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|Executive Summary||August 5, 2011|
It's been a rough two weeks for the market, with the debt ceiling debacle dominating the news and investors' minds. And the climate of fear didn't end when a temporary resolution was reached on that front, with the European debt woes and domestic economic concerns blasting stocks this Thursday. But despite what many in the media are saying, the U.S. economy has actually been continuing to improve, though we've no doubt been in a soft patch.
That was evident in July's manufacturing numbers. The Institute for Supply Management reported that manufacturing activity came quite close to contracting in July, with ISM's manufacturing index falling to 50.9 (a reading below 50 indicates a contraction). It was the lowest reading since the index turned positive back in August 2009. The group's new orders sub-index did fall into contraction territory, for the first time since June 2009.
As I've noted before, however, the manufacturing rebound we've seen since the summer of 2009 has been rather remarkable, with the sector having expanded for 24 straight months, and at a very solid pace. It's quite normal for there to be ebbs and flows during an expansion, so July's reading isn't cause for alarm. There was also a bit of good news within the report, as the data showed inflation pressures waned for the third straight month. Back in April, ISM's prices index reached its highest mark in nearly three years, but since then it has declined significantly. While some inflation is a sign that the economy is growing in a healthy way, inflation that is too high poses a threat to the recovery.
Personal consumption expenditures -- consumer spending -- declined in June, meanwhile, according to new data from the Commerce Department. It was just the second decline since September 2009. That's not good news for an economy driven largely by consumer spending, but the 0.2% decline wasn't a dramatic drop, and right now it seems to be another sign of a soft patch -- not evidence of a renewed economic downturn.
The consumer sector may have rebounded a bit in July. ISM's non-manufacturing, or service sector, index remained in expansion territory for the 20th straight month. Some have pointed out that the index was at its lowest level in over a year, but, at 52.7, it was still fairly comfortably in expansion territory, a good sign.
What's interesting is that, while many of the June and July numbers for economic activity have showed a slowdown, new claims for unemployment have been falling. They've dropped more than 5% over the past two weeks and are now at their lowest point in four months. ADP's payroll report for July, meanwhile, showed modest job growth for the month, with 114,000 private sector jobs added. Today the Labor Department is scheduled to release its figures for July, and the report as always will be watched closely by investors.
There was also some decent news from the housing market this week. The National Association of Realtors said pending homes sales rose in June for the second straight month.
As for the debt ceiling imbroglio, it, of course, reached a conclusion (for now) this week. But the drawn-out, contentious path legislators took to get there has no doubt impacted markets and consumers in terms of confidence, both in the economy and in our legislators' ability to effect change. In the short term, that could mean some continued hiccups for the market. In the long term, though, it's good that steps are being taken to deal with the deficit -- though given the economy's current state, it will be important that legislators walk the line between fiscal responsibility and the type of draconian cuts that would only imperil the recovery.
The other big debt-related issue has been the country's credit rating. Moody's and Fitch both re-affirmed their AAA ratings for the U.S. this week, but warned that a failure to reduce the country's debt going forward could lead to a downgrade. It seems odd to place much value on the rating agencies' assessements -- they failed miserably in their grading of mortgage-backed securities leading up to the financial crisis, after all. Still, their opinions still carry a lot of weight in the financial world. One of the top economic forecasters I keep an eye on thinks a debt downgrade wouldn't be as problematic as many fear, however. Liz Ann Sonders of Charles Schwab said this week that some countries -- Japan, for example -- have experienced downgrades that did not result in big increases in borrowing costs. And she says that if a U.S. debt downgrade did lead to an increase in interest rates, it would likely be minimal.
Given all of the debt-related fears, it's been rough sledding for the market over the past fortnight. Since our last newsletter, the S&P 500 returned -10.7%, while the Hot List returned -15.2%. So far in 2011, the portfolio has returned -8.6% vs. -4.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 146.7% vs. the S&P's 20.0% gain.
Giving Debt Its Due
With all of the talk of deficits and fiscal responsibility lately, I thought it might be a good time to take a look at debt -- though not the governmental type, but the corporate sort. Of all the dozens of variables that my Guru Strategies examine, debt -- not earnings, or sales, or price/earnings ratios -- is the one that most frequently pops up.
