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Executive Summary March 20, 2009

The Economy

The economic news hasn't been great over the past two weeks, but it apparently has provided enough silver linings to bring a good deal of jittery investors back into the stock market.

One of those silver linings involved consumer spending. A Commerce Department report released last week showed that retail sales fell by just 0.1 percent in February, and that the January retail figures were actually higher than previously thought (they increased 1.8 percent, compared to the preliminary estimate of 1.0 percent).

Economists, who had been expecting a February decrease of 0.5 percent, according to CNN, afterwards were divided on whether the data was an indication of the start of a real recovery, or a short-term increase that won't last. Either way, investors were encouraged, as consumer discretionary-type stocks continued a surge that had started about two weeks ago.

While the retail sales figures helped continue the rally, the upward move was really triggered by the news early last week that Citigroup has been profitable for the first two months of the year, and that the troubled banking giant is on track to bring in more than $8 billion in profit for the first quarter -- though those figures don't include one-time charges. Financial stocks -- beaten to a pulp over the six months before the Citigroup news, have taken off since then, with many of the big banks' shares jumping 70 percent or more. Another much-maligned financial group -- General Electric's finance unit -- announced yesterday that it expects to post a profit in the first quarter, another good sign.

Then, of course, there was the government's latest plunge into the rescue pool. Wednesday, the Federal Reserve announced that it will start a $1 trillion plan to buy up Treasury bonds and mortgage-backed securities as a way to try to loosen the still-clogged credit markets. The scope of the plan is huge -- almost doubling all of the rescue efforts the Fed has made over the past year, according to The New York Times.

If and when the Fed's latest effort will start showing benefits are questions whose answers remain to be seen. But Wall Street was heartened by the news, and I am too. Still, while the pieces appear to be lining up for a recovery, the economy is a long way from healthy. New unemployment claims dipped a bit in the week ending March 14 (by about 1.8 percent), but that comes on the heels of continuing claims that rose about 3.5 percent -- to about 5.5 million -- in the week ending March 4, according to CNN, a sign that those out of work are having more trouble finding jobs.

A report from the Federal Reserve also said industrial production fell for the fourth straight month in February, this time by 1.4 percent, reaching its lowest level since April 2002. The capacity utilization rate fell to 70.9 percent, which is 10 percentage points below the average from 1972 to 2008, and the lowest recorded since December 1982.

But as I've noted many times before, the stock market almost always turns upward before the economy does, and the decent news coming out of the financial sector has, for the moment, provided the trigger needed to spur the market forward. Since our last newsletter, the S&P 500 has gained 14.9 percent, while the Hot List is up an even-better 23.1 percent. For the year, the S&P is down 13.2 percent, with the Hot List down 11.0 percent. Since its inception almost six years ago, the portfolio remains well ahead of the index, having gained 45.9 percent while the S&P has lost 21.6 percent.

Inflation Nation?

Given the unprecedented situation we find ourselves in, there are a myriad of questions that must be answered before the U.S. economy is back on its feet. But, at the risk of getting ahead of ourselves, I think it is important to address a key issue involving what we should expect if, indeed, the Fed's plan does work: inflation. (As you'll soon see, the issue is particularly relevant considering the direction the Hot List has taken this rebalancing.)

Early last September, the Fed's "Total Factors Supplying Reserve Funds" stood at about $946.3 billion. Since then, that figure has increased by more than 120 percent, standing at about $2.09 trillion as of March 18 -- and that's before the new plan to inject more than a trillion more dollars into the market as part of its Treasury/asset-backed security plan. The ramp-up in the Fed's balance sheet -- most of which occurred last September and October -- had led many top investment minds to warn that inflation could be a big problem, even before the new Fed plan was announced. Warren Buffett recently told CNBC that the government's stimulus efforts could lead to inflation worse than the levels seen in the 1970s. And last week, officials at bond giant PIMCO said that inflation could return as soon as 2010.

Now, the Fed's new trillion-dollar plan -- while possibly necessary -- has further heightened inflation fears. Oil and raw materials stocks have jumped over the past few days, while the dollar has tumbled. The Hot List is playing into that strength, adding four oil industry stocks this week: Exxon Mobil, Lufkin Industries, Oil States International, and World Fuel Services. While they've posted some nice recent gains, my models still view these stocks as very undervalued. In fact, all of them get multi-guru approval, with two getting triple-guru approval and one even getting the thumbs-up from four of my strategies. With inflation ticking upward in February for the first time in several months and the Fed about to pump more and more money into the system, these stocks could get a nice extra boost on top of their strong fundamentals.

