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Executive Summary October 15, 2010

The Economy

While fear remains elevated in the market and on Main Street, the economy and Corporate America continue to show improvement. Since our last newsletter, new data has shown that the manufacturing sector expanded in September for the 14th straight month. The Institute for Supply Management's manufacturing index showed that growth in the sector wasn't as strong as it had been earlier this year, but the index remained comfortably in expansion territory. The data also showed that employment conditions improved in the sector for the 10th straight month.

The service sector also grew in September, according to ISM, and it did so at an accelerating rate -- a very good sign given the U.S.'s service-driven economy. ISM's data also showed growth in service sector jobs, reversing the decline that occurred in August.

In general, however, the employment situation remains a concern. The Labor Department said last week that the unemployment rate held steady at 9.6% in September. The private sector added 64,000 jobs, but government jobs declined by 159,000. The unemployment rate doesn't take into account those "marginally attached" to the labor market (such as discouraged workers who've stopped looking for work), and those working part-time because that is their only option. That figure rose in September to 17.1%, up from 16.7% in August.

But while they aren't adding a lot of jobs, U.S. corporations are posting strong profits. Several bellwethers have reported nice third-quarter results, including Google. The tech giant's net income rose 32%, while revenue jumped 23%. Intel also posted strong results, beating both revenue and profit estimates. Financial sector bellwether JPMorgan, meanwhile, reported a 23% jump in profits.

In the housing market, pending home sales increased 4.3%, according to the National Association of Realtors. The market is continuing to readjust after many buyers rushed to get their purchases in by the homebuyer tax credit deadline.

The biggest economic news of the past fortnight doesn't involve a number or a report, however -- it's the continued speculation that the Federal Reserve will take another crack at trying to spur the economy. At this point, nothing is for sure, but the speculation is that the Fed would do so by broadening its asset purchase plan.

Investors seem to think another round of Fed assistance will help stocks -- talk of Fed action helped drive the S&P up 2.9% since our last newsletter, while the Hot List returned 4.9%. For the year, the portfolio stands at 4.5% vs. 5.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 152.0% vs. the S&P's 17.3% gain.

It's Not (Just) The Economy, Stupid

In today's world of instant information, it can be easy to get caught up in the reems of economic data that investors are deluged with every day. Unemployment statistics, manufacturing growth, housing market numbers -- investors hang on these and a myriad of other sets of data every day.

But as you wade through the ocean of economic figures, it's important not to lose sight of a key broader point: The stock market is not the economy.

Yes, the economy is, over the long term, the driving engine of the stock market. An economy that cannot overcome challenges, sustain growth, and inspire confidence over the long haul does not make for a healthy environment to invest -- that's why we give an update on the economy in each Hot List. But in the shorter term -- and the shorter term can mean periods of years -- the economy and the market can become quite detached. Strong growth does not guarantee strong stock returns, nor does weak growth guarantee poor stock market performance. In fact, forget "guarantee" -- the reality is that strong growth doesn't even mean that strong stock performance is likely, and weak growth doesn't mean weak market performance is likely.

That's what the historical data shows, according to a 2009 paper published by Rajiv Jain and Daniel Kranson of Vontobel Asset Management. It examined stock market return data from 16 developed countries from 1900 to 2002, and the returns' correlation to gross domestic product growth. (The paper used data from Elroy Dimson, Paul Marsh, and Mike Staunton's book Triumph of the Optimists: 101 Years of Global Investment Returns), with updated figures for 2001-02 from University of Florida professor Jay Ritter.)

Jain and Kranson's conclusion: "The data clearly shows that, over long periods and when adjusted for inflation, stock market returns and GDP per capital growth are negatively correlated." At best, they added, "there is no relationship between GDP per capita and stock returns over the long term."

Ritter also looked at similar data for 19 developed countries from 1970 to 2002, and from 13 other countries, mostly emerging markets, from 1988 through 2002. The data for the first group showed a negative correlation between per-capita GDP and equity returns, Jain and Kranson say; the data for the second group shows a "marginally positive correlation".

How can that be? Shouldn't economic growth and stock market returns be attached at the hip? Well, a big reason for the lack of (or in some cases, negative) correlation involves expectations. Much like popular growth stocks, countries producing stronger growth are going to attract a lot of investors, which bids up the prices for stocks in those regions. Just look at how investors have been pouring money into emerging markets lately, while shunning the U.S., Europe, and other developed markets that are expected to produce slower growth. Much as with beaten-down value stocks, economies going through shorter-term slowdowns can thus present opportunities to "buy low".

Expectations aren't the only reason stock returns and the economy often don't jive. Jain and Kranson offer several other reasons. Among them:

GDP is analogous to sales; stock returns to corporate profits: GDP takes into account the value of goods and services produced in a country -- regardless of the margins being earned on those goods. If a company cuts prices and margins to boost sales, it will be adding to GDP, but not doing much for profits, which drive share prices.