And for good reason. What the gurus knew was that, while debt can be a benefit if used wisely, too much debt leads to big problems for a company. It bogs down future earnings because of interest payments; it ties up revenues that could be going to expansion, capital upgrades, or dividends and share buybacks; and it can leave a company without much flexibility if it hits a rough patch (or, as we saw in 2008, if the economy hits a rough patch).
Most of the gurus shun debt, regardless of their specific investing style. In his 2010 letter to shareholders, for example, Warren Buffett -- a conservative, deep value investor -- said that debt can be "lethal" to businesses. Discussing the concept of debt generally, he wrote, "unquestionably, some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade -- and some relearned in 2008 -- any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."
But top growth investors like Martin Zweig also are leery of debt. In his book Winning on Wall Street, Zweig wrote, "If a company has a tremendously high level of debt, the earnings or earnings growth rate would be worthless because of the potential risk. Companies with high amounts of debt have high interest expense, and interest expense is a fixed cost. If business turns down moderately, the high fixed cost can have a very negative effect on earnings. So be careful not to overpay for companies with high debt. Indeed, you may want to avoid them entirely." (his emphasis added)
All in all, 10 of the 12 individual guru-inspired models that go into the Hot List assess a company's debt level. The specifics of how the gurus examined debt differ slightly, however. Here's a look at some of the criteria they employed. (Note: Depending on the model, certain types of companies, like financials or utilities, are exempt from these criteria because of the nature of their businesses.)
Debt/Equity Ratio: This is the most commonly used metric among the gurus I follow, though the standards used vary. My Peter Lynch-based model uses an upper limit of 80%; my Kenneth Fisher-based approach uses a stricter standard of 40%; my David Dreman-based model is stricter still, using a 20% limit. The strictest though, is my Motley Fool-based model, which permits long-term debt/equity ratios up to only 5%.
Debt/Equity Ratio vs. Industry: The Zweig approach puts a twist on the use of the debt/equity ratio. Zweig found that companies in different industries tended to carry different levels of debt, so he compared a firm's debt/equity ratio to that of its industry average.
Decreasing Debt/Equity Ratio: You might not think momentum investors would be concerned with debt, but our Momentum Investor model is. If a company has a high level of debt, it can pass this model's debt criterion if it has consistently cut its debt/equity ratio over the past three years. (If it has a debt/equity ratio less than 200%, it also passes.)
Long-Term Debt vs. Net Current Assets: This criterion was employed by Benjamin Graham, the man known as the "Father of Value Investing". Graham wanted long-term debt to be no greater than net current assets (that is, current assets minus current liabilities). Essentially, this means that if you liquidated a company and paid off all its debts, you would still at least break even.
Change in Long-Term Debt/Assets Ratio: This was the criterion Joseph Piotroski used. He just wanted to make sure there was no deterioration here -- as long as the company's long-term debt/assets ratio wasn't higher in the most recent year than it was the previous year, it passed the test.
Debt vs. Annual Earnings: The Warren Buffett-based model uses this criterion. It targets companies that have enough annual earnings that they could, if need be, use those earnings to pay off all debt within five years (and preferably within two years).
Earnings Yield: This might not seem like a debt-related criterion. But it is the way Joel Greenblatt uses it, which is the same way my Greenblatt-inspired model calculates it. Greenblatt found that using a simple earnings/price ratio to determine earnings yield could be misleading, because earnings can be skewed by the amount of debt a firm uses. So instead of share price, this strategy uses enterprise value, which includes both share price and the amount of debt a company has.
As the success of all of these gurus shows, there's no one "right" way to examine debt; debt can be assessed through a myriad of different lenses. The main idea is that you should use some way to assess whether a company is using high enough leverage that it poses a danger to its future profits. I think that with the Hot List, part of the reason for the portfolio's success has been its use of numerous different debt-related criteria (i.e., all of the criteria used by my individual Guru Strategies).
Government debts are important, too. When a country is bogged down with debt, the impact trickles down to citizens and companies in ways that can be very complex. Countries have an advantage over businesses and individuals, however: They can print money, which reduces the value of its debt in real terms. (This, of course, can also have wide-ranging consequences.)
For investors, the more important point, I believe, is that many companies can -- and have been able to -- increase profits and sales during periods when national debts are high or rising. So while huge national debts and deficits have negative implications, they are not so overwhelming that they will have a terrible, universal impact on all companies or all stocks. Regardless of the country's debt situation, smart investors will be able to find good, well-financed companies whose shares are trading on the cheap. (In fact, thanks to the fears surrounding the country's debt issues, there may be more of these types of companies selling on the cheap than usual.) And over the long haul, they should be rewarded.
