|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||January 9, 2009|
New year, same problems.
As 2009 begins, the economy is still working through the issues that have troubled investors for many months now.
For starters, the search for a bottom in the housing market is, unfortunately, continuing. Pending home sales for November fell to their lowest level in the seven-plus years since tracking began, the National Association of Realtors reported earlier this week. With sales continuing to fall despite rapidly falling prices, the Realtor group says the government must take action to address the housing woes in its next stimulus package. "The housing correction is intensifying," NAR Chief Economist Lawrence Yun warned. "Home values were clearly overpriced in many markets, but prices have already tumbled back to the real world -- to those levels that can be fundamentally justified based on income and mortgage rates. Overcorrecting will deepen economic troubles, raise foreclosures, and lead to another round of credit freezes as banks' balance sheets deteriorate even more."
Thursday came some good news on this issue, with Citigroup and Democratic legislators reaching an agreement that would let bankruptcy judges alter home loans to help prevent foreclosures. The legislators are planning to attach the plan to President-Elect Obama's coming stimulus bill, the Associated Press stated.
But bad news continues to flow in from the retail sector. Sales figures are showing that the holiday season was the weakest since at least 1969, AP reported, as the huge discounts that many stores offered to try to lure shoppers have now led many to cut their earnings outlooks. Even Wal-Mart -- which had been a bright spot during the downturn -- posted worse-than-expected results this week, scaring many investors.
Manufacturers are also continuing to struggle. The Institute for Supply Management's manufacturing index fell to its lowest level since June 1980 last month, according to CNNMoney, with none of the industries in the manufacturing sector showing growth.
Unemployment is also still in the forefront of economic news, but there was some good data on that front recently: New jobless claims dropped sharply last week -- the second straight week they've fallen, according to statistics from the Labor Department. The bad news is that some economists are saying seasonal variations due the holidays made the figures artificially low. New unemployment rate figures are due out today.
One of the major bright spots in the economy also remains the same as we move into 2009: oil prices. A barrel of crude was trading in the $41 range Thursday afternoon, less than a third of what it was selling for over the summer. That means gas prices are far better than they were several months ago, good news for those in cold winter climates.
The economic news is gloomy, to be sure, but there are at least two silver linings. First, much of the bad news we've gotten lately has been expected; most economists and strategists don't think things will turn around until mid-2009, so the continued troubles are at least not coming as a surprise.
Secondly, while the economy keeps struggling, stocks keep showing signs of life. Even with Wednesday's big down day, the S&P 500 still gained 4.2 percent over the past two weeks. The Hot List has done even better, surging 9.5 percent in that time. For 2009, the Hot List is also outpacing the index with a return of 4.5 percent vs. the S&P 500's .7%. The portfolio also outperformed the S&P 500 for 2008, though it was not immune to the substantial problems that hit the market. For the year, the portfolio lost 35 percent while the S&P fell 38.5 percent. Since its inception about five-and-a-half years ago, however, the Hot List has gained 71.4 percent while the S&P has fallen 9.1 percent.
Five Reasons to Be Bullish in 2009
The past year has been one of the worst in the history of the stock market. Even including dividends, the S&P 500 finished down 37 percent, the Dow Jones Industrial Average down more than 32 percent, and the Nasdaq Composite down more than 40 percent.
But while the same economic factors that sparked thee market meltdown are still dogging the economy, there are many reasons for long-term stock investors to be optimistic as we head into the New Year. That's not to short-change the problems we're now facing; they remain substantial. But good investors must have the ability to look past the near-term and see the forest for the trees. To me, the forest that is the stock market looks quite inviting right now. Here are five major reasons why:
Valuations: Yes, many investors were tricked before the recent crash by "low" P/E ratios that were the result of extreme leverage propping up earnings. But now, we've had almost a full year of recessionary earnings, and P/E ratios and just about every other valuation measure out there indicate stocks are no longer overvalued. And forward-looking P/Es, which reflect the pessimism in the market, are also very low by historical standards. Standard & Poor's is expecting operating earnings of $81.80 per share for the S&P 500 in 2009, which would put the index's forward P/E at about 11.0. More conservative earnings estimates -- like those that 12 strategists recently gave Barron's, which averaged about $60 a share -- still put the forward P/E at a reasonable 15.
