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Executive Summary February 13, 2015

The Economy

Led by some of the best jobs growth we've seen in nearly two decades, the US economy just keeps on gaining steam.

The private sector added 267,000 jobs in December, the Labor Department said, with total nonfarm payrolls rising by 257,000. In addition, December's and January's jobs-added figures were revised upward -- sharply. In total, 147,000 more jobs were added in those months than previously thought. That meant that, over the past three months, the economy has added more than 1 million jobs -- the first time that has happened since 1997.

Just as importantly, those long stagnant wages pushed higher in January. Average wages for hourly workers jumped 12 cents, the biggest increase since before the financial crisis. The unemployment rate edged higher by a tenth of a percentage point to 5.7%; the broader "U-6" rate (which unlike the headline number takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job) also ticked higher by a tenth of a point to 11.3%. That was probably because more people were looking for a job, thanks to the pickup and hiring over the last several months -- the number of people not in the labor force fell by more than 350,000.

It doesn't look like the hiring push is slowing down. In January, job openings jumped to the highest level since 2001, according to the Labor Department.

Manufacturing growth slowed in January, meanwhile, with the Institute for Supply Management's manufacturing index coming in at its lowest mark in the past year. That is more a commentary on how strong manufacturing has been in the past year, however, as the index was still comfortably in expansion territory for the 20th straight month.

ISM also said the service sector expanded in January for the 60th straight month, doing so at about the same strong pace that it did in December. The new orders sub-index also remained at a very high level, which bodes well for coming months.

The latest consumer data from the Commerce Department showed that personal income rose 0.3% in December. Real disposable personal income jumped 0.5%. After surging in November, real personal consumption expenditures slipped 0.1% in December. That helped push the personal savings rate up to 4.9%, from 4.3% a month earlier.

Oil and gas prices finally are moving higher. As of Feb. 11, the average price for a gallon of regular unleaded was $2.21, according to AAA, up 7 cents from $2.14 a month ago. Still, gas prices are down 33% from where they were a year ago.

Since our last newsletter, the S&P 500 returned 3.3%, while the Hot List returned 3.3%. So far in 2015, the portfolio has returned 7.8% vs. 1.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 248.6% vs. the S&P's 108.8% gain..

The Valuation Situation

It's been close to six months since we've looked at broader market valuation, and in that time quite a bit has happened -- oil's dramatic plunge, the dollar's sharp increase, and the US economy's marked improvement, to name just a few of the major forces at work. Given all of that, it's time we checked back in to see how valuations have been impacted.

As always, let's start with earnings. Using the S&P 500's Thursday morning price of 2,080, the index is trading for about 19.9 times trailing 12-month (TTM) as-reported earnings per share, up from 19.3 in August, when last we checked in.

Using projected operating earnings for the next year, the P/E is about 17.5, up from 15.6 in August. P/Es are significantly higher than they were a year or two ago, but these earnings-related valuations are far from exuberant; they're probably on the high side of the "fair value" range, particularly in a low-interest-rate environment.

The S&P's price/sales ratio, meanwhile, is 1.65, almost exactly where it was when we last checked in, according to Morningstar.com. Its price/book ratio is 2.45, up a bit from 2.33 in August. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Dividend yields, meanwhile, remain attractive, though they've dipped slightly since August. Back then the S&P's yield was 2.3%; now it's 2.2%.

One figure that remains quite high is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It is now 123.9%, down slightly from 124.5% in August, according to GuruFocus.com. That puts it in the "Significantly Overvalued" range, based on the site's analysis of historical data. The current figure is higher than the 2007 peak, but still well short of the 2000 bull market peak, when the ratio climbed to about 150%.

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 27.5, using Yale Economist Robert Shiller's earnings data and Thursday morning's S&P 500 price of 2,080. That's up from 26.2 in August, and is right around where it peaked in 2007. It's also well above the 16.6 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.5 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.

