Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary September 30, 2011

The Economy

Nobel Prize-winning economist Paul Samuelson once quipped that the stock market has correctly predicted "nine of the last five recessions". Well, for a good two months now, many investors (and pundits and forecasters) have made it seem a foregone conclusion that another U.S. recession is imminent. And week after week, the data continues to show that -- to this point -- the recession they've been predicting appears to be one of those four non-recessions to which Samuelson referred.

This week, for example, we got some positive news from the labor market, with new unemployment claims falling about 9% to reach their lowest level in nearly six months. They're still high by historical standards, but we're just not seeing the surge in unemployment that many were forecasting when the stock market was swooning in July and August.

Decent news also came from the housing market. After falling in three of the past four months, existing-home sales jumped 7.7% in August, the National Association of Realtors reported. And both the 10-city and 20-city S&P/Case-Shiller Home Price Indices rose 0.9% in July, new data showed. When adjusting for seasonal factors, however, the indices were both about flat for the month. Pending home sales, a forward-looking indicator based on contract signings, declined slightly in August, falling 1.2%, NAR reported.

Regional manufacturing reports, meanwhile, were disappointing. The New York Federal Reserve's manufacturing index indicated the sector contracted for the fourth straight month, falling at about the same pace (-8.8%) as the previous month (-7.7%). The Philadelphia Fed's mid-Atlantic manufacturing index also remained in negative territory, though it indicated that the sector contracted at a significantly slower pace than it did in August (the September reading was -17.5, vs. -30.7 in August). Businesses appear to think the recent downturn is temporary, however; the Philly Fed's report showed a big jump in companies' expectations for what business conditions will be like in six months, and the New York Fed's six-month forward-looking indicator also rose.

It's also important to keep in mind that the New York and Philly numbers haven't exactly been an accurate bellwether for the nation in the past couple months -- broader national manufacturing figures have remained positive even as those two indices have been weak.

Supporting the improving outlook for manufacturers was a new Commerce Department report that said new orders for non-defense capital goods (goods used to produce finished products and services) rose 5.2% in August, despite all the talk of a possible double-dip recession.

Good news also came regarding the U.S. consumer. According to new Federal Reserve data, Americans' household debt service ratio (which compares debt payments to disposable income) fell in the April-June period for the ninth quarter in a row. In fact, it reached its lowest level since the fourth quarter of 1994.

Of course, the market hasn't been too concerned with fundamental data of late. It's instead remained fixated on the European debt crisis. And the speculation on how that will turn out has improved recently, as more countries have agreed to participate in the European Financial Stability Facility, the Eurozone's bailout fund. Much remains to be done, however, and it's likely that investors will continue to fret over the unpredictable, day-to-day news that emerges from Europe until some resolution is reached.

Investors have also been speculating about the impact of the Federal Reserve's new "Operation Twist" plan, through which the Fed will extend the average maturity of its securities holdings. The move is designed to keep downward pressure on long-term interest rates. With rates already extremely low -- 30-year mortgage rates fell to the lowest level in at least 40 years this week -- many are criticizing the move as unnecessary. We'll have to wait and see if it has the impact the Fed desires.

Since our last newsletter, the S&P 500 returned -4.0%, while the Hot List returned -14.6%. So far in 2011, the portfolio has returned -22.3% vs. -7.7% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 109.7% vs. the S&P's 16.0% gain.

Fear, Facts, and Fundamentals

Europe, Europe Europe -- it's all anyone seems concerned with these days, and that can be a difficult environment for disciplined, bottom up, stick-to-the-facts investors like me. It's not that the impact of Europe's financial situation is overblown (though it may well be -- I've previously noted that only about 15% of sales of S&P 500 companies' sales come from Europe; given all the Europe fear, you'd think it would be more like 50%). The issue, rather, is that very, very few people -- perhaps not even policymakers who are involved -- have any idea how the Europe situation is going to play out. Seventeen countries need to approve the enhanced Eurozone bailout plan for it to go into effect, and each has its own unique set of internal politics. It's hard enough to predict what one country will do, let alone all 17.

Yet every short-term event -- and the "events" are often mere statements by European officials -- is taken as a strong, clear signal that the debt crisis resolution will be "good" or "bad" for the world. Investors rush for the door on what they perceive as bad news, only to rush to get back in on what they view as good news.

This process -- the process of jumping in and out of the market based on the tenor of comments that some European official makes on a particular day -- is nothing more than sheer speculation. It is the sort of thing that I believe would make Benjamin Graham, Warren Buffett, or any of the highly successful gurus I follow, shake their heads in disapproval. In his classic The Intelligent Investor, Graham said of speculation, "The people who persist in trying it are either (a) unintelligent, or (b) willing to lose money for the fun of the game, or (c) gifted with some uncommon and incommunicable talent. In any case, they are not investors." I agree.

