The economic news continues to be mixed, But there have been some major changes in the sources of the good news and bad news over the past couple weeks.
The manufacturing sector, a major driver of the economic recovery that began in mid-2009, contracted for the first time in three years last month, for example, according to the Institute for Supply Management. ISM's manufacturing index came in at 49.7 for June -- just below the 50 level that serves as the mark between expansion and contraction. It's not a horrible reading, and it is extremely impressive that the sector expanded for three years straight before finally showing a narrow contraction -- in past expansions, it has been fairly common for much worse readings to pop up from time to time. What is somewhat disturbing is the major dip in the group's New Orders sub-index, which fell from 60.1 to 47.8. ISM reported that slowdowns in both Europe and China are being cited for the poor June figures.
Good news came, however, from two areas that had been providing investors with plenty of headaches: housing and Europe. For the first time in seven months, the S&P/Case-Shiller Home Price Indices showed that U.S. housing prices rose in April, increasing 1.3% over March (and 0.7% when seasonally adjusted). That is certainly good news, given that the housing market's collapse triggered the Great Recession and that the sector -- usually a key to recoveries -- has been absent from this one. Still, prices are about 2% below where they were a year ago and about 34% below their 2006 peak, so April's gains, while encouraging, were baby steps forward.
In Europe, meanwhile, debt woes still rule the day, but good news came in the form of government support. Eurozone leaders agreed on a preliminary plan to provide bailout funds directly to European banks, with Germany apparently yielding to some of its previous objections to such a proposal. It was a big show of support that had been lacking, though details are still being worked out, and the markets responded very positively. The global economic enthusiasm was tempered this week, however, when China decided to cut a key interest rate for the second time in a month, leading analysts to believe that the giant global growth engine is experiencing more of a slowdown than previously thought.
In other areas at home, new claims for unemployment have fallen about 4.6% since our last newsletter (on a seasonally adjusted basis), a good sign. They are now 13.7% lower than they were a year ago (unadjusted). Continuing claims fell slightly, and are about 12% below year-ago levels. Decent news also came from the service sector, which expanded for the 30th straight month in June, according to ISM, though at a slightly slower pace than it did the previous month. And the personal savings rate increased slightly in May, according to a new Commerce Department report. It rose from 3.7% to 3.9%, reaching its highest level since January.
Since our last newsletter, the S&P 500 returned 3.2%, while the Hot List returned 5.7%. So far in 2012, the portfolio has returned 14.1% vs. 8.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 158.0% vs. the S&P's 36.7% gain.
Boring Is Beautiful
When you see the phrase "elite investment strategist", or "star stock investor", what sort of person comes to mind? I'd be willing to bet that, for most people, the answer is some version of Michael Douglas' character in Wall Street -- a smooth-talking, highly connected, risk-taking player, someone whose portfolio is as flashy as his or her impeccable wardrobe; the sort of Wall Street guru who made millions by snatching up dazzling tech stocks and red-hot start-ups, somehow having the foresight to buy them before just about everyone else thought to.
Such an image makes for a great character on the big screen, of course. But after more than a dozen years studying history's best investors, I've found that far more often than not, the best investors and their portfolios are far from flashy and exciting. John Neff, for example, who produced a remarkable three-decade track record at the Windsor fund, once called his portfolio "relatively prosaic, dull, [and] conservative". In discussing the key to successful investing, James O'Shaughnessy -- whose study into the performance of various investment strategies is perhaps the most in-depth of its kind -- didn't cite great foresight or timing or intricate business knowledge, but instead the discipline to "consistently, patiently, and slavishly stick with a strategy". And the great Benjamin Graham once wrote that investing should be viewed "more as a hazard to be guarded against than as a source of profit through prophecy."
It's a great irony, really -- that by investing in unexciting companies using a highly disciplined approach, elite strategists have made the sort of money that conjures up images of lavish mansions, rare sports cars, and private islands. And recently, this concept -- let's call it "boring is beautiful" -- has been borne out by some hard data. In a study entitled "Betting Against Beta" that was published in the Swiss Finance Institute Research Paper Series, authors Andrea Frazzini and Lasse Pedersen presented some powerful evidence that stocks with low betas (i.e., low volatility) produce the best returns over the long haul. It's a proposition that flies in the face of conventional wisdom, which holds that, in order to produce market-beating returns, you have to bet on riskier stocks (and many -- perhaps erroneously -- use "risk" and "volatility" synonymously when discussing stocks).
