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Executive Summary October 28, 2011

The Economy

For months now, U.S. economic news has been better than many have been predicting, but the stock market has scuffled amid worries that Europe's debt woes would spill over into the rest of the world. This past fortnight, the latest data shows that the U.S. economy continues to show resilience -- and with European officials finally reaching a deal that should address the continent's debt problems, the market is responding.

The Eurozone deal calls for private banks and insurers to take losses of 50% on their Greek debt holdings. It also calls for the recapitalization of European banks, and for the European Financial Stability Facility -- the region's bailout fund -- to be levered up to about 1 trillion euros.

While details of the deal need to be hammered out, the initial relief will hopefully allow investors to focus on the economic data at home, which has been better than many seem to realize. Yesterday, the government announced that gross domestic product grew at a 2.5% pace in the third quarter -- not exactly gangbusters, but not at all bad considering all of the "double-dip" recession talk we've been hearing for the past few months. The report also showed that, while recent consumer confidence readings have been very low, consumers felt good enough to spend in the third quarter. Personal consumption expenditures rose 2.4%, more than three times the second-quarter increase. (The recently released September retail and food service sales data also showed that the consumer isn't "tapped out", with sales jumping 1.1% for the month.)

One issue to keep an eye on, however: Savings as a percentage of disposable income declined by a full percentage point (from 5.1% to 4.1%) in the third quarter. Ideally, consumers would be spending more because they are making more -- not because they are dipping into savings. (Of course, given how low interest rates are right now, it's easy to see why consumers wouldn't hesitate to dig into savings.)

Consumers may well be dipping into their savings because wages have been relatively stagnant, and because the unemployment rate remains persistently high. New claims for unemployment the last 2 weeks stayed in the low 400,000s. The good news is that that is well below levels seen earlier this year, and well below where many thought they'd be given all of the double-dip recession talk. The bad news is that that remains higher than levels that would indicate a healthy labor market.

The industrial and manufacturing sectors, meanwhile, continue to show improvement. Industrial production increased 0.2% in September, a new Federal Reserve report showed, and that was despite a 1.8% decline from the utility sector, which tends to fluctuate more than the other two major industrial sectors -- manufacturing and mining -- because of its reliance on weather conditions. Despite all of the fears that Europe's woes would derail the U.S. economy (and despite a down quarter for utility production), overall industrial production increased at a 5.1% annual rate in the third quarter. That's the fastest pace in a year.

Some mixed news came from perhaps the most-maligned area of the economy: housing. On the positive side: Home construction starts jumped 15% in September, hitting their highest level in almost a year-and-a-half. On the negative side: Starts are still less than half of the levels seen in normal expansions, and permits authorized for new projects fell during the month. Falling somewhere in the middle was the latest S&P/Case-Shiller Home Price Indices data, which showed that prices rose in August for both the 10-city and 20-city indices by 0.2%. On a seasonally-adjusted basis, however, the 10-city index was down 0.2%, and the 20-city index was flat.

Since our last newsletter, the S&P 500 returned 6.7%, while the Hot List returned 9.2%. So far in 2011, the portfolio has returned -11.3% vs. 2.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 139.4% vs. the S&P's 28.4% gain.

A First Sigh of Relief?

Thursday's news about the plan to fix the European debt crisis was a big boost to the market. But there's a long way to go before healing investors' psyches. The Europe problems, rampant fears of a "double-dip" recession that doesn't seem to be materializing, and the lingering effects of the 2008-09 financial crisis and market plunge have all made for a very pessimistic climate, both in terms of the economy and the market. From June through September, for example, investors pulled more than $111 billion out of stock and mixed equity mutual funds and exchange-traded funds, according to Lipper Analytical Services.

A lot was also made this past week about the latest consumer confidence figures, as the Conference Board's consumer confidence index fell in September to its lowest level since March 2009. And, to be sure, there's a lot to be worried about. While corporations' earnings have been booming since the end of the Great Recession, average workers haven't gotten nearly the same benefit. Many haven't been able to find jobs at all, with the unemployment rate still up over 9% more than two years after the recession ended.

But the leap that many pundits seem to make is that the weak consumer confidence numbers portend a poor holiday shopping season, and poor stock market performance. I think there's a good chance both predictions are off-base. In fact, the current pessimistic environment may be setting up a pretty bullish environment for investors.

