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|Executive Summary||August 19, 2011|
With EuroZone debt fears spiking and U.S. debt fears lingering, it's been another tumultuous week for the equity markets. But the hard data beneath the fear-filled headlines actually shows that things aren't as bad as they may seem.
Consider recent unemployment claims reports. While still high compared to historical levels, the four-week moving average of new claims has fallen to its lowest level in almost four months. New claims for last week were about 15% below their 2011 high, and 16% below their year-ago level.
The U.S. consumer also continues to show remarkable resilience. Though wearied from the recession and quickly losing faith in their elected representatives, consumers felt good enough to increase their retail spending in July, according to the Commerce Department. Retail and food service sales rose 0.5% for the month, it said. June's increase was also revised upward. The figure has now risen in 24 of the 28 months since hitting a low in March 2009.
Early manufacturing data for August has, however, been disappointing. The Federal Reserve Bank of New York's monthly manufacturing survey showed that general business conditions declined in the state for the third time in four months. The Philadelphia Fed's regional manufacturing index (which covers several mid-Atlantic states), meanwhile, was downright ugly. After being slightly in positive territory in July, the index fell to -30.7 in August, with 45.7% of respondents reporting a decline in business conditions and only 14.7% reporting an increase. Keep in mind, however, that in some past months regional manufacturing reports have been weak but overall national numbers have ended up comfortably in positive territory.
The housing market, which was perhaps the main factor in the "Great Recession", continues to struggle. Existing-home sales fell 3.5% in July, according to new data from the National Association of Realtors. A government report also showed that new building permits for private housing fell 3.2% in July, and new housing starts slipped 1.5%.
The individual reports have thus been mixed. The markets, however, have been more concerned with broader fears about debt -- particularly European debt. Yes, fears of a burgeoning U.S. debt are certainly present, but do investors really fear a U.S. default? If they did, would Treasury prices have soared -- and yields thereby plunged -- the day after Standard & Poor's issued its downgrade of U.S. debt? And while recent economic reports have been mixed, few -- perhaps only the Philadelphia Fed manufacturing report -- have been as surprisingly bad as to merit the huge swings we've seen in stocks. No, the downdraft we've seen seems to be more of a reaction to fears about Europe.
This pattern goes back to last year -- the correction that began in late April 2010 started exactly one day after Moody's downgraded Greece's debt, and on the same day that Greece's prime minister asked for a major aid package from the European Union and International Monetary Fund. (And at that time, the markets seemed truly worried about a Greek default, as Greek debt yields soared.)
Amid all the fear, it's been a tough, volatile fortnight for the market. Since our last newsletter, the S&P 500 has returned -5.0%, while the Hot List has returned -7.8%. So far in 2011, the portfolio has returned -15.7% vs. -9.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 127.5% vs. the S&P's 14.0% gain.
Deja Vu All Over Again?
There's no denying it: On the surface, the last couple weeks have felt more than a little like the fall of 2008. The major stock market indices have been swinging 4, 5, even 6 percent in a single day. The headlines are filled with debt-related fears. And investors are cramming into "safe" investments like Treasury bills at an astonishing rate.
Some key differences exist between today and the fall of 2008, however. For one thing, back then, piles of mortgage-backed securities weren't just dragging down banks' balance sheets -- they were making it impossible to even determine what exactly was on those balance sheets. Were those securities worth 75% of what they were thought to be worth? 50%? 30%? Or were they, quite simply, worthless? Today, debt is again the issue, but it's a more quantifiable sort. That doesn't mean it's not a problem. But more of the cards are on the table this time around, and, given how much the market doesn't like negative surprises, that's a good thing.
U.S. financials have thus also had nearly three years to recapitalize (with extensive help from Uncle Sam), and to deal with those MBS's that were clogging their balance sheets.
Just as financials have recapitalized, U.S. consumers have gained liquidity. The personal savings rate (savings as a percentage of disposable income) for June (the most recent month for which government data is available) was 5.4%, more than double what it was when the 2007-09 recession began. And consider this: Americans' "financial obligations ratio" -- that is, the amount of debt the average American has as a percentage of disposable income -- was 18.85% in the third quarter of 2007, right before the recession began. The Federal Reserve's web site has data going back to 1980, and that was the highest level on record. In the first quarter of 2011 (the most recent data available), the figure had fallen to 16.39%, the lowest level in 17 years. That's right, Americans' debt loads are down to 1994 levels, something that has been largely lost amid the negative headlines that have dominated the financial world the past couple years.
Finally, U.S. non-financial companies have gotten incredibly lean. It's come at the expense of jobs -- many companies have been hoarding cash rather than hiring, likely because they fear another 2008. But they collectively have liquidity that they did not have back in 2008.
There are also, to be sure, some negative factors not present back in 2008. For one, to repeat a metaphor that has been beaten to death, the Federal Reserve doesn't have nearly the amount of bullets that it had at its disposal back then. Interest rates are at rock bottom, and the Fed's balance sheet has more than tripled over the past four years by virtue of its wide-ranging quantitative easing programs. Nevertheless, on the whole, I'd say we're significantly better off than we were in late 2008.
