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|Executive Summary||February 4, 2011|
Strong performance from the economy continues to underpin the stock market's rise, with good news coming this week in several economic reports and corporate earnings announcements.
Leading the way, as it has throughout the economy's year-and-a-half-long rebound, was the manufacturing sector. The Institute for Supply Management's manufacturing index rose in January for the 18th straight month, and it did so at the fastest rate in more than six-and-a-half years. The group's employment sub-index also rose -- and it did so at the fastest pace in more than 37 years.
Other employment data offered hopeful signs. Payroll processor ADP said the private sector added 187,000 jobs in January, a solid number that hopefully will be a precursor of a strong January employment report from the Labor Department, which is due out today. And the Challenger, Gray & Christmas' jobs report showed that the number of job cuts last month was the lowest for a January -- typically the month with the highest number of job cuts -- in the 19 years Challenger has been tracking the monthly data. In the previous 18 years, employers announced an average of more than 104,000 job cuts in January. This year, the figure was below 40,000.
The strong January for the economy followed a solid end of 2010. The Commerce Department reported last week that gross domestic product grew by 3.2% in the fourth quarter, with real GDP reaching its pre-recession level. Interestingly, government spending itself was not the driving force behind the gain (though government policies, such as low interest rates, no doubt continue to help the private sector). Instead, the American consumer was largely to thank. Consumer spending jumped 4.4% in the fourth quarter, the Commerce Department said, the biggest increase in four years.
Corporate America is also continuing its impressive rebound. As of Monday, 2010 was on pace to have the third-best full-year profit gains since 1998. And the gains aren't just due to easy year-over-year comparisons for financials; according to The Wall Street Journal, non-financial S&P 500 companies' as-reported earnings are up 17% for the year, with about 50% of firms having reported fourth-quarter results.
Early in the recovery, many cautioned that profit growth was being driven not by increased demand, but by unsustainable cost-cutting measures that companies undertook. But the Journal also reported that through last week, 72% of the companies having reported had beaten analysts' revenue projections. Revenues for the S&P were on track to grow more than 8% in the fourth quarter. Translation: Reports of the death of the American consumer have been greatly exaggerated, to paraphrase Mark Twain, a notion supported by January retail sales figures. More than two dozen retailers tracked by Thomson Reuters reported average same-store sales gains of 4.2% for the month, easily beating analysts expectations of a 2.7% rise, despite the terrible winter weather that had been expected to curb consumer activity.
One area of the economy to keep an eye on: inflation. For the past year or two, many -- including myself -- have said that the U.S. is headed for some substantial inflation, given the scope of its massive stimulus efforts. But because much of the stimulus had ended up sitting on corporate balance sheets, and not making its way into the economy, it seemed that it would be some time before inflation because a real issue; in fact, many -- including the Federal Reserve -- have been more concerned with deflation than with inflation.
But if ISM's figures are any indication, inflation may be coming sooner rather than later. The group's "prices" index for manufacturers (which measures how much companies are paying for their goods and services, not how much consumers are paying), jumped more than 12% in January, climbing to its highest level in more than two years. And ISM's report showed that prices for all 30 of the commodities it tracks rose in January.
One issue that has generated some fear in the market is the Egypt political protests. With Egypt's demonstrations following on the heels of the Tunisian government's overthrow --and leading to shakeups in other countries like Jordan -- some have feared that a domino effect could destabilize the region and hurt American interests. So far, it's too early to determine just what the past few weeks' events will mean over the long term, but thus far they haven't created any major problems for the U.S. economy or market.
Overall for the past fortnight, the S&P returned 2.1%, while the Hot List returned -0.9%. For the year, the portfolio stands at 1.0% vs. 3.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 172.6% vs. the S&P's 30.7% gain.
Inflation: Coming to an Economy Near You?
When the Federal Reserve and federal government began to open wide their monetary and fiscal faucets in late 2008 and early 2009, many strategists, including gurus I follow like Warren Buffett, James O'Shaughnessy, and David Dreman, said the U.S. was putting itself on the path toward significant inflation.
