|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||December 7, 2012|
The economy has been offering some mixed signals recently, as concerns among businesses about the "fiscal cliff" seem to be slowing growth, for the short term at least.
One example: After two months of expansion, the manufacturing sector contracted in November, though just barely, according to the Institute for Supply Management. The group's manufacturing index came in at 49.5, just short of the 50 mark that denotes the cutoff between expansion and contraction. The group's New Orders and Employment sub-indices also both fell. ISM's report said some survey respondents cited the "fiscal cliff" as a major factor right now, with some saying they are holding off on any expansion plans until the issue is resolved. ISM did say that the overall economy grew in November, for the 42nd straight month, however.
ISM's service sector index rose, meanwhile, indicating the sector expanded for the 35th straight month. The service sector New Orders sub-index also increased. The employment sub-index dropped rather significantly, though, perhaps another sign that employers are leery of the cliff and its repercussions.
The housing market continues to be a bright spot. Home prices rose 0.4% on average across 20 U.S. cities in September, according to the S&P/Case-Shiller Home Price Indices. It was the sixth straight month prices rose; prices in those 20 cities are now an average of 3.0% higher than they were a year ago.
The National Association of Realtors also said that pending home sales rose in October to their highest level in more than five years. They were up 5.2% from September, and are now 18.0% above their year-ago level. Sales of new single-family houses dipped just slightly, by 0.3%, in October, meanwhile, the Commerce Department said. They remain about 16% above year-ago levels, however, and average sales prices were up about 8% from a year ago.
Elsewhere, new government data showed consumers cut back somewhat in October. Real disposable income fell 0.1% in the month, the Commerce Department reported, while real personal consumption expenditures fell 0.3%, with purchases of motor vehicles and parts accounting for most of the dip. The personal savings rate edged up slightly, to 3.4% (from 3.3% in October), a good sign.
Interestingly, consumers are getting more confident, however. Confidence hit its highest level in more than four years in October, according to separate reports from The Conference Board and the University of Michigan. Though it remains below levels associated with a healthy economy, confidence has been rising as Americans have been getting more optimistic about the jobs market, The Conference Board found.
The Commerce Department also said that gross domestic product increased more than previously expected in the third quarter. It grew at 2.7%, the department said, up from the 2.0% figure cited in previous estimates.
Since our last newsletter, the S&P 500 returned 1.6%, while the Hot List returned 2.6%. So far in 2012, the portfolio has returned 15.4% vs. 12.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 160.9% vs. the S&P's 41.3% gain.
In our last newsletter, I looked at the broader market's valuation, using a variety of metrics to get a sense of where the overall U.S. market stands. I also looked at some of the Hot List portfolio's newest holdings, and discussed their very attractive valuations. This week, I wanted to piggyback on that and highlight a new study that shows why value is so important.
The study comes from The Brandes Institute, whose excellent research I've highlighted in previous newsletters, and is titled, "Value vs. Glamour: A Global Phenomenon". In it, Brandes updates past research on how value stocks (those with lower price/earnings, price/book, and/or price/cash flow ratios) have performed historically against "glamour stocks" (those with higher P/E, P/B, and/or P/CF ratios). The group looked not only at the U.S. market, but also at markets in the developed and emerging world. Their findings: "While the recent underperformance of value stocks is noteworthy, the long-term results confirm a historically persistent value premium measurable across global equity markets," the study states. "Generally, we identified a persistent value premium for the world's developed markets in aggregate and on an individual country basis, a value premium was evident or probable for the markets that offered enough robust data to provide reasonable conclusions." And, in emerging markets, the value premium was even greater than it was in non-U.S. developed countries.
Brandes said that what may have been the most significant finding was how consistent the value premium was "across valuation metrics, such as P/B, P/CF, P/E and sales growth; across time, which in this study applies to the 1968-2012 period for U.S. stocks, and the 1980-2012 period for non-U.S. stocks; across regions, as the results indicated a value premium in developed markets in North America, Europe and Asia; across market capitalizations, as the relative outperformance of value stocks to glamour stocks was evident among both large- and small-cap stock universes."
