Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary July 19, 2013

The Economy

The housing rebound has been driving the U.S. economy for several months, but over the past few weeks other areas -- including the labor market, industrial arena, and consumer sector -- have been supplying the good news.

For starters, the private sector added 202,000 jobs in June, the Labor Department said, the third straight month the figure has been around 200,000. Wages also increased, and average weekly earnings are now 2.5% above where they were a year ago -- not tremendous growth, but significantly better than inflation.

Most of the jobs gained in June came from the service sector, but manufacturing appears to have picked up a bit, too. New Federal Reserve data showed that industrial production increased 0.3% in June, after being flat in May. The gains were driven by a 0.3% increase in manufacturing output and a 0.8% increase in mining output. Utility output dropped 0.1%

Retail sales, meanwhile, increased 0.4% in June, according to the Commerce Department. They are now 3.7% above where they were a year ago. The June increase was driven largely by a big jump in auto sales, which likely has something to do with the rebound in the housing sector, as truck sales have been quite strong.

As for housing, the latest report actually wasn't too good. Housing starts fell 9.9% in June, according to the Census Bureau, while permit issuance for new construction was down 7.5%. Starts are now about 8% above their year-ago level, and permit issuance is about 10% above where it was a year ago. Those figures are much lower than the year-over-year gains we've been seeing in recent months. But as we get further into the housing recovery, the year-over-year comparisons get more difficult, and one down month does not make a trend.

Overseas, much of the focus remains on China. GDP in the Asian power grew at a 7.5% clip in the second quarter, according to government data, down from 7.7% in the first quarter. Industrial output for June, meanwhile, was weaker than expected, growing at 8.9%, The New York Times reported. Retail sales were better than expected, however, rising 13.3% in June. Though China's growth does seem to be slowing down, there are two key things to remember about the numbers: First, Chinese policymakers have been engineering a slowdown to make sure the country's economy doesn't get overheated, so, while the slowdown may be a bit greater than anticipated, it shouldn't come as a shock. In addition, China's government isn't the most transparent, so it's hard to say exactly how big the slowdown is. For now, perhaps the best we can say is that growth is slowing, but not to an overly troubling degree.

Since our last newsletter, the S&P 500 returned 3.5%, while the Hot List returned 5.3%. So far in 2013, the portfolio has returned 27.4% vs. 18.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 245.6% vs. the S&P's 68.9% gain.

 
Editor-in-Chief: John Reese










Advertisement
Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

Are you looking for an alternative to your underperforming mutual funds or financial advisor? Click here to download Validea Capital's investment kit and learn more about the firm's guru-based portfolios.

Get More Information on Validea Capital!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.


Portfolio Update

The solid economic data, combined with more comfort with the Federal Reserve's quantitative easing plans, have made for a good fortnight for the broader market and the Hot List. As of early afternoon trading on July 18, three of the portfolio's holdings had notched double-digit gains since our last newsletter. Florida property and casualty insurer HCI Group was leading the way with a 15.4% gain. There didn't appear to be a specific catalyst, but as a small-cap financial, HCI tends to be very sensitive to economic sentiment, and the good economic news is likely a big part of its rise.

USANA Health Sciences, meanwhile, continued its meteoric rise, gaining 11.3%. That put the nutritional supplement product company's shares up more than 140% since its Dec. 21 entrance into the portfolio. And hard drive maker Western Digital gained 10.1%. While it and USANA were likely boosted by the economic data, Western also may have been helped by its July 10 announcement that it would be buying data storage software provider VeloBit for an undisclosed sum.

Stamps.com was the lone Hot List holding in the red, down less than 1% after an analyst downgraded the stock from "buy" to "neutral" on July 16. Prior to that, the stock had actually been performing well, gaining nearly 7% since our last newsletter. The downgrade caused it to tumble, and it was then downgraded by my Motley Fool-based strategy on July 17 since its relative strength fell. Shares did start to rebound on Wednesday and Thursday, though. We'll have to wait two weeks until our next rebalancing to see whether all of this affects its place in the portfolio.



Guru Spotlight: Kenneth Fisher

For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.

But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.

While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.

Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.

It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.

So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 256.4%, or 13.5% annualized, while the S&P 500 gained just 68.2%, or 5.3% annualized (figures through July 15). That makes it one of my most successful long-term strategies.

Price-to-Sales and "The Glitch"

Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.

But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.

The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.

According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.

One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.

Beyond the PSR

While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.

Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5%; the debt/equity ratio (this should be no greater than 40%, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15% per year).

Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5% were the best case, and those between 5 and 10% were still indicative of bargains. Those between 10 and 15% were borderline, while those over 15% should be avoided.

One of the Best

The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul -- all while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul.

Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio.

