|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||May 11, 2012|
While the chaos in Europe continues to dominate the headlines, the US economy has been pushing onward, making some incremental gains despite the headwinds. That's been borne out by several new economic reports that have been released since our last newsletter. They included:
April Jobs: The April jobs numbers weren't as good as many had hoped, but nonetheless there was progress, with the private sector adding 130,000 jobs from March to April, on a seasonally adjusted basis, according to the Labor Department. The unadjusted numbers, meanwhile, showed that the private sector has added about 1.94 million jobs since last April. That year-over-year gain is less than the pace we saw in January and February, but close to the average for what we've seen over the past year. The unemployment rate dipped slightly to 8.1%, reaching its lowest level since January 2009. But the so-called "U-6" unemployment rate, which also includes discouraged workers who have given up looking for a job, held steady at 14.5%.
Weekly Unemployment Claims: After a bit of a rise in previous weeks, new claims have fallen by about 6% since our last newsletter, on a seasonally adjusted basis. On an unadjusted basis, new claims are now about 15% below where they were last year at this time. Continuing claims, meanwhile, the data for which lags new claims by week, have fallen 3% since our last newsletter (seasonally adjusted). They are about 14% lower than they were in the year ago week (unadjusted).
April Manufacturing Sector: Manufacturing continues to be a bright spot for the economy, with the Institute for Supply Management's manufacturing index showing that the sector expanded in April for the 33rd straight month. What's more, it did so at the fastest pace since last June. Looking forward, there was good news too, as the group's new orders sub-index jumped to its highest level since last April.
April Service Sector: The ISM service sector report wasn't as strong as the manufacturing report, but it still showed that the service sector expanded in April for the 28th straight month, though it did so at a slower pace than it did in any of the past three months. The new orders and employment sub-indices were also in positive territory, though they also increased at a slower pace than they did in previous months.
First Quarter GDP: Gross Domestic Product grew at a 2.2% annualized pace in the 1st quarter, according to the Commerce Department. That was lower than the 3.0% rate posted in last year's 4th quarter, and was also lower than many economists had predicted. A solid jump in consumer spending was more than offset by significant cuts in government spending.
Income and Personal Saving: A new Commerce Department report showed that personal income increased 0.4% in March, slightly more than it had in either of the two previous months. The personal savings rate, which measures savings as a percentage of disposable income, also increased slightly in March, rising to 3.8% from 3.7% in February.
Of course, Europe's troubles -- chaotic elections cast new doubt on the continent's ability to stem its financial crisis -- overshadowed the U.S.'s small improvements. While the U.S. seems to be persevering, the threat of some spillover is certainly something to keep an eye on moving forward.
Since our last newsletter, the S&P 500 returned -3.0%, while the Hot List returned -8.4%. So far in 2011, the portfolio has returned 10.5% vs. 8.0% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 149.7% vs. the S&P's 35.7% gain.
Diversification and Risk
So far, 2012 has been a good year for the Hot List. The portfolio has been comfortably ahead of the broader market for most if not all of the year, extending the wide lead it has built up on the market over the long term. This rebalancing we are adding five new stocks to the portfolio, and their excellent financials and fundamentals only add to the portfolio's strong position right now.
While the year has been good so far, one of the departing stocks this rebalancing was a big loser. Body Central Corp. announced first-quarter earnings that met expectations last week, but second-quarter and full-year guidance that was significantly below what analysts were expecting. That caused the stock to lose nearly half its value in a single day. The stock's poor performance has triggered our rarely used stop-loss provision, so the portfolio is selling the stock today.
Body Central's poor performance makes it a good time to review our philosophy on diversification. After all, no one -- not Warren Buffett or Peter Lynch or David Tepper -- is right on every single stock pick. And when you are wrong, you don't want the losers to take down the rest of the portfolio with them. So the question, then, is how many stocks is enough -- and how many stocks is too much. You want enough stocks in your portfolio to diversify away stock-specific risk, but you don't want so many that you water down the portfolio and end up putting money into your, say, 150th-best idea.
And that -- putting money into the 150th-best idea -- is what most mutual funds do. In fact, average mutual funds hold close to 200 stocks, according to a study from investment research firm Morningstar. That's despite the fact that there's evidence showing that you can achieve good diversification in portfolios of much, much smaller size. In my book, The Guru Investor, I looked at a 2003 study performed by California State University-Chico Professor H. Christine Hsu and H. Jeffrey Wei, for example. They found that "the benefit of risk diversification is somewhat limited when the number of stocks in the portfolio goes beyond 50."
