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Executive Summary October 10, 2014

The Economy

The past couple weeks have featured some of the most significant volatility we've seen in several months. But while investors have been fretting over everything from ISIS to Ebola to interest rates, the economy has actually continued to put up some pretty strong numbers.

The Labor Department, for example, said the private sector added 236,000 jobs in September, with total nonfarm payrolls rising by 248,000. It also revised its July and August jobs-added figures to indicate a total of 69,000 more jobs were added in those months than previously thought. The unemployment rate fell to 5.9% in September, the best it has been since July 2008; 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) fell to 11.8%, the lowest it has been since October 2008. While wages have been rather stagnant, the job growth we've seen in 2014 has been quite strong -- in fact, from January through September, the economy added an average of 227,000 jobs, the best January-September average since 1999.

New claims for unemployment also declined in each of the past two weeks, and in the most recent week they were a whopping 23.2% lower than they were in the year-ago period. Continuing claims, the data for which lag new claims by a week, also fell since our last newsletter and are 18% below year-ago levels.

We've also gotten pretty strong data from the manufacturing and service sectors. The Institute for Supply Management said manufacturing activity increased in September for the 16th straight month. The rate of increase wasn't as strong as August, but was still the third fastest pace of this year. The sub-indices for new orders and employment also declined, but that was more a factor of August's exceptional results, as both sub-indices remained at very healthy levels.

ISM also said the service sector expanded in August for the 56th straight month. The rate of expansion was down from August's record high, but was still at a very strong level. The new orders sub-index fell and the employment sub-index rose, but both remained at high levels. The prices sub-index fell, a good sign given how elevated it has been.

New consumer data from the Commerce Department, meanwhile, showed that personal income rose 0.3% in August. Real disposable personal income was up 0.3%, while real personal consumption expenditures jumped 0.5% as consumers opened their wallets a bit. That pushed the personal savings rate lower, but it remains at a very healthy level (5.4%).

Finally, gas prices continue to decline. A gallon of regular unleaded on average cost $3.27 as of Oct. 8, down 17 cents from a month earlier, according to AAA.

Since our last newsletter, the S&P 500 returned -1.9%, while the Hot List returned -7.8%. So far in 2014, the portfolio has returned -20.9% vs. 4.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 187.7% vs. the S&P's 92.7% gain.

Portfolio Update

It has been a pretty wild week or two for stocks. So far in October we have already seen five days in which stocks moved more than 1% -- as many 1% moves as occurred in the prior five months combined, according to Yahoo!Finance. A number of factors seem to be putting investors on edge, ranging from the Ebola outbreaks, to fears about slowdowns in China and other emerging markets, to worries about the Federal Reserve potentially raising interest rates sooner rather than later, which has in particular hurt smaller stocks.

Amid all of this, the Hot List has had a very tough go of it, in part because of some of the concerns I just mentioned and in part because of other stock-specific issues. Eight of the portfolio's 10 holdings were in the red since our last newsletter as of Thursday's close. The big laggard for the fortnight was Russian firm CTC Media. On Sept. 29 it tumbled 23% on news that proposed amendments to Russia's "On Mass Media" law passed second and third readings in the lower house of the Russian parliament, TheStreet reported. The legislation would limit the direct or indirect foreign ownership of Russian mass market businesses, according to CTC Media. If the law passes it will take effect on Jan. 1, 2016, and would make it so non-Russian people and companies can't own more than 20% of Russian mass media firms, TheStreet said. All of this has crushed the company's shares since our last newsletter -- the stock is down 40%. If those losses hold up, it would trigger our stop-loss target on the stock on our next rebalancing.

Another big drag on the portfolio was Liquidity Services, which was down 15%. The online surplus asset auctioneer said it will cut about 130 full-time and temporary jobs through 2015 after it paid more for a contract with the U.S. Department of Defense to auction goods, according to Reuters. The realignment will cost about $1.2 million, which will be reflected in Liquidity's fourth-quarter results, the firm said.

The final big decliner was Piper Jaffray, which was down more than 14%. There didn't seem to be a major catalyst for the investment banking firm's decline. It was a difficult stretch for brokerage stocks as a group, however, and Jaffray's small size ($800 million market cap) may have made it among the brokerage stocks that were hit hardest.

It wasn't all bad news for the portfolio, however. Silicon Motion Technology was up more than 6%. It said it expects sequential sales growth of 23% to 25% in the third quarter. That would mean a range of $85.36 million to $86.75 million, well above analysts' estimates of $79.1 million, Investor's Business Daily reported.

While the Hot List has had a rough go of it lately, its long-term track record remains exceptional. I believe that the recent underperformance will pass, and that the portfolio over the long-term will continue to be a stellar performer. In our next newsletter, I'll review just how the Hot List works, and talk more about why I remain very confident in the approach.

Editor-in-Chief: John Reese

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Guru Spotlight: Joseph Piotroski

If you haven't heard of Joseph Piotroski, you're not alone. He's probably the least well-known of the investment "gurus" who inspired my strategies. Actually, he's not even a professional investor, but instead an accountant and college professor.

In 2000, however, Piotroski showed that you don't need to be a smooth-talking Wall Street hotshot to make it big in the market. While teaching at the University of Chicago, he authored a research paper that showed how assessing stocks with simple accounting-based methods could produce excellent returns over the