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Executive Summary January 8, 2010

The Economy

As 2010 begins, the economy is continuing to do its best impression of The Little Engine that Could, slowly and steadily climbing its way out of the Great Recession -- though not without some bumps in the road.

Among the continued positive signs since our last newsletter: New data showed the manufacturing sector grew for the fifth straight month in December, with the Institute for Supply Management's manufacturing index hitting its highest level in almost four years. New orders rose for the sixth straight month, hitting their highest level in five years, and for the third straight month, ISM's employment index indicated that hiring is picking up.

Retail sales also picked up in December, coming in almost 3% higher than a year ago. In addition, a number of retailers, including major players like Macy's, Kohl's, and Sears, increased their fourth-quarter earnings guidance.

Unemployment remains a major problem, though the past week has offered signs that things are slowly moving in the right direction. The government reported that new claims for unemployment remained almost flat in the most recent week, bringing the four-week average down to within about 6% of the level that is believed to signal new job creation. Automatic Data Processing also said that about 84,000 private sector jobs were lost in December, the lowest total in almost two years. The real employment test will come today, when the government releases the December unemployment rate.

Another key area of the economy -- housing -- offered some bad news this week. The National Association of Realtors reported that its pending home sales index plunged 16% in November, ending a streak of nine straight monthly increases. Officials said a big reason for the decline was that numerous buyers had in previous months tried to beat the initial deadline for the government's first-time homebuyer tax credit. That caused pending sales figures to be quite high in those months, making November's figures pale in comparison. Nevertheless, the pending sales index was still 15.5% higher in November than it was a year earlier, a sign of how far the housing market has come in the past year.

All in all, the economic news was good enough to help the market climb higher for the fortnight, with the S&P 500 gaining 1.3%. The Hot List fared better, gaining 5.0%.

The portfolio finished 2009 with its best full year since we started tracking it more than six years ago, gaining 47.0%. That doubled the S&P's 23.5% return, and almost completely wiped out the loss the portfolio sustained in the market plunge of 2008. (From the start of '08 through the end of '09, the Hot List was down just 4.5%; the S&P lost more than 24% in the same period.)

The Hot List has also started 2010 off on the right foot, gaining 5.4% so far vs. 2.4% for the S&P. Since its inception in July 2003, the portfolio is now up 154.0%, generating more than ten times the S&P's 14.1% return.

Five Reasons for Optimism in 2010

One week into 2010, things are certainly looking better than they did last year at this time. A year ago, manufacturing and industrial figures were plunging, retail sales figures were dreadful, and the housing market seemed to be weakening by the day. And for investors, stocks were down more than 40% from their highs -- and about to head further downward.

Today, the economy has stabilized, in part because of massive government intervention, and in part because the economy has gone through the natural process of working off much of the excesses that had built up heading into the recession.

So as we head into the New Year, what can we expect from equities? Well, as you know, I'm not one for short-term predictions -- the market is far too complex and unpredictable for anyone to have a truly good grasp on what will happen in the coming 12 months.

What I will say is that I see a number of reasons that equities remain attractive for long-term investors, even after their huge run-up. I briefly mentioned some of those reasons in our last newsletter, but I think it's important to delve a bit deeper into a handful of them now.

  • Valuations are reasonable:
  • Yes, stocks aren't as cheap as they were nine or ten months ago. But that's irrelevant. The question is, how expensive are they now? I'd argue that, while they're not dirt cheap, they aren't particularly expensive. S&P 500 firms are currently expected to earn $74.98 per share in 2010. At the index's current value, that makes for a forward P/E a bit over 15 -- far from expensive, especially when you consider that current interest rates are at or near historic lows. (Lower interest rates have historically meant that investors are willing to pay higher P/Es, because Treasuries and fixed-income investments offer little competition to stocks in terms of potential upside gains during low-interest-rate climates.)

