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Executive Summary September 25, 2015

The Economy

While concerns about global growth -- which the Federal Reserve highlighted in its announcement that it would not raise interest rates -- continue to weigh on markets, US economic news has been decent since our last newsletter.

New claims for unemployment have fallen, for example, and are now about 8% below where they were a year ago. Continuing claims, the data for which lag new claims by a week, also moved lower since our last newsletter and are also 8% below year-ago levels..

Retail sales edged higher by 0.2% in August, according to a new report from the Census Bureau. That's just 1.6% higher than the year-ago level, however, which is not a particularly strong increase. Still, gains are gains.

Housing starts fell 3%, in August, meanwhile, according to the Census Bureau, but are about 16% above year-ago levels. Permit issuance for new construction rose 3.5%, and is 10% above where it stood a year ago.

New home sales jumped 5.7% in August, according to the Census Bureau. Compared to a year ago, they are an impressive 25% higher. Median sale prices were about 0.3% above where they were a year ago.

Inflation continues to be sluggish. The Consumer Price Index slid 0.1% in August, according to the Labor Department. That put it just 0.2% ahead of its year-ago pace, mostly because of the oil and gas price declines. But if you strip out volatile food and energy prices, so-called "core" inflation, which was up 0.1% in July, is 1.8% ahead of its year-ago pace.

As for oil and gas prices, they keep tumbling. As of Sept. 22, a gallon of regular unleaded on average cost $2.28, down from $2.62 a month earlier. That's 32% below where it was one year ago.

Since our last newsletter, the S&P 500 returned -1.0%, while the Hot List returned -0.2%. So far in 2015, the portfolio has returned -5.4% vs. -6.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 206.0% vs. the S&P's 93.1% gain.

How Many Stocks Is Enough?

Amid the volatility that the market experienced in the second half of the summer, the Hot List has, unfortunately, had its fair share of fairly sizable losers. I've noted before that these short-term periods of trouble are to be expected when running a concentrated portfolio like the 10-stock Hot List. But perhaps you're asking, if that's the case, why run a concentrated portfolio at all?

It's a good question. After all, a bad apple in a 10-stock portfolio is going to have a much more dramatic impact than a bad apple in, say, a 500-stock index fund. And the truth is that in the stock market, there are lots of bad apples. From 1980 through 2014, about 40% of all Russell 3000 companies suffered a decline from their peaks of at least 70% and failed to rebound significantly, according to a report from J.P. Morgan. The report also found that, over the same period (or over its lifetime, if the stock did not exist for the full period), the median stock in the Russell 3000 underperformed the index by 54%, and that 40% of Russell 3000 stocks had negative returns.

Those are daunting numbers, and the thrust of the J.P. Morgan report was that, given how many companies fail in capitalism's competitive "creative destruction" environment, investors should make sure they are properly diversified. But Morgan did not seem to be saying that investors should be holding hundreds of stocks -- indeed, one standard the report used to determine whether a concentrated holder of a particular stock would have benefited from diversification was whether risk/reward metrics indicated that, in an optimal portfolio, that stock should have a weighting of no more than 20%. That's twice the target weighting for Hot List holdings.

So what does the research show about portfolio size and risk management? Well, much of the prevailing research indicates that you can get enough diversification without having to get anywhere near the couple hundred stocks that most mutual funds own. Nobel Prize-winning researcher William Sharpe wrote in a 1972 article, for example, that once you have 25 to 30 stocks in a portfolio, the addition of more stocks offers only a very minor decrease in risk. Edwin Elton and Martin Gruber published a paper five years later showing that most of the advantages of diversification are reached once you hold 15 or so stocks, though going beyond that amount did appear to offer "significant" additional benefit. In their later book Modern Portfolio Theory and Investment Analysis, Elton and Gruber found that if you own 1,000 stocks, your portfolio will be 61% less volatile than if you own just one stock, James Glassman recently noted in a piece for Kiplinger. But, they found that if you own just 20 stocks, your risk decreases almost as much -- 59%.