Another study, from Morningstar, looked at how focused funds (those with no more than 40 stocks) fared compared to those 200-stock mutual funds. Discussing the study's findings in late 2009, The Wall Street Journal's Larry Light wrote that "as a group, these [focused] funds haven't consistently outperformed or underperformed funds with more diverse holdings. [And] based on recent performance and an earlier Morningstar study, concentrated funds aren't more volatile than more diversified funds, on average, and some are surprisingly steady despite their small number of holdings." It shouldn't be a surprise, then, that many of the top-performing fund managers -- David Herro, Donald Yacktman, Bruce Berkowitz, to name a few -- hold relatively concentrated portfolios.
In my own experience, I've found that even a 10-stock portfolio can offer enough diversification. As you probably know, while the 10-stock Hot List portfolio is our flagship portfolio, we also track a 20-stock version. We also track both 10- and 20-stock portfolios for each of my individual Guru Strategies, as well as for the Top 5 Gurus strategy (which selects the same number of stocks from each of five top-performing strategies). We have a good amount of data to learn from, with most of these portfolios now being nearly nine years old.
The data shows that the results in terms of 10-stock portfolio performance versus 20-stock portfolio performance can vary widely from strategy to strategy. For example, the 10-stock Motley Fool portfolio has produced annualized returns of 13.4% over the long haul -- far better than the 7.8% annualized return its 20-stock cousin has generated. But the 10-stock Peter Lynch portfolio, on the other hand, has produced a 6.2% return, well below the 13.4% annualized return for the 20-stock version. (All of the performance data here and below is through May 9, 2012.)
On average, however, the results for the 10-and 20-stock portfolios have been remarkably similar over the long term. The fourteen 10-stock portfolios have annualized returns of 8.14% since their inceptions; the fourteen 20-stock portfolios have averaged 8.10%. When you look strategy by strategy, in seven cases the 10-stock version has performed better, while in seven cases, the 20-stock version has performed better.
What's also very interesting is what we find when we look at the risk for the different size portfolios. (Beta is a measure of volatility, and shows how closely a portfolio tracks the broader market.) For six of the strategies, the 10-stock version has a lower beta. For seven of them, the 20-stock version has the lower beta. (In one case, the betas are the same.) Overall, the fourteen 10-stock portfolios have an average beta of 1.13. The average beta on the fourteen 20-stock portfolios? It's 1.13. The standard deviations, which measure standalone risk, are higher on the 10 stocks portfolios on average, though. So the 10 stock portfolios have been more risky on a standalone basis, but not more risky when considered as part of a diversified portfolio.
As for the Hot List itself, its 10-stock version has outperformed the 20-stock version over the long haul, producing annualized returns of 10.9% versus 9.6% for the larger portfolio. It's done so with almost exactly the same beta (1.19 for the 10-stock and 1.18 for the 20-stock), and its worst year was actually better than the worst year for the 20-stock version (2008, when the 10-stock fell 35.0% and the 20-stock lost 38.9%). And it may be worth noting that the other multi-strategy approach we track, the Top 5 Gurus strategy, has produced much better results over the long term with its smaller portfolio. The 10-stock version has averaged 13.8% annualized returns, while the 20-stock version has averaged 8.7%. The 10-stock version also has a lower beta than the 20-stock portfolio (1.07 to 1.09), and it lost significantly less in its worst year (31.0%) than the 20-stock portfolio lost in its worst year (39.1%).
In the short term, running a 10-stock focused portfolio like the Hot List means additonal volatility on a standalone basis and that a big loss on an individual position will of course be felt more than it would in a larger portfolio. But our data shows that investors who can stay the course through that volatility will be rewarded with better returns over time.
There will be situations in which a 20-stock or 50-stock portfolio does add beneficial additional diversification versus a 10-stock portfolio. But what's also key here, I believe, is the nature of the Hot List's underlying approach. Its rigorous, fundamental-based stock selection system puts companies through a wide array of financial strength and valuation tests. Because it looks at companies and stocks from so many angles, it does a good job avoiding questionable companies and risky stocks. Its focus on quality may thus allow it to function quite well in a 10-stock format when other less-rigorous methods might require somewhat larger portfolios. (The performance of the multi-strategy Top 5 Gurus approach also lends credence to this notion.)