As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: Skechers Usa, Inc. (SKX), Lincoln Educational Services Corporation (LINC), At&t Inc. (T), Rue21, Inc. (RUE), Sanofi Sa (Adr) (SNY) and Coinstar, Inc. (CSTR).
4 stocks remain in the portfolio. They are: Amtech Systems, Inc. (ASYS), Astrazeneca Plc (Adr) (AZN), Dollar Tree, Inc. (DLTR) and Bridgepoint Education, Inc. (BPI).
We are adding 6 stocks to the portfolio. These include: Cash America International, Inc. (CSH), Quality Systems, Inc. (QSII), Conocophillips (COP), Banco Macro Sa (Adr) (BMA), Acme Packet, Inc. (APKT) and Amtrust Financial Services, Inc. (AFSI).
Newcomers to the Validea Hot List
Acme Packet (APKT): Located in Bedford, Mass., Acme offers session border control solutions that enable the delivery of interactive communications -- voice, video and multimedia sessions -- and data services across IP network borders. The firm has a $3.8 billion market cap.
Acme gets solid scores from two of my growth approaches, my Martin Zweig-inspired model and my Motley Fool-based strategy. Read more about its fundamentals in the "Detailed Stock Analysis" section below.
Cash America International, Inc. (CSH): Based in Texas, Cash America operates in more than 1,000 locations in the U.S. and Mexico, providing secured non-recourse loans -- pawn loans. It also offers short-term cash advances and check cashing services. The firm has a market cap of about $1.6 billion.
Cash America gets approval from my Martin Zweig- and James O'Shaughnessy-based growth strategies. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
ConocoPhillips (COP): Houston-based Conoco is the third-largest U.S. integrated energy company, with operations in more than 30 countries. It is involved in the oil, natural gas, and chemical and plastics arenas. It has taken in more than $227 billion in sales over the past year.
Conoco gets strong interest from my Joel Greenblatt- and James O'Shaughnessy-based models. For more on why its fundamentals are impressive, scroll down to the "Detailed Stock Analysis" section below.
Quality Systems, Inc. (QSII): Based in Irvine, California, Quality Systems is a healthcare I/T firm, providing healthcare companies with products and services that include electronic health records and "revenue cycle management" (which allows companies to outsource their billing and collections).
Quality Systems ($2.6 billion market cap) gets strong interest from my Warren Buffett- and Martin Zweig-based models, as well as my Momentum Investor approach. You can read more about its financials and fundamentals in the "Detailed Stock Analysis" section below.
Banco Macro SA (BMA): Based in Buenos Aires, Banco Macro is one of the largest banks in Argentina, having expanded through a string of acquisitions in recent years. The $2.1-billion-market-cap firm gets approval from two of my models, those I base on the writings of Peter Lynch and David Dreman. To read more about it, see the "Detailed Stock Analysis" section below.
AmTrust Financial Services (AFSI): Founded as a workers' compensation insurance firm, this New York City-based company has expanded into a multi-national property and casualty insurer. It specializes in coverage for small- and medium-sized businesses.
AmTrust gets strong interest from my Peter Lynch- and Motley Fool-based models. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Lincoln Educational Services (LINC): On Aug. 3, Lincoln reported second-quarter earnings that were down 63% from the year-ago period, as enrollment fell 26% and student starts fell 48%, according to The Wall Street Journal. The declines came amid new federal regulations designed to improve admission standards, and Lincoln officials said they expect the recent decline in student starts to abate later this year and be behind the firm in early 2012. Still, Lincoln cut its fully-year 2011 revenue and earnings outlooks sharply. Shares of the firm fell 23% Wednesday on the news, and the Hot List has sold the stock due to fundamental deterioration.
Bridgepoint Education (BPI): On Aug. 2, Bridgepoint announced second-quarter results that far exceeded analysts' expectations. Earnings per share were up 55% over the year-ago period; revenues surged 38%, as enrollment rose by 25%. The company also upped its full-year earnings outlook. It expects enrollment to fall in the second half of the year, however, and its full-year revenue outlook came in slightly below analysts' expectations. Investors chose to focus on the negative, and the stock fell 13% on the day of the earnings announcement. The Hot List thinks they're making a mistake, and continues to see value in the stock, which is up about 20% since joining the portfolio in mid-March.
The Next Issue
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