Stocks are also now cheap based on their book values (the value of their tangible assets minus their debts and liabilities), even after the huge writedowns and profit cuts we've witnessed. James O'Shaughnessy, one of the gurus I follow, recently noted that three years ago, only nine of the 500 firms in the S&P 500 were trading at prices below their book values; today, 153 of them are. Coming off a period in which many companies' growing profits were propped up by high leverage, this is a bullish sign.
Even the most conservative of the more commonly used valuation tools, the 10-year P/E ratio (which averages earnings over a 10-year period), has recently indicated that stocks are cheaper than they've been in two decades. All of this has led even some notorious bears like Jeremy Grantham to say that the market is finally cheap.
The Post-Bear Market Guru Track Record: The gurus upon whom I base my strategies all have tremendous long-term track records. But they tend to really excel following down periods like the one we're going through. One big reason: their reliance on facts and numbers -- not hype. While many investors are leery of stocks after periods of bad news, the gurus and our models focus solely on the numbers -- earnings, sales, debt, and other fundamentals. While others allow emotion to get the best of them and avoid the great bargains available after fear-provoking downturns, the gurus -- and our models -- snatch up those good stocks selling on the cheap.
Want proof? Consider the bear of 1973-74, which ended in October of 1974. In 1975, when the S&P bounced back 37.2 percent, John Neff's Windsor Fund returned 54.5 percent, and James O'Shaughnessy produced back-tested returns of 47.9 percent. Neff's fund and O'Shaughnessy's back-tested results again handily beat the market in 1976, as did the back-tested book/market method Joseph Piotroski used (1976 was the first year his research covered). Warren Buffett was the only one of our gurus to underperform in one of those two years -- and he followed his 5 percent loss in 1975 with a whopping 134.2 percent gain in 1976.
After the bear market that ended in August of 1982, the gurus also outperformed. While the S&P gained 22.4 percent in 1983, the gurus' returns for the year were as follows: Neff -- 30.1 percent; Buffett -- 69 percent; Peter Lynch -- 82.8 percent; O'Shaughnessy -- 35.6 percent; Piotroski -- 32.4 percent. Only Martin Zweig lagged the S&P, producing returns of 17.4 percent.
Coming off the most recent bear market and recession, we had a similar experience with our Guru Strategies. The eight individual models we began tracking in July 2003 (shortly after the market began its post-bear market turnaround) each gained between 20 percent and 52 percent for the remainder of that year, while the S&P rose 11.1 percent. In 2004, seven of those eight models more than doubled the S&P's return.
Pessimism: Right now, Americans are at or near all-time lows in terms of confidence in the economy and stock market, and for good reason. The markets have plummeted, the leaders of our financial system have allowed greed and short-sightedness to make a train wreck out of economy, and the Madoff scandal has left investors wondering just who they can trust. Back in July, 55 percent of Americans said they expected stocks to fall in the following 12 months -- an all-time high. And that was before the stock market meltdown and financial sector bailout and Madoff scandal.
But pessimism isn't a bad thing. As the great Sir John Templeton once said, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell."
The data shows that Templeton was right. Citing data from The New York Times, The Motley Fool's Jim Mueller recently showed that every time the stock market pessimism rate has exceeded 35 percent, the market has gone on to gain ground in the next 12 months. Those instances, and the following 12-month returns of the S&P 500:
November 1987 --- +19 percent
October 1990 --- +29 percent
December 1991 --- +4 percent
April 1994 --- +14 percent
October 1998 --- +24 percent
March 2003 --- +33 percent
Average --- +20.5 percent
Now, given the steep declines we've seen recently, I'm not saying that the S&P will end 2009 above its July 2008 mid-1,200s level. But the general point that the data makes -- that periods of extreme pessimism don't last forever, and usually give way to strong market gains -- certainly bodes well as we enter the new year.
Uncle Sam: I know -- putting the government on a list of reasons for optimism about anything seems oxymoronic. To be sure, there's been plenty of criticism of the government's handling of the financial crisis -- it's decision to let Lehman Brothers fail, Congress's delay in passing the initial bailout, the switch from plans to buy up bad debt to plans to inject capital directly into firms.
