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|Executive Summary||June 25, 2010|
The economic news has been mixed since our last newsletter, with new data highlighting both signs that the recovery continues -- and that substantial headwinds remain.
On the positive side, industrial and manufacturing firms continues to rebound. Industrial production increased in May for the tenth time in eleven months, the Federal Reserve announced. And the increase was significant -- the 1.2% gain matched the second-largest monthly gain for the industrial sector in the past decade. Capacity utilization also rose to almost 75% -- reaching its highest level since October 2008.
There was also a bit of good news in the job market, with the number of new claims for unemployment benefits falling about 4% in the most recent week (ending June 19). The number of continuing claims also dipped slightly, though it's unclear how much of that is due to people getting jobs and how much is due to long-term unemployed workers exhausting their benefits. Whatever the case, the broader unemployment picture is much better than it was a year ago, but still far from positive.
An interesting tandem of data points came, meanwhile, from the U.S. consumer. According to the Commerce Department, retail sales fell 1.2% in May -- the first decline in eight months. But consumer confidence appears to be on the rise, as the Conference Board's Consumer Confidence Index rose in May to its highest level since March 2008. And the group's expectation index (which gives an idea of what consumers are expecting in the next few months) rose to its highest level in almost three years. Given that consumer spending accounts for about 70% of U.S. economic activity (and the impact that psychology can have on economic trends), that certainly bodes well.
The housing market, a key to the economic recovery, also offered some mixed -- though not unexpected -- news. Existing-home sales remained elevated (almost 20% above their year-ago level) in May, according to the National Association of Realtors. The high number came as homebuyers took advantage of the government's homebuyer tax credit and very low mortgage rates, the Realtor's group said.
While those figures include sales made before the homebuyer tax credits ended, May data on new home sales from the Commerce Department did not. And they painted a very different picture, falling 33% to record-low levels. At this point, it's hard to draw major conclusions from the housing data; it is certainly possible, and in fact likely, that many buyers made sure to make their purchases before the tax credit offer expired, meaning that their buys -- which otherwise might have been made later in the year -- counted for previous months. That would have made the May sales levels look artificially low. Nonetheless, the issue of how the housing market fares without the government's tax credit boost is certainly something to keep an eye on.
The mixed economic news at home -- and continued worries about Europe's debt mess -- have made for some ups and downs for the market since our last newsletter. The S&P 500 ended the fortnight with a return of -1.2%, while the Hot List returned -0.4%. For the year, the portfolio is now down -6.8% vs. -3.7% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 124.6% vs. the S&P's 7.3% gain.
Get Your Head Out of the Game
The last couple months have had investors on a bit of an emotional roller-coaster. From the European debt woes to the massive oil spill in the Gulf of Mexico to the U.S.'s soaring budget deficit, investors have found plenty to worry about -- and that has meant some volatile times for the market.
Volatile times can, of course, mean emotional times for investors. And, if you're a regular Hot List reader, you know that I believe emotion is perhaps the greatest enemy of the investor.
It's not our fault, really -- in fact, the fields of behavioral finance and neuroeconomics show that as emotional creatures, we humans are, for the most part, born bad investors. Our emotions make us prone to numerous behavioral biases that, while in many cases are good for our survival, are dangerous for our portfolios.
One intriguing new study in this area highlights one of those biases -- the so-called "herd mentality" -- and offers a look at why many investors succumb to it. The study (recently highlighted by The Wall Street Journal's Jason Zweig) was performed by researchers at University College London and Denmark's Aarhus University and published in the journal Current Biology. Entitled "How the Opinion of Others Affects Our Valuation of Objects", it actually focuses on music, not stocks. Participants whose brainwaves were being monitored were asked to list songs that they most wanted to buy online. Then, they were given ratings of those songs by two professional music "experts". After reading the reviews, they were then asked if they wanted to revise their lists.
The results showed that the experts' opinions did indeed have an impact on the participants. And it's more than just a safety-in-numbers issue. "The brain scans showed that as soon as people learned they had chosen the same song as the experts, cells in the ventral striatum -- a reward center wired with dopamine neurons that respond to pleasures like sugar and sex -- fired intensely," Zweig explains. In other words, the study shows that it feels good to have someone agree with you.
And, Zweig says, the scans showed something else: that finding out experts agreed with each other (regardless of whether they agreed with the participants) triggered activity in the participant's insula, a part of the brain associated with pain and heightened body awareness. "This suggests that the agreement of others may have a special ability to grab our mental attention," Zweig says. "No wonder a consensus opinion is almost impossible for investors to ignore."
If you want a good example of investors succumbing to the herd mentality, look at the Internet bubble of the late 1990s. At that time, technology stocks were all the rage; if you didn't get in on the tech stock bonanza, others made you feel bad about it -- you were called old, stodgy, and out of touch with the times. Investors piled into these high-flying stocks not because they'd analyzed them and found real value -- indeed, many of the companies behind these stocks had no value at all; instead, they piled in because they let other people's opinions affect them. And they paid dearly for doing so when the bubble burst and they were left holding onto worthless stocks.
The tendency to follow the herd is far from the only behavioral bias that can impact investors. Another big one: hindsight bias -- the tendency to think, after the fact, that we could have easily avoided mistakes. The result is a false sense that you can avoid trouble in the future now that you've "learned your lesson". For those who try to jump in and out of the market without any sort of system, this is particularly dangerous -- so many factors go into stock movements in the short term that almost no one can be successful in such endeavors, and those who think they've "figured it out" are usually wrong. (The proof is in the pudding: According to data from DALBAR, Inc., the average equity fund investor has gained just 3.17% per year over the past two decades -- a period in which the S&P 500 has gained 8.2% annually.)