You and I, however, are investors. And as investors, we look at facts and data, and use them to make rational decisions about value. Given all of the fears surrounding stocks today, I thought it would be a good time to review some of the cold, hard facts and data about the current market's valuation, to try to give a comprehensive, rational picture of where we stand.

For starters, let's look at price/earnings ratios, of which there are several. First we'll look at trailing 12-month P/E ratios, using both operating earnings and as-reported earnings (we'll use the S&P 500 as a proxy for "the market"). Using the S&P's Thursday afternoon price of 1162 or so, the index trades for about 12.8 times trailing 12-month operating earnings, and 13.9 times as-reported earnings, according to Standard & Poor's data.

How does that compare to historical norms? Pretty well. The as-reported figure is below the 1872-2000 historical average for U.S. stocks, which is 14.5, according to SmartMoney. The operating figure is much lower than the historical average of 19.1, but that average is based on a relatively small sample -- S&P keeps historical data on operating earnings P/Es going back only to 1988.

Now, on to projected earnings. They aren't my favorite way to gauge valuations, given how often analysts' projections are wrong. But, just for kicks, let's see how the market's forward-looking P/E looks. According to Standard & Poor's, the S&P 500 trades for about 11.2 times projected operating earnings for the next year, and about 12.4 times projected as-reported earnings. Again, a pretty good picture, for what it's worth.

Beyond Earnings

Of course, some say corporate earnings have been goosed by the Federal Reserve's money-printing binge. So let's look at some non-earnings-based metrics, like the stock market/GDP ratio. This compares the total market value of the stock market to the value of all the goods and services produced annually in the U.S. -- the gross domestic product. Warren Buffett has said the stock market/GNP (gross national product) is one of his favorite valuations metrics, and GDP and GNP tend to run quite close to each other. The website GuruFocus.com tracks the daily stock market/GDP ratio, and as of Sept. 29, the ratio was 79.9%. That sits toward the cheaper end of the "fair value" range (75% to 90%), which was derived by an analysis of historical data, the site says. (It uses the Wilshire Total Market Index, not the S&P 500, as a proxy for the market.) Another good sign.

Then there's the price/sales ratio, which was pioneered by Kenneth Fisher, one of the gurus upon whose writings I base one of my top-performing strategies. Fisher developed the PSR in the 1980s as a way to value individual stocks. His logic: While earnings can fluctuate wildly from year to year because of factors that have nothing to do with a firm's underlying business (accounting changes, lawsuits won or lost, tax changes), sales are far more stable, and provide a better gauge of a company's position.

My Fisher-based model finds PSRs below 0.75 to be tremendous values, and those between 0.75 and 1.5 to be good values. My James O'Shaughnessy-based model also uses the metric, looking for PSRs below 1.5. Currently, according to data from Morningstar, the S&P 500 has a PSR of 1.2.

The Longer View

Critics who say recent earnings have been boosted by the Fed also point to longer-term P/E ratios, like the 10-Year Price/Earnings Ratio. Graham was a pioneer of this metric, and Yale Economist Robert Shiller is now the tool's foremost proponent. His 10-Year Cyclically-Adjusted Price/Earnings Ratio (CAPE) looks at earnings over the past 10 years and factors in inflation. The benefit of this particular P/E is that it compensates for short-term anomalies in earnings results. At the end of the first quarter of 2009, for example, the S&P traded for 116 times TTM as-reported earnings, a figure that looks on the surface to indicate that the market was wildly overvalued. But that was due to the fact that a horrific short-term stretch had driven TTM earnings down to less than $7 -- a figure that surely underestimated the future earnings power of the companies in the index.

The downside of the 10-year P/E is that the timeframe it examines is somewhat arbitrary. Typically, business cycles run significantly shorter than 10 years -- the average has been about six years in the post-World War II era, according to the National Bureau for Economic Research, the group charged with declaring the start and end points of recessions and expansions. Going back to the 1850s, the average is even lower, at about four-and-a-half years. So depending on when you look at the CAPE, the past decade of earnings can include a combination of recessionary and expansionary periods that is atypical.

How does the 10-year P/E look now? It's hovered around 20 for the past couple months. That's significantly above its 140-year historical average of about 16, though far from the peaks hit in 1999 (44.2) and 2007 (about 27.5). The latest data on Shiller's web site uses the Sept. 26 close (which is almost identical to the S&P's price as of this writing on Sept. 29), and shows the 10-year P/E to be 19.8. That's an overvaluation of about 24%.