A 2003 study that I highlighted in my book, The Guru Investor, meanwhile, was performed by California State University-Chico Professor H. Christine Hsu and H. Jeffrey Wei. They found that "the benefit of risk diversification is somewhat limited when the number of stocks in the portfolio goes beyond 50."

So, if these studies show that portfolios of 15 to 50 stocks provided optimal diversification, why do we have only 10 stocks in the Hot List? Well, keep in mind that most of those studies are operating under the premise of randomly selected portfolios -- essentially, they are saying that if you were to randomly pick stocks, you should pick 15 to 50 to get proper diversification. It's not accidental that these studies focus on random picks - efficient market hypothesis thinking is prevalent in the academic world, and the EMH stipulates that the market is too efficient for any stockpicker to consistently do better than a randomly selected portfolio. I respectfully disagree, as I think that successful investors like Warren Buffett, Peter Lynch, Joel Greenblatt, and Benjamin Graham have proven that you can use careful stock analysis to beat the market.

This issue has a big impact on optimal portfolio size, and helps explain why the Hot List has 10 stocks. The idea of diversification is that you need to have enough holdings so that a bad apple (or a few bad apples) won't ruin your whole basket. And there are more bad apples out there than you might think -- think about the J.P. Morgan study I mentioned above, which showed that over a three-decade-plus span, 40% of all stocks in the Russell 3000 sustained a decline of at least 70% from which they did not recover.

But let's talk about what sort of stocks sustain those kind declines. Generally, stocks that suffer that type of terrible loss are likely to be companies that go through significant financial distress, or stocks that are so greatly overvalued that much of their market valuation is just fluff. If you are randomly selecting stocks for your portfolio, you are bound to get a few of these - in fact, based on J.P. Morgan's research, you're likely to get more than a few. You better have a good amount of stocks in your portfolio to diversify away the risk that risk.

But these types of stocks -- those in financial distress and those that are wildly overvalued -- are just the types of stocks that the Hot List is designed to avoid. Its rigorous financial and valuation tests analyze companies and their stocks from numerous different angles to make sure that the company is both financially healthy and trading a reasonable valuation. It's always possible that a small number of high-risk stocks might slip through the cracks if their financials are misleading. But from the outset, the Hot List take steps to remove from consideration many of the most risky stocks in the market -- stocks you very well might end up with in a randomly chosen portfolio, which would require you to have a greater number of holdings to offset those risky positions.

In addition, the Hot List uses a dynamic stop-loss that starts at 40% and moves up or down depending on what the broader market is doing while a particular stock is in the portfolio. So even if the portfolio does buy a problem stock, the downside is going to be minimized much more than it would be in a randomly selected portfolio with no stop-loss system. You're not going to see a Hot List position fall 80% or 90%. By limiting the potential loss for any one holding, we can hold a smaller number of stocks. That's important because it means we can put more of our portfolio into our best ideas.

The numbers bear all of this out. As you probably know, while the 10-stock Hot List portfolio is our flagship portfolio, we also track a 20-stock version. And we 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).

The data shows that 10-stock portfolio performance versus 20-stock portfolio performance can vary widely from strategy to strategy. (All of the performance data here and below is through September 22, 2015.) 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 averaged annualized returns of 8.16% since their inceptions; the fourteen 20-stock portfolios have averaged 8.08%. When you look strategy by strategy, in six cases the 10-stock version has performed better, while in eight cases, the 20-stock version has performed better.

What's also very interesting is the betas 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 1.12. The average beta on the fourteen 20-stock portfolios? It's 1.12.

In other words, on average, the larger portfolios have performed no better than the 10-stock portfolios, and have offered no less volatility.