Some of those criticisms may have merit, but the bottom line now is this: As flawed as its methods may or may not have been, the government has taken extraordinary measures to prevent the collapse of the financial system. Many experts have said that the steps the U.S. took in the first couple months after the crisis boiled over were more significant than Japan took over the course of years in trying to stem its real estate-triggered decade-long recession.
While the specifics on what legislators and the Obama Administration have been planning in terms of a second stimulus are somewhat lacking, it is apparent that the government is going to continue to take major steps to try to get the economy back on track and prevent a further meltdown. That's encouraging.
Inflation: While the cost of inaction likely would have been worse, the federal government's pumping of more than a trillion dollars into the market is likely to have at least one major problematic effect: inflation. And that's a reason for investors to buy stocks.
The research of David Dreman and Jeremy Siegel shows that, throughout history, stocks -- not gold -- are the true inflation-beaters because they can produce increasing earnings streams while fixed income investments cannot. From 1946 (when inflation really became a permanent part of our economy) through 2006, stocks averaged real annual compound returns of 6.9 percent; long-term government bonds, meanwhile, averaged 1.6 percent, short-term government bonds 0.6 percent, and gold brought up the rear at 0.5 percent.
Stocks even beat real estate over the long run. From 1945 to 2007, inflation-adjusted home prices in the U.S. increased at a compound rate of only about 1.3 percent per year -- and that's before the precipitous drop in home prices that we saw in 2008 (figure computed using housing data of Yale Professor Robert Shiller).
A Time of Opportunity
Whether or not 2009 will be a good year for stocks, no one knows. While the data certainly seems to support the notion that equities are undervalued, investors don't always go by data -- they go by emotion, and that means anything can happen in the short term.
But what I believe is that 2009 will go down as having been a great buying opportunity for stock investors. It may take a year, three years, or even five years for the bargain shopping to pay off, but those who buy now while values abound will end up with strong returns in the long run. I'm far from the only one of that opinion. Several of the gurus upon whom I base my strategies -- including Warren Buffett, John Neff, David Dreman, James O'Shaughnessy, and Kenneth Fisher -- have talked about the market being flush with opportunity recently. Those gurus have lengthy track records of being right before, and I believe they'll be right again this time.
Guru Spotlight: Peter Lynch
Picking the greatest mutual fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff (whose three-decade plus track record we looked at in our last Guru Spotlight) -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".
If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Lynch's fame goes beyond his success in the market. His quick wit and "everyman" approach have made him a favorite in the media even after he retired nearly two decades ago. But make no mistake: Much like Warren Buffett, Lynch's true appeal comes not from his sense of humor or ability to relate to the average person -- it comes from that impeccable track record.
Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.
But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.
The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the higher the P/E ratio you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.
The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG really makes him a hybrid growth-value investor.
One Size Doesn't Fit All
One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).
The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.
"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.
One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.
Other differences in Lynch's treatment of the three categories of stocks discussed above: For fast-growers, the model I base on his writings also looks at the P/E ratio itself; for companies with sales greater than $1 billion, it requires the P/E to be below 40, since larger companies can have trouble keeping growth rates high enough to support such a high P/E. For stalwarts, meanwhile, my Lynch-based model also looks at earnings per share. The EPS of a stalwart should be positive. And for slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.
Lynch also mentions other categories of stocks in his writings, but they either were of lesser interest to him, or were not of a quantitative nature, meaning I couldn't replicate them with my computer models. They are:
Cyclicals: These firms (which include automakers and steel manufacturers) tend to do well when the economy's doing well, and struggle when the economy struggles. Lynch strongly suggested that one work in a profession connected to the industry to profit from these business cycles.
Turnarounds: These companies are in trouble and attempting to turn their situation around. Turnaround candidates can make up lost ground very quickly.
Asset Plays: A stock is an asset play if it is sitting on something valuable that Wall Street has overlooked. An example: a supermarket chain that owns a lot of property, but which is keeping those properties on its books at original cost, which is much less than current value.
