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Executive Summary January 18, 2013

The Economy

With fiscal cliff fears behind us, a new fear is now worrying investors: a potential debt ceiling imbroglio. But, just as it did amid the fiscal cliff fears, the economy continues to improve despite the worries.

Case in point: Housing starts jumped 12.1% in December, putting them 44% above their year-ago level, according to a new government report. Permit issuance for new homes, meanwhile, rose slightly, gaining 0.3% for the month. They are now 24% above year-ago levels. (Here and below, all month-over-month or week-over week figures are seasonally adjusted; year-over-year numbers are not.)

The December jobs report was also pretty good. It showed that the private sector added 168,000 jobs during the month. That brought the total number of private sector jobs added in 2012 to about 2 million, or 160,000 or so a month. That's not tremendous job growth by any means, but it's a continuation of the slow and steady improvement we've seen over the past couple years. The unemployment rate ended 2012 at 7.8%, 0.7 percentage points below where it ended 2011. The so-called "U-6" rate, which unlike the headline figure includes part-time workers who want a full-time job and those who have given up looking for work, was unchanged in December at a still-high 14.4%. It dipped nearly a full percentage point in 2012 however, another sign that things are going in the right direction.

Industrial production, meanwhile, increased 0.3% in December, according to a new Federal Reserve report. The gains came despite a 4.8% drop in utility output, which was due to unseasonably warm weather. Manufacturing output increased 0.8%, while mining output rose 0.6%. Production of business equipment was particularly strong for the second straight month, increasing 1.3%.

Good news also came from the service sector, which expanded for the 36th straight month, according to the Institute for Supply Management. And it did so at an accelerating pace: ISM's service sector index in December notched its highest reading since February, and its employment and new orders sub-indices also both were at their highest levels in several months.

The Federal Reserve also recently released the latest data on Americans' Debt Service Ratio (which looks at debt obligations as a percentage of disposable personal income), and the news was quite good. For the third quarter, the DSR came in at 10.61% -- the lowest it has been since the fourth quarter of 1983. When the Great Recession hit in late 2007, the figure was all the way up over 14%.

Consumers, who saw a big rise in personal income in November, increased their spending at a healthy level in December. Retail and food service sales were up 0.5% for the month. However, the year-over-year non-seasonally-adjusted gain was just 2.5%, less than half of what it had been in the previous two months.

Since our last newsletter, the S&P 500 returned 1.5%, while the Hot List returned 3.2%. So far in 2013, the portfolio has returned 6.5% vs. 3.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 188.8% vs. the S&P's 48.0% gain.

Fear Factor

The 2013 year has started off with a bang for investors, with the S&P 500 already up about 4% (through yesterday). In many cases, a 4% gain over two weeks would be a sign that investors are feeling pretty good about things. Not so with this 4% gain, however. Clouds continue to hover over the investment world -- some fear that the U.S. debt ceiling battle won't be resolved, causing America to default on its debt for the first time ever; some say earnings estimates are still too high, and that growth is going to grind to a halt at some point this year; and some fear that turmoil in the Middle East will jolt markets sometime soon.

Those issues are all legitimate and must be dealt with. But, frankly, from an investment perspective, their presence is probably a bullish factor. All you have to do is look at the past few years to understand why. Since 2008, the financial world has jumped from fears of a global economic and financial system collapse, to fears of Middle East turmoil causing major oil market disruptions, to fears of a Eurozone demise, to fears of a U.S. default, to fears of the U.S. fiscal cliff, and now back to fears of a U.S. default. And, while all of those issues were serious ones, each time the fear turned out to be worse than the reality. We have not fallen into a depression; the Eurozone has not collapsed; the U.S. did not belly flop off the fiscal cliff. In fact, things have improved quite a bit in recent years. Unemployment has fallen from a peak of 10% down to 7.8%; the service sector has expanded every month for the past three years; housing starts are way up, as are home prices; and the stock market is up nearly 120% from its March 2009 low.