    The 10-year P/E ratio, designed to even out earnings fluctuations, was a bit high at the end of '09, coming in around 20. But historically, 10-year P/Es at such levels have not meant a clear signal that stocks will head lower.

    More importantly, the Hot List isn't buying the market. It's buying the most fundamentally sound stocks in the market, and, because of its value bias, it's getting those stocks at attractive valuations -- regardless of what the broader market's P/E is.

  • The "Lost Decade":
  • Of course, a nice market tailwind does help. And history is offering signs that the next decade should be a good one for stocks. That's because the past decade has involved the worst ever 10-year return for stocks. Since 1926, when trailing 10-year compound annual returns have been 1% or less, the market has produced average annual returns of 10.7% for the next decade, according to data from Legg Mason and Steven Leuthold.

  • Stimulus:
  • To be sure, the economy has been improving, and some of that is due to the government's stimulus package. But much of that enormous package has yet to work its way into the system. According to ISI Group, $440 billion of the $787 billion stimulus package is designed to hit the economy in 2010. That should go a long way toward bolstering corporate profits, and, hopefully, facilitating job growth in coming years.

  • Interest Rates:
  • The low-rate environment we've been in is a big part of why stocks have surged. Companies have been able to borrow money at very low rates, increasing their profitability. And, as noted earlier, the low rates have meant low yields for Treasuries and fixed-income investments, making stocks one of the few places offering potentially high returns. It appears that low-rate climate will be with us for some time. In December, the Federal Reserve said it would keep rates "exceptionally low ... for an extended period", which should continue to benefit stocks.

  • More Funds Left to Flow:
  • While the market has surged, many individual investors have stayed on the sidelines. According to the Investment Company Institute, net flows to/from U.S. equity mutual funds were negative (-$5.4 billion) from April 1 through Nov. 30 of 2009. During that same period, investors were pumping money into bond funds -- a net of almost $300 billion. If the economy continues to improve and the market shows stability, there's a good chance a big chunk of that money could come back to stocks as investors become more risk-tolerant.

    Of course, 2010 will also feature obstacles for the economy and the stock market. The factors that led to the market crash and deep recession we've just been through -- bad loans, overleveraging, etc. -- were years in the making; it will take more than a year for them to truly be behind us. But there will always be obstacles. The Hot List has proven that it can withstand some exceptionally bad ones and excel over the long term, and I'm confident it will continue to do so in 2010 and beyond.
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    Guru Spotlight: Martin Zweig

    In the dozen or so years I've spent researching investment strategies, one of the greatest lessons I've learned is that there is no one single way to beat the market -- you can do so by taking numerous approaches. So while most of my strategies are either value oriented or a blend of value and growth, you can definitely make hay with a growth-oriented approach -- if it's a good one.

    Martin Zweig's approach is a great example of a good growth strategy. Zweig's investment newsletter, the Zweig Forecast, was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.

    Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls. He even owns the sperm costume from Woody Allen's film Everything You Always Wanted to Know About Sex. His collecting interests also span the historic (several old stock certificates, including one signed by Commodore Vanderbilt) as well as the nostalgic (like the two old-fashioned gas pumps that are almost identical to those he'd seen at the nearby Mobil station while growing up in Cleveland), Financial World has reported.

    Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. He examined earnings in a rigorous fashion, making sure growth wasn't just strong, but also consistent, accelerating, and sustainable. His method spanned several categories:

    Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

    Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

    Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

    Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

    While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

    In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not sost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

    Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).

    Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

    There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).

    Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-based portfolio has gained 64.3% since its July 2003 inception (that's 9.0% annually), while the S&P 500 has gained just 14.1% (2.1% annually).