Why might consumer spending be better in the coming months than many expect? A couple reasons. First, the troubles surrounding Europe have not only depressed the stock market in recent months; they've also caused major declines in commodity prices. Gasoline prices are down 12.7% since their May highs, for example, while the United Nations' food price index has fallen in each of the past three months. That translates to more money in consumers' pockets, which may make for some upside surprises in consumer spending this holiday season.

In addition, consumer confidence has been low for a while now -- in fact, it hasn't risen above "normal" levels at any point during the recovery. And yet consumer spending has jumped significantly during the post-recession months. According to the Commerce Department, retail and food service sales are now 19% higher than they were at their 2009 recessionary low, and 4.5% higher than their pre-recessionary high. And that's happened with consumer savings rates considerably higher than they were leading up to the recession.

I would submit that consumer confidence having remained low during the recovery -- and tumbling even lower in recent months -- is as much about the depth and breadth of the last recession as it is about facts. The Great Recession was so steep that it had an impact on Americans' psyches that won't be undone in a matter of months, or even a year or two. It's what Wells Capital Management's James Paulsen has termed, "post-traumatic-armageddon-hypochondria" -- any hints of trouble make investors and consumers flash back to 2008, and they fear the worst, even though they're in much better position than they were in 2008. It's thus not surprising that there's been a big disconnect between how consumers say they feel (i.e., very scared), and what they're actually doing with their money (i.e., spending it).

Just as importantly, keep in mind that periods of high pessimism are often followed by strong gains for the market. That's because people, being emotional creatures, are prone to overreaction. When they realize that the reality isn't as bad as their fears, a sense of relief hits, and many investors come rushing back to the market.

There is hard data to support this. One study, performed by money manager Kenneth L. Fisher -- one of the gurus upon whom I base my strategies -- and finance professor Meir Statman found that months in which consumer confidence was low tended to be followed by months in which stock returns were high, particularly for small-cap and Nasdaq stocks. "Consumer confidence declines when stock prices decline but investors need not fear that declines in consumer confidence would be followed by low stocks returns," Fisher and Statman wrote. "Low consumer confidence is followed by high stock returns more often than it is followed by low stock returns."

Liz Ann Sonders of Charles Schwab also presented some interesting data on consumer confidence and stock market returns earlier this year. Looking at data from the Conference Board and Ned Davis Research, Sonders found that, going back to 1969, when the consumer confidence reading has been above 110 the stock market has gone on to lose 0.2% per annum; when the reading has been between 66 and 110, the stock market has averaged 6.4% per annum gains; and when the reading has been 66 or below, the market has gone on to gain 14.9% per annum. (The most recent monthly reading for the index was just under 40.) "Much like investor sentiment, which works its contrarian magic on stocks, the same can be said for weak consumer confidence," Sonders wrote in commentary on Schwab's site. "The best performance for the stock market has historically come when consumer confidence was its weakest. Remember, consumers are generally reactive, while the stock market looks ahead."

Of course, as with anything in the stock market, there is never a silver bullet, and the low consumer sentiment numbers don't mean that the market is going to take off today or tomorrow. And it certainly doesn't mean that the market is going to head upward in a straight line. But it does mean that the low consumer confidence readings are not reason to be alarmed, and they are not reason to flee the stock market. In fact, it may be the opposite. We saw what happened this week when the gloom and doom surrounding Europe cleared a bit; if that continues to happen, investors may finally start to focus on the fact that U.S. economic data has been better than many have been predicting. And that's when we could really see some major gains for the market, and particularly for the type of fundamentally sound, undervalued stocks now in the Hot List.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Career Education Corp. (CECO), Hi-tech Pharmacal Co. (HITK), Devry Inc. (DV) and Jos. A. Bank Clothiers, Inc. (JOSB).

The Keepers

6 stocks remain in the portfolio. They are: Forest Laboratories, Inc. (FRX), Asiainfo-linkage, Inc. (ASIA), Petroleo Brasileiro Sa (Adr) (PBR), Ternium S.a. (Adr) (TX), Capella Education Company (CPLA) and Bridgepoint Education, Inc. (BPI).

The Newbies

We are adding 4 stocks to the portfolio. These include: Telecom Argentina S.a. (Adr) (TEO), Bank Of The Ozarks, Inc. (OZRK), Aeropostale, Inc. (ARO) and Stamps.com Inc. (STMP).