There's a broader point to keep in mind regarding inflation. It's one that I've discussed before, but, given the amount of money that the government has pumped into the economy, it's one that bears repeating. Throughout history, inflation -- even normal inflation -- has whittled away the returns of fixed income investments. Stocks, however, have managed to outpace inflation by a significant amount. For example, in his Stocks for the Long Run, Jeremy Siegel shows that from 1946 (when inflation really became a permanent part of our economy) through 2006, stocks averaged nominal annual compound returns of 11.2 percent. Long-term government bonds, meanwhile, averaged 5.7 percent -- doesn't sound bad, when you consider that the bonds come with much less volatility and short-term risk than the stock market does.

But, Siegel found that after inflation was factored in -- showing the real purchasing power investors were gaining -- stocks averaged a 6.9 percent annual compound return, while long-term government bonds averaged just 1.6 percent per year. Short-term bonds were even worse after inflation, averaging just 0.6 percent per year, coming in just ahead of gold's 0.5 percent per year real return. Those figures are important to consider as we move forward into what very possibly could turn into a period of significant inflation.

The Real Deal?

In terms of the current market, the big question on everyone's mind is whether or not the bounce we've seen over the past two weeks is the start of a new bull market, or simply another up-fake that won't last. Some well-known investors have called a bottom, while many others say stocks will go significantly lower.

In reality, any bottom-call is just an educated guess -- and, given the depth of this crisis, the unprecedented government actions made in response to it, and the sheer panic gripping many investors, trying to figure out whether we've actually hit bottom yet is something of an exercise in futility. You could analyze the heck out of every indicator you can get your hands on, and in the end you might not be much better off than if you'd just flipped a coin to decide whether we've bottomed or not.

For long-term investors -- those with horizons of three, five, ten years (which, in my opinion, should be the only type of investor dealing in stocks) -- now is a time to step back and consider the bigger picture, and not get caught up in overanalyzing where the bottom is. The bottom line is that stocks, by just about every valuation measure, are undervalued. Yes, valuations fooled most investors a year or two ago, when massive leverage had propped up earnings, making P/E ratios and other metrics artificially low. But now, we've been in a recessionary climate for more than 15 months, credit is moving at a snail's pace, and the most conservative valuation measures are saying stocks are cheap.

For example, The New York Times reported last week that, as of March 3, the 10-year P/E ratio (which Yale professor Robert Shiller designed to iron out yearly fluctuations) was around 12, significantly below the 1890-2009 average of 16.4. Then, this week, John Mihaljevic (CFA and managing editor of The Manual of Ideas blog) explained that another conservative valuation measure -- the Tobin's Q ratio made famous by Nobel Laureate James Tobin -- indicates that stocks are undervalued right now. The Q Ratio divides the total market value of stocks by their total asset value (or replacement cost). From 1900-2008, Mihaljevic says, the adjusted average Q Ratio was 0.76 for the market. At the end of 2007, stocks were above that level, at 0.89, indicating they were overvalued. But as of March 15, he estimated Tobin's Q at 0.43, a pretty significantly undervaluation.

Of course, as both Shiller and Mihaljevic have noted, those undervaluations don't mean stocks can't go lower. The Shiller P/E and/or Tobin's Q have, in fact, been lower during other economic crises, like the Great Depression or the recessions of 1973-74 and 1980-82. Given the seriousness of the current situation, it would seem pretty reasonable to expect that they could slip even lower today, probably meaning a decline for stocks.

The problem is that if stocks retreat to even lower valuations from here, it will be because of either fear, or some new, yet-unknown fundamental event or events. So, if you think you can predict investors' emotional states, or how an unprecedented economic crisis will play out, then go ahead and wait for the bottom. I suffer no such delusions, however. Rather than playing the risky game of bottom-calling -- which more often than not leads to investors missing the big initial push of a new bull run -- I'll continue to put money into undervalued stocks. And, just as it has tended to do throughout more than two centuries of stock market history, I expect such a practice to yield strong returns over the long haul, regardless of what happens today, tomorrow, or next week.
Editor-in-Chief: John Reese


The Fallen

As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: American Eagle Outfitters (AEO), Esterline Technologies Corporation (ESL), Kennametal Inc. (KMT), Lincoln Electric Holdings, Inc. (LECO), Gildan Activewear Inc. (Usa) (GIL) and Logitech International Sa (Usa) (LOGI).

