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Executive Summary September 12, 2014

The Economy

A bit of a disappointing August jobs report was offset by strong data from the manufacturing and service sectors since our last newsletter, and all in all the US economy seems like it's continuing to gain steam.

The Labor Department said the private sector added 134,000 jobs in November, the lowest tally in a while. It also revised its June and July jobs-added figures to indicate a total of 28,000 fewer jobs were added in those months than previously thought. The unemployment rate declined, however, to 6.1%, in part because 268,000 people left the workforce. But the "U-6" rate, which unlike the headline rate also includes those working part-time who want full-time work and discouraged workers who have given up looking for a job, also fell. It's now at 12.0%, 0.2 percentage points lower than it was in July and 1.6 percentage points lower than it was last year at this time.

New claims for unemployment rose slightly in each of the past two weeks. They still remain at pretty good levels, though in the most recent week they were actually higher than they were in the year ago period for the first time in quite some time. Continuing claims, the data for which lag new claims by a week, are 12% below year ago levels, however.

The so-so jobs data was balanced by strong reports from the Institute for Supply Management. ISM said manufacturing activity increased in August for the 15th straight month, and did so at the fastest pace since March 2011. The group's manufacturing sub-index for new orders also jumped, and the employment sub-index stayed at a very healthy level.

ISM also said the service sector expanded in August for the 56th straight month, doing so at the fastest pace since the group started tracking it at the beginning of 2008. The new orders and employment sub-indices both remained at very strong levels, while the prices sub-index fell significantly, a good sign given how elevated it has been.

New consumer data from the Commerce Department, meanwhile, showed that personal income rose 0.2% in July. Real disposable personal income was up 0.1%, while real personal consumption expenditures fell 0.2% as consumers cut back a bit. That helped boost the personal savings rate to a very healthy 5.7%, however, up from 5.4% the previous month.

Since our last newsletter, the S&P 500 returned 0.0%, while the Hot List returned -0.0%. So far in 2014, the portfolio has returned -10.1% vs. 8.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 227.3% vs. the S&P's 99.7% gain.

Portfolio Update

It's been a pretty mixed fortnight for the Hot List's holdings, with six of the ten in the black as of this writing (mid-afternoon on September 11).

Leading the way has been firearms maker Sturm Ruger, which increased nearly 5% since our last newsletter. Ruger was added to the portfolio during our last rebalancing, which occurred just after its shares had been hit amid some industry concerns. Those involved fellow firearms maker Smith & Wesson announcing disappointing results and saying that high inventories of modern sporting rifles industry-wide were leading it to cut its second-quarter outlook. An analyst soon downgraded Ruger, citing inventory issues. But as so often happens, investors seem to have overreacted to the bad news, and the Hot List nabbed the stock at a good time.

Another strong performer for the fortnight was Monster Beverage, which gained 3.3%. Monster's gains may have been the case of continuing momentum after the mid-August announcement that Coca-Cola had taken a minority position in the company, which had sent shares skyrocketing.

On the downside, Valero Energy fell 6% since our last newsletter. One big factor seems to be the Energy Information Administration reporting that gasoline stockpiles rose by 2.4 million barrels last week.

Amtrust Financial also had a rough couple weeks, losing 4.3%. There was no clear catalyst for the decline, though the firm did announce that it priced on September 9 an $80 million underwritten public offering of 3.2 million of its depositary shares, each representing a small interest in a share of its preferred stock. The stock tends to be a good deal more volatile than the broader market, so the decline was likely a case of some short-term meaningless gyrations. Amtrust still gets very good scores from my Guru Strategies, however. In two weeks we will rebalance, at which point we'll see if Amtrust and the Hot List's other current holdings have what it takes to remain in the portfolio.
 
Editor-in-Chief: John Reese










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Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.

Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past five years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 57.8%; the Greenblatt-based portfolio has gained 144.1% -- that's 10.7% annualized, vs. 5.3% annualized for the S&P (all performance data through Sept. 10). The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009, vs. 23.5% for the S&P. After beating the market again in 2010, it struggled in 2011 and 2012, however. Those ups and downs are proof of what Greenblatt stresses: that the strategy won't beat the market every month or even every year, which is important to remember. In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisciplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains they leave behind.

Indeed, in 2013, the Greenblatt-based portfolio bounced back strong, returning more than 50%. This year it's up 12.8%. Below is a look at its current holdings.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.

EBIX Inc. (EBIX)
Nu Skin Enterprises, Inc. (NUS)
Sturm Ruger & Co Inc. (RGR)
CTC Media, Inc. (CTCM)
Performant Financial Corporation (PFMT)
Time, Inc. (TIME)
GameStop Corp. (GME)
AOL Inc. (AOL)
Smith & Wesson Holding Corporation (SWHC)
Sanderson Farms, Inc. (SAFM)




News about Validea Hot List Stocks

Valero Energy (VLO): Valero shares fell close to 7% from Sept. 8-11 amid some negative industry news. Tuesday the Energy Information Administration (EIA) gave its updated demand growth report and Wednesday OPEC gave its report on the oil market, both projecting lower demand growth this year and next, 24/7 Wall Street reported. EIA on Wednesday also issued its weekly report on petroleum inventories, which said that gasoline stockpiles rose by 2.4 million barrels last week. Valero is still getting very high scores from my Guru Strategies, however.