Portfolio Changes

Newcomers to the Validea Hot List

Stamps.com Inc. (STMP) : This Los Angeles-based company ($343 million market cap) allows customers to pay for and print postage for a variety of letters and packages online. The 15-year-old firm gets solid marks from several of my growth-focused models, including my Momentum Investor model and my Martin Zweig- and Motley Fool-based strategies. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.

Aeropostale, Inc. (ARO): Headquartered in New York, this mall-based clothing retailer targets youngsters age 14 to age 17 through more than 900 stores in 49 states, Puerto Rico, and Canada. Its P.S. from Aeropostale stores are aimed at 7- to 12-year-olds.

Aeropostale has a market cap of about $1.1 billion. It gets approval from my Peter Lynch-, Warren Buffett-, Kenneth Fisher-, and Joel Greenblatt-based models. To read more about the stock, see the "Detailed Stock Analysis" section below.

Telecom Argentina S.A. (TEO): This telecom firm has extensive operations in Argentina, offering local, long distance, cellular, data, Internet, and other services, and also offers cellular services in Paraguay. It is majority-owned by Nortel SA.

TEO ($2.2 billion market cap) gets strong interest from my Peter Lynch- and Kenneth Fisher-based models. To read more about the stock, see the "Detailed Stock Analysis" section below.

Bank of the Ozarks, Inc. (OZRK): This Arkansas-based bank has more than 100 locations throughout the southeastern US. It has close to $4 billion in assets, and a market cap of about $840 million.

Ozarks gets strong interest from my Motley Fool-based strategy, and solid scores from several of my other strategies. To read more about it, scroll down to the " Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Capella Education Company (CPLA): Capella reported third-quarter net income of $9.9 million, or 66 cents a share, down from $13.5 million, or 80 cents a share, a year earlier. Revenues were down 3% to $102.3 million. The results beat analysts' expectations of 60 cents a share on revenue of $101.6 million, according to Thomson Reuters I/B/E/S. New student sign-ups fell by 36% in the third quarter, but the firm said it expects that figure to decline by only 10% in the fourth quarter, according to Reuters. The better outlook helped boost shares, which jumped sharply higher on Oct. 25 on the news.

Forest Laboratories (FRX): Forest reported that net income fell 13% to $249.8 million, or 91 cents per share, in its fiscal second quarter. Revenues increased 7% to $1.17 billion. Analysts expected earnings of 99 cents per share on $1.15 billion in revenue, according to FactSet. The earnings decline came as Forest increased spending on three new drugs launched this year, according to the Associated Press, which added that the company is maintaining its full-year profit forecast of $3.60 to $3.70 per share. Analysts expect a profit of $3.73 per share for the year ending March 31.

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

BPI   |   FRX   |   ARO   |   TEO   |   TX   |   CPLA   |   STMP   |   PBR   |   ASIA   |   OZRK   |  

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Aeropostale, Inc. is a mall-based, specialty retailer of casual apparel and accessories, principally targeting 14 to 17 year-old young women and men through its Aeropostale stores and 7 to 12 year-old kids through its P.S. from Aeropostale stores. The Company designs, sources, markets and sells all of its own merchandise. P.S. from Aeropostale products can be purchased in P.S. from Aeropostale stores, in certain Aeropostale stores, including its new Times Square store in New York City and online at www.ps4u.com. As of January 29, 2011, it operated 965 Aeropostale stores, consisting of 906 stores in 49 states and Puerto Rico, 59 stores in Canada, as well as 47 P.S. from Aeropostale stores in 13 states. In addition, pursuant to a Licensing Agreement, one of its international licensees operated 10 Aeropostale stores in the United Arab Emirates as of January 29, 2011. During March 2011, it announced that it had signed a second licensing agreement.

Telecom Argentina SA (Telecom) is an Argentina-based company primarily engaged in the provision of national fixed-line telecommunication services, international long-distance service, data transmission and Internet services and mobile telephony. The Company also offers such solutions as online business and Web hosting, virtual private network (VPN), mobile operating systems developed by Microsoft and Blackberry, toll-free telephone numbers, call centers and voice over Internet protocol (VoIP) line, as well as other services mainly aimed at corporate clients. The Company's subsidiaries are structured in two business segments: Fixed Telephony, comprising Telecom Argentina USA Inc and Micro Sistemas Sociedad Anonima, and Mobile Services, including Telecom Personal SA, Nucleo SA and Springville SA. As of December 31, 2010, the Company's majority shareholder was Nortel SA, 54.74% of its interest.