The Q ratio also indicates that the market is significantly overvalued. Based on a methodology developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. Using the most recent report, which came at the end of the third quarter, the Q ratio is 1.11, down from 1.17 in August, according to an analysis done by Doug Short of Advisor Perspectives in early February. That was 63% higher than the historical average using the arithmetic mean and 75% higher than the geometric mean. As has been the case for some time, the current Q indicates the market is significantly overvalued, but it's not nearly as high as it has gotten at some market tops.

Overall, I think that all of this data indicates that, after nearly six years, we've reached the point in the bull market where the broader market has gotten somewhat overvalued. But that should be neither a surprise nor a major concern. While the market crashes of 2000 and 2008 have made investors hypersensitive to any hint of overvaluation, the fact is that the market is going to trade above its average valuation quite a bit. By definition, it can't always be under the average. And bull markets can run for a long time when valuations are at above-average levels. You should get concerned not when valuations become above-average, but when they become extremely bloated, and I don't think we are near that point yet.

In fact, there are still an array of attractively valued individual stocks out there. Take Hot List newcomer Lannett Company, a generic pharmaceutical maker. The firm has less than $1 million in debt compared to more than $290 million in net current assets, a current ratio of 7.7, a 41% return on equity, 34% profit margins, and 47% long-term earnings growth. Despite those tremendous fundamentals, the stock trades for a very reasonable 16.6 times earnings, and has a PE-to-growth ratio of 0.35.

As long as fundamentally sound stocks like Lannett are out there, we will continue to buy them. And one of the beauties of using a quantitative screening system like the Hot List is that we can scan through thousands of stocks in a matter of seconds to find those types of stocks. With so many potential opportunities so easily accessible, we can almost always find enough attractively priced, financially sound companies to fill out a portfolio. Those are the types of stocks that should fare well over the long term, regardless of what the short-term broader market valuation situation is.

Editor-in-Chief: John Reese

The Fallen

As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Universal Insurance Holdings, Inc. (UVE), Silicon Motion Technology Corp. (Adr) (SIMO), Agco Corporation (AGCO), Skyworks Solutions Inc (SWKS) and Blackrock, Inc. (BLK).

The Keepers

5 stocks remain in the portfolio. They are: Sasol Limited (Adr) (SSL), Sanderson Farms, Inc. (SAFM), Zumiez Inc. (ZUMZ), Amtrust Financial Services Inc (AFSI) and Starwood Property Trust, Inc. (STWD).

The Newbies

We are adding 5 stocks to the portfolio. These include: Apple Inc. (AAPL), Middleby Corp (MIDD), Jones Lang Lasalle Inc (JLL), Lannett Company, Inc. (LCI) and Hibbett Sports, Inc. (HIBB).

Portfolio Changes

Newcomers to the Validea Hot List

Apple, Inc. (AAPL): The largest publicly traded company in the world is joining the Hot List this week. The tech sector giant has taken in nearly $200 billion in sales over the past year, and has a $727 billion market cap. Its fundamentals are impeccable: a 35% return on equity, 22% profit margins, 27% long-term revenue growth, and a 0.58 PE-to-Growth ratio.

Apple gets strong interest from my Warren Buffett- and Peter Lynch-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Hibbett Sports (HIBB): This Alabama-based sporting goods retailer is no stranger to the Hot List, having appeared last year. It focuses on small and mid-sized markets, mostly in the South, Southwest, Mid-Atlantic and Midwest. It has more than 900 retail stores across the US, mostly under the Hibbett Sports name but with some also under the Sports Additions and Sports & Co. names.

Hibbett gets strong interest from my Warren Buffett- and Peter Lynch-based models and high marks from some other strategies as well. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Jones Lang LaSalle (JLL): Another former Hot List favorite, JLL is a financial and professional services firm specializing in real estate. It has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries, offering integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients.

