|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||February 5, 2010|
The economy is continuing to offer a mixed bag, though in general the stabilization process that began in mid-2009 seems to have continued through the end of the year and into 2010.
New data released last week, for example, showed that the U.S. economy grew at a 5.7% annual rate in the fourth quarter, the second straight quarter of growth following four straight quarters of contraction. The 5.7% figure was the third-highest of the 2000s decade, trailing only the third quarter of 2003 (6.9%) and the second quarter of 2000 (8.0%). The growth was driven largely by inventory replenishment, which accounted for 3.4 of the 5.7 percentage points -- not a big surprise given how much companies cut inventories during the financial crisis and its immediate aftermath.
Of course, inventories can grow only so long before demand needs to drive growth. And we're seeing some signs that the American consumer may not be as tapped out as some thought. Retail sales were up in the 2.5% to 3.5% range in January, year over year, according to multiple organizations, the fifth straight month that they've risen. Of course, the same months in late '08 and early '09 provided very weak comparisons. Nevertheless, things appear to still be headed in the right direction.
Heading even more so in the right direction is manufacturing activity. New data from the Institute for Supply Management indicated that the manufacturing sector expanded in January for the sixth straight month, and at the fastest pace in more than five years. It also showed that new orders are accelerating, as they rose again for the seventh straight month. The non-manufacturing sector also showed growth, reversing a two-month trend in which it contracted slightly, according to ISM.
The job market, meanwhile, continues to scuffle, with new jobless claims rising in the most recent week. The less than 2% increase was by no means terrible news, but it seemed to be another sign that the jobs picture isn't about to turn on a dime. Still, to keep things in perspective, in the same week a year ago initial claims were well above 600,000. The President and Congress pledging to make jobs creation a renewed priority, and hopefully they'll be able to make a meaningful impact.
Finally, the real estate market is showing mixed signs. Existing home sales tumbled 16.7% in December, the National Association of Realtors reported last week. That followed a string of three straight big monthly gains, however, and the figure was still up 15% over December 2008 levels. Sale prices rose for the first time since June.
Pending home sales, meanwhile, reversed a big November decline. They rose 1% in December, and year-over-year were up more than 10%, according to the NAR. The big fluctuations in home sales data in recent months have been attributed to the fact that the government's first-time homebuyer tax credit was initially scheduled to end in November, which caused many first-time buyers to rush to take advantage of the credit (which since has been extended).
Finally, global economic concerns are having a big impact on the U.S. markets. News of debt troubles for several European countries rattled the markets Thursday; China's attempts to slow its rapid growth by implementing measures to cool off its booming housing market did the same the previous week.
All in all, those factors helped drive the U.S. markets lower, with the S&P 500 down 4.8% since our last newsletter. The Hot List also lost ground, falling 7.3%. So far in 2010, the portfolio is down 4.8%, vs. 4.7% for the S&P. Over the long-term, the Hot List is well ahead of the index, however, having gained 129.5% since its July 2003 inception, compared to just 6.3% for the S&P.
Finding Profits in the "Lost Decade"
That 6.3% gain for the S&P over the past six-and-a-half years is striking. And, if you go back a bit further, the numbers get flat-out ugly. As you've probably heard or read by now, the S&P lost 24.1% in the 2000s decade, an annualized loss of about 2.7% per year. Those figures have led some to dub the period the "Lost Decade".
But while it was likely a lost decade for investors who plopped money into broader U.S. market index funds at its beginning -- or, if history is any guide, for those who tried to time the market -- the 2000s weren't lost for others. If you had a simple, sensible, disciplined approach, you could have kept your portfolio in the black; you might even have generated some big gains.
One important thing to keep in mind regarding this topic is that, while they are often used as synonyms for the broader stock market (and I may at times be guilty of that), often-used indexes like the S&P 500 or Dow Jones Industrial Average don't represent a real investor's portfolio -- in fact, as Ron Lieber noted in a recent piece for The New York Times, they don't even fully reflect the broader market, particularly in today's global world. Lieber says that if you'd have put $50,000 in the Vanguard Total Stock Market Index Fund (a much broader market measure that includes thousands more stocks than the S&P 500), and another $50,000 in Vanguard's Total International Stock Index Fund (both with dividends reinvested, in tax-deferred accounts), you'd have ended up with about $109,000 -- a 9% gain rather than the S&P's 24% loss during the "Lost Decade".
Of course, most investors also don't put all of their money into one asset. So Lieber looked at how an investor would've fared if he or she'd put 50% in stocks (using that half U.S./half International breakdown) and half in a diversified bond index fund. The results: a 45.6% gain. While not spectacular (that amounts to less than 4% per year), it's a far cry from a "lost" decade.
Disciplined investors could've made even more, however. If you'd used the same breakdown and added $1,000 a month to your portfolio, and rebalanced it annually back to those allocation targets, you'd have ended up with more than $300,000 -- annualized gains of about 12% per year, Lieber writes.