Ternium SA is a steel company in Latin America that manufactures and processes flat and long steel products for the construction, home appliances, capital goods, container, food, energy and automotive industries. The Company operates in three segments: Flat Steel Products, comprising the manufacturing and marketing of hot rolled coils and sheets, cold rolled coils and sheets, tin plate, welded pipes, hot dipped galvanized and electro-galvanized sheets and pre-painted sheets; Long Steel Products, comprising the manufacturing and marketing of billets (steel in its basic, semi-finished state), wire rod and bars; Others, comprising mainly pig iron, pellets and pre-engineered metal buildings. During the year ended December 31, 2010, Flat Steel Products accounted to 86% of the Company's overall revenues. Approximately 57% of Ternium's sales were generated in North America and 41% in South and Central America.

Capella Education Company is an online postsecondary education services company. Through its wholly owned subsidiary, Capella University, the Company offers a range of doctoral, master's and bachelor's programs. As December 31, 2010, it offered over 1,250 online courses and 43 academic programs with 136 specializations to over 39,000 learners. It also offers certificate programs, which consist of a series of courses focused on a particular area of study. In addition, Capella Education Company also offers academic services, such as new learner orientation, technical support, academic advising, research services (particularly for doctoral degree candidates), writing services and online tutoring. It also provides appropriate educational accommodations to learners with documented disabilities through its disability support services team. During the year ended December 31, 2010, it formed the joint-venture Sophia Learning, LLC, as majority owner.

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 the 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 large enterprises, and within these segments it targets both mailers and shippers.

Petroleo Brasileiro SA Petrobras (Petrobras) is a Brazilian integrated oil and gas company. It operates in five segments: exploration and production; refining, commercialization and transport of oil and natural gas; petrochemicals; distribution of derivatives, electrical energy, biofuels and other renewable energy sources. Directly or through its subsidiaries, Petrobras is engaged in the research, extraction, refining, processing, commercialization and transport of oil from wells, shales and other rocks, its derivatives, natural gas and other liquid hydrocarbons, as well as in activities related to energy, promoting research, development, production, transport, distribution and commercialization of all forms of energy. As of December 31, 2010, it had 132 production platforms, 16 refineries, 291 vessels, 29,398 kilometers of pipelines, six biofuel plants, 16 thermoelectric plants, one pilot wind farm, 8,477 service stations and two fertilizer plants, as well as presence in 30 countries.

AsiaInfo-Linkage, Inc. (AsiaInfo-Linkage), formerly AsiaInfo Holdings, Inc., is a provider of telecommunications software solutions and information technology products and services in China. The Company's software and services enables its customers to build, maintain, operate, manage and improve their communications infrastructure. It's products and services in telecom business include business operation support systems, including billing and partnership relationship management applications; business intelligence systems, including data warehousing platforms and data mining applications; operating support systems (OSS) package, including protocol adaptor, service fulfilment, process management and service activation; service and data applications, such as mail centers, mobile device management and mobile e-commerce platforms, and network infrastructure services, including network design and implementation, integrated network management and professional maintenance and support.

Bank of the Ozarks, Inc. is a bank holding company. The Company owns an Arkansas state chartered subsidiary bank, Bank of the Ozarks (the Bank). As of December 31, 2010, the Company, through the Bank, conducted banking operations through 90 offices, including 66 offices in Arkansas, seven in Texas, 10 in Georgia, three in Florida, two in North Carolina, and one each in South Carolina and Alabama and it opened its eighth and ninth Texas offices and acquired two additional Georgia offices. It also owns Ozark Capital Statutory Trust II, Ozark Capital Statutory Trust III, Ozark Capital Statutory Trust IV and Ozark Capital Statutory Trust V, all 100%-owned finance subsidiary business trusts formed in connection with the issuance of certain subordinated debentures and related trust preferred securities, and indirectly through the Bank, a subsidiary engaged in the development of real estate. On October 26, 2010, it closed four of the Woodlands offices.

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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