Over the past two years, however, that inflation has failed to materialize. With banks using federal money to shore up their tattered balance sheets, corporations hoarding cash due to fear of another crisis, and consumers tightening their belts, paying down debt, and saving more, much of the stimulus funding remained stuck in the pipes.
Recently, however, some signs have pointed toward the possibility that we're getting closer to sizeable inflation. In fact, in energy and food prices -- which the Federal Reserve excludes from its "core" inflation reading, since their volatility can distort month-to-month inflation readings -- inflation is already here. Brent crude oil prices this week reached their highest level since September 2008, while U.S. crude prices are up over the $90 mark, two years after flirting with $30 prices.
And, as I mentioned in our last newsletter, food prices have gone through the roof. The United Nation's Food and Agriculture Organization Food Price Index this week hit its highest level since the group started tracking the figures in 1990.
The food price increases have been attributed largely to the extreme weather many areas of the world have experienced over the past several months, such as drought in Russia and flooding in Australia. Because of that, it might seem easy to pass off the food inflation as a result of short-term, anomalous factors. After all, the Fed doesn't even include it in its key "core inflation" number. But that might not be the right line of thinking. In a 2002 paper, William T. Gavin and Rachel J. Mandal of the St. Louis Federal Reserve Bank found that the food component of the Personal Consumption Expenditures Price Index was one of the index's least volatile components, and "also has been a relatively good predictor of future inflation". Their analysis actually found that food prices were the best predictor of future inflation out of about a dozen different PCEPI components.
Whether the food price inflation we've seen lately is a short-term anomaly or indeed a sign of things to come remains to be seen. But the food and energy price increases, the ISM price and commodity figures I referenced earlier, and the general recent strength of the economy are all starting to make inflation a bigger potential issue than it's been in some time.
Whatever the case, given the size of the federal government's fiscal and monetary programs, I continue to think that inflation will come home to roost at some point -- not hyperinflation, but certainly some above-average inflation. And given the recent food prices surge and the January ISM data, I thought it would be a good time to review just what inflation means for stocks.
David Dreman, whose approach we'll be looking at in this week's Guru Spotlight, has written extensively about the impact of inflation on investment returns. In his book Contrarian Investment Strategies, Dreman referred to inflation as "virulent new risk" that entered the investment world after World War II. "Nothing is safe from this virus," he wrote, "although its major victims are savings accounts, T-bills, bonds, and other types of fixed-income investments."
Dreman looked at the returns of several asset classes, and he found that in the 50-year period after World War II, inflation destroyed the real returns of bonds, Treasury bills, and gold. In fact, only stocks produced a positive annualized return after you factored in inflation. Bonds' and T-bills' nominal returns may have looked good, but they weren't good enough to keep up with inflation. Stocks and gold, meanwhile, can keep up with inflation as asset prices rise, but only stocks have the ability to also produce increasing earnings streams to stay ahead of inflation, according to Dreman.
Wharton Professor Jeremy Siegel provided more extensive historical data on asset class returns in his 2007 book Stocks for the Long Run. Siegel showed that from 1946 (when inflation really became a permanent part of our economy) through 2006, stocks averaged nominal annual compound returns of 11.2%. Long-term government bonds, meanwhile, averaged 5.7% -- 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 getting -- stocks averaged a 6.9% annual compound return, while long-term bonds averaged just 1.6% per year. Short-term bonds were even worse after inflation, averaging just 0.6% per year, just barely coming in ahead of gold's 0.5% per year real return.
Stocks even beat real estate over the long run. From 1945 to 2007, inflation-adjusted home prices in the U.S. increased at a compound rate of only about 1.3%per year -- and that's before the precipitous drop in home prices that we saw in 2008. (Calculated using data from: Irrational Exuberance, by Yale economist Robert Shiller.)
The Oracle on Inflation
While Siegel and Dreman looked at inflation's impact over lengthy periods, Warren Buffett has offered some interesting takes on inflation's more immediate impact. Back in May of 1977 -- just months before the U.S. would see consecutive annual inflation rates of 9.0%, 13.3%, 12.5%, and 8.9% -- Buffett wrote a column for Fortune entitled "How Inflation Swindles the Equity Investor".
