Economy & Markets

Corporate profits have been stellar this year, with the S&P 500 reporting a 24.6% gain in the second quarter alone. Interest rates are inching up, causing some concern that yields have narrowed and short-term rates could leap over long-term yields, an indicator a recession is near. But from a far longer-term perspective, rates remain low. Individual investors are pretty optimistic. The American Association of Individual Investors survey shows bullishness rising to a six-week high of 38.5%. The indexes have hit highs this week as investors shake off concern that the Fed might act too aggressively on rates. It seems the expectation is the S&P is gathering energy for a move still higher. The S&P 500 is trading at 19.9 times trailing earnings, and the Dow Jones Industrial Average is trading at 17.7. Technology and consumer discretionary lead the index, while consumer staples is the laggard.

Some positive numbers:

1. Indexes like the S&P 500 and the Russell 2000 hit record highs as the bull market officially became the longest in history.

2. Jobless claims dropped for the third straight week and Thursday's report showed no signs of disruption from the trade wars.

3. Retail sales surged 0.5% in July, far stronger than the 0.1% expected, a sign consumers are optimistic about the continued growth of the economy.

Some not-so-positive numbers

1. New homes sales fell to a 9 month low, an unexpectedly week number that shows the housing market is cooling.

2. The U.S. economy is expected to grow steadily through next spring, but a poll of 100 economists earlier this month showed they expect it will lose momentum after that.

3. A bumper crop is weighing on soybean prices as farmers also have to contend with the negative effects of trade tariffs on their exports to China. Soybean futures are down 16 percent since April.

Recommended Reading

Morningstar recently interviewed Oakmark International's David Herro about how international investing has changed since the 1980s. One of the biggest changes, he said, was the pace at which information flows and the benefits and negatives as a result. The markets may have become more volatile is one conclusion. "I think all too often people may react too rapidly without thinking," he told Morningstar. "They get the information, they do a knee-jerk reaction and maybe do something they wish they wouldn't have done." To see the interview, click here . And see below for blog posts and articles you may have missed.

Thinking Graham WSJ columnist Jason Zweig recently updated and gave commentary on the 3 ^rd edition of Benjamin Graham's The Intelligent Investor. He summed up the qualities: patience, independent thinking, discipline, eagerness to learn, self-control and self-knowledge. Read more

Hedge Woes David Einhorn's once high-flying Greenlight Capital has seen assets under management drop from a reported $12 billion in 2014 to about $5.5 billion, and investors are losing patience with poor performance. Read more

Fed Moves Bloomberg recently reported that the Fed's efforts to pare back its swollen balance sheet are having unintentionally negative consequences for the stock market. Even the though moves have been widely telegraphed, volatility in emerging markets is back. Read more

Miller Views Bill Miller says value investing isn't just about picking cheap stocks. Look for companies focused on high returns on invested capital and free cash-flow growth, he says. Read more

Currency Play If a U.S. recession is in the offing, analysts from JPMorgan Chase say it's time to own Swiss francs, Singapore dollars, U.S. dollars or Japanese yen based on trends from the last five recessions, according to Bloomberg. Read more

Casino Royale Wall Street is still peddling complicated investment products because investors are constantly looking for ways to beat the odds. Georgetown professor James Angel says an aspect of finance is that "we're also in the entertainment and gaming industry." Read more

Berkshire Buybacks Last month, Berkshire Hathaway's board announced that its removing a cap on stock buybacks, giving chairman Warren Buffett the freedom to dole out profits rather than continue his hunt for acquisitions. Read more

Fund Closing Commodity hedge funds are shutting down despite a rally in raw materials during the past year, according to the Wall Street Journal. In 2017 closures outnumbered launches for the first time in data going back to 2000. Read more

Yield Worries There's a lot of worry about what might happen if and when short term yields surpass long-term yields. It could mean recession. But maybe things are different this time. Read more

Hot List Performance Update

Since our last newsletter, the S&P 500 returned 0.1%, while the Hot List returned 1.1%. So far in 2015, the portfolio has returned -6.6% vs. 6.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 239.7% vs. the S&P's 185.6% gain.

Latest Changes

Knowing when your investment process has failed

There's a paradox in investing where a flawed process can work in the short term but a well-considered process will break down. The trick is in figuring out whether your process is truly flawed or only temporarily held back by fleeting circumstances. And there does come a time when you may have to shift gears because a once successful process is no longer working.

We can look to the sports world for inspiration. Baseball is a game of statistics. Four years ago, the Houston Astros baseball team was a disaster. In 2013 it lost a franchise-record 111 games, the third straight 100-loss year. Veteran players were cut loose so the team could rebuild. Fans stopped going to games, and the ones who did booed the team. For the nicknamed "Lastros," it seemed hopeless.

But the Astros had a plan. In 2014, they managed to break their 100-loss streak going 70-92. The following year they made the playoffs for the first time in a decade and beat the New York Yankees in the wild card game. Last year they won the World Series.