CBS MoneyWatch's Allan Roth recently talked of similar virtues in rebalancing. Roth said that investors who used Vanguard stock index funds and a 60% stocks (two-thirds from the U.S.) and 40% bonds allocation could've boosted returns by about 1.5% per year by adding a fixed amount to their portfolio each year, and rebalancing back to those target weights each year, during the "Lost Decade".
Now, I bring all of this up not to encourage you to rush out into bonds or the Chinese yuan or pork belly futures or any other type of non-stock asset, or to hide the fact that it was a rough decade for stocks. I do it, instead, to highlight two broader points.
The first is that, while the Hot List has been and will remain an all-stock portfolio (that's our specialty), most investors should be diversified over other asset classes. How many asset classes, and to what degree, are dependent on factors like your age and your risk tolerance.
Second, and perhaps more importantly, is that investors shouldn't be fooled by headlines that a down day, month, year, or even decade for the S&P 500, Dow, or Nasdaq means that there's no money to be made in stocks -- which brings me to the Hot List. While the Hot List portfolio wasn't around for the entire "Lost Decade" -- we launched it in 2003 -- its nearly seven years of existence have been accompanied by poor returns for the major indices. Since the portfolio's July 15, 2003 launch, the S&P 500 has gained a paltry 6.5%, or 0.9% per year; the Vanguard Total Stock Market Index has been better, but is still only up about 13%, or less than 2% annually.
In that period of very weak stock returns, however, the Hot List has gained 129.5%, or 13.5% per year. And it hasn't done so with risky trading or esoteric schemes or lucky breaks; it's done so by sticking to some basic concepts: that the numbers (a stock's fundamentals and balance sheet) should drive buys and sells -- not emotion or gut feelings; that using a disciplined rebalancing system -- whether it involves rebalancing every month, quarter, or year -- is critical; and that sticking to a proven strategy is crucial, even when things get very, very tough.
By doing so, the Hot List has posted excellent returns during a period that is being portrayed as a disaster for stock investors. Similarly, as the studies above show, investors who managed their portfolios with a dose of common sense and a good amount of discipline were able not only to preserve their wealth during the "Lost Decade", but to grow it significantly. To me, all of that is proof that those who use a solid approach, and have the stomach to stick with it, should reap the benefits over the long haul -- wherever the broader market goes this month, year, or even decade.
Guru Spotlight: Joseph Piotroski
If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.
In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hot-shot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge -- just a straightforward assessment of a company's balance sheet.
His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares).
Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.
Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percent annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23 percent average annual return from 1976 and 1996.
Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market, though with some big ups and downs. Over its first four-and-a-half years or so, it was more than five times ahead of the S&P 500. It was hit hard -- like the rest of the market -- in 2008, however, falling more than 37%, and it didn't bounce back much in 2009, gaining just 6.8%. Still, despite the recent struggles, the portfolio is up 16.7% since inception, a period in which the S&P 500 has lost 4.3%.
Let's take a look at how Piotroski's approach, and the model I base off of it, work.
Diving into The Balance Sheet
Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.
The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use.
That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.
Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business -- not because of accounting changes, lawsuits, or other one-time gains.
Several of Piotroski' other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting. Looking at how a company's fundamentals had been changing allowed him to not only get an idea of the firm's financial position, but also of whether that position was improving or declining.
Among the other "change" criteria Piotroski examined were the long-term debt-asset ratio, which he wanted to be declining; the current ratio (current assets/current liabilities), which he wanted to be increasing; gross margin, which should be rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be increasing).
As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks that rate high enough to make it into its 10-stock portfolio:
Overseas Shipholding Group (OSG)
Petroleum Development Corporation (PTD)
SkyWest, Inc. (SKYW)
The Pantry, Inc. (PTRY)
Imation Corp. (IMN)
Omnicare, Inc. (OCR)
Ceradyne, Inc. (CRDN)
Assurant, Inc. (AIZ)
Winn-Dixie Stores (WINN)
Think Small -- And Boring
One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks. For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products. But while they're not the most flashy firms, they're quite often the type of stocks that can pay excellent returns over the long haul.
News about Validea Hot List Stocks
Aeropostale Inc. (ARO): On Feb. 3, Aeropostale announced a 3-for-2 stock split, the Associated Press reported. Shareholders of record at the close of business on Feb. 24 will get one share for each two that they own, with the new shares being distributed on or about March 4. Cash will be paid in place of fractional shares, based on the March 4 closing stock price as adjusted for the split, AP reported. Aeropostale has about 62.7 million shares outstanding; after the split it should have about 94 million, the company said.
National Oilwell-Varco (NOV): On Feb. 3, Varco announced a net fourth-quarter profit of $394 million, or $0.94 per share, down 33% from the year-ago period. Excluding items, earnings were $0.96 a share, beating analysts' estimates of $0.77 per share, Fox Business News reported. The better-than-expected results were driven by strong new orders numbers ($580 million vs. analysts' estimates of $500 million). Revenues were $3.13 billion, beating analysts' expectations of $2.86 billion.
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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