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Executive Summary August 19, 2011

The Economy

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.

 
Editor-in-Chief: John Reese










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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 hotlist@validea.com.


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Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.





AmTrust Financial Services Inc. (AmTrust) is a multinational specialty property and casualty insurance company. The Company operates in three segments: Small Commercial Business, Specialty Risk and Extended Warranty and Specialty Middle Market Business. The Company's insurance subsidiaries include Technology Insurance Company, Inc. (TIC), Rochdale Insurance Company (RIC), Wesco Insurance Company (WIC), Associated Industries Insurance Company, Inc. (AIIC), Milwaukee Casualty Insurance Company (MCIC), Security National Insurance Company (SNIC), AmTrust Insurance Company of Kansas, Inc. (AICK) and Trinity Lloyd's Insurance Company (TLIC), which are domiciled in New Hampshire, New York, Delaware, Florida, Wisconsin, Texas, Kansas and Texas respectively, and AmTrust International Insurance Ltd. (AII), AmTrust International Underwriters Limited (AIU) and IGI Insurance Company, Ltd. (IGI), which are domiciled in Bermuda, Ireland and England, respectively.





Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. These services include secured non-recourse loans, commonly referred to as pawn loans and unsecured consumer loans. The Company's consumer loan portfolio includes short-term single payment loans, longer-term multi-payment installment loans, credit services and participation interests purchased from third parties in the micro line of credit (MLOC) services channel. Through the Credit Services Organization program (the CSO program), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization on behalf of consumers. As of December 31, 2010, it operated in two segments: retail services and e-commerce. During the year ended December 31, 2010, the Company renamed its Internet Services Division as the E-Commerce Division.





Amtech Systems, Inc. (Amtech), incorporated in October 1981, through its wholly owned subsidiaries, supplies horizontal diffusion furnace systems used for solar (photovoltaic) cell and semiconductor manufacturing. The Company provides products and services to two industries: the solar industry and the semiconductor industry. The Company's solar and semiconductor equipment is sold under brand names of Tempress Systems and Bruce Technologies, which have customers in both the solar industry and the semiconductor industry. Within the solar industry, its provide diffusion and automation equipment to solar cell manufacturers and it also offers plasma enhanced chemical vapor deposition (PECVD) and phosphocilicate glass (PSG) equipment. Within the semiconductor industry, it provides equipment to manufacturers of analog, power, automotive and microcontroller chips with geometries greater than 0.3 micron.





Banco Macro SA (the Bank) is an Argentina-based financial institution. The Bank offers traditional banking products and services to companies and individuals nationwide. Banco Macro divides its operations into personal banking, which provides services for individuals and microenterprises, and corporate baking, which covers small, medium and large companies, as well as major corporations. The Bank's products and services portfolio includes loans, insurance, debit and credit cards, investment advice and investment accounts, among others. As of December 31, 2010, Banco Macro held interest in such entities as Macro Securities SA Sociedad de Bolsa, Sud Inversiones & Analisis SA, Banco del Tucuman SA and Banco Privado de Inversiones SA.





AstraZeneca PLC (AstraZeneca) is a global biopharmaceutical company. AstraZeneca discovers, develops and commercializes prescription medicines for six areas of healthcare: Cardiovascular, Gastrointestinal, Infection, Neuroscience, Oncology, and Respiratory and Inflammation. It has a range of medicines that includes treatments for illnesses, such as its antibiotic, Merrem/Meronem and Losec/Prilosec for acid related diseases. AstraZeneca's products include Crestor, Seloken/Toprol-XL, Atacand, Nexium, Synagis, Seroquel IR, Seroquel XR, Arimidex, Zoladex and Symbicort. The Company owns and operates a range of research and development (R&D), production and marketing facilities worldwide. AstraZeneca operates in over 100 countries, including China, Mexico, Brazil and Russia. On March 3, 2010, AstraZeneca completed the acquisition of Novexel S.A. Novexel is a France-based research company focused on the infection therapy area.





Quality Systems, Inc. develops and markets healthcare information systems that automate certain aspects of physician, inpatient and dental practices, networks of practices, such as physician hospital organizations (PHOs) and management service organizations (MSOs), ambulatory care centers, community health centers, Federal Qualified Health Centers (FQHC) and medical and dental schools. The Company also provides inpatient electronic health records (EHR) and financial solutions for community hospitals, as well as revenue cycle management (RCM) services through the Practice Solutions Division. The Company along with its wholly owned subsidiaries operates as four business divisions: the QSI Dental Division, the NextGen Division, the Inpatient Solutions Division, and the Practice Solutions Division.





Dollar Tree, Inc. is an operator of discount variety stores offering merchandise at the fixed price of $1. At January 29, 2011, the Company operated 4,101 discount variety retail stores. Its stores operate under the names of Dollar Tree, Deal$, Dollar Tree Deal$, Dollar Giant and Dollar Bills. Approximately 3,935 of these stores sell substantially all items for $1 or less in the United States and $1.25 or less in Canada. Substantially all of the remaining stores, operating as Deal$, sell items for $1 or less but also sell items for more than $1. The Company's optimal store is between 8,000 and 10,000 selling square feet. This store size provides the appropriate amount of space for its merchandise offerings while allowing it to provide service. At January 29, 2011, it operated 4,015 stores in 48 states and the District of Columbia, as well as 86 stores in Canada. In November 2010, it acquired 86 Dollar Giant stores based in Vancouver, British Columbia.





Acme Packet, Inc. is a provider in session border control solutions, which enable the delivery interactive communications, such as voice, video and multimedia sessions, and data services across Internet protocol (IP), network borders. The Company's Net-Net product family of session border controllers (SBCs), session aware load balancers (SLBs), session routing proxies (SRPs), and multiservice security gateways (MSGs), supports multiple applications in enterprise networks and fixed line, mobile, over-the-top and application service provider networks. These applications range from voice over IP (VoIP), trunking to hosted enterprise and residential services to fixed-mobile convergence. Its products satisfy critical security, service assurance and regulatory requirements in these networks. On January 20, 2011, the Company acquired Newfound Communications, Inc. ( Newfound Communications).





ConocoPhillips is an international, integrated energy company. the Company operates in six segments: Exploration and Production (E&P), which explores for, produces, transports and markets crude oil, bitumen, natural gas, liquefied natural gas (LNG) and natural gas liquids on a worldwide basis; Midstream, which gathers, processes and markets natural gas produced by it and others, and fractionates and markets natural gas liquids, in the United States and Trinidad; Refining and Marketing (R&M), which purchases, refines, markets and transports crude oil and petroleum products, in the United States, Europe and Asia; LUKOIL Investment, which consists of its investment in the ordinary shares of OAO LUKOIL; Chemicals, which manufactures and markets petrochemicals and plastics worldwide, and Emerging Businesses, which represents investment in new technologies or businesses outside its operations.





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.





Disclaimer


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.