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Executive Summary February 3, 2012

The Economy

Pushing against several headwinds, the US economy is continuing its slow and steady recovery -- with a light possibly even forming at the end of the long, arduous tunnel that is the housing market.

Since our last newsletter, a new Federal Reserve report showed that industrial production increased 0.4% in December, despite the fact that unseasonably warm temperatures caused utility sector output to decline significantly. For the fourth quarter, industrial production was up 3.1%, and for the full year it was up 4.1%, the second greatest improvement since 2000. And, manufacturing activity continued to expand in January, according to the Institute for Supply Management. Its manufacturing index showed that the sector expanded at an accelerating rate in January. It was the 30th straight month that the index has indicated an expansion in manufacturing activity.

The labor market also keeps showing hopeful signs. New claims for unemployment are continuing to come in at a weekly rate well below the 400,000 mark that had proved such a barrier for so long, according to the Labor Department, and are now nearly 50% of what they were during the peak of the Great Recession. And continuing claims remain at levels not seen since before the Lehman Brothers collapse that triggered the 2008 financial crisis.

Another piece of good news involved Americans' bank accounts. The personal savings rate (personal saving as a percentage of disposable income) rose by half a percentage point in December to 4.0%. That reversed a recent decline over the past few months, which had made it unclear if continuing gains in retail sales were the result of consumers overextending themselves. The new data indicates that Americans are continuing to spend without stretching themselves too thin.

In the housing market, meanwhile, we're seeing the most hopeful signs we've seen in quite some time. Existing home sales rose 5.0% in December, according to the National Association of Realtors. It marked the 3rd straight month that the figure has increased, and put existing sales 3.6% ahead of where they were a year ago. NAR's Pending Home Sales Index declined 3.5% for the month, but remained 5.6% above its year-ago level.

Perhaps more importantly, while 2011 marked the worst year for new home construction since at least 1963, the environment is improving. Homebuilder confidence about the newly built, single-family home market increased for a fourth straight month in January, according to the NAHB/Wells Fargo Housing Market Index, which hit its highest level since June of 2007. "Builders are seeing greater interest among potential buyers as employment and consumer confidence slowly improve in a growing number of markets, and this has helped to move the confidence gauge up from near-historic lows in the first half of 2011," the National Association of Homebuilders' chief economist said.

Of course, Europe's debt woes continue to weigh heavily on investors' minds. Progress continues to be slow, but so far we haven't seen any major spillover effect on the U.S. economy.

Since our last newsletter, the S&P 500 returned 0.8%, while the Hot List returned 3.7%. So far in 2012, the portfolio has returned 12.1% vs. 5.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 153.5% vs. the S&P's 32.5% gain.

Inside the Portfolio

In several recent newsletters, I've looked at the valuation of the broader stock market, seeing how stocks as a group stack up against a number of different valuation metrics, ranging from price-to-earnings ratios to price-to-book ratios to stock market-to-GDP ratios. All in all, as I've said before, I think the market is somewhere around fairly valued, if not a bit on the cheap side.

Broader market valuations are of course important, and can give you an idea about whether market sentiment is too high, too low, or somewhere in the middle. But what's really critical for investors to remember is that in just about any climate, you can find individual stocks of good companies that are trading on the cheap. And, while those stocks can get caught up in broader market movements in the short term, over the long term they are the types of investments that can pay off big time regardless of what the broader market does.

With that in mind, I thought that this week we could look a bit more deeply at the individual positions in the Hot List right now, to get an idea of just how attractive some of the best values in the market are right now.

For starters, let's look at financial strength and position -- it doesn't matter how much you're paying for a stock if it's a dog. So, how does the Hot List stack up? Its 10 holdings currently have an average return on equity of 27.9%, which measures up very well against the broader market. In fact, it far exceeds the ROE target my David Dreman-based model uses, which involves taking the 1,500 largest stocks in the market, ranking them by ROE, and then take the average of the top 500. That average is currently 18.1%.

When it comes to debt and balance sheets, the Hot List holdings are averaging a debt/equity ratio of 7.5% (not including the two financials, since other metrics are better used in establishing their financial strength). Five of the eight non-financials have no long-term debt, and none has a D/E higher than 34.5%. They on average have current ratios of 2.5 (anything over 2.0 is a sign of good liquidity, according to my Benjamin Graham-based model), and they on average have more than eight-and-a-half times as much net current assets ($1.1 billion) as long-term debt ($129 million). The non-financials also have very strong net cash positions -- the great Peter Lynch defined net cash as cash and marketable securities minus long term debt, and the model I base on his writings gives a bonus to stocks with net cash/prices ratios over 30% -- a very difficult target. Three of the non-financials in the Hot List meet that standard, and, collectively, the eight come darn close, averaging 26.1%.

For non-financials, the equity/assets ratio and return on assets rate are better for assessing financial position. My Lynch-based model uses targets of 5% or the equity/assets ratio and 1% for return on assets; the two financials in the portfolio (Cash America International and Altisource Portfolio Solutions) are averaging a 65.5% equity/assets ratio and a 21.8% return on assets, blowing those targets away.