Beyond The PEG
While Lynch applied different criteria to his different stock categories, the PEG wasn't the only criterion he applied to all categories of stocks. He also made an astute observation about inventory, which can be applied to firms that sell physical products (not services). He viewed it as a red flag when inventory increased more quickly than sales. (Inventory piling up indicates the products aren't as in-demand as the company had hoped.) My Lynch-based model thus likes the inventory/sales ratio to stay the same or decrease from year to year, but will allow for an increase of up to 5 percentage points if all other financials are in order.
Another crucial variable Lynch applied to all categories of stocks: the debt/equity ratio. He liked firms to be conservatively financed, and the model I base on his writings requires firms to have debt/equity ratios no greater than 80 percent.
There is an exception to this test, however: For financial firms, debt is often a required part of business. Recognizing this, Lynch didn't apply the debt/equity ratio to financials. Instead, he looks at how a company's equity compares to its assets for a sign of financial health, and at how much of a return it is generating on those assets for a sign of its profitability.
The model I base on Lynch's writings calls for financial firms to have an equity/assets ratio of at least 5 percent, and a return on assets of at least 1 percent.
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.
Using these fundamental tests, the Validea Lynch-based portfolio has put together a strong track record. Since its inception about five-and-a-half years ago, it has gained 31.5 percent, while the S&P 500 is down 9.4 percent. The portfolio really excelled in 2003, 2004, 2005, and 2006, before stumbling on tough times in 2007 and 2008, along with the rest of the market.
While it will pick up some fast-growing stocks, the Lynch model isn't particularly volatile. Its beta is just 1.09, meaning it is only slightly more volatile than the broader market.
One difference in Lynch's own approach and our Lynch-based strategy is that we allow our model to roam the technology sector. Like Ben Graham and Buffett, Lynch stayed away from tech stocks because he thought they were too risky. While that may have been true in the 1980s, technology has become a huge part of our economy today, and many tech stocks have now established long records of consistent success. That makes well-run tech stocks a lot less risky than the tech stocks of Lynch's era, so we feel it appropriate to include them in our universe of stocks. Here are the stocks in our 10-stock Lynch portfolio, if it were to be rebalanced today:
Skechers USA, Inc. (SKX)
Viad Corp (VVI)
McDermott International (MDR)
CDI Corp. (CDI)
Sierra Wireless, Inc. (SWIR)
Administaff, Inc. (ASF)
Net17 1 UEPS Technologies (UEPS)
Perini Corporation (PCR)
Intersil Corporation (ISIL)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do at times like this, when the market has plummeted. But the fear and anxiety investors feel after such a plunge make it more important than ever to heed this piece of Lynch advice: "The real key to making money in stocks is not to get scared out of them."
News about Validea Hot List Stocks
Skechers (SKX): The retailer announced it is launching a children's clothing line in Fall 2009, adding that Adjmi Apparel Group will design, distribute and market the line, bizjournals.com reported on Jan. 6. The Skechers-branded line will be geared towards younger boys and girls, and will be sold at department, specialty, and online retailers that carry Skechers Kids footwear, bizjournals.com stated.
JAKKS Pacific (JAKK): On Dec. 30, the toy maker closed on its deal with Disguise Inc., a Halloween costume and accessory maker. JAKKS revealed that the deal included $28.3 million in cash as well as $27.6 million for license transfer fees and liabilities, the Associated Press reported. An analyst estimated that the deal could add about 15 cents per share to JAKKS' 2009 earnings, AP stated.
American Eagle Outfitters (AEO): The clothing retailer cut its fourth-quarter guidance and reported a worse-than-expected 17 percent same-store drop in December same-store sales, the Associated Press reported. Eagle cuts its fourth-quarter profit range from $0.30-$0.36 to $0.19-$0.21, because of weaker sales and discounts as it clears out unsold merchandise, AP stated, adding that the drop in same-store sales for December was caused by weak customer traffic and poor sales of its namesake brand clothes during the holiday period.
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.
The use of the name of a financial analyst, identified as a "guru" represents the interpretation by Validea of that person's key investment analysis principles, as derived from published sources. The use of a guru's name does not mean that he personally endorses, or even agrees with any of the representations made with respect to specific securities as derived by Validea from its interpretation of his or her investment methodology.
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Fundamental data provided by Reuters