Frazzini and Pedersen found, however, that Warren Buffett's Berkshire Hathaway has far outperformed the broader market not by going after stocks with more volatility, but instead by investing in low-beta stocks, and using leverage when buying them. What's more, they found that U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures have all demonstrated a similar pattern over the long run, with high-beta assets actually underperforming their lower-beta peers.
A big part of the phenomenon, Frazzini and Pedersen surmised, was that most investors can't use large amounts of leverage the way that Buffett and Berkshire do when loading up on less volatile plays. Instead they turn to high-beta stocks in search of more risk and higher return, and in doing so, they bid up the prices of those stocks. Those stocks become overvalued, which of course limits their future returns.
Frazzini and Pedersen aren't alone in their findings. In another study published last year in the Financial Analysts Journal, authors Malcolm Baker, Brendan Bradley, and Jeffrey Wurgler looked at the 1,000 largest stocks from 1968-2008, breaking them down into five quintiles based on their betas. They found that investing a dollar in the quintile of stocks with the lowest betas would've produced a gain of $10.12, after inflation, by the end of the 41-year period. A dollar invested in the stocks with the highest betas would have left one with less than 10 cents. They hypothesized that a number of behavioral factors, including overconfidence, tend to push investors into high-beta stocks, making them overvalued, which, again, limits future returns.
O'Shaughnessy last fall also presented some data that turned the higher-risk-equals-higher-reward tenet on its head. In the new, updated version of his What Works on Wall Street, he found that the consumer staples sector has produced the best returns over the 1968-2009 period -- and that it did so while being one of the least volatile sectors in the market. Over that period, he found, consumer staples averaged compound annual returns of 13.57%, beating the next-best sector (financials) by 1.2 percentage points per year. And, the sector had the second-lowest standard deviation out of the market's 10 sectors; the only one that was less volatile was utilities.
O'Shaughnessy wrote that the apparently strange finding actually makes a good deal of sense. "Industries that make goods and services that people have to buy, regardless of economic circumstances, are bound to do well whatever the economic conditions," he writes. He adds that the sector is also filled with companies that have wide economic moats that protect them against competition, and strong brand recognition -- which he says are major advantages for a business. O'Shaughnessy also found that looking for the most fundamentally sound stocks within the consumer staples sector could really improve your odds of success. For example, companies in the top quintile based on shareholder yield (buyback yield plus dividend yield) returned 17.8% compounded over the 42-year study. And, they did so with a lower standard deviation and a lower maximum drawdown than the sector as a whole.
In light of all the data that has emerged over the past year, I thought it would be interesting to see where the stocks in the Hot List stand according to their betas. I wanted to get a good sample size that encompassed both the 2007-09 bear market and the succeeding recovery, so I looked at the stocks' five-year beta (vs. the S&P 500; a tip of the cap to Zack's Investment Research for the beta data). Here's what I found:
Coinstar -- 0.92
The TJX Companies -- 0.56
Stamps.com -- 1.17
LKQ Corporation -- 0.84
SolarWinds Inc. -- 0.75
Apollo Group -- 0.37
MWI Veterinary Supply -- 0.74
Altisource Portfolio Solutions -- -0.15
Northrop Grumman -- 1.09
Tractor Supply Company -- 0.80
As you can see, 8 of the 10 holdings have lower betas than the S&P 500 (which is 1.0), indicating they've been less volatile than the broader market over the past five years. Of course, we don't implicitly look for low-beta stocks, and neither did the gurus upon whom my models are based. But I think that many of the qualities my models do look for -- low valuations, good liquidity, conservative financing, consistent earnings growth -- tend to often lead the portfolio to solid, stable firms whose shares are less volatile than the flashy high-fliers many investors get captivated by. Consider the portfolio's current holdings. Sure, there are some well-known companies in there, but many are far from household names, and far from flashy, exciting businesses; you're certainly not likely to hear anyone bring up MWI Veterinary Supply or Tractor Supply Company when discussing hot stocks at a cocktail party.