There's some logic to using post-World War II data on any cyclically-adjusted P/E, however, since it was after World War II that policymakers began to make inflation a permanent part of the economy, and inflation is a dagger for stocks' biggest competitor, bonds. I thought it would be interesting to look at the post-World War II era, and tweak Shiller's data to use the average post-World War II business cycle of 70 months worth of earnings (rather than ten years). On that basis, the cyclically adjusted P/E ratio has averaged 17.3. The current level: 18.3. Still elevated, but only by about 6.1%.

Finally, let's look at one last measure of market value -- dividend yield. In what has been a rarity in recent decades, the S&P 500's dividend yield is well above the 10-year Treasury yield. As of Sept. 28, the S&P's dividend yield was 2.64%, while the 10-year Treasury yield was 2.03%.

The Facts

While most investors seem to be focusing on fear-filled headlines, smart investors will keep their focus on the facts. And right now, when it comes to assessing market valuation, the broader market seems reasonably priced. By all of the one-year earnings metrics, it looks cheap. And if you don't trust recent and projected earnings, the market is also trading at a reasonable price compared to sales and GDP. Plus, its dividend yield is some 30% higher than that of the 10-year Treasury bill.

The lone metric we examined that shows an overpriced market is the 10-year P/E. That's cause for some concern. But when we adjust the metric to more accurately reflect normal business cycle time periods, the gap between the current P/E and the average post-World War II P/E shrinks to about 6% -- indicating only a slight overvaluation.

In the short term, of course, the market will continue to move based on the macroeconomic headlines. But over the longer term, valuation will matter. And, looking at the totality of the information, stocks appear to be priced at levels from which solid long-term returns typically follow -- returns that are much better than those of bonds or bills or even gold. And, more importantly, many individual stocks are trading at exceptionally low valuations, despite having strong track records of earnings and sales growth. For stock-pickers like the Hot List, that's very good news.

Does that mean the market is guaranteed to surge in the next month, or quarter, or year? Of course not. There are never any guarantees in the stock market. But at some point, I believe the Europe fears will pass, and the market will recognize the many bargains that investors have been ignoring amid the fear-filled headlines -- and those who have stayed disciplined will be rewarded.

Editor-in-Chief: John Reese

Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

Are you looking for an alternative to your underperforming mutual funds or financial advisor? Click here to download Validea Capital's investment kit and learn more about the firm's guru-based portfolios.

Get More Information on Validea Capital!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

The Fallen

As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Micron Technology, Inc. (MU), Gt Advanced Technologies Inc (GTAT) and Marketaxess Holdings Inc. (MKTX).

The Keepers

7 stocks remain in the portfolio. They are: Forest Laboratories, Inc. (FRX), Devry Inc. (DV), Career Education Corp. (CECO), Asiainfo-linkage, Inc. (ASIA), Ternium S.a. (Adr) (TX), Capella Education Company (CPLA) and Bridgepoint Education, Inc. (BPI).

The Newbies

We are adding 3 stocks to the portfolio. These include: Hi-tech Pharmacal Co. (HITK), Jos. A. Bank Clothiers, Inc. (JOSB) and Petroleo Brasileiro Sa (Adr) (PBR).

Portfolio Changes

Newcomers to the Validea Hot List

Hi-Tech Pharmacal Co. (HITK): This three-decade-old specialty pharma firm focuses on difficult-to-manufacture liquid and semi-solid dosage forms, and manufactures a range of sterile ophthalmic, otic and inhalation products. It's also a leader in over-the-counter and nutritional products targeted at diabetics.

Amityville, N.Y.-based Hi-Tech ($422 million market cap) gets high marks from four of my models -- my Joel Greenblatt- and Peter Lynch-based models, the model I base on the writings of Motley Fool creators Tom and David Gardner, and my Momentum Investor approach. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.

Jos. A. Bank Clothiers (JOSB): Based in Hampstead, Maryland, this prior Hot List favorite is back. The 100-plus-year-old retailer sells a variety of men's tailored, casual, and sports clothing, as well as shoes and accessories such as hats and belts. The small-cap ($1.4 billion), has about 500 stores across the U.S.

Bank, which has had several previous stints in the Hot List -- including one in which it gained 78.2% from Feb. 20 to Oct. 2 of 2009 -- gets strong interest from my James O'Shaughnessy growth model and my Warren Buffett-based strategy. To find out more about the stock's fundamentals, see the "Detailed Stock Analysis" section below.

Petroleo Brasileiro SA (PBR): Brazil-based "Petrobras" is active in 28 countries, and is one of the world's largest integrated oil and gas companies ($146 billion market cap). It gets high marks from several of my strategies, including my Peter Lynch-, John Neff-, and James O'Shaughnessy-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

AsiaInfo-Linkage, Inc. (ASIA): AsiaInfo's shares tumbled last week after the stock was downgraded from "positive" to "neutral" by an analyst, who cited industry concerns. Through Sept. 28, the stock was down about 23% since the Hot List acquired it on Sept. 2. The firm's fundamentals remain intact, however, and the Hot List is holding onto the stock.