The Keepers

4 stocks remain in the portfolio. They are: The Dress Barn, Inc. (DBRN), Ameron International Corporation (AMN), Jos. A. Bank Clothiers, Inc. (JOSB) and Schnitzer Steel Industries, Inc. (SCHN).

The Newbies

We are adding 6 stocks to the portfolio. These include: Ceradyne, Inc. (CRDN), Fossil, Inc. (FOSL), Lufkin Industries, Inc. (LUFK), World Fuel Services Corporation (INT), Exxon Mobil Corporation (XOM) and Oil States International, Inc. (OIS).

Portfolio Changes

Newcomers to the Validea Hot List

Ceradyne Inc. (CRDN): Based in Costa Mesa, Calif., Ceradyne makes advanced technical ceramic products and components for the defense, industrial, automotive, nuclear, electronic and medical industries. Its products range from body armor to tools used in oil drilling to dental abutments and crowns. Ceradyne has a market cap of about $480 million, and it has taken in about $680 million in sales in the past year.

Ceradyne's strong fundamentals earn it approval from three of my Guru Strategies, those I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher. To see why, scroll down to the "Detailed Stock Analysis" section below.

Exxon Mobil Corp. (XOM): By far the largest publicly traded U.S. company, this Irving, Tex.-based energy giant has a market cap of about $340 billion and has raked in more than $475 billion in sales in the past year. In addition to its oil and natural gas businesses, Exxon is also one of the largest worldwide petrochemical companies.

Exxon is one of only two companies in the market that currently get strong interest from four of my Guru Strategies, earning high marks from the models I base on the approaches of Kenneth Fisher, Peter Lynch, Warren Buffett, and Joel Greenblatt. See the "Detailed Stock Analysis" section below to find out why.

Lufkin Industries, Inc. (LUFK): Based in Lufkin, Texas, Lufkin designs, engineers, manufactures, sells, installs and services oil field equipment and power transmission products for energy firms around the world.

Lufkin is a small cap, with a market cap of $516 million, but it has taken in more than $740 million in sales in the past year. It gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based models. To see why, check out the "Detailed Stock Analysis" section below.

Oil States International (OIS): Another Texas oil firm that has garnered the Hot List's attention, this Houston-based oil services company makes products used in deepwater oil production facilities and sub-sea pipelines. It also provides several types of services and products to the oil and gas industry, including production-related rental tools, work force accommodations and logistics, and land drilling services. The stock has been pummeled since oil prices peaked last July, but sales have continued to be strong (almost $3 billion over the past year, and more than $900 million in the fourth quarter of 2008, a 55 percent increase from '07's fourth quarter). It's a small cap, with a market cap of $665 million.

To read more about why my Peter Lynch-, Kenneth Fisher-, and Benjamin Graham-based models all give high marks to Oil States, see the "Detailed Stock Analysis" section below.

World Fuel Services Corp. (INT): The final oil firm added to the portfolio this rebalancing is this Miami-based company, which provides fuel and services to aircraft, petroleum distributors, and ships at more than 2,500 locations around the world. World Fuel has 43 offices in 23 countries across five different continents. Its market cap is just under $900 million, and it has brought in more than twice that in sales over the past 12 months.

World Fuel gets approval from my Peter Lynch- and James O'Shaughnessy-based approaches. Find out why in the "Detailed Stock Analysis" section below.

Fossil Inc. (FOSL): While its name and its Richardson, Tex. headquarters might give the appearance of yet another oil stock, there's no fossil fuel connection with this new Hot List member. Fossil designs and sells a variety of fashion accessories that are sold in more than 90 countries across the world. Its most notable product line is probably its extensive collection of watches, but the firm also makes small leather goods, belts, handbags, sunglasses, jewelry and apparel. Fossil's market cap is right around $1 billion, and it has taken in almost $1.6 billion in sales over the past year.