While you can never fully ensure that a stock you buy won't turn into a big loser, using a comprehensive, rigorous system like the Hot List should help you significantly limit the amount of times that occurs. In fact, since its inception in July 2003, only 11 of the Hot List's hundreds and hundreds of picks have lost 40% or more. (Five of those came during the financial crisis in late 2008/early 2009, which was a historically bad period for stocks as a whole. And one of them -- Ascena Retail Group -- lost about 40%, but rejoined the portfolio a couple months later and gained over 70% in its second go-round, making up all the ground it lost.) A system like this should also help you find more winners than losers over the long haul, and put you far ahead of the broader market. That's what the Hot List has done for nearly nine years now, and I expect that to continue.
Earlier this week, I was invited on CNBC to talk about my Warren Buffett-inspired Guru Strategy and some potential Berkshire Hathaway buys. I discussed how my Buffett-based model (which has doubled the S&P 500 since its inception) works, and took a look at how a number of companies currently stack up against the approach. If you'd like to watch the video, click here.
As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Bridgepoint Education Inc (BPI), Body Central Corp (BODY), Forest Laboratories, Inc. (FRX), Cash America International, Inc. (CSH) and Northrop Grumman Corporation (NOC).
5 stocks remain in the portfolio. They are: The Tjx Companies, Inc. (TJX), Apollo Group Inc (APOL), Finish Line Inc (FINL), Coinstar, Inc. (CSTR) and Advance Auto Parts, Inc. (AAP).
We are adding 5 stocks to the portfolio. These include: Lkq Corporation (LKQX), Stamps.com Inc. (STMP), Mwi Veterinary Supply, Inc. (MWIV), Discover Financial Services (DFS) and Solarwinds Inc (SWI).
Newcomers to the Validea Hot List
Discover Financial Services (DFS): Illinois-based Discover offers direct banking and payment services. Its payment services options include its Discover cards, as well as Diners Club International and PULSE cards. The $18-billion-market-cap firm has taken in about $6.4 billion in revenues in the past year.
Discover gets strong interest from my Peter Lynch-based model and some interest from several strategies. To read more about it, see the "Detailed Stock Analysis" section below.
Stamps.com Inc. (STMP) : This Los Angeles-based company ($450 million market cap) allows customers to pay for and print postage for a variety of letters and packages online. The 15-year-old firm gets solid marks from several of my models, including my Peter Lynch-, Martin Zweig-, and Motley Fool-based strategies. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.
SolarWinds, Inc. (SWI): Don't be fooled by the name -- SolarWinds is in the information/technology business, not the energy sector. The Austin, Tex.-based company provides a wide array of I/T services to more than 90,000 customers worldwide, including more than 85% of Fortune 500 companies.
SolarWinds has a $3.4 billion market cap, and gets solid scores from my Martin Zweig- and Motley Fool-based models as well as my Momentum Investor approach. To read more about it, see the "Detailed Stock Analysis" section below.
LKQ Corporation (LKQX):: This Chicago-based auto part firm offers a variety of original, aftermarket, and used parts and systems. It has over 450 locations in the U.S., Canada, and the U.K.
LKQ ($5.1 billion market cap) gets strong interest from my James O'Shaughnessy- and Peter Lynch-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.
MWI Veterinary Supply, Inc. (MWIV):This Idaho-based medical equipment small-cap ($1.2 billion) keys on a very specialized group of end-users: animals. It sells its products, which include pharmaceuticals, vaccines, parasiticides, diagnostics, capital equipment, and pet food and nutritional products, to veterinarians in the U.S. and U.K. In the past year, it has taken in more than $1.8 billion in sales.
MWI gets strong interest from my Peter Lynch-, Martin Zweig-, and James O'Shaughnessy-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Body Central Corp. (BODY): Body Central's shares tumbled last week after the company announced first-quarter earnings that matched analysts' expectations but announced disappointing guidance numbers. Profit rose 10% in the first quarter to 36 cents per share, which met analysts' expectations, according to the Associated Press. Revenues were up 12%, but that was due to the opening of new stores -- same-store revenue fell 1.4%. For the second quarter the firm is now forecasting EPS of 26 cents to 28 cents on revenue of $80 million to $82 million, falling short of analysts' expectations of 36 cents per share on revenue of $86.6 million, AP stated, adding that revenue in stores open at least one year is expected to fall 5% to 7%. Body Central's shares fell nearly 50% on May 4 on the news, and the portfolio is selling the stock this rebalancing.
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 my strategies and investment approach. If you have any questions, please feel free to contact us at email@example.com.
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.