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   |   VLO   |   AFSI   |   PJC   |   LQDT   |   ANIK   |   RGR   |   FL   |   BBBY   |   MNST   |  



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.





Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.





Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four business segments: small commercial business, specialty program and personal lines reinsurance. The Company transacts business through 11 insurance company subsidiaries: Technology Insurance Company, Inc. (TIC), Rochdale Insurance Company (RIC), Wesco Insurance Company (WIC), Associated Industries Insurance Company, Inc. (AIIC), Milwaukee Casualty Insurance Company (MCIC), Security National Insurance Company (SNIC), AmTrust Insurance Company of Kansas, Inc. (AICK) and AmTrust Lloyd's Insurance Company of Texas (ALIC). In December 2013, the Company announced that it its wholly owned subsidiary completed the acquisition of Sagicor Europe Limited. In January 2014, the Company acquired Insco Dico Group.





Piper Jaffray Companies is an investment bank and asset management firm, serving the needs of corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The Company operates in two segments: Capital Markets and Asset Management. The Capital Markets segment provides investment banking and institutional sales, trading and research services for various equity and fixed income products. The Asset Management segment includes traditional asset management activities and related services. The Company markets the investment banking and institutional securities business under Piper Jaffray name. Its asset management business is marketed under Advisory Research, Inc. In July 2013, Piper Jaffray Companies announced that it has completed its purchase of Seattle-Northwest Securities Corporation. In July 2013, the Company announced that it has completed its purchase of Edgeview Partners L.P.





Liquidity Services, Inc. is an auction marketplace for surplus and salvage assets. The Company enables buyers and sellers to transact in an automated online auction environment offering over 500 product categories. The Company's marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with digital images and other relevant product information. It organizes its products into categories across industry verticals, such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware and specialty equipment. It's online auction marketplaces are www.liquidation.com, www.govliquidation.com, www.govdeals.com and www.liquibiz.com. It also operates a wholesale industry portal www.goWholesale.com. In July 2012, the Company acquired GoIndustry-DoveBid plc. In November 2012, the Company acquired National Electronics Service Association.





Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.





Sturm Ruger & Co Inc, formerly Sturm, Ruger & Company, Inc., is engaged in the design, manufacture, and sale of firearms to domestic customers. The Company operates in two segments: firearms and investment castings. The firearms segment manufactures and sells rifles, pistols, revolvers, and shotguns principally to a select number of licensed independent wholesale distributors primarily located in the United States. The investment castings segment manufactures and sells steel investment castings. The Company offers products in four industry product categories, which include rifles, shotguns, pistols, and revolvers. The Company's firearms are sold through independent wholesale distributors, principally to the commercial sporting market. The Company's customers include Jerry's/Ellett Brothers, Davidson's, Sports South and Lipsey's.





Foot Locker, Inc. is a global retailer of shoes and apparel, operating 3,473 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand as of February 1, 2014. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailers whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction, SIX:02, as well as the retail stores of Runners Point Group, including Runners Point, Sidestep and Run2. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., CCS, and Tredex, which sells to customers through Internet Websites, mobile devices, and catalogs.





Bed Bath & Beyond Inc. is a chain of retail stores, operating under the names Bed Bath & Beyond (BBB), Christmas Tree Shops (CTS), Harmon and Harmon Face Values (Harmon), buybuy BABY and World Market or Cost Plus World Market (World Market). In addition, it is a partner in a joint venture, which operates three stores in the Mexico City market under the name Bed Bath & Beyond. The Company sells a range of domestics merchandise and home furnishings. Domestics merchandise includes categories, such as bed linens and related items, bath items and kitchen textiles. Home furnishings include categories, such as kitchen and tabletop items, fine tabletop, basic housewares and general home. During fiscal year ended March 2, 2013 (fiscal 2012), the Company opened a total of 38 stores, including 12 BBB stores throughout the United States and Canada, five CTS stores, one Harmon store and 18 buybuy BABY stores, and six World Market stores throughout the United States and closed one BBB store.





Monster Beverage Corporation is a holding company. The Company develops, markets, sells and distributes alternative beverage, such as non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, single-serve juices and fruit beverages, ready-to-drink dairy and coffee drinks, energy drinks, sports drinks, and single-serve still water (flavored and unflavored) with beverages, including sodas that are considered natural, sparkling juices and flavored sparkling beverages. It has two reportable segments, namely Direct Store Delivery (DSD), whose principal products comprise energy drinks, and Warehouse (Warehouse), whose principal products comprise juice-based and soda beverages. The DSD segment develops, markets and sells products primarily through an exclusive distributor network. The Warehouse segment develops, markets and sells products directly to retailers.





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.





Disclaimer


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.