Fossil gets approval from three of my Guru Strategies, those I base on the approaches of Warren Buffett, Benjamin Graham, and Kenneth Fisher. See the "Detailed Stock Analysis" section below to learn why.

News about Validea Hot List Stocks

Jos. A. Bank Clothiers (JOSB): Jos. A. Bank announced on March 16 that it will refund customers up to $199 for a suit purchased by April 9 if they lose their job between April 16 and July 1, according to the Birmingham Business Journal. If the customer provides proof of purchase and unemployment, they can keep the suit and the cash.

Bank's shares also rose more than 40 percent from our last Hot List through yesterday afternoon, as retailers got a big bounce in the market's rally.

Dress Barn Inc. (DBRN): The clothing retailer also jumped amid the market's climb, with shares surging more than 25 percent from our last Hot List through yesterday afternoon.

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 one of my individual Guru Strategies. 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

JOSB   |   LUFK   |   SCHN   |   AMN   |   DBRN   |   FOSL   |   INT   |   CRDN   |   OIS   |   XOM   |  

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, retailer and direct marketer of men's tailored and casual clothing and accessories through stores, catalog and Internet. The Company sells substantially all of its products exclusively under the Jos. A. Bank label through its retail stores, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. As of February 2, 2008, Jos. A. Bank operated 422 retail stores, which included seven outlet stores and 12 franchise stores located throughout 42 states and the District of Columbia in the United States. The Company's product are offering include the Jos. A. Bank Executive collection, as well as the Jos. A. Bank Signature and Jos. A. Bank Signature Gold collections. The Company sources substantially all of its products through third-party suppliers, manufacturers and/or agents using Jos. A. Bank designs and specifications. Jos. A. Bank operates through two segments: Stores and Direct Marketing.

Lufkin Industries, Inc., is a supplier of oil field and power transmission products. The Company is divided into two operating segments: Oil Field and Power Transmission. Through its Oil Field segment, the Company manufactures and services artificial reciprocating rod lift equipment and related products, which are used to extract crude oil and other fluids from wells. Through its Power Transmission segment, the Company manufactures and services high-speed and low-speed increasing and reducing gearboxes for industrial applications. In January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfil contractual obligations and close all trailer facilities. In March 2009, the Company acquired International Lift Systems, LLC (ILS), a manufacturer of artificial lift systems serving oil and gas companies.

Schnitzer Steel Industries, Inc. is a recycler of ferrous and non-ferrous metals. The Company is a recycler of used and salvaged vehicles, and a manufacturer of finished steel products. The Company provides an end of life cycle solution for a variety of products through its vertically integrated businesses, including sale of used auto parts, procuring autobodies and other metal products and manufacturing them into finished steel products. It operates in three business segments: the Metals Recycling Business (MRB), the Auto Parts Business (APB) and the Steel Manufacturing Business (SMB). In September 2007, the Company acquired a mobile metals recycling business that provides additional sources of scrap metal to the Everett, Massachusetts facility. In February 2008, it acquired the remaining 50% equity interest in Pick-N-Pull Auto Dismantlers, LLC Nevada. In August 2008, the Company acquired a self-service used auto parts business with three locations in the Southern United States.

Ameron International Corporation (Ameron) is a multinational manufacturer of engineered products and materials for the chemical, industrial, energy, transportation and infrastructure markets. It has three segments: Fiberglass-Composite Pipe Group, Water Transmission Group and Infrastructure Products Group. The Fiberglass-Composite Pipe Group manufactures and markets filament-wound and molded fiberglass pipe, tubing, fittings and well screens.The Water Transmission Group manufactures and supplies concrete and steel pressure pipe, concrete non-pressure pipe, protective linings for pipe and fabricated steel products, such as large-diameter wind towers. The Infrastructure Products Group consists of two operating segments, which are aggregated: the Hawaii Division and the Pole Products Division. In October 2007, Ameron acquired the business of Polyplaster, Ltda., a Brazilian fiberglass-pipe operation.