Fears being worse than reality isn't anything new in the investment world. We humans are emotional creatures, and we tend to overreact to news (both on the downside and the upside. And in late 2008 and early 2009, things got so scary that many have become particularly prone to thinking that the worst is going to happen whenever problems emerge. The media doesn't help -- doom and gloom has been dominating the headlines for years now, drowning out the many positive signs that have emerged. Having been caught with their pants down when the 2008 crisis hit, I think most news outlets are leaning toward the negative side, fearing that they will lose more credibility if they fail to see another crisis coming. Plus, let's face it: Negative news attracts more viewers and readers.

But remember, fear is an investor's ally. Warren Buffett has famously said that "if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful." His fellow investing great, Peter Lynch, has also stressed the importance of not giving into fear, once saying that "the real key to making money in stocks is not to get scared out of them."

That advice goes for both the broader market, and individual stocks. In a September 2011 interview on CNBC, Joel Greenblatt, another of the great investors upon whom I base my strategies, explained the common thread among the companies that his quantitative system tends to target: "Each one of those companies is hated brutally by people," he said. At the time, Greenblatt was very bullish on stocks, even though the marketplace was filled with fear. "It's a very scary time to invest," he said, "and that's when you get your best bargains." In the 16 months since that interview, the S&P 500 is up about 26%.

The Hot List has often benefited from other investors' fears over the years. Perhaps most recently, it did so with its pick of Nu Skin Enterprises. Nu Skin shares were been pummeled for much of 2012, taking a particularly big hit in December. Part of the reason probably involved the fact that it's a more economically sensitive small-cap, the sort of stock hit hard by the fiscal cliff/recession fears. Part of it was also probably the fact that Nu Skin is a similar business to Herbalife, a firm that hedge fund guru David Einhorn recently said he is extremely bearish on. Nu Skin was likely thus hurt by guilt by association.

But the Hot List was more focused on Nu Skin's fundamentals, which were quite good when it added the firm to the portfolio on Dec. 21. Since then, its shares have rebounded forcefully, gaining about 35%.

On today's rebalancing, the Hot List is selling Nu Skin and three other positions and replacing them with four new stocks that now rate higher. This new quartet has its fair share of clouds hanging over it. Three of the stocks -- Hibbett Sports, rue21, and Guess? -- are retailers. And with the debt ceiling issue and other economic concerns dogging investors, many fear retailers -- which have excelled since the March 2009 bottom -- have come to the end of their run.

But look at the numbers: Guess? has upped earnings per share in 8 of the past 10 years. Hibbett has done so in 9 of the last 10. Rue21 has done so in all 10. All of them increased EPS in 2008 and 2009, when the Great Recession was occurring. Together, the three companies are averaging a return on equity of nearly 20% over the past 10 years. Among them, they have a total of just $8.7 million in debt, and more than $1 billion in net current assets.

Those are some great fundamentals. But because of the economic fears, the prices of these three stocks are quite reasonable. The fourth addition to the portfolio, meanwhile, is downright dirt-cheap. Despite having about five times as much annual earnings as debt and $3.85 in free cash flow per share, Northrop Grumman shares trade for 8.6 times trailing 12-month EPS, 9 times projected 12-month EPS, and 0.65 times sales. The reason? The big budget cuts that would go into effect if Congress and the President can't reach a compromise on the budget aspects of the fiscal cliff, which weren't addressed by the deal reached earlier this month. Budget cuts, with or without a deal, are no doubt a legitimate threat, but current estimates for Grumman in 2013 already include a significant profit cut. In fact, even if profits fell by 40% in 2013, at its current price Grumman would be trading at a very reasonable P/E of about 15. Investors certainly seem to be overreacting.

All in all, fears may not be as intense right now as they've been at other points in the past four years. They remain, however, and no doubt will wax and wane at different points in 2013. But fear in and of itself isn't a reason to sell a stock or jump out of the market altogether. Good investors have rational, systematic approaches that determine when to sell, or when to lighten up on an asset class. And, after more than a dozen years studying history's most successful investors, I can tell you this: Far more often than not, the greatest strategists saw times of fear, or stocks that were feared, as some of the biggest sources of opportunity. However events unfold in 2013, that's something to keep in the forefront of your mind.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Statoil Asa(Adr) (STO), Nu Skin Enterprises, Inc. (NUS), Western Digital Corp. (WDC) and Hollyfrontier Corp (HFC).