Globalization: Many of the largest companies in the world sell their products and services in a number of countries, not just their home markets. So when a U.S. firm has overseas operations that are bringing in lots of sales and profits, it's good for the company -- but not included in U.S. GDP.

Not the "Full" Economy: The performance of private, government-owned, or newly-formed companies often isn't reflected in the stock market, but it does count toward GDP.

There are other reasons to look far beyond GDP growth, too. For instance, in emerging markets, demand may drive excellent sales growth, and, therefore, strong GDP growth. But to make money for shareholders, corporations need to turn those sales into profits. For new, up-and-coming firms, it may take time to work out the kinks and become more efficient to get the most out of their sales.

So, what does all of this mean? Does it mean we should hope for weak economic growth for the U.S.? Of course not. At the end of the day, the stock market is as strong as the companies behind its stocks, and successful companies over the long haul will spur solid economic growth.

What it does mean, however, is that in the end, good investing comes back to finding value in individual companies, wherever they are located -- not making sweeping decisions based on one piece of macroeconomic data. Blindly dumping money into emerging market stocks because those markets are expected to grow GDP more quickly than others is no recipe for success. Similarly, avoiding the U.S. and other developed markets because of fears of prolonged anemic growth is equally narrow-minded. That's the tact that many investors are taking right now, however.

Like a number of the gurus I follow, I believe the fears of prolonged slow U.S. growth are a) overblown, and b) helping create a myriad of buying opportunities in individual stocks. While focusing on slow-growth fears that they don't even know will come to fruition, investors are ignoring factors like valuations (which, for many strong companies' shares, are very cheap); interest rates (which, being incredibly low, mean fixed-income investments offer little competition to stocks); and the high levels of cash on the sidelines and on many companies' balance sheets (which they can put to use through share buybacks, acquisitions, or dividend payouts, all of which benefit shareholders). Even if growth is weak for an extended period -- which I don't think it will be -- those other factors are combining to make for some excellent opportunities right here in the U.S. And those who continue to focus solely on the macro forecasts are likely to regret not taking advantage of them.
Editor-in-Chief: John Reese

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Guru Spotlight: Joel Greenblatt

Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.

Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.

Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.

Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.

In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

The Details

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past three years or so. So far, the model has been an exceptional performer. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has fallen about 7%, but the portfolio has gained about 50%, or 8.7% per year.

The Greenblatt portfolio also did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% last year, vs. 23.5% for the S&P. This year it's been volatile. Greenblatt stresses that the strategy won't beat the market every month or even every year, and for much of 2010 the portfolio has significantly lagged the S&P. But it began to bounce back strongly recently, and is now in the black for the year (through Oct. 13), showing that patience is rewarded.

One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.

Here's a look at the current holdings of my Greenblatt-based portfolio:

Aeropostale (ARO)
Bridgepoint Education Inc. (BPI)
H&R Block, Inc. (HRB)
China Yuchai International Limited (CYD)
GameStop Corp. (GME)
Almost Family, Inc. (AFAM)
United Online, Inc. (UNTD)
LHC Group (LHCG)
VirnetX Holding Corporation (VHC)
AmSurg Corp (AMSG)

"Magic"? Or Discipline?

While Greenblatt's methodology is completely quantitative, one of the most important aspects of his approach is psychological -- and it's something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn't in the specifics of the variables; it's having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn't always work -- a notion that is true for any good strategy.

News about Validea Hot List Stocks

Dollar Tree Inc. (DLTR): Dollar Tree has announced that it is buying Canada's Dollar Giant Store Ltd. for approximately $52 million in cash, the firm's first expansion of retail operations outside the U.S. The deal is expected to close by mid-November, and includes 85 Dollar Giant stores, including substantially all assets, inventory, leasehold rights and intellectual property. A company official said the move gives Dollar Tree a platform for significant growth in the Canadian market.

Sanofi-Aventis SA (SNY): Biotech firm Genzyme rejected Sanofi's $18.5 billion hostile takeover bid last week, saying that it was too low. Sanofi also announced that it will be cutting about 25% of its U.S. Pharmaceutical Operations workforce, eliminating about 1,700 jobs. The cuts, which will be finalized by mid-December, come as part of Sanofi's "ongoing transformation to better respond to patients and customers in a challenging healthcare marketplace," the firm said. Sanofi's U.S. Pharmaceutical segment will now focus on Diabetes, Atrial Fibrillation and Oncology. The restructuring is designed to position the firm for growth after the impact of patent expiries, as well as increase business development and "ensure appropriate investment in late-life cycle products," the company said.