Most investors, however, don't think about all that. They see the declines in their portfolio, and feel the wild gyrations of the market, and flash back to '08. It's to be expected -- that's how we're hardwired. "Recency bias" -- the tendency to weigh recent events more heavily when trying to predict what will happen in the future -- impacts everyone, both in terms of investing and other parts of life. In this case, it seems to be manifesting as a financial version of post-traumatic stress disorder. Any hint of the feelings they felt in '08, and investors are jolted to the point that they'll run the opposite direction from stocks.
Not everyone, of course. Some of the world's best investors, including Warren Buffett, David Herro, and even the often-gloomy Jeremy Grantham, have all said they've been buying up shares as the market has tumbled.
What they know, and what many forget, is that it all comes back to value. And right now, there seems to be plenty of value in the market. Using the average of last year's operating and as-reported earnings, the S&P 500 now trades at a price/earnings ratio of about 14. Using an average of operating and as-reported earnings for the past five years, the P/E is about 17.5 -- hardly frothy (and that includes earnings from one of the worst periods in history.)
More importantly, plenty of individual stocks are offering exceptional values. Of course, as always, you never know when those values will be realized. A couple of our holdings have had some very rough periods recently, and in the short term the rough sledding could continue. Given the emotional battering investors have taken in the past decade or so, and the legitimate economic concerns hovering over many parts of the world, it may take them a while to start snatching up stocks again.
But even if that is the case, to me, it's worth a bit of a wait, especially considering the alternatives. Bond prices have been going through the roof and offering little in the way of yield; gold has been climbing higher and higher, but has no real source of revenue or earnings behind it -- you can't assess its true value in any tangible way; and cash is yielding next to nothing.
So we'll continue to focus on attractive shares of solid companies, remembering that history has shown that staying disciplined through tough times is the way to make money over the long term. As the great Peter Lynch said, "The real key to making money in stocks is not to get scared out of them." We don't intend to.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
A Strong Rebounder
My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned about 25%, about twice what the S&P 500 has gained.
While the portfolio hasn't been one of my best performers, it has excelled coming out of downturns. In 2004, as we were emerging from the lengthy recession associated with the tech stock bust, the Buffett portfolio surged 37.3%, more than quadrupling the S&P's 9% gain. In addition, after struggling in 2007 and 2008 amid the latest recession and bear market, the portfolio bounced back strong in 2009 -- very strong. It gained 50.3%, more than doubling the gains of the broader market.
This strong performance out of downturns is no surprise, given Buffett's penchant for pouncing on good, beaten down stocks, which usually abound during tough times as investors let fear get the best of them. One of Buffett's mantras is that investors "should try to be fearful when others are greedy and greedy only when others are fearful", and he's lived up to that recently -- while others have run from stocks during the recent downdraft, he says he's been buying quite a bit.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings. It's an interesting group, and some of the holdings might not seem like "Buffett-type" plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
Ross Stores, Inc. (ROST)
The TJX Companies, Inc. (TJX)
Urban Outfitters Inc. (URBN)
PetMed Express, Inc. (PETS)
Rollins Inc. (ROL)
World Acceptance Corp. (WRLD)
Coach, Inc. (COH)
Varian Medical Systems Inc. (VAR)
FactSet Research Systems Inc. (FDS)
Infosys Technologies Limited (INFY)
News about Validea Hot List Stocks
Dollar Tree Inc. (DLTR): Dollar Tree reported second-quarter earnings that beat analysts' estimates, and it raised its full-year 2011 profit outlook. Net income was $94.9 million, or 77 cents a share, compared with $78 million, or 61 cents a share, in the year-ago period. Analysts, on average, had forecast 75 cents a share, according to Thomson Reuters I/B/E/S. Net sales were up 12% to $1.54 billion, coming in slightly below analysts' estimates of $1.55 billion. Cost reductions resulted in increased margins, and the firm raised its full-year projection to $3.82-$3.95 EPS, vs. previous estimates of $3.69-$3.85
AmTech Systems Inc. (ASYS): AmTech announced very strong earnings and sales for the most recent quarter, but its shares have tumbled. The company said it had record net revenues of $71.9 million in its fiscal third-quarter, up 67% from the year-ago quarter. Earnings per share were $0.74 on a diluted basis, up 76% from the year-ago period. But the company also said operating margins for the fourth quarter should be impacted negatively by several factors, and it said total orders fell from $72.5 million the prior quarter to $13.5 million in the fiscal third quarter. Investors focused on those figures, and the stock was down about 35% since our last newsletter (as of Thursday afternoon).
Acme Packet Inc. (APKT): Acme shares tumbled Thursday, though the decline was not due to fundamentals. It instead came after an analyst downgraded the firm, citing industry concerns. The stock was down about 17% for the day.
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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