The Keepers

6 stocks remain in the portfolio. They are: Oracle Corporation (ORCL), Ross Stores, Inc. (ROST), The Tjx Companies, Inc. (TJX), Jos. A. Bank Clothiers Inc (JOSB), Usana Health Sciences, Inc. (USNA) and Main Street Capital Corporation (MAIN).

The Newbies

We are adding 4 stocks to the portfolio. These include: Guess?, Inc. (GES), Northrop Grumman Corporation (NOC), Hibbett Sports, Inc. (HIBB) and Rue21, Inc. (RUE).

Portfolio Changes

Newcomers to the Validea Hot List

rue21 Inc. (RUE): This trendy Pennsylvania-based specialty apparel retailer caters to 11- to 17-year-olds. It recently opened its 700th store in the U.S., and operates in 46 states.

Rue21 ($713 million market cap) gets strong interest from my James O'Shaughnessy-based growth strategy and my Peter Lynch-based model. For more on the stock, see the "Detailed Stock Analysis" section below.

Hibbett Sports, Inc. (HIBB): Alabama-based Hibbett operates sporting goods stores in small and mid-sized markets, mostly in the South, Southwest, Mid-Atlantic and Midwest. It has about 850 retail stores across 26 states, mostly under the Hibbett Sports name but with some also under the Sports Additions and Sports & Co. names.

Hibbett gets strong interest from my Warren Buffett-based model and high marks from some other strategies as well. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Northrop Grumman Corporation (NOC): One of the country's largest defense contractors, this Virginia-based firm is involved in the aerospace, electronics, information systems, and technical services arenas, serving government and commercial customers across the globe. Its products include unmanned aircraft systems, B-2 stealth bombers, the James Webb space telescope, radar systems, 911 public safety systems, and cybersecurity solutions, to name just a few.

Grumman has a $16 billion market cap, and gets strong interest from my Peter Lynch-, Joel Greenblatt-, and Kenneth Fisher-based models. To read more about it, see the "Detailed Stock Analysis" section below.

Guess?, Inc. (GES): Los Angeles-based Guess makes trendy apparel, denim, handbags, watches, footwear and other related consumer products. It directly operates about 500 retail stores in the United States and Canada and 264 retail stores in Europe, Asia and Latin America. Its licensees and distributors operate more than 800 more retail stores outside of the U.S. and Canada.

Guess is a previous Hot List pick that is returning to the portfolio, thanks to the strong interest rating it gets from my Peter Lynch-based model and the some interest rating it gets from two other models. See the "Detailed Stock Analysis" section below to learn more about the stock.

News about Validea Hot List Stocks

Nu Skin Enterprises, Inc. (NUS): Since joining the portfolio on Dec. 21, Nu Skin shares were up nearly 35% (through late morning trading on Jan. 17). There was no clear catalyst for the jump, though the allaying of fiscal cliff concerns probably had some impact, as did Nu Skin's strong fundamentals. Nu Skin shares have also correlated quite a bit with fellow multi-level-marketing firm Herbalife, which has come under great scrutiny in recent months. Herbalife's recent rebound may thus have helped Nu Skin shares. The Hot List is taking the profits, selling off Nu Skin this rebalancing because other stocks are now rated more highly than it is.

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

MAIN   |   USNA   |   JOSB   |   ORCL   |   GES   |   HIBB   |   NOC   |   RUE   |   ROST   |   TJX   |  

Main Street Capital Corporation is a United States-based principal investment firm that primarily provides long-term debt and equity capital to lower middle market companies. The Firm targets investments associated with ownership transitions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives for later stage businesses. In addition to providing companies with necessary capital, Main Street provides management with expertise in corporate finance, operations and growth strategy implementation.