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 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

CAAS   |   HS   |   WDC   |   RIMM   |   LLEN   |   SNY   |   GME   |   DLTR   |   ARO   |   JOSB   |  

China Automotive Systems, Inc. (China Automotive) is a holding company and has no significant business operations or assets other than its interest in Great Genesis Holdings Limited (Genesis). Through Genesis, the Company manufactures power steering systems and other component parts for automobiles. All operations are conducted through eight Sino-foreign joint ventures in China and a wholly owned subsidiary in the United States. The Company has business relations with more than 60 vehicle manufacturers, including FAW Group and Dongfeng Auto Group, automobile manufacturers in China; Shenyang Brilliance Jinbei Co., Ltd., light vehicle manufacturer in China; Chery Automobile Co., Ltd, state-owned car manufacturer in China, and Xi'an BYD Auto Co., Ltd and Zhejiang Geely Automobile Co., Ltd., car manufacturers.

HealthSpring, Inc. (HealthSpring) is a managed care organization with a primary focus on Medicare, the federal government-sponsored health insurance program for United States citizens aged 65 and older, qualifying disabled persons and persons suffering from end-stage renal disease. As of December 31, 2009, the Company operated coordinated care Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas. As of January 1, 2010, it also commenced operations of Medicare Advantage plans in three counties in Northern Georgia. As of December 31, 2009, the Company's Medicare Advantage plans had over 189,000 members. The Company also offers prescription drug benefits in accordance with Medicare Part D to its Medicare Advantage plan members, in addition to providing other medical benefits (MA-PD) plans. It also offers prescription drug benefits nationally on a stand-alone basis in accordance with Medicare Part D (PDP).

Western Digital Corporation (WD) designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufacturers (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. Its hard drives are used in desktop computers, notebook computers, and enterprise applications such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Its hard drives are used in CE applications, such as digital video recorders (DVRs), and satellite and cable set-top boxes (STBs). It also sells its hard drives as stand-alone storage products by integrating them into finished enclosures, embedding application software and offering the products as WD-branded external storage appliances for personal data backup and portable or expanded storage of digital music, video and other digital data.

Research In Motion Limited (RIM) is a designer, manufacturer and marketer of wireless solutions for the worldwide mobile communications market. Through the development of integrated hardware, software and services that support multiple wireless network standards, RIM provides platforms and solutions for seamless access to time-sensitive information, including e-mail, phone, short message service (SMS), Internet and intranet-based applications. RIM's portfolio of products, services and embedded technologies are used by organizations worldwide and include the BlackBerry wireless solution, the RIM Wireless Handheld product line, software development tools and other software and hardware. Its subsidiaries include Research In Motion Corporation, Research In Motion UK Limited and RIM Finance, LLC. On June 2, 2010, Harman International sold its software operating systems unit, QNX Software Systems, to the Company.

L & L Energy, Inc. (L & L) is engaged in the businesses of coal mining, coal washing, coal coking and coal wholesaling. The Company's operations are conducted in Yunnan and Guizhou provinces in the southwest region of the People's Republic of China. As of April 30, 2010, the Company had three operating subsidiaries: KMC, which has coal wholesale operations and Ping Yi Coal Mine (mining operations PYC); two coal mining operations (DaPuAn Mine and SuTsong Mine), including DaPuAn's coal washing operations (the 2 Mines or LLC), and L&L Yunnan Tianneng Industry Co. Ltd. (including Hong Xing coal washing and ZoneLin coking operations) (TNI).

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. The Company is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, the Company specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

Dollar Tree, Inc. (Dollar Tree) is an operator of discount variety stores offering merchandise at the fixed price of one dollar. At January 30, 2010, the Company operated 3,806 discount variety retail stores. Approximately 3,650 of these stores sell substantially all items for one dollar or less. The remaining stores, operating as Deal$, sell items for one dollar or less but also sell items for more than one dollar. Dollar Tree's stores operate under the names of Dollar Tree, Deal$ and Dollar Bills.

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aropostale merchandise through its e-commerce Website, www.aeropostale.com. During the fiscal year ended January 30, 2010 (fiscal 2009), the Company launched P.S. from Aeropostale, which offers casual clothing and accessories focused on elementary school children between the ages of 7 and 12. During fiscal 2009, the Company completed the closure of its 14 store Jimmy'Z concept. Jimmy'Z Surf Co., Inc., a wholly owned subsidiary of Aeropostale, Inc., was a contemporary lifestyle brand targeting young women and men aged 18 to 25.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, manufacturer, retailer and direct marketer (through stores, catalog and Internet) of men's tailored and casual clothing and accessories. The Company sells substantially all of its products exclusively under the Jos. A. Bank label through its 473 retail stores (as of January 30, 2010, which includes seven outlet stores and 13 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. Jos. A. Bank operates through two segments: Stores and Direct Marketing. The Company's Stores segment consists of its 453 Full-line Stores. The Company opened 14 stores (and closed one store) during the fiscal year ended January 30, 2010 (fiscal 2009). The Company's Direct Marketing segment consists of its Internet and catalog channels.

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.


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.

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