Buffett, who more recently has said he expects the U.S. response to the financial crisis and recession to lead to significant inflation, wrote that while stock returns can vary greatly from year to year, return on equity for U.S. corporations as a group had been remarkably stable. "In the aggregate, the return on book value tends to keep coming back to a level around 12 percent," he wrote. "It shows no signs of exceeding that level significantly in inflationary years (or in years of stable prices, for that matter)."
That 12% is somewhat like the coupon rate you get on a bond, Buffett explained. If you buy the stock market when it is selling at a "normal" level compared to book value, you can expect a long-term return of 12% per year going forward (before inflation and taxes). Buy the market below book value, and it's like buying a bond below par value -- your returns should be greater than that 12%; buy the market when it's selling at elevated price/book levels, however, and it's like buying a bond above par. Your returns likely won't be as great as that 12% figure over the long haul.
The point of all this is that, for a company to benefit from an inflationary period, Buffett said, it would have to increase its ROE, and that could be done only in one of five main ways:
-- increasing turnover (the ratio between sales and total assets employed in the business);
-- cheaper leverage;
-- more leverage (though he cautioned against using too much debt);
-- lower income taxes;
-- wider operating margins on sales
Those are tough things for a company to do. Because of that, Buffett said he didn't think inflationary periods would help most stocks; in fact, it could hurt them, he said. But don't be fooled by the title of his article -- he concluded that in an inflationary environment, stocks were still probably the best bet.
As I noted earlier, I don't know whether inflation is now just around the corner, or whether it is still hovering somewhere off in the distance. But I do think it is unlikely that, when the time comes, the Federal Reserve will time its liquidity mop-up just right. And, given that it has made avoiding deflation a crucial part of its efforts to right the ship following the financial crisis, it seems likely that it will err on the side of caution, which would open the door for some significant inflation at some point. If that does occur, however, I'm comfortable holding stocks. History has shown that stocks as a group stand up to inflation much better than other asset classes, and the fundamentally sound, high-quality businesses that the Hot List keys on should in particular be able to hold their own in an inflationary climate.
Guru Spotlight: David Dreman
While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.
But while most of these gurus are contrarians, one in particular is known for being, well, the most contrarian: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).
How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.
Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.
Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."
This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.
But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio has reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and 23.1% in 2010 (vs. 12.8% for the S&P). It has now returned about 95% (more than 9% annualized) since its July 2003 inception, compared to about 30% (or 3.6% annualized) for the S&P 500.
As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Here's the full list of its current holdings:
AT&T Inc. (T)
Exelon Corporation (EXC)
BBVA Banco Frances S.A. (BFR)
Bristol Myers Squibb Co. (BMY)
Public Service Enterprise Group Inc. (PEG)
Western Gas Partners LP (WES)
PartnerRe Ltd. (PRE)
Telefonica S.A. (TEF)
USA Mobility, Inc. (USMO)
Vodafone Group PLC (VOD)
News about Validea Hot List Stocks
Atwood Oceanics (ATW): Atwood this week reported net fourth-quarter income of $52.9 million, or $0.81 per diluted share, on revenues of $146.3 million. The results were down from the year-ago quarter's net income of $67.0 million, or $1.03 per diluted share, on revenues of $164.2 million, but the profit figure beat analysts' expectations. Reuters also reported that one of the firm's customers in Egypt is trying to get out of its contract because of the unrest there.
Sanofi-Aventis (SNY): Sanofi and Genzyme have agreed in principle on the terms of a deal for Sanofi to buy the biotech firm, Reuters reported this week. Sanofi will offer at least $72 or $73 a share in cash plus a "contingent value right" (CVR) that could be worth $2 to $5, based on the performance of Lemtrada, an experimental multiple sclerosis drug, French newspaper Le Figaro reported. Genzyme has already rejected Sanofi's initial $18.5 billion ($69 a share) offer, which is on the table until Feb. 15, according to Reuters. Le Figaro reported that a deal could be announced early next week if things go smoothly.
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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