This seemingly random set of events - driven by pure luck, perhaps - was anything but. Exchanging the expensive veterans for unpredictable, but cheap, rookies was not a blind gamble. The team's new management was going off historical evidence to build a process.

It would take an agonizing (for the fans) amount of time to pay off, but the point is they stuck to their conviction even through the tough times, resisting the temptation to abandon the plan when the fans stopped cheering and the criticism mounted.

This is an important lesson for investors. Process is more important than outcome, and we can see this over the long-term. But there is no guarantee that a process will work under all conditions all of the time. While it's wise to find a process you can believe in and stick to it through the normal ups and downs of a market, it's important to take a step back and reexamine whether the process might need some adjustments or whether a new process is needed.

Here are some things to think about when making that decision:

1. Your process should have data that backs it up. This is the proof that shows you have a well-thought out plan that isn't going to be compromised by human emotion. Value and momentum investing are based on factors that don't change over time. Index investing can point to the index itself over time. Picking stocks based on the flavor of the month or what a prominent hedge fund manager is doing doesn't have the data to support it. So, ask yourself if your process makes sense and whether you have the data to prove it.

The best data goes back for decades. Some trends can last half a decade or longer, so data that only goes back 3 or 5 years wouldn't necessarily screen them out. Value investing has been out of favor for the last decade, and people who developed a strategy based only on that time frame would miss out on the relative outperformance of value investing going back nearly a century. Relying on the short term data would lead to an incorrect conclusion and a flawed process. This is why understanding the strategy is important. It should be designed with sound economic and financial principals that affect a company's value and performance. Otherwise it's more likely luck that determined the outcome.

2. Is the outcome within the expected parameters? We know markets go through ups and downs. Strategies flow in and out of favor, and for some, the out-of-favor periods can last a painfully long time. But that doesn't mean they aren't sound strategies. We can look and see that value investing has waxed and waned over the decades and come out on top. You would expect this going in. If your expectations aren't met, it is worth it to reevaluate your investment process.

3. Are Things Really Different This Time? It has been said that the belief that things are different this time is one of the most dangerous things in investing. But the belief that things are never different can be equally as dangerous. Sometime things change. Sometimes what has worked historically doesn't anymore. Identifying those situations is incredibly tricky.

The price/book ratio has been a reliable indicator of value supported by copious amounts of long-term data. And it goes in and out of favor. So it meets the first two of our criteria set forth above. But we have transformed from an economy dominated by old-line companies that make things with equipment to high-tech companies that have few tangible assets and a lot of intangibles. Intangible assets are not reflected in the price/book ratio. It could be time to rethink using the ratio or replacing it with other measures of value.

The more important point is that sometimes things do change and those changes warrant a thoughtful review of your investment strategy. The fact that your process is supported by long-term data is not a guarantee it will continue to work.

In the end, there is no magic bullet that identifies when an investment process has failed. There is also no way to say whether other teams who adopt a similar process to the Astros will achieve the same result. Statistically speaking, the amount of time it would take to say for sure that a process no longer works is often longer than the period we have to evaluate it. As a result, there will always be a large element of judgement that goes into the decision.

Like most decisions, though, it is important to have a framework to analyze the relevant results. That will provide the greatest chance to achieve the long-term outcome you desire.

A good process will be evidence-based, make sense, enforce discipline and be repeatable. At Validea we have developed a system that is fundamentally based and systematic, based on the approaches outlined by some of history's best investors. Using these techniques in a disciplined, unemotional manner can lead to long-term market outperformance, the ultimate goal for any investor.

Newcomers to the Hot List

D. R. Horton Inc. (DHI) - This home builder scores highly on the models tracking the styles of gurus James O'Shaughnessy, John Neff and Peter Lynch.

Patrick Industries Inc. (PATK) - This maker of parts for recreational vehicles scores highly on the models tracking the style of James O'Shaughnessy and the Validea momentum investor.

Signet Jewelers, Ltd. (SIG) - This diamond and jewelry retailer scores highly on the models tracking the styles of James O'Shaughnessy, Benjamin Graham and Kenneth Fisher.

Thor Industries, Inc. (THO) - This recreational vehicle maker scores highly on the model tracking the styles of Kenneth Fisher, Joel Greenblatt and Peter Lynch.

Universal Forest Products, Inc. (UFPI) - This supplier of wood and wood products scores highly on the models tracking James O'Shaughnessy, Kenneth Fisher and Peter Lynch.

Universal Insurance Holdings, Inc. (UVE) - This residential home insurer scores highly on the models tracking the styles of Peter Lynch and Validea's momentum investor.

Zagg Inc. (ZAGG) - This maker of accessories for mobile devices scores highly on the models tracking the styles of Peter Lynch and Joel Greenblatt.

News on Hot List Stocks

Universal Insurance Holdings named Darryl Lewis as chief legal officer, effective August 1. He resigned from the board of directors to take the position.

Credit Acceptance Corp. completed a $398 million asset-based financing.

Guru Analysis

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The top scoring stocks not currently in the Hot List portfolio.

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