What's just as important to note, I think, is that when the portfolio does happen to buy a stock that is more volatile than the broader market, it isn't because we're playing a hunch or trying to ride the wave of a hot stock. It's because the stock's fundamentals and financials are sound. So, for example, while Stamps.com has a beta of 1.17 -- the highest of any Hot List stock right now -- it trades for just 10.1 times trailing 12-month earnings per share and has a P/E-to-Growth ratio of just 0.29. In other words, while it's been more volatile than the broader market in recent years, it hasn't been bid up in price, which is the problem with many high-beta stocks, according to the two studies I referenced above. And given the company's growth (35% per year over the long term) and financial position (it has no long-term debt), it seems like some extra volatility is worth it.
The big point in all of this, I think, is not to fall into the trap of thinking that you need to take big risks on sexy, hyped-up stocks in order to make money in stocks. While there are exceptions -- Apple gets high marks from my strategies -- more often than not, the stocks that are getting talked up by pundits and friends and co-workers end up being more hype than substance. Focusing on fundamentals, however, will lead you to quality companies and undervalued stocks. Over the long haul, that should help you produce some pretty exciting returns, even if many of the stocks that help you get there are far from glamorous.
|Editor-in-Chief: John Reese
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As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include:
Guess?, Inc. (GES), Discover Financial Services (DFS)
World Acceptance Corp. (WRLD).
7 stocks remain in the portfolio. They are:
The Tjx Companies, Inc. (TJX), Coinstar, Inc. (CSTR), Lkq Corporation (LKQ), Stamps.com Inc. (STMP), Mwi Veterinary Supply, Inc. (MWIV), Solarwinds Inc (SWI)
Altisource Portfolio Solutions S.a. (ASPS).
We are adding 3 stocks to the portfolio. These include:
Apollo Group Inc (APOL), Northrop Grumman Corporation (NOC)
Tractor Supply Company (TSCO).
Newcomers to the Validea Hot List
Apollo Group (APOL): Apollo owns the University of Phoenix and several other schools that offer undergraduate, master's, and doctoral degrees through both on-campus and online courses. The Phoenix, Ariz.-based firm has a $4.2 billion market cap and has taken in about $4.4 billion in revenue in the past year.
For-profit education companies have been dealing with several challenges over the past few years, not the least of which is the potential for increased government regulation of their operations. But my models think that Apollo should be getting more love from investors. It gets high marks from my Joel Greenblatt- and Peter Lynch-based models. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.
Northrop Grumman Corporation (NOC): One of the country's largest defense contractors, this Virginia-based firm is involved in the aerospace, electronics, information systems, and technical services arenas, serving government and commercial customers across the globe. Its products include unmanned aircraft systems, B-2 stealth bombers, the James Webb space telescope, radar systems, 911 public safety systems, and cybersecurity solutions, to name just a few.
Grumman has a $16 billion market cap, and gets strong interest from my Peter Lynch-, Joel Greenblatt-, and Kenneth Fisher-based models. To read more about it, see the "Detailed Stock Analysis" section below.
Tractor Supply Company (TSCO): Tractor Supply is the largest retail farm and ranch store chain in the U.S., with more than 1,000 retail stores in 44 states. The Brentwood, Tenn.-based firm has a $6 billion market cap, and has taken in more than $4.4 billion in sales in the past year.
Tractor Supply was a nice winner for the Hot List last year, gaining 18.1% during a one-month stint in the portfolio. It's back again, getting strong interest from my Warren Buffett- and James O'Shaughnessy-based approaches. See the "Detailed Stock Analysis" section below to learn more about it.
News about Validea Hot List Stocks
Coinstar Inc. (CSTR): On June 26, Coinstar said it had completed a $100 million acquisition of DVD rental kiosks and other assets from one of its rivals, NCR Corp., the Associated Press reported. Coinstar also assumed certain NCR liabilities related to the assets and entered into a supplier agreement to buy products and services from NCR, according to AP. The firm said the deal will cause it to initially incur extra costs, but the move will begin adding to profits in 2013. For 2012, it expects the deal will decrease profit by 40 cents to 50 cents per share and increase its capital expenditures by between $40 million and $45 million, AP reported.
The TJX Companies (TJX): While retail sales reports for June were mixed across the sector, TJX reported that its sales rose 7% for the month, more than expected, the Associated Press reported. Shares jumped nearly 4% on July 5 on the news.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. If you have any questions, please feel free to contact us at firstname.lastname@example.org.