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.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer (through stores, catalog call center and Internet) of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. Jos. A. Bank sells all of its products under the Jos. A. Bank label through 556 retail stores (as of January 28, 2012, which includes 25 outlet and factory stores and 15 franchise stores) located throughout 43 states and the District of Columbia in the United States, as well as through its catalog call center 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. It has two segments: Stores and Direct Marketing. The Stores segment includes all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment includes the catalog call center and the Internet.

Oracle Corporation is a provider of enterprise software and computer hardware products and services. The Company's software, hardware systems, and services businesses develops, manufactures, markets, hosts and supports database and middleware software, applications software, and hardware systems, with the latter consisting primarily of computer server and storage products. It is organized into three businesses: software, hardware systems and services. Its software business consists of two segments: new software licenses and software license updates and product support. Its hardware systems business consists of two segments: hardware systems products and hardware systems support. The Company's services business consists of the remainder of its segments and offers consulting services, managed cloud services, and education services. On January 25, 2012, it acquired RightNow Technologies, Inc. (RightNow). On April 5, 2012, the Company acquired Taleo Corporation (Taleo).

Guess?, Inc. (GUESS?) designs, markets, distributes and licenses apparel and accessories for men, women and children. The Company operates in five: Europe, North American Retail, Asia, North American Wholesale and Licensing. Its products are sold through retail, wholesale, e-commerce and licensing distribution channels. The lines include full collections of clothing, including jeans, pants, skirts, dresses, shorts, blouses, shirts, jackets, knitwear and intimate apparel. It also grant licenses to manufactures and distributes a range of products, including eyewear, watches, handbags, footwear, kids' and infants' apparel, leather apparel, swimwear, fragrance, jewelry and other fashion accessories. In fiscal 2012, it, along with its distributors and licensees, opened 224 stores in all concepts combined outside of the United Sates and Canada, which consisted of 120 stores in Europe and the Middle East, 89 stores in Asia and 15 stores in the combined area of Central and South America.

Hibbett Sports, Inc. owns and operates sporting goods stores in small to mid-sized markets predominantly in the Southeast, Southwest, Mid- Atlantic and the Midwest. The companys stores provide footwear, athletic equipment, and apparel products to individual customers as well as for school, athletic, and youth programs through educational institutions and youth associations.

Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business. In September 2012, it acquired M5 Network Security Pty Ltd.

rue21, inc. (rue21) is a specialty apparel retailer. As of January 28, 2012, the Company operated 713 stores in 46 states throughout the United States. It offers a line of apparel and accessories for girls and guys, including graphic t-shirts, denim, dresses, shirts, hoodies, belts, jewelry, handbags, footwear, intimate apparel and other accessories. Its apparel and accessory brands include rue21 (Girls apparel), rue21 etc! (Girls accessories), tarea by rue21 (Girls intimate apparel), Carbon and CJ Black (Guys apparel), and Carbon Elements (Guys accessories). During the fiscal year ended January 28, 2012 (fiscal 2011), the Company opened 120 new stores.

Ross Stores, Inc., along with its subsidiaries, operates two brands of off-price retail apparel and home fashion stores. As of January 28, 2012, the Company operated a total of 1,125 stores, of which 1,037 were Ross Dress for Less (Ross) locations in 29 states, the District of Columbia, and Guam, and 88 were dd's DISCOUNTS stores in seven states: 48 in California, 19 in Texas, 12 in Florida, four in Arizona, two in Georgia, two in Nevada, and one in Maryland. Ross focuses on customers primarily from middle income households, while dd's DISCOUNTS focuses on customers from more moderate income households. During the fiscal year ended January 28, 2012 (fiscal 2012), it opened 59 new Ross stores and closed ten existing stores. During fiscal 2011, it opened 21 new dd's DISCOUNTS stores. The average approximate dd's DISCOUNTS store size is 23,900 square feet. In April 2011, it purchased a 449,000 square foot warehouse for packaway storage in Riverside, California.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office. In December 2012, the Company acquired Sierra Trading Post, an off-price Internet retailer.

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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