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Executive Summary February 5, 2010

The Economy

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.
Editor-in-Chief: John Reese

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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:

IAC/InterActiveCorp (IACI)
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 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

FUQI   |   ARO   |   ESI   |   EME   |   DRC   |   TEF   |   CVS   |   GME   |   TDW   |   NOV   |  

Fuqi International, Inc. (Fuqi) is a designer of precious metal jewelry in China, developing, promoting, and selling a range of products in the Chinese luxury goods market. The Company's products consist of a range of styles and designs made from gold and other precious metals, such as platinum and Karat gold (K-gold). The Company also produce jewelry items that contain diamonds and other precious stones on a custom-order basis. Its design database contains over 30,000 products. The Company operates through its wholly owned subsidiary Fuqi International Holdings Co., Ltd. (Fuqi BVI) and its wholly owned subsidiary, Shenzhen Fuqi Jewelry Co., Ltd. (Fuqi China). As of December 31, 2008, the Company had 69 jewelry retail counters and stores in China.

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aeropostale merchandise through its e-commerce Website, www.aeropostale.com. As of January 31, 2009, it operated 914 stores, consisting of 874 Aeropostale stores in 48 states and Puerto Rico, 29 Aeropostale stores in Canada, and 11 Jimmy'Z stores in 10 states. The Company locates its stores primarily in shopping malls, outlet centers and, to a much lesser degree, lifestyle and off-mall shopping centers. The Company has developed a new retail store concept called P.S. from Aeropostale, which will offer casual clothing and accessories focusing on elementary school children between the ages of seven and 12. It offers a focused collection of apparel, including graphic t-shirts, tops, bottoms, sweaters, jeans, outerwear and accessories.

ITT Educational Services, Inc. (ITT/ESI), is a provider of postsecondary degree programs in the United States based on revenue and student enrollment. As of December 31, 2008, the Company offered master, bachelor and associate degree programs to approximately 62,000 students. As of December 31, 2008, it had 105 institutes and nine learning sites located in 37 states. All of its institutes are authorized by the applicable education authorities of the states, in which they operate, and are accredited by an accrediting commission recognized by the United States Department of Education (ED). During the year ended December 31, 2008, the Company began its operations at eight new institutes. As of December 31, 2008, the Company offered 33 degree programs in various fields schools of study: information technology (IT); electronics technology; drafting and design; business; criminal justice, and health sciences.

EMCOR Group, Inc. (EMCOR) is an electrical and mechanical construction and facilities services company in the United States, Canada, the United Kingdom and in the world. The Company's segments include United States electrical construction and facilities services, United States mechanical construction and facilities services, United States facilities services, Canada construction and facilities services, United Kingdom construction and facilities services, and Other international construction and facilities services. The Company specializes in providing construction services relating to electrical and mechanical systems in facilities of all types and in providing services for the operation, maintenance and management of all aspects of such facilities (referred to as facilities services).

Dresser-Rand Group Inc. is the global supplier of custom-engineered rotating equipment solutions for the applications in the oil, gas, petrochemical and process industries. The products and service applications include oil and gas production; high-pressure field injection, gas lift, and enhanced oil recovery; natural gas processing; gas liquefaction; gas transmission and storage; refining; petrochemical production; and general industrial markets, such as paper, steel, sugar, distributed power and United States Navy. The Company operates globally with manufacturing facilities in the United States, France, United Kingdom, Germany, Norway, China and India. It operates a range of products and clients to the global client base in over 140 countries from the global locations in 18 United States states and 26 countries. The Company operates in two business segments: new units, and aftermarket parts and services.

Telefonica, S.A. (Telefonica), together with its subsidiaries and investees, operates in the telecommunications, media and contact center industries. The Company is also involved in the media and contact center activities through investments in Telefonica de Contenidos and Atento. The Company operates in three business areas: Telefonica Spain, Telefonica Europe and Telefonica Latin America. In Latin America, Telefonica provides service to more than 158 million customers in Brazil, Argentina, Chile and Peru, and has substantial operations in Colombia, Ecuador, El Salvador, Guatemala, Mexico, Morocco, Nicaragua, Panama, Puerto Rico, Uruguay and Venezuela. In Europe, it has operating companies in the United Kingdom, Ireland, Germany, Czech Republic and Slovakia. On April 3, 2008, Vivo Participacoes, S.A. completed the acquisition of 53.90% of Telemig Celular Participacoes, S.A. In December 2009, the Company acquired JAJAH.

CVS Caremark Corporation (CVS Caremark) is a provider of prescriptions and related healthcare services in the United States. It is a pharmacy services company and drives value for its customers through its approximately 6,900 CVS/pharmacy and Longs Drug retail stores; CVS Caremark's pharmacy benefit management, mail order and specialty pharmacy division, Caremark Pharmacy Services; its retail-based health clinic subsidiary, MinuteClinic, and Its online pharmacy, CVS.com. The Company operates in two business segments: Pharmacy Services and Retail Pharmacy. October 20, 2008, CVS Caremark acquired Longs Drug Stores Corporation, which includes 529 retail drug stores (the Longs Drug Stores) and RxAmerica LLC (RxAmerica), which provides pharmacy benefit management services, and certain other related assets.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 31, 2009, the Company operated 6,207 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. During the fiscal year ended January 31, 2009, GameStop operated its business in four segments: United States, Canada, Australia and Europe. On April 5, 2008, GameStop acquired Free Record Shop Norway AS. In July 2008, the Company purchased certain assets and Website operations from The Gamesman Limited, a video game and entertainment software retailer, including eight stores in New Zealand. On November 17, 2008, GameStop France SAS, a wholly owned subsidiary of the Company, acquired SFMI Micromania SAS.

Tidewater Inc. provides offshore supply vessels and marine support services to the offshore energy industry through the operation of offshore marine service vessels. As of March 31, 2008, the Company had a total of 430 vessels, of which 10 were operated through joint ventures, 61 were stacked and 11 vessels withdrawn from service. The Company provides services supporting all phases of offshore exploration, development and production, including towing of and anchor handling of mobile drilling rigs and equipment; transporting supplies and personnel necessary to sustain drilling, workover and production activities; assisting in offshore construction activities, and a variety of specialized services, including pipe laying, cable laying and three-dimensional (3-D) seismic work. The Company operates in two segments: United States and International.

National Oilwell Varco, Inc. (NOV) is a provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates in three segments. The Rig Technology segment designs, manufactures, sells and services systems for the drilling, completion and servicing of oil and gas wells. The Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells, service pipelines, flowlines and other oilfield tubular goods. The Distribution Services segment provides maintenance, repair and operating (MRO) supplies, and spare parts to drill site and production locations worldwide. In April 2009, NOV acquired ASEP Group Holding B.V. and Anson Limited.In December 2009, National-Oilwell Varco, Inc. acquired Hochang Machinery Industries Co., Ltd. and South Seas Inspection (S) Pte. Ltd.

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.