JLL ($7 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

The Middleby Corporation (MIDD): This commercial cooking equipment manufacturer was a pretty amazing growth story 10 to 15 years ago -- from 1998 to late-2002, Middleby more than doubled its market share in the U.S. commercial cooking equipment market, from 11% to 26%, according to U.S. Business Review. That helped the stock become one of the best-performing stocks of the 2000s, with its shares jumping about 1,700%. Growth has slowed, of course, but it's still strong (23% over the long term), and my Warren Buffett-based model is high on the mid-cap ($6 billion). For more on Middleby, see the "Detailed Stock Analysis" section below.

Lannett Company, Inc. (LCI): This 73-year-old Philadelphia-based firm makes generic prescription pharmaceutical products for customers throughout the United States. Lannett ($2 billion market cap) markets its products primarily to drug wholesalers, retail drug chains, distributors, and government agencies.

Lannett gets strong interest from my Peter Lynch- and Joel Greenblatt-based models, and my Momentum Investor approach. For more on the stock, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

AmTrust Financial Services, Inc. (AFSI): Amtrust announced fourth-quarter net income attributable to common stockholders of $71.6 million, or $0.88 per diluted share, an increase of 10.6% from $64.7 million, or $0.82 per diluted share, in the fourth quarter 2013. For the full year, net income attributable to common stockholders grew to $434.3 million, or $5.45 per diluted share, an increase of 56.1% from $278.2 million, or $3.56 per diluted share, in 2013. Fourth quarter revenue was $1.05 billion, an increase of 28.3% from $816.4 million in the fourth quarter 2013.

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

SAFM   |   ZUMZ   |   LCI   |   AAPL   |   JLL   |   AFSI   |   MIDD   |   SSL   |   STWD   |   HIBB   |  

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.

Zumiez Inc. (Zumiez) is a specialty retailer of action sports related apparel, footwear, equipment and accessories operating under the Zumiez brand name. As of January 28, 2012, the Company operated 434 stores in the United States and 10 stores in Canada. In addition, the Company operates a Website that sells merchandise online. At January 28, 2012, its stores averaged approximately 2,900 square feet. Its apparel offerings include tops, bottoms, outerwear and accessories, such as caps, bags and backpacks, belts, jewelry and sunglasses. Zumiez's footwear offerings primarily consist of action sports related athletic shoes and sandals. Its equipment offerings, or hardgoods, include skateboards, snowboards and ancillary gear, such as boots and bindings. The Company also offers a selection of other items, such as miscellaneous novelties.

Lannett Company, Inc. is engaged in developing, manufacturing, marketing and distributing generic versions of branded pharmaceutical products. All of the Company's products manufactured and/or sold are prescription products. The Company's products containing Levo are produced and marketed with 12 varying potencies. In addition to generic Levo tablets, the Company also markets and distributes Unithroid tablets, a branded version of Levo, which is produced and marketed with 11 varying potencies. The Company's Levo tablets are used to treat hypothyroidism and other thyroid disorders. The Company's generic Levo tablets and Unithroid tablets are manufactured by Jerome Stevens Pharmaceuticals (JSP). As of June 30, 2012, the Company manufactured and/or distributed 30 products.

Apple Inc. designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players and sells a variety of related software, services, peripherals, networking solutions and third-party digital content and applications. The Company's products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud and a variety of accessory, service and support offerings. The Company offers a range of mobile communication and media devices, personal computing products and portable digital music players, as well as a variety of related software, services, peripherals, networking solutions and third-party hardware and software products. The Company's primary products include iPhone, iPad, Mac, iPod, iTunes, Mac App Store, iCloud, Operating System Software, Application Software and Other Application Software.

