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Executive Summary March 28, 2014

The Economy

As much of the country begins at long last to thaw from a frigid, unrelenting winter, the U.S. economy is showing signs that its winter doldrums were indeed largely weather-related.

Industrial production, for example, increased 0.6% in February even though utility output (which is largely weather-dependent) declined slightly, according to a new Federal Reserve report. The February gain more than wiped out the 0.2% decline we saw in January. Manufacturing output was up 0.8% for the month, snapping back strong from a very weak January in which it had declined 0.9%. Mining output rose 0.3%.

Good news has also come on the employment front. New claims for unemployment fell in each of the last two weeks, reaching their lowest level in several months. Compared to a year ago, new claims are down 13.4%. Continuing claims, the data for which lags new claims by a week, were also down in the most recent week. They are now about 7.6% below year-ago levels. The overall level of new claims is now in a range seen for much of the past couple economic expansions; the continuing claims number remains a bit high compared to those past expansions.

Retail sales, meanwhile, rose by 0.3% in February after having declined 0.6% in January, according to the Commerce Department. The February figure was, however, only 1.5% above the year-ago level, a fairly weak year-over-year increase.

The housing market hasn't been sizzling, but it seems to be stabilizing after an uninspiring stretch, as well. After a sharp decline in January, housing starts were just about flat in February, decreasing 0.2%, according to the Census Bureau. They are, however, 5.6% below where they were in February 2013. There may be good news ahead, though. Housing permit issuance increased 7.7% in February, the Census Bureau said. Permit issuance is 7.3% above its year-ago pace.

As for home sales new home sales declined 3.3% in February, according to another government report. Prices did rise slightly, rising on average 1.5%. New sales are down about 3% over the past year. Existing home sales, meanwhile, declined 0.4% in February, according to the National Association of Realtors. That put them about 7% below year-ago levels, though average prices did rise slightly and were significantly ahead of where they were last year. The Realtor group cited the winter weather is a significant reason for the decline in sales during the month.

Since our last newsletter, the S&P 500 returned 0.1%, while the Hot List returned -4.6%. So far in 2014, the portfolio has returned -12.5% vs. 0.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 218.5% vs. the S&P's 84.8% gain.

Portfolio Update

It's been a difficult fortnight for the Hot List. While the breakdown of holdings in the red and holdings in the black wasn't too bad -- four have gained since our last newsletter, while six have fallen -- the magnitude of some of the decliners has far exceeded the magnitude of the gainers. BofI (Bank of Internet) was the worst of the bunch, declining 23.6% (performance figures as of mid-day on March 27). The catalyst for the decline seemed to be a questionable one: Some commentators said that a single bearish article about the stock, which contended that BOFI was highly overvalued, set off a selling spree. Whether or not that was the case, my models continue to think that the stock merits its higher-than-average valuation (which of course is now much lower than it was) because of its exceptional growth and other strong fundamentals. Were the portfolio to be rebalanced as of this writing, BOFI would still be a member of the Hot List.

Another big decliner over the past two weeks has been Lannett Company. The biotech firm's shares were down 16.7%. The Lannett declines came amid a broader biotech selloff that may in part have been triggered by three Democrats on the House's Energy and Commerce Committee requesting a briefing with industry bellwether Gilead about the high price of a new Hepatitis C drug, Markets Emerging reported. Many "generalist" investors who'd been piling into biotech stocks amid strong recent performance may have taken profits because of fears about the Gilead inquiry. "We think the generalist money is sitting on a lot of profit and is 'getting spooked' because of 'government' starting to raise questions about drug pricing," RBC Bank surmised, according to Markets Emerging. RBC said the Gilead pricing concerns are "headline noise."

The third Hot List holding making a significant decline over the past two weeks was CaesarStone, which was down more than 9%. There did not appear to be a clear catalyst for the stock's tumble. As with BofI and Lannett Company, Caesarstone is a small-cap that had been quite hot prior to the recent declines. For all three, the bad couple weeks may have been a case of investors getting jittery on minor company-specific or macroeconomic news, and deciding to take profits given the big run ups each of these stocks has had. I believe that bodes well for these stocks in terms of potential bounce-back gains, as their fundamentals remain strong. In fact, I wouldn't be surprised if all three of these stocks rebound as other investors see the recent declines as a big buying opportunity.