I also looked at the worst year for each portfolio, wondering if the 10-stock portfolios may have been more susceptible to a big down year. I found that for 8 of the 14 strategies the 20-stock version's worst annual loss was better than the 10-stock version's worst annual loss. But the averages were extremely close. The worst year on average for a 10-stock portfolio involved a 38.64% loss; the worst year on average for a 20-stock portfolio involved a 38.57% loss. Again, bumping the portfolio size up to 20 hasn't offered much more protection. (What it would do, however -- and this is important -- is add to trading costs.)

As for the Hot List itself, its 10-stock version has outperformed the 20-stock version over the long haul, producing annualized returns of 9.6% versus 9.1% for the larger portfolio. It's done so with almost exactly the same beta (1.18 for the 10-stock and 1.17 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 14.1% annualized returns, while the 20-stock version has averaged 6.7%. The 10-stock version also has a lower beta than the 20-stock portfolio (1.07 to 1.08), 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 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 even if we double the portfolio size, we don't get any real benefit in terms of risk or performance over the long haul. In fact, our testing shows that a 100-stock portfolio picked using the Hot List system wouldn't have produced significantly better risk-adusted returns than the 10-stock portfolio since the Hot List's July 2003 inception.

This doesn't necessarily mean that a 10-stock portfolio is the right option for you. As is often the case in investing, your personal temperament should drive a lot of your portfolio management style. If you are the type of investor -- and many people are -- who would become extremely agitated if you only held 10 stocks and one of them took a tumble, you very well may want to have a somewhat larger portfolio in terms of the number of holdings. The important thing is that you feel comfortable enough that short-term losses don't lead you to scrap your strategy and bail on the market. What I'm saying here is that, if you have the right temperament, a portfolio of just 10 stocks can work over the long haul.

The bottom line is that risk management comes in a variety of forms, and diversification in terms of your number of holdings is just one of those forms. With the portfolios we run, the rigorous stock-selection methodologies we use serve as another form of risk management, by screening out financially troubled stocks or those that are wildly overvalued. And our stop-loss system adds another layer of risk management.

Over the long-term, our results have shown that this multifaceted approach to risk management can, indeed, allow us to run fairly concentrated portfolios without adding high amounts of risk. That doesn't mean we won't have some sizable losers from time, as we have in recent months. But I'm confident that over the long haul, this system will allow us to continue to beat the market.

 
Editor-in-Chief: John Reese












The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Forum Energy Technologies Inc (FET), Myr Group Inc (MYRG), G-iii Apparel Group, Ltd. (GIII) and South State Corp (SSB).

The Keepers

6 stocks remain in the portfolio. They are: Sanderson Farms, Inc. (SAFM), Universal Insurance Holdings, Inc. (UVE), Foot Locker, Inc. (FL), Bofi Holding, Inc. (BOFI), Chart Industries, Inc. (GTLS) and Travelers Companies Inc (TRV).

The Newbies

We are adding 4 stocks to the portfolio. These include: Zumiez Inc. (ZUMZ), Wisdomtree Investments, Inc. (WETF), Marcus & Millichap Inc (MMI) and Heritage Insurance Holdings Inc (HRTG).

Portfolio Changes



Newcomers to the Validea Hot List

Heritage Insurance Holdings, Inc. (HRTG): This property and casualty insurance holding company provides personal residential insurance for single-family homeowners and condominium owners in Florida. Its subsidiary, Heritage Property & Casualty Insurance Company, writes approximately $500 million of personal and commercial residential premium through a large network of agents.

Heritage ($575 million market cap) gets interest from my Motley Fool-, Martin Zweig-, and Peter Lynch-based models. For more on the stock, see the "Detailed Stock Analysis" section below.

Marcus & Millichap (MMI): This $1.7-billion-market-cap brokerage firm specializes in commercial real estate investment sales, financing, research and advisory services. The company also offers market research, consulting and advisory services to developers, lenders, owners and investors.

M&M gets strong interest from my Peter Lynch-based model and my Momentum Investor approach. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

Zumiez (ZUMZ): This Washington State-based retailer sells skateboards, snowboards, and a variety of other "action sports" clothing and accessories. It has a market cap of about $415 million.

