|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||February 3, 2012|
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.
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)
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 email@example.com.
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