How about earnings growth? On average, the 10 Hot List holdings have increased earnings per share in all but two years of the past decade. They're averaging long-term EPS growth of 26.2%, and none of the ten has a long-term growth rate below 15%.

Now, let's look at valuation, and what we're paying for these quality stocks. For starters, the 10 holdings are trading at an average P/E ratio (using 12-month trailing earnings) of 11.5, significantly below current and long-term market averages. They are also trading at an average P/E-to-Growth ratio of 0.39, enough to fall into the "best-case" zone of my Lynch-based strategy (below 0.5). That means you're paying very little for some impressive growth. The group also averages a 0.99 price/sales ratio, which is below the current S&P 500 average of 1.3 (which itself is a solid figure).

One metric that shows the Hot List holdings to be on the pricier side is the price/book ratio. The holdings average a P/B of 2.5, which is above the current S&P average of 2.0, though just slightly above the average of 2.43 since the late 1970s (that figure comes from Bespoke Investment Group).

The Hot List also isn't heavy on dividends. While Telecom Argentina pays an impressive 7.3% yield and Ternium pays a healthy 3.2%, the portfolio as a whole averages a 1.1% dividend yield. But, seven of the eight stocks that aren't paying solid dividends are averaging an 18.5% return on retained earnings (earnings kept and not paid as dividends) over the past decade. That's well above the 12% minimum that Warren Buffett has used in analyzing stocks, according to the book Buffettology. And the eighth non-dividend-payer, Altisource Portfolio (which I excluded so it wouldn't skew the numbers too far in the positive direction), has generated a whopping 275% return on retained earnings over that time. So by generating big returns on the earnings they hold on to, many of these firms are probably doing more good for shareholders than they would by paying out those earnings as dividends.

The bottom line of all this is that, regardless of what you think of the broader market's value, or the economy's direction, there are plenty of individual stocks out there that look extremely attractive. Companies with lengthy histories of strong earnings and sales growth, high returns on equity and assets, and low or no debt are trading at very reasonable prices, regardless of what's happening in Europe or what's happening with the broader market or economy. Now, the market could recognize those values tomorrow, or it could take a good deal longer -- the past few weeks are a hopeful sign that it may be occurring sooner rather than later, but in the short term anything can happen. Over the long haul, however, history shows that value and fundamentals do matter, and that financially and fundamentally sound stocks tend to be winners. To paraphrase hedge fund guru Joel Greenblatt, buying good companies at bargain prices just makes sense -- and that's something that I just can't see changing.

Editor-in-Chief: John Reese

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** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

Guru Spotlight: Joseph Piotroski

If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge -- just a straightforward assessment of a company's balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.

Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percentage points annually. In addition, he found that buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23% average annual return from 1976 and 1996.

Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has outperformed the market handily, returning 6.0% annualized vs. 1.8% for the S&P 500. But it's not for the faint of heart, as it can be very volatile -- in fact, its beta of 1.37 is the highest of any of my 10-stock portfolios. It fared very well in 2004, 2005, and 2006, before struggling in 2007, 2008, and 2009. Then it roared back in 2010, gaining 55.9% -- more than four times the S&P 500's 12.8% gain. Last year, however, it was again hit hard, losing 24.4% while the broader market was flat. But so far in 2012 it has again bounced back strong, already gaining 17.8% vs. the S&P's 5.3% gain. (All 2012 and since-inception figures through Feb. 1.) The big swings are likely a result of the strategy keying on smaller, beaten-down stocks at a time when investors have been prone to bouts of fear -- primarily about macroeconomic issues. When those macro issues spark anxiety, investors dump smaller unloved stocks; then, when the fears subside, they dive back into the smaller value plays. So while you can make some nice profits over the long haul following a strategy like this, you have to have discipline -- or else you'll end up buying high, like after 2010, and selling low, like after 2011.

Let's take a look at how Piotroski's approach, and the model I base on it, work.

Diving into The Balance Sheet

Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.

The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use.

That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business -- not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski' other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting. Looking at how a company's fundamentals had been changing allowed him to not only get an idea of the firm's financial position, but also of whether that position was improving or declining.

Among the other "change" criteria Piotroski examined were the long-term debt/assets ratio, which he wanted to be steady or declining; the current ratio (current assets/current liabilities), which he wanted to be steady or increasing; gross margin, which should be steady or rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns (That should be steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are the ten stocks currently in its 10-stock portfolio:

SkyWest, Inc. (SKYW)
Alpha Natural Resources (ANR)
HealthWays, Inc. (HWAY)
AU Optronics Corp. (AUO)
Digital Generation, Inc. (DGIT)
Legg Mason, Inc. (LM)
Brasil Telecom SA (BTM)
Ternium S.A. (TX)
ArcelorMittal (MT)
Invacare Corporation (IVC)

Think Small -- And Boring

One final note on the Piotroski-based strategy: It usually ends up focusing on small stocks. Piotroski found that smaller high book/market firms were more likely to produce high returns than their larger counterparts, because small stocks are more likely to fly under the radar of analysts and investors. That means you are more likely to uncover winners using fundamental analysis of these smaller, less-followed stocks.