It was not all bad news for the portfolio. Coach and USANA Health Sciences led the gainers, both rising over 2% since our last newsletter. With USANA, the stock rebounded sharply after fellow multilevel marketer NU Skin Enterprises Inc. received a far less serious penalty than many had expected from Chinese regulators, who had been investigating its business practices. Because they are all multi-level marketers, NU Skin, USANA, and Herbalife have moved on each other's news in recent months as investors have tried to see what impact, if any, regulatory decisions could have on their businesses.

While the past couple weeks were difficult for the Hot List, its holdings remain fundamentally strong and the portfolio remains well-positioned for the long term. We'll check in again on performance in our next newsletter two weeks from now.

Editor-in-Chief: John Reese

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Guru Spotlight: Peter Lynch

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".

If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.

Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.

But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.

The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.

To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.

The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.

One Size Doesn't Fit All

One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).

The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.

"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.

One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.

Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.

Beyond The PEG

The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)

The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.

A Market-Beater

Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. In 2013 it was a particularly strong performer, with my 10-stock Lynch-based portfolio gaining 68.6% to more than double the S&P 500. Overall since I started tracking it in July 2003, the portfolio has averaged annualized returns of 10.0%, easily beating the 6.0% annualized return for the S&P 500 (all performance figures are through March 25). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 15.4% annualized over that period.

Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:

Silicon Motion Technology Corporation (SIMO)
Cisco Systems, Inc. (CSCO)
Celestica Inc. (CLS)
Banco Macro SA (BMA)
NetApp, Inc. (NTAP)
USANA Health Sciences, Inc (USNA)
CNOOC Limited (CEO)
Ecopetrol SA (EC)
Smith & Wesson Holding Corporation (SWHC)

News about Validea Hot List Stocks

Lannett Company (LCI): Lannett shares tumbled recently, falling about 17% on March 21 and 24. There was no clear catalyst for the declines, though one factor may have been the company's Chief Operating Officer selling $727,910 in shares on March 17, a move reported by Ticker Report. Still, the COO still owns 217,856 shares of the company's stock, valued at approximately $9,552,986, so it's unlikely the sale was the main factor in the declines. Another possible reason for the declines may have been the news that three Democrats on the House's Energy and Commerce Committee requested a briefing with industry bellwether Gilead about the high price of a new Hepatitis C drug, which may have triggered industry-wide concerns about government intervention.

Drew Industries (DW): On March 17, Drew announced that its wholly-owned subsidiary, Lippert Components, Inc., had completed the previously announced acquisition of certain assets and the business of Star Design, LLC., an Elkhart, Indiana-based manufacturer of thermoformed sheet plastic products for the RV, bus and specialty vehicle industries. The deal was for $12.3 million, and company officials said they expect the move to be immediately accretive to Drew's earnings.

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

AGCO   |   NTES   |   PRXL   |   BOFI   |   CSTE   |   COH   |   DW   |   HY   |   USNA   |   LCI   |  

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

NetEase, Inc. is a holding company. The Company is an Internet technology company. The Company operates in three segments: Online Game Services, Advertising Services and E-mail, Wireless Value-added Services and Others. The Company provides its Internet and wireless value-added applications, services and technologies and advertising services to Guangzhou NetEase and Guangyitong Advertising and they operate the NetEase Websites and the online advertising business. Guangzhou NetEase has two majority-owned subsidiaries, Youdao Computer (a search business operator) and Wangyibao (the operator of its Wangyibao payment system). Through its subsidiaries and contracts with its affiliates Guangzhou NetEase, Guangyitong Advertising and Shanghai EaseNet and their respective shareholders, it operates an interactive online community in China and is a provider of Chinese language content and services through its online games, Internet portal and wireless value-added services businesses.

PAREXEL International Corporation (PAREXEL) is a biopharmaceutical services company, providing a range of expertise in clinical research, medical communications, consulting, and advanced technology products and services to the worldwide pharmaceutical, biotechnology, and medical device industries. It operates it three segments: Clinical Research Services (CRS), PAREXEL Consulting and Medical Communications Services (PCMS) and Perceptive Informatics, Inc. (Perceptive). The Company's product and service offerings include clinical trials management, observational studies and patient/disease registries, data management, biostatistical analysis, epidemiology, health economics / outcomes research, pharmacovigilance, medical communications, clinical pharmacology, patient recruitment, post-marketing surveillance. In May 2013, PAREXEL International Corp acquired the entire share capital of HERON Group Ltd.

