overvalued.

Portfolio Applications

The notion of Affect and the latest research into the concept supports something that Dreman has said for years: that investors allow emotions to make them overvalue stocks that are considered "good" -- those flashy stocks with exciting growth stories behind them -- and undervalue stocks that are considered bad -- those that are getting bad press because of short-term problems, industry concerns, or some other factor. Because of that, buying unloved stocks -- those trading at low prices compared to their book value, earnings, cash flow, or dividend payout -- has been a very profitable strategy over many decades. Investors overreact in the short term, pushing the prices of these stocks down too low; then, once rationality returns to the market, those stocks tend to bounce back strongly.

I've noted in many other newsletters how Dreman's research has shown that investing in these low price-to-book, price-to-cash flow, price-to-earnings, and price-to-dividend stocks has generated exceptional returns going back several decades. But that research was published in 1998, before the bursting of the tech bubble, the succeeding bull market, and the financial crisis and recovery of the past few years.

So, how have those strategies fared more recently? Dreman's new work examines that question. And while emotions have ruled several short-term periods in the past decade or so, the data shows that investors who stuck with a disciplined, value-based approach fared far better than most. From 2000 through 2010, here's how the cheapest quintile of stocks based on those four valuation metrics fared in terms of annualized returns:

Low P/E stocks: 11.7%
Low price/dividend stocks: 11.5%
Low price/cash flow stocks: 9.8%
Low price/book value stocks: 8.7%
Market Average: 5.6%

And here's how the most expensive quintile of stocks based on those metrics fared:

Market Average: 5.6%
High price/dividend stocks: 2.4%
High price/earnings stocks: 0.0%
High price/cash flow stocks: -2.9%
High price/book value stocks: -3.0%

Even in a turbulent period marked by the bursting of two major asset bubbles, investing in contrarian stocks produced solid returns while the broader market struggled. My Dreman-inspired 10-stock portfolio has also done much better than the broader market. Since its mid-2003 inception, the portfolio has averaged annualized returns of 7.2%, more than doubling the 3.2% annualized returns of the S&P 500.

The success of contrarian-type stocks, both over the past decade or so and over the longer term, shows that it's essential to keep emotions at bay, and focus on the facts and figures. That's a concept that is at the core of Dreman's research, and I believe it's at the core of any good investment strategy.
Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Petroleo Brasileiro Sa (Adr) (PBR), Big Lots, Inc. (BIG) and Devry Inc. (DV).

The Keepers

7 stocks remain in the portfolio. They are: Forest Laboratories, Inc. (FRX), Cash America International, Inc. (CSH), Jos. A. Bank Clothiers, Inc. (JOSB), Aeropostale, Inc. (ARO), Ternium S.a. (Adr) (TX), Capella Education Company (CPLA) and Bridgepoint Education, Inc. (BPI).

The Newbies

We are adding 3 stocks to the portfolio. These include: Tech Data Corp (TECD), Telecom Argentina S.a. (Adr) (TEO) and Altisource Portfolio Solutions S.a. (ASPS).

Portfolio Changes

Newcomers to the Validea Hot List

Tech Data Corporation (TECD): With more than $26 billion in sales over the past year, this Florida-based firm is one of the largest wholesale I/T distributors in the world. It has a market cap of about $2.1 billion. Tech Data gets strong interest from two of my models, my Peter Lynch-based strategy and my James O'Shaughnessy-inspired approach. See the "Detailed Stock Analysis" section below for more details on the stock.

Altisource Portfolio Solutions S.A. (ASPS): This Luxembourg-based company provides real estate mortgage portfolio management and related technology products, as well as asset recovery and customer relationship management services. It serves government agencies, lenders, servicers, investors, mortgage bankers, credit unions, financial services companies and hedge funds across the U.S. It has a $1.2 billion market cap, and has increased earnings per share in each of the past five years. The stock gets strong interest from my Martin Zweig-based strategy. To read more about it, see the "Detailed Stock Analysis" section below.

Telecom Argentina S.A. (TEO): This telecom firm has extensive operations in Argentina, offering local, long distance, cellular, data, Internet, and other services, and also offers cellular services in Paraguay. It is majority-owned by Nortel SA.

TEO ($2.2 billion market cap) gets strong interest from my Peter Lynch- and Kenneth Fisher-based models. To read more about the stock, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Cash America International, Inc. (CSH): Cash America warned that fourth-quarter earnings will fall short of most analysts' estimates, MarketWatch reported on Jan. 18. The firm is expecting a profit of about $4.25 a share for 2011, which would be a 16% increase over 2010 but below its previous forecast of $4.28 to $4.48 a share. Shares fell about 6% on Wednesday but were rebounding on Thursday.

Forest Laboratories Inc. (FRX): Forest reported fiscal third-quarter earnings of $278.4 million, or $1.04 per share, down from $320.7 million, or $1.11 per share, in the year-ago quarter, the Associated Press reported. Total revenue rose 8% to $1.21 billion for the quarter ending Dec. 31. The figures beat analysts' expectations of $1.01 earnings per share on $1.18 billion in revenue, according to AP. Forest also raised its earnings guidance by five cents per share for the fiscal year (ending March 31). Shares responded positively, and since our last newsletter were up about 6% as of Thursday afternoon.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. 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

BPI   |   FRX   |   ARO   |   TEO   |   TX   |   CPLA   |   TECD   |   ASPS   |   JOSB   |   CSH   |  

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

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.

Aeropostale, Inc. is a mall-based, specialty retailer of casual apparel and accessories, principally targeting 14 to 17 year-old young women and men through its Aeropostale stores and 7 to 12 year-old kids through its P.S. from Aeropostale stores. The Company designs, sources, markets and sells all of its own merchandise. P.S. from Aeropostale products can be purchased in P.S. from Aeropostale stores, in certain Aeropostale stores, including its new Times Square store in New York City and online at www.ps4u.com. As of January 29, 2011, it operated 965 Aeropostale stores, consisting of 906 stores in 49 states and Puerto Rico, 59 stores in Canada, as well as 47 P.S. from Aeropostale stores in 13 states. In addition, pursuant to a Licensing Agreement, one of its international licensees operated 10 Aeropostale stores in the United Arab Emirates as of January 29, 2011. During March 2011, it announced that it had signed a second licensing agreement.

Telecom Argentina SA (Telecom) is an Argentina-based company primarily engaged in the provision of national fixed-line telecommunication services, international long-distance service, data transmission and Internet services and mobile telephony. The Company also offers such solutions as online business and Web hosting, virtual private network (VPN), mobile operating systems developed by Microsoft and Blackberry, toll-free telephone numbers, call centers and voice over Internet protocol (VoIP) line, as well as other services mainly aimed at corporate clients. The Company's subsidiaries are structured in two business segments: Fixed Telephony, comprising Telecom Argentina USA Inc and Micro Sistemas Sociedad Anonima, and Mobile Services, including Telecom Personal SA, Nucleo SA and Springville SA. As of December 31, 2010, the Company's majority shareholder was Nortel SA, 54.74% of its interest.

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

Tech Data Corporation (Tech Data) is a distributor of technology products. The Company serves approximately 125,000 value-added resellers (VARs), direct marketers, retailers and corporate resellers in more than 100 countries throughout North America, Latin America and Europe. In February 2011, the Company announced that it had created two new business divisions: HP Solutions Division And Networking Solutions Group. On October 1, 2010, the Company completed the acquisition of Triade Holding B.V. (Triade). On October 1, 2010, Brightstar Europe Limited (BEL), a consolidated joint venture between the Company and Brightstar Corporation, acquired Mobile Communication Company B.V. and Mobile Communications Company Belgium N.V. In October 2011, Mensch und Maschine Software SE sold its complete distribution business to the Company.

Altisource Portfolio Solutions S.A. (Altisource) together with its subsidiaries, is a provider of services focused on high value, knowledge-based functions principally related to real estate and mortgage portfolio management, asset recovery and customer relationship management. The Company utilizing integrated technology that includes decision models and behavioral-based scripting engines. The Company has three segments: Mortgage Services consists of mortgage management services that span the mortgage lifecycle; Financial Services principally consists of unsecured asset recovery and customer relationship management, and Technology Services consists of modular, integrated technological solutions for loan servicing, vendor management and invoice presentment and payment, as well as providing infrastructure support. In February 2010, Altisource acquired the interests of The Mortgage Partnership of America, L.L.C. (MPA).

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. It sells substantially all of its products exclusively under the Jos. A. Bank label through its 506 retail stores (as of January 29, 2011, which includes 12 outlet and factory stores and 14 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. It sources substantially all of its merchandise from suppliers and manufacturers or through buying agents using Jos. A. Bank designs and specifications. The Company operates in two segments: Stores and Direct Marketing. The Stores segment consists of all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment consists of its Internet and catalog operations.

Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. These services include secured non-recourse loans, commonly referred to as pawn loans and unsecured consumer loans. The Company's consumer loan portfolio includes short-term single payment loans, longer-term multi-payment installment loans, credit services and participation interests purchased from third parties in the micro line of credit (MLOC) services channel. Through the Credit Services Organization program (the CSO program), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization on behalf of consumers. As of December 31, 2010, it operated in two segments: retail services and e-commerce. During the year ended December 31, 2010, the Company renamed its Internet Services Division as the E-Commerce Division.

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.


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