Value stocks didn't just produce better returns, the study found; they also have done so with lower volatility. For example, from 1980-2012, Brandes looked at rolling five-year returns in over 23 markets across the globe (including the U.S.). It found that the most expensive decile of stocks based on P/B ratio posted annualized returns of 7.76%, with a standard deviation of 19.16%. The cheapest decile posted average annualized returns of 14.22%, with a standard deviation of 17.05%. That's nearly twice the returns, with less volatility.
Of course, value will sometimes underperform, as it has in recent years. But it's rare -- very rare. In fact, from 1980-2012 (again using those rolling five-year returns), large-cap value stocks lost to large-cap glamour stocks just 6 times. And small-cap value stocks lost to small-cap glamour just four times.
Unfortunately some of those losing periods have come since the financial crisis and Great Recession hit. There are probably several reasons for this, not the least of which is the fact that those events left investors feeling pretty fearful and quite risk-averse -- and value stocks tend to come with short-term problems that lead fearful investors to shun them. But Brandes' research indicates that such periods don't last; eventually, the market recognizes the value in value stocks. And over the long term, value investors win out.
The value premium is what led great investors like Benjamin Graham, Warren Buffett, and Joel Greenblatt to key on unloved value plays. And it's why the Hot List portfolio usually has a significant value bias. Right now, for example, the average P/E ratio (using trailing 12-month earnings) of the portfolio's 10 holdings is just 10.8, far below the S&P 500 average. Seven of the ten have price/book ratios at or below the S&P average of 2.0, and seven of the ten have price/sales ratios at or below the S&P average of 1.3. Their price/cash flow average is a bit higher than the S&P average, but their average dividend yield (3.0%) is better than that of the index (2.3%), and their average P/E-to-Growth ratio is exceptional (0.49). And for those attractive valuations, you get a portfolio of companies that on average have generated a 27.4% return on equity and that (for the nine non-financials) average a very solid 2.1 current ratio. (Data as of Dec. 5; S&P averages from Morningstar.com.)
These are the kind of stocks that the Hot List focuses on. They are the kind of stocks that have generated strong returns over decades and decades, from the time that Graham essentially created value investing in the first half of the 20th century, to the current era when gurus like Buffett and Greenblatt have used the same value-focused philosophy to beat the market over the long haul. That value-focused philosophy works because investors are people, and people are emotional. And because of that they overreact to the upside when valuing popular "glamour" stocks, and they overreact to the downside when valuing unloved value stocks. These periods of overreaction can last a reasonably long time -- longer than many investors are comfortable with, to be certain. But decades of history show that over the long haul, those who stick with value win out. That's what we've seen with the Hot List in its nearly ten years of existence, and I expect the same will be true another ten years from now.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned 67.0%, more than twice what the S&P 500 has gained (33.4%; figures through November). That's 5.9% annualized, vs. just 3.3% for the S&P.
The portfolio has been a very strong performer over the last two years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. And in 2012, it's up more than 15%.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings. It's an interesting group, and some of the holdings might not seem like "Buffett-type" plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
The TJX Companies, Inc. (TJX)
Oracle Corporation (ORCL)
Monster Beverage Corp. (MNST)
World Acceptance Corp. (WRLD)
Coach, Inc. (COH)
Ross Stores, Inc. (ROST)
CNOOC Limited (CEO)
Hibbett Sports, Inc. (HIBB)
Fossil, Inc. (FOSL)
AstraZeneca PLC (AZN)
News about Validea Hot List Stocks
Vale SA (VALE): Vale reported that its capital expenditures likely peaked in 2011 and 2012. The mining firm cut its estimated capital spending for next year by 24%, and is rethinking expansion plans after the global slowdown and iron ore price declines, Reuters said. The firm's CEO said growth would likely be slow in 2013, but resume in 2014.
The TJX Companies (TJX): TJX's same-store sales rose 3% in November, according to the Associated Press. Fellow Hot List member Ross Stores' sales were up 2%, meanwhile. TJX shares rose slightly the day of the announcements, while Ross shares were about flat.
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 email@example.com.
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