Zumiez gets strong interest from my Peter Lynch-, Benjamin Graham-, and Kenneth Fisher-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.

WisdomTree Investments (WETF): This asset management company ($2.4 billion market cap) focuses on exchange-traded funds, offering a family of ETFs that includes fundamentally weighted funds that track its own indexes, funds that track third party indexes and actively managed funds.

WisdomTree gets strong interest from my Motley Fool- and Martin Zweig-based models. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.



News about Validea Hot List Stocks

Sanderson Farms, Inc. (SAFM): Sanderson announced that its Board of Directors has declared a regular quarterly cash dividend of $0.22 per share. The board has also authorized a special cash dividend payment of $0.50 per share. Both the regular quarterly cash dividend and the special cash dividend are payable on October 13, 2015, to stockholders of record on September 29, 2015. Payment of the regular quarterly cash dividend will remain subject to board approval each quarter.



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 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

BOFI   |   GTLS   |   UVE   |   TRV   |   SAFM   |   FL   |   ZUMZ   |   HRTG   |   MMI   |   WETF   |  



BofI HOLDING, INC., is the holding company for BofI Federal Bank. The Bank has deposit and loan customers nationwide including consumer and business checking, savings and time deposit accounts and financing for single family and multifamily residential properties, small-to-medium size businesses in target sectors, and selected specialty finance receivables. The Bank provides consumer and business banking products through the branchless distribution channels and affinity partners. The Bank's deposit products are demand accounts, savings accounts and time deposits marketed to consumers and businesses located in all 50 states. The Bank's primary lending products are residential single family and multifamily mortgage loans. The Bank's business is primarily concentrated in the state of California and is subject to the general economic conditions of that state.





Chart Industries, Inc. (Chart) is a diversified manufacturer of engineered equipment engineered equipment for the industrial gas, energy, and biomedical industries. The Company's equipment and engineered systems are used for low-temperature and cryogenic applications. It operates through three segments: Energy & Chemicals (E&C), Distribution & Storage (D&S) and BioMedical. Its products include vacuum insulated containment vessels, heat exchangers, cold boxes and other cryogenic components. Its E&C and D&S segments manufacture products used in energy-related and industrial applications, such as the separation, liquefaction, distribution and storage of hydrocarbon and industrial gases. Through its BioMedical segment, it supplies cryogenic and other equipment used in the medical, biological research and animal breeding industries. The Company, through Thermax, Inc., provides cryogenic fluid vaporizers utilized in industrial gas, petro-chemical and liquefied natural gas applications.





Universal Insurance Holdings, Inc. (UIH), with its wholly owned subsidiaries, is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. The Company's offers homeowners' insurance through the Insurance Entities, Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC). Substantially all aspects of insurance underwriting, distribution and claims processing are performed by the Company's subsidiaries. UPCIC, a wholly owned subsidiary of the Company, is a writer of homeowners insurance in Florida and has commenced its operations in North Carolina, South Carolina, Hawaii, Georgia, Massachusetts, Maryland, Delaware, and Indiana. APPCIC, also a wholly owned subsidiary, writes homeowners multi-peril insurance on Florida homes valued in excess of $1 million, which are limits and coverages currently not targeted through its affiliate UPCIC.





The Travelers Companies, Inc. is a holding company. Through its subsidiaries, the Company is engaged in providing a range of commercial and personal property and casualty insurance products and services to businesses, Government units, associations and individuals. The Company has three operating segments: Business and International Insurance segment, Bond & Specialty Insurance segment and the Personal Insurance segment. Business and International Insurance segment offers a range of property and casualty insurance and insurance related services to its customers, primarily in the United States, as well as in Canada, the United Kingdom, the Republic of Ireland and throughout other parts of the world. Bond & Specialty Insurance segment provides surety, crime, management and professional liability coverages, and related risk management services. Personal Insurance segment includes a range of property and casualty insurance covering individuals' personal risks.