The truth is that the future is never as obvious as it seems in hindsight, and the 2008 financial crisis is a great example. Today, there no doubt are many investors who believe they've "learned their lesson" from the market crash, and will now be able to avoid the next market plunge -- just think about all of the stories you've seen in the past year or so that claim to identified "the next bubble". But the reason that the crash was so severe and shocking was precisely because so few strategists rang the warning bell ahead of time. If it had been more obvious, the real estate and credit bubbles and corresponding stock market rise never would have lasted as long as they did.
Nevertheless, you can bet that many investors will try to outsmart the market to avoid future downturns. And in doing so, you can also bet that many will key on false warning signals, and in the process jump in and out of the market at inopportune times.
Many behavioral biases really rear their heads when it comes to deciding when to sell stocks. One of the big ones: "myopic loss aversion". Coined by behavioral finance pioneers Richard Thaler and Shlomo Benartzi, myopic loss aversion is the notion that investors hold on to losing stocks too long, not wanting to lock in losses. And there's biology behind it -- studies show that losses cause roughly twice as much emotional pain as gains create emotional pleasure. Investors will thus delay that pain by refusing to lock in losses, even if the stock has little in the way of future prospects.
"Anchoring" is another bias that can lead investors to hold on to a stock too long. It is when one bases one's expectations on facts that are no longer relevant. For example, you'll often hear strategists touting a particular stock (or the market in general) saying that the stock is still well off its highs. And, on the surface, the fact that a stock is selling for, say, $40 when it used to trade at $60 makes it sound like a bargain. But that previous high may not be relevant anymore. If something has changed within a company's fundamentals, then it may not be realistic to expect its stock to climb back to its previous high. But many investors will "anchor" on that $60 figure, and assume that the stock has room to run.
Another big foe for investors: "recency bias" -- the penchant for people to extrapolate the recent past into the future. For example, one argument against investing in stocks over the past year or two has been the poor performance of equities over the past decade. Why invest in stocks if the broader market has been in the red for the last ten years?
What that argument leaves out, however, is the fact that over the longer haul, stocks have performed very well compared to other asset classes -- and they've done particularly well following poor periods. That doesn't mean that the coming decade will be a great one for stocks -- but it means you shouldn't just assume that stocks will fare poorly going forward just because they've fared poorly in recent years.
There are still more cognitive biases that derail investors -- contra-positive investing occurs when one buys a stock because he or she has had a good experience with it previously, expectation bias makes us prone to focusing on data that supports our point of view -- but these should give you an idea of what investors are up against. The big question, then, is how do we keep these natural tendencies from destroying our portfolios?
The answer, I believe, is that you stay disciplined and stick to the numbers -- that is, the numbers on a company's balance sheet and in its stock's fundamentals. By basing buying and selling decisions on what those numbers say -- rather than on what your gut, or your neighbor, or a pundit on TV tells you -- you keep many of those pesky biases I discussed (the tendency to follow the herd, for example) at bay. In addition, by using a disciplined rebalancing system that forces you to buy and sell stocks at regular intervals based on their fundamentals, you can avoid other pitfalls to which investors fall prey (such as myopic loss aversion or anchoring).
In the end, staying disciplined and focusing on the numbers won't lead you to winners on every pick you make -- nothing can do that. But over the long haul, a disciplined, numbers-focused approach should put the odds in your favor. It's no coincidence that most, if not all, of the highly successful gurus on whom I base my strategies used an array of quantitative tests in picking stocks -- and it's also no coincidence that just about every one of them talked extensively about the need to stay disciplined. Their ability to do those things is a big part of what made them so successful, and it's a key reason for the Hot List's long-term success. In volatile times like these, that's particularly important to keep in mind.
Guru Spotlight: Peter Lynch
Picking the greatest mutual fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- 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, as evidenced by its best-seller status. 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.
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 more 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 as a way to make sure he wasn't paying too much for growth 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.
Another difference: 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.
Beyond The PEG
The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)
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.
Since I started tracking it in July 2003, my Lynch-based 10-stock portfolio has been one of my better performers, gaining an average of about 8% per year -- while the S&P 500 has averaged annualized returns a little over 1%. It performed very well in 2003, 2004, 2005, and 2006, before having rough years in 2007 and 2008. It bounced back very strong in 2009, however, surging 45.7%.
Here's a look at the stocks that currently make up my Lynch-based portfolio:
EMCOR Group (EME)
USA Mobility (USMO)
Oplink Communications (OPLK)
Integrated Device Technology (IDTI)
Tech Data Corporation (TECD)
Humana Inc. (HUM)
HealthSpring, Inc. (HS)
Net 1 UEPS Technologies (UEPS)
Blyth, Inc. (BTH)
Universal American Corporation (UAM)
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 when the market gets volatile. But the fear and anxiety investors feel during such times make it more important than ever to heed Lynch's advice: "The real key to making money in stocks," he once said, "is not to get scared out of them."
News about Validea Hot List Stocks
Sanofi-Aventis (SNY): Sanofi has made a deal with Regulus Therapeutics Inc to discover, develop, and commercialize microRNA therapeutics, MarketWatch reported on June 22. The alliance is potentially valued at over $750 million, and will initially focus on the therapeutic area of fibrosis.
Jos. A. Bank Clothiers (JOSB): Bank announced this week that it will pay shareholders a dividend of one share of common stock for each two shares they own as of July 30, according to the Baltimore Business Journal. CEO R. Neal Black said the dividend reflects the company's growth in sales, earnings and cash flow.
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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