    The model tends to choose stocks from a variety of areas, usually holding onto them for a period of a few months (though it is not averse to longer periods if the stock continues to be a prospect for more growth.) Here's a look at the 10-stock portfolios current holdings:

    Strayer Education (STRA)
    National Presto Industries (NPK)
    Mantech International (MANT)
    Panera Bread Company (PNRA)
    CVS Caremark Corporation (CVS)
    ITT Educational Services (ESI)
    Fuqi International (FUQI)
    HCC Insurance Holdings (HCC)
    Sturm, Ruger & Company (RGR)
    World Acceptance Corp. (WRLD)

    What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

    News about Validea Hot List Stocks

    Aeropostale (ARO): The teen clothing retailer reported same-store sales rose 10.1% in December, more than tripling expectations of 3.1%, according to Reuters. Aeropostale also raised its outlook for the current quarter.

    Chevron (CVX): Two contract workers were shot dead by Nigerian soldiers in southern Nigeria at an under-construction Chevron plant this week, the Associated Press reported. The shootings stemmed from what a government spokesman called "a minor disagreement that got out of hand," and caused a riot that lasted from Monday afternoon through Tuesday, AP reported. Several buildings were destroyed and Chevron operations were halted, but officials had restored order by Wednesday, AP stated. Government officials are investigating.

    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.

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    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   |   TDW   |   NOV   |   DRC   |   WRLD   |   CVX   |   TLVT   |   OIS   |  

    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.

    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.

    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.

    World Acceptance Corporation is engaged in the small-loan consumer finance business, offering short-term small loans, medium-term larger loans, related credit insurance and ancillary products and services to individuals. The Company offers standardized installment loans through 944 offices in South Carolina, Georgia, Texas, Oklahoma, Louisiana, Tennessee, Illinois, Missouri, New Mexico, Kentucky, Alabama and Mexico as of March 31, 2009. World Acceptance Corporation serves individuals with limited access to consumer credit from banks, savings and loans, other consumer finance businesses and credit card lenders. The Company also offers income tax return preparation services and access to refund anticipation loans through a third party bank to its customers and others. During the fiscal year ended March 31, 2009 (fiscal 2009), the Company opened 98 new offices, 11 other offices were purchased and three offices were closed or merged into other existing offices.

    Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates, and provides administrative, financial, management and technology support to the United States and International subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining operations of coal and other minerals, power generation and energy services. Exploration and production (upstream) operations consist of exploring for, developing and producing crude oil and natural gas, and also marketing natural gas. Refining, marketing and transportation (downstream) operations relate to refining crude oil into finished petroleum products; marketing crude oil and the many products derived from petroleum, and transporting crude oil, natural gas and petroleum products by pipeline, marine vessel, motor equipment and rail car. In April 2009, Reliance Industries Limited bought back Chevron Corporation's 5% stake in Reliance Petroleum Limited.

    Telvent GIT, S.A. is an information technology (IT) company that specializes in value-added real time products, services and integrated solutions to customers in targeted industrial sectors (Energy, Transportation, Environment and Agriculture), as well as Global Services, primarily in Europe, North America, Latin America, the Asia-Pacific region, the Middle-East and Africa. Products and services solutions include systems integration, consulting services, design and engineering services, real-time business-to-business information services and software. The Company has five segments: Energy, Transportation, Environment, Agriculture and Global Services. On October 28, 2008, the Company's subsidiary, Telvent Export, acquired 100% of DTN Holding Company, Inc., a business information service provider in North America, for a purchase price of United States.

    Oil States International, Inc. (Oil States) through its subsidiaries, is a provider of specialty products and services to oil and gas drilling and production companies worldwide. The Company operates in a number of oil and gas producing regions, including the Gulf of Mexico, United States onshore, West Africa, the North Sea, Canada, South America and Southeast and Central Asia. Its customers include many of the national oil companies, major and independent oil and gas companies and other oilfield service companies. Oil States operates in three principal business segments: offshore products, tubular services and well site services. The Company's well site services segment includes the accommodations, rental tools and drilling services businesses. On February 1, 2008, Oil States purchased all of Christina Lake Enterprises Ltd., the owners of an accommodations lodge (Christina Lake Lodge) in the Conklin area of Alberta, Canada.

    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.

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