Sanderson Farms, Inc. is a poultry processing company which is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared chicken items. In addition, the Company is engaged in the processing, marketing and distribution of prepared chicken through its wholly owned subsidiary, Sanderson Farms, Inc. (Foods Division). It produces a range of processed chicken products and prepared chicken items. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, and casual dining operators in the south-eastern, south-western, north-eastern and western United States and to customers who resell frozen chicken into export markets. During the fiscal year ended October 31, 2013 (fiscal 2013), it processed 452 million chickens, or over 3.0 billion dressed pounds.





Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailer whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction and SIX:02, as well as the retail stores of Runners Point Group, including Runners Point and Sidestep. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., and the direct-to-customer subsidiary of Runners Point Group, which sell to customers through their Internet and mobile sites and catalogs. As of January 31, 2015, the Company operated 3,423 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand. As of January 31, 2015, the Company operated a total of 78 franchised stores, of which 31 are in the Middle East, 27 in Germany and Switzerland, and 20 in the Republic of Korea.





Zumiez Inc. is a multi-channel specialty retailer of apparel, footwear, accessories and hardgoods. As of January 31, 2015, the Company operated 603 stores; 550 in the United States, 35 in Canada and 18 in Europe. The Company operates under the names Zumiez and Blue Tomato. Additionally, it operates e-commerce websites at www.zumiez.com and www.bluetomato.com. In apparel the Company offers t-shirts; baseball tees; hoodies and sweatshirts; tank tops; shorts; board shorts; joggers; shirts; jackets; jeans and pants; sweaters, and snow outerwear. The Company offers accessories, including hats, socks, watches, sunglasses, jewelry, backpacks, beanies, belts, wallets, underwear and bags. In addition it also offers cameras and tech; headphones; home; travel gear; hacky sacks; shoe laces; digital video discs (DVDs), scarves and gloves.





Heritage Insurance Holdings, Inc. (Heritage Insurance), formerly Heritage Insurance Holdings, LLC, is a property and casualty insurance holding company. The Company is engaged in providing personal and commercial residential insurance. Through Its subsidiary, Heritage Property & Casualty Insurance Company (Heritage P&C), it provides personal residential insurance for single-family homeowners and condominium owners, rental property insurance and commercial residential insurance in the state of Florida. The Company is vertically integrated and control or manage all aspects of insurance underwriting, actulato analysis, distribution and claims processing, and adjusting. It has approximately 207,000 personal residential policies in force and approximately 2,400 commercial residential policies in force.





Marcus & Millichap, Inc. is a brokerage firm specializing in commercial real estate investment sales, financing, research and advisory services. The Company also offers market research, consulting and advisory services to developers, lenders, owners and investors. It also offers two services to its clients: commercial real estate investment brokerage and financing. The Company divides the commercial real estate market into three segments by investment: Private client segment, which include properties with prices under $10 million; Hybrid segment, which include properties with prices equal to or over $10 million and less than $20 million, and Institutional segment, which include properties with prices of $20 million and above. As of December 31, 2014, the Company had nearly 1,500 investment sales and financing professionals in 78 offices in the United States and Canada that provide investment brokerage and financing services to sellers and buyers of commercial real estate.





WisdomTree Investments, Inc. is an asset management company that focuses on exchange-traded funds (ETFs). The Company's family of ETFs includes fundamentally weighted funds that track its own indexes, funds that track third party indexes and actively managed funds. The Company distributes its ETFs through all major channels within the asset management industry, including brokerage firms, registered investment advisers, institutional investors, private wealth managers and discount brokers. Most of its index-based funds employ a fundamental weighted investment methodology, which weights securities on the basis of factors, such as dividends or earnings, whereas most other ETF industry indexes use a capitalization weighted methodology. In addition, it also offers actively managed ETFs, which are ETFs that are not-based on a particular index but rather are actively managed with complete transparency into the ETF's portfolio on a daily basis.





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.





Disclaimer


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.