The Dress Barn, Inc. operates women's apparel specialty stores, principally under the names dressbarn, dressbarn woman and maurices. As of July 26, 2008, the Company operated 1,503 stores in 48 states and the District of Columbia, including 656 dressbarn Combo stores (a combination of its dressbarn and dressbarn woman brands), 677 maurices stores, 134 dressbarn stores and 36 dressbarn woman stores. Its dressbarn stores are typically operated as Combo stores, offering both dressbarn and larger-sized dressbarn woman merchandise. The Dress Barn, Inc. also operates stand-alone dressbarn and dressbarn woman stores in certain markets. Its dressbarn brands cater to 35 to 55 year-old women, sizes 4 to 24. The dressbarn stores offer in-season and casual fashion located primarily in convenient strip shopping centers in major trading and markets and surrounding suburban areas. As of July 26, 2008, the Company operated 1,503 stores in 48 states.

Fossil, Inc. is a global design, marketing and distribution company that specializes in consumer fashion accessories. The Company's principal offerings include a line of men's and women's fashion watches and jewelry sold under licensed brands, handbags, small leather goods, belts, sunglasses, footwear, cold weather accessories and apparel. In the watch and jewelry product category, Fossil, Inc. has a diverse portfolio of owned and licensed brand names, under which its products are marketed. The Company's products are distributed globally through various distribution channels, including wholesale, export and direct to the consumer at varying price points to service the needs of its customers. The Company sells its products through diversified distribution networks that includes department stores, specialty retail locations, specialty watch and jewelry stores, owned retail and factory outlet stores, mass market stores, owned and affiliate Internet sites and through its FOSSIL catalog.

World Fuel Services Corporation is engaged in the marketing and sale of marine, aviation and land fuel products and related services on a worldwide basis. The Company operates in three segments: marine, aviation and land. In its marine segment it offers fuel and related services to maritime customers, including international container and tanker fleets, commercial cruise lines and time-charter operators. In its aviation segment, it offers fuel and related services to major commercial airlines, second and third-tier airlines, cargo carriers, regional and low-cost carriers, corporate fleets, fractional operators, private aircraft, military fleets. In its land segment, it offers fuel and related services to petroleum distributors operating in the land transportation market. In June 2008, it acquired certain assets of Texor Petroleum Company, Inc..

Ceradyne, Inc. develops, manufactures and markets advanced technical ceramic products, ceramic powders and components for defense, industrial, automotive/diesel and commercial applications. The Company's products include lightweight ceramic armor for soldiers and other military applications; ceramic industrial components for erosion and corrosion resistant applications; ceramic powders, including boron carbide, boron nitride, titanium diboride, calcium hexaboride, zirconium diboride, and fused silica, which are used in manufacture of armor and a range of industrial products and consumer products; evaporation boats for metallization of materials for food packaging and other products; reduced friction, ceramic diesel engine components; functional and frictional coatings primarily for automotive applications; translucent ceramic orthodontic brackets, and ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes.

Oil States International, Inc. (Oil States) through its subsidiaries, is a provider of specialty products and services to oil and gas drilling and production companies worldwide. The Company operates in a number of oil and gas producing regions, including the Gulf of Mexico, United States onshore, West Africa, the North Sea, Canada, South America and Southeast and Central Asia. Its customers include many of the national oil companies, major and independent oil and gas companies and other oilfield service companies. Oil States operates in three principal business segments: offshore products, tubular services and well site services. The Company's well site services segment includes the accommodations, rental tools and drilling services businesses. On February 1, 2008, Oil States purchased all of Christina Lake Enterprises Ltd., the owners of an accommodations lodge (Christina Lake Lodge) in the Conklin area of Alberta, Canada.

Exxon Mobil Corporation (Exxon Mobil) through its divisions and affiliates is engaged in exploration for, and production of, crude oil and natural gas, manufacture of petroleum products and transportation and sale of crude oil, natural gas and petroleum products. ExxonMobil is a manufacturer and marketer of commodity petrochemicals, including olefins, aromatics, polyethylene and polypropylene plastics and a wide variety of specialty products. It also has interests in electric power generation facilities. Affiliates of ExxonMobil conduct research programs in support of these businesses. Exxon Mobil Corporation has several divisions and affiliates, many with names that include Exxon Mobil, Exxon, Esso or Mobil. The Company operates in three segments: Upstream, Downstream and Chemicals. In November 2008, Sunoco Logistics Partners L.P. completed the acquisition of the MagTex refined products pipeline system located in Texas, from affiliates of Exxon Mobil Corporation.

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.


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