Jones Lang LaSalle Incorporated (Jones Lang LaSalle), is a financial and professional services firm specializing in real estate. Jones Lang LaSalle has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries. The Company offers integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients. It delivers an array of Real Estate Services (RES) across its three geographic business segments: the Americas, Europe, Middle East and Africa (EMEA), and Asia Pacific. LaSalle Investment Management, a wholly owned member of the Jones Lang LaSalle group that consists of its fourth business segment, is a diversified real estate investment management company. In July 2014, Jones Lang LaSalle Inc acquired CLEO Construction Management (CLEO), a construction project management services firm that specializes in medical facilities.

Amtrust Financial Services, Inc., (AmTrust) is a provider of property and casualty insurance. The Company operates in four business segments: small commercial business, Specialty Risk and Extended Warranty, specialty program and personal lines reinsurance. Small Commercial Business segment provides workers' compensation to small businesses. The Company's Specialty Risk and Extended Warranty segment provides coverage for consumer and commercial goods and custom designed coverages. The Company's Specialty Program segment provides workers' compensation, package products, general liability, commercial auto liability, excess and surplus lines programs and other specialty commercial property and casualty insurance. The Company subsidiaries include: Technology Insurance Company, Inc. (TIC), Rochdale Insurance Company (RIC), AmTrust Insurance Company of Kansas, Inc. (AICK), AmTrust Lloyd's Insurance Company of Texas (ALIC), Oryx Insurance Brokerage, Inc. and TMI Solutions, LLC.

The Middleby Corporation (Middleby), through its operating subsidiary Middleby Marshall Inc. (Middleby Marshall) and its subsidiaries, is engaged in the design, manufacture, marketing, distribution, and service of a line of cooking and warming equipment used in all types of commercial restaurants and institutional kitchens, and food preparation, cooking and packaging equipment for food processing operations. The Company conducts its business through three principal business segments: the Commercial Foodservice Equipment Group, the Food Processing Equipment Group and the Residential Kitchen Equipment Group.

Sasol Limited (Sasol) is an integrated energy and chemicals company. Sasol mines coal in South Africa and produce natural gas and condensate in Mozambique, oil in Gabon and shale gas in Canada. In South Africa it refines imported crude oil and retail liquid fuels. It has chemical manufacturing and marketing operations in South Africa, Europe, the Middle East, Asia and the Americas. It operates in four segments: South African energy cluster, International Energy Cluster, Chemical Cluster and Other businesses. Effective March 31, 2013, Sasol Olefins & Surfactants sold G.D. Portbury Ltd. On 16 August 2013, Sasol Investment Company (Pty) Limited, a wholly owned subsidiary of Sasol, entered into a definitive sale and share purchase agreement pursuant to which Main Street 1095 (Pty) Limited, completed the acquisition of 100% of the interest of SPI International (Pty) Limited (SPII). SPII is the indirect owner of a 50% interest in the Iranian joint venture, Arya Sasol Polymer Company.

Starwood Property Trust, Inc. is a holding company. The Company, through its subsidiaries is focused on originating, acquiring, financing and managing commercial mortgage loans and other commercial real estate debt investments, commercial mortgage-backed securities (CMBS), and other commercial real estate-related debt investments in both the United States and Europe. The Company operates in two segments: Real estate investment lending (the Lending Segment) and LNR. Real estate investment includes all business activities of the Company comprising investments in real estate related loans and securities that are held-for-investment.

Hibbett Sports, Inc. operates sporting goods stores in small and mid-sized markets predominantly in the South, Southwest, Mid-Atlantic and the Midwest. The Company operates 927 stores consisting of 910 Hibbett Sports stores and 17 smaller-format Sports. The Company's merchandise assortment emphasizes team sports complemented by localized apparel, footwear and accessories designed to appeal to a range of customers within each individual market. The Company's primary retail format is Hibbett Sports, an approximately 5,000 square foot store located primarily in strip centers, which are usually near a Wal-Mart store. Of these stores, 730 Hibbett Sports stores are located in strip centers, which include free-standing stores, with the remaining 180 stores located in enclosed malls, which are the only enclosed malls in their county.

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.


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