For the same reason, the stocks that my Piotroski-based model usually chooses tend to be from boring industries or make boring products, though it will go into more "interesting" areas when valuations are right (as it is right now, with a few tech stocks among its holdings). But while they're not the flashiest firms, they're quite often the type of stocks that can pay excellent returns over the long haul.

News about Validea Hot List Stocks

Cash America International (CSH): Cash America reported fourth-quarter net income of $37.8 million, or $1.18 a share, compared with $34.7 million, or $1.10 a share from the year-ago period, but fell short of analysts' earnings expectations of $1.23 per share, according to Reuters. Revenue was up 26% to $463.3 million, which topped analysts' estimates of $436.4 million. The earnings shortfall was in part due to higher operating expenses to promote holiday sales, the company said. For the full 2011 year, earnings were $4.25 per share, falling short of estimates of $4.28 per share. Still, through Feb. 2, shares were up about 5.7% since our last newsletter.

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.

Current Portfolio

Detailed Stock Analysis

Disclaimer: The analysis is from Validea's selection and interpretation of content from the guru's book or published writings, and is not from nor endorsed by the guru. See Full Disclaimer

FRX   |   JOSB   |   TEO   |   TX   |   BPI   |   TECD   |   ASPS   |   ARO   |   CSH   |   CPLA   |  

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer of men's tailored and casual clothing and accessories and is a retailer of tuxedo rental products. It sells substantially all of its products exclusively under the Jos. A. Bank label through its 506 retail stores (as of January 29, 2011, which includes 12 outlet and factory stores and 14 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. It sources substantially all of its merchandise from suppliers and manufacturers or through buying agents using Jos. A. Bank designs and specifications. The Company operates in two segments: Stores and Direct Marketing. The Stores segment consists of all Company-owned stores, excluding outlet and factory stores (full-line stores). The Direct Marketing segment consists of its Internet and catalog operations.

Telecom Argentina SA (Telecom) is an Argentina-based company primarily engaged in the provision of national fixed-line telecommunication services, international long-distance service, data transmission and Internet services and mobile telephony. The Company also offers such solutions as online business and Web hosting, virtual private network (VPN), mobile operating systems developed by Microsoft and Blackberry, toll-free telephone numbers, call centers and voice over Internet protocol (VoIP) line, as well as other services mainly aimed at corporate clients. The Company's subsidiaries are structured in two business segments: Fixed Telephony, comprising Telecom Argentina USA Inc and Micro Sistemas Sociedad Anonima, and Mobile Services, including Telecom Personal SA, Nucleo SA and Springville SA. As of December 31, 2010, the Company's majority shareholder was Nortel SA, 54.74% of its interest.

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

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.

Tech Data Corporation (Tech Data) is a distributor of technology products. The Company serves approximately 125,000 value-added resellers (VARs), direct marketers, retailers and corporate resellers in more than 100 countries throughout North America, Latin America and Europe. In February 2011, the Company announced that it had created two new business divisions: HP Solutions Division And Networking Solutions Group. On October 1, 2010, the Company completed the acquisition of Triade Holding B.V. (Triade). On October 1, 2010, Brightstar Europe Limited (BEL), a consolidated joint venture between the Company and Brightstar Corporation, acquired Mobile Communication Company B.V. and Mobile Communications Company Belgium N.V. In October 2011, Mensch und Maschine Software SE sold its complete distribution business to the Company.

Altisource Portfolio Solutions S.A. (Altisource) together with its subsidiaries, is a provider of services focused on high value, knowledge-based functions principally related to real estate and mortgage portfolio management, asset recovery and customer relationship management. The Company utilizing integrated technology that includes decision models and behavioral-based scripting engines. The Company has three segments: Mortgage Services consists of mortgage management services that span the mortgage lifecycle; Financial Services principally consists of unsecured asset recovery and customer relationship management, and Technology Services consists of modular, integrated technological solutions for loan servicing, vendor management and invoice presentment and payment, as well as providing infrastructure support. In February 2010, Altisource acquired the interests of The Mortgage Partnership of America, L.L.C. (MPA).

Aeropostale, Inc. is a mall-based, specialty retailer of casual apparel and accessories, principally targeting 14 to 17 year-old young women and men through its Aeropostale stores and 7 to 12 year-old kids through its P.S. from Aeropostale stores. The Company designs, sources, markets and sells all of its own merchandise. P.S. from Aeropostale products can be purchased in P.S. from Aeropostale stores, in certain Aeropostale stores, including its new Times Square store in New York City and online at www.ps4u.com. As of January 29, 2011, it operated 965 Aeropostale stores, consisting of 906 stores in 49 states and Puerto Rico, 59 stores in Canada, as well as 47 P.S. from Aeropostale stores in 13 states. In addition, pursuant to a Licensing Agreement, one of its international licensees operated 10 Aeropostale stores in the United Arab Emirates as of January 29, 2011. During March 2011, it announced that it had signed a second licensing agreement.

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.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

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.


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.