Lear Corporation (LEA)
Zagg Inc. (ZAGG)
HollyFrontier Corp. (HFC)
Telecom Argentina (TEO)
Ascena Retail Group (ASNA)
Bridgepoint Education (BPI)
Royal Dutch Shell Plc (RDS.A)
USANA Health Sciences, Inc. (USNA)
Williams-Sonoma Inc. (WSM)
Signet Jewelers Ltd. (SIG)





News about Validea Hot List Stocks

Western Digital (WDC): Western Digital said on July 10 that it had bought data storage software provider VeloBit for an undisclosed amount, the Associated Press reported. VeloBit is a privately held, Massachusetts-based company that makes software that increases storage system performance. Western Digital said the move is part of its strategy to increase the overall value of data-center storage products by integrating its solid-state drives with software, AP reported.

Chevron Corporation (CVX): Chevron has signed the first agreement with Argentina's government since it nationalized YPF SA in 2012, paying $1.24 billion to help develop shale oil and natural gas in Vaca Muerta, the second-largest shale gas deposit and fourth-largest shale oil reservoir in the world, Bloomberg reported. While the initial investment is $1.24 billion, the deal may reach as much as $15 billion eventually, Bloomberg stated. Argentina had seized control of YPF from Spain's Repsol SA a little over a year ago to help slow rapidly rising fuel imports.



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

HCI   |   LEA   |   USNA   |   WSM   |   AFSI   |   HFC   |   RDS.A   |   CVX   |   WDC   |   STMP   |  



HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.





Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.





USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.





Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The direct-to-customer segment of the Company's business sells its products through its six e-commerce Websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and rejuvenation.com) and seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed and Bath, PBteen, West Elm and Rejuvenation). Its e-commerce platform is available to customers in more than 75 countries, while its catalogs reach customers throughout the United States. The retail segment of its business sells products through its five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation). As of January 29, 2012, it operated 576 stores in 44 states, Washington, D.C., Canada and Puerto Rico. On November 1, 2011, the Company acquired Rejuvenation Inc.





Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four segments: small commercial business, specialty program and personal lines reinsurance. In January 2013, the Company acquired First Nonprofit Companies, Inc. In February 2013, its subsidiary acquired Car Care Plan (Holdings) Limited from Ally Insurance Holdings, Inc. In April 2013, it acquired Sequoia Insurance Company and its subsidiaries, Sequoia Indemnity Company and Personal Express Insurance Company. In May 2013, the Company acquired Mutual Insurers Holding Company (MIHC) and MIHC's subsidiary, First Nonprofit Insurance Company.





HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.





Royal Dutch Shell plc (Shell) is an independent oil and gas company. The Company owns, directly or indirectly, investments in the numerous companies constituting Shell. Shell is engaged worldwide in the principal aspects of the oil and gas industry and also has interests in chemicals and other energy-related businesses. The Company operates in three segments: Upstream, Downstream and Corporate. Upstream combines the operating segments Upstream International and Upstream Americas, which are engaged in searching for and recovering crude oil and natural gas; the liquefaction and transportation of gas; the extraction of bitumen from oil sands that is converted into synthetic crude oil, and wind energy. Downstream is engaged in manufacturing; distribution and marketing activities for oil products and chemicals. Corporate represents the key support functions, comprising holdings and treasury, headquarters, central functions and Shells self-insurance activities.





Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates and provides administrative, financial, management and technology support to the United States and international subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining activities, power generation and energy services. Upstream operations consist primarily of exploring for, developing and producing crude oil and natural gas; processing, transportation and regasification associated with liquefied natural gas; transporting crude oil by international oil export pipelines; transporting, storage and marketing of natural gas, and a gas-to-liquids project. Downstream operations consist primarily of refining crude oil into petroleum products; transporting crude oil and refined products by pipeline, marine vessel, motor equipment and rail car, and manufacturing and marketing of commodity petrochemicals, plastics for industrial uses and fuel and lubricant additives.





Western Digital Corporation (WD) is a provider of solutions for the collection, storage, management, protection and use of digital content, including audio and video. Its principal products are hard drives, which are devices that use one or more rotating magnetic disks (magnetic media) to store and allow access to data. Its hard drives are used in desktop and notebook computers, corporate and cloud computing data centers, home entertainment equipment and stand-alone consumer storage devices. In addition to hard drives, its other products include solid-state drives and home entertainment and networking products. Effective March 8, 2012, it acquired Viviti Technologies Ltd. In May 2012, the Company completed the divestiture of certain 3.5-inch hard drive assets to Toshiba Corporation. As part of its deal with Toshiba, WD also completed its purchase of Toshiba Storage Device (Thailand) Company Limited (TSDT). Effective July 10, 2013, Western Digital Corp acquired VeloBit Inc.





Stamps.com Inc. is a provider of Internet-based postage solutions. The Company's customers use its service to mail and ship a variety of mail pieces, including postcards, envelopes, flats and packages, using a range of United States Postal Service (the USPS) mail classes, including First Class Mail, Priority Mail, Express Mail, Media Mail, Parcel Post, and others. Its customers include individuals, small businesses, home offices, medium-size businesses and enterprises.





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.