BofI Holding, Inc. is a holding company for BofI Federal Bank, a diversified financial services company. The Bank operate its bank from a single location in San Diego, California, serving approximately 40,000 retail deposit and loan customers across all 50 states. As of June 30, 2012, it had total assets of $2,386.8 million, loans of $1,799.7 million, mortgage-backed and other investment securities of $483.0 million, total deposits of $1,615.1 million and borrowings of $547.2 million. It distributes its deposit products through a range of retail distributions channels, and its deposits consist of demand, savings and time deposits accounts. It distributes its loan products through its retail, correspondent and wholesale channels, and the loans it retains are primarily first mortgages secured by single family real property and by multifamily real property.

Caesarstone Sdot-Yam Ltd. (Caesarstone) through its subsidiaries is engaged in the manufacturing of engineered quartz surfaces sold under its premium Caesarstone brand. Caesarstone's products consist of engineered quartz slabs, which are sold in 42 countries. The Company's products are primarily used as kitchen countertops in the renovation and remodeling end markets. Other applications include vanity tops, wall panels, back splashes, floor tiles, stairs and other interior surfaces that are used in a range of residential and non-residential applications. Through its design and manufacturing processes it offers a range of colors, styles, designs and textures. Its four diverse collections include Classico, Supremo, Motivo and Concetto. Kibbutz Sdot-Yam owns 70.1% of the Company's outstanding shares. On May 18, 2011, it acquired 75% of the shares of U.S. Quartz Products, Inc. During the year ended December 31, 2011, it acquired its former United States distributor, Caesarstone USA.

Coach, Inc. (Coach) is a marketer of accessories and gifts for women and men. The Company offers a range of modern, fashionable handbags and accessories. Its product offerings include women's and men's bags, accessories, footwear, wearables, jewelry, travel bags, sunwear, watches and fragrance. The Company operates in two segments: North America, which includes sales to North American consumers through Company-operated stores, including the Internet, and sales to wholesale customers and distributors and International, which includes sales to consumers through Company-operated stores in Japan and mainland China, including the Internet, Hong Kong, Macau, Singapore, Taiwan, Malaysia and Korea and sales to wholesale customers and distributors in 25 countries.

Drew Industries, is a supplier of components for recreational vehicle (RVs) and manufactured housing. The Company operates in two segments: the RV products segment (RV Segment), and the manufactured housing products segment (MH Segment). The Company's operations are conducted through its wholly owned subsidiaries, Lippert Components, Inc. and its subsidiaries (Lippert) and Kinro, Inc. and its subsidiaries (Kinro), each of which has operations in both the RV Segment and the MH Segment. During the year ended December 31, 2012, the RV Segment accounted for 87% of net sales and the MH segment accounted for 13% of net sales. In February 2014, the Company's wholly-owned subsidiary, Lippert Components, Inc has acquired Innovative Design Solutions, Inc. (IDS). In March 2014, the Company's subsidiary Lippert Components, Inc, completed the acquisition of certain assets and the business of Star Design, LLC.

Hyster-Yale Materials Handling, Inc. (Hyster-Yale), formerly NMHG Holding Co., , designs, engineers, manufactures, sells and services a line of lift trucks and aftermarket parts. The Company's products are marketed globally under the Hyster and Yale brand names. The Company segments include three management units: Americas, Europe and Asia-Pacific. Americas includes its operations in the United States, Canada, Mexico, Brazil and Latin America. Europe includes its operations in Europe, the Middle East and Africa. Asia-Pacific includes its operations in the Asia-Pacific region and China. Lift trucks and component parts are manufactured in the United States, Northern Ireland, Mexico, The Netherlands, the Philippines, Italy, Japan, Vietnam, Brazil and China. Hyster-Yale has a 20% ownership interest in Hyster-Yale Financial Services, Inc. (NFS). Hyster-Yale is a wholly owned subsidiary of NACCO Industries, Inc. (NACCO).

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

Lannett Company, Inc. is engaged in developing, manufacturing, marketing and distributing generic versions of branded pharmaceutical products. All of the Company's products manufactured and/or sold are prescription products. The Company's products containing Levo are produced and marketed with 12 varying potencies. In addition to generic Levo tablets, the Company also markets and distributes Unithroid tablets, a branded version of Levo, which is produced and marketed with 11 varying potencies. The Company's Levo tablets are used to treat hypothyroidism and other thyroid disorders. The Company's generic Levo tablets and Unithroid tablets are manufactured by Jerome Stevens Pharmaceuticals (JSP). As of June 30, 2012, the Company manufactured and/or distributed 30 products.

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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