GT Advanced Technologies (GTAT): Like those of many solar industry firms, GT's shares have fallen sharply since our last newsletter. A few reasons seem to be behind the decline, including the controversy surrounding solar firm Solyndra, a glut of solar panels, and falling prices for the panels, according to Forbes. My strategies remain fairly high on GTAT, but not high enough. Other options have passed it by, and it's being sold from the portfolio this week.

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

BPI   |   FRX   |   TX   |   CPLA   |   PBR   |   DV   |   ASIA   |   CECO   |   JOSB   |   HITK   |  

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

Petroleo Brasileiro SA Petrobras (Petrobras) is a Brazilian integrated oil and gas company. It operates in five segments: exploration and production; refining, commercialization and transport of oil and natural gas; petrochemicals; distribution of derivatives, electrical energy, biofuels and other renewable energy sources. Directly or through its subsidiaries, Petrobras is engaged in the research, extraction, refining, processing, commercialization and transport of oil from wells, shales and other rocks, its derivatives, natural gas and other liquid hydrocarbons, as well as in activities related to energy, promoting research, development, production, transport, distribution and commercialization of all forms of energy. As of December 31, 2010, it had 132 production platforms, 16 refineries, 291 vessels, 29,398 kilometers of pipelines, six biofuel plants, 16 thermoelectric plants, one pilot wind farm, 8,477 service stations and two fertilizer plants, as well as presence in 30 countries.

DeVry Inc. (DeVry) is a provider of educational services and the parent organization of Advanced Academics, Becker Professional Education, Carrington College and Carrington College California, Chamberlain College of Nursing, DeVry Brasil, DeVry University, and Ross University. These institutions offer a range of programs in business, healthcare and technology and serve students in middle school through postsecondary education, as well as accounting and finance professionals. In August 2011, the Company acquired he business operations of privately held American University of the Caribbean.

AsiaInfo-Linkage, Inc. (AsiaInfo-Linkage), formerly AsiaInfo Holdings, Inc., is a provider of telecommunications software solutions and information technology products and services in China. The Company's software and services enables its customers to build, maintain, operate, manage and improve their communications infrastructure. It's products and services in telecom business include business operation support systems, including billing and partnership relationship management applications; business intelligence systems, including data warehousing platforms and data mining applications; operating support systems (OSS) package, including protocol adaptor, service fulfilment, process management and service activation; service and data applications, such as mail centers, mobile device management and mobile e-commerce platforms, and network infrastructure services, including network design and implementation, integrated network management and professional maintenance and support.

Career Education Corporation (CEC), through colleges, schools and universities that are part of the CEC family, offers education to a diverse student population of over 116,000 students in a variety of career-oriented disciplines. The Company has more than 90 campuses that serve these students are located throughout the United States and in France, Italy and the United Kingdom and Monaco. Its institutions includes American InterContinental University (AIU), Brooks Institute; Colorado Technical University (CTU), Harrington College of Design, INSEEC Group (INSEEC) Schools, International University of Monaco (IUM), International Academy of Design & Technology (IADT), Istituto Marangoni, Le Cordon Bleu North America (LCB), and Sanford-Brown Institutes and Colleges. CEC organized its businesses across four segments: University, Health Education, Culinary Arts and International. On April 15, 2010, the Company acquired IUM, an international business university.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. It sells substantially all of its products exclusively under the Jos. A. Bank label through its 506 retail stores (as of January 29, 2011, which includes 12 outlet and factory stores and 14 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog 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. The Company operates in two segments: Stores and Direct Marketing. The Stores segment consists of all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment consists of its Internet and catalog operations.

Hi-Tech Pharmacal Co., Inc. (Hi-Tech) is a specialty manufacturer and marketer of prescription, over-the-counter (OTC) and nutritional products. Hi-Tech develops, manufactures and markets products in three categories: generics, prescription brands and OTC brands. The Company produces a range of products for various disease states, including glaucoma, asthma, bronchial disorders, dermatological disorders, allergies, pain, stomach, oral care and other conditions. Its generic products are primarily prescription items and include oral solutions and suspensions, topical creams and ointments, as well as nasal sprays. It also specializes in the manufacture of products in its sterile facility capable of producing liquid ophthalmic, otic and inhalation products. The generic product category includes a small amount of contract manufacturing sales for both the prescription and OTC markets. On May 9, 2011, the Company divested the Midlothian Laboratories division.

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.

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.