|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||January 20, 2012|
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.
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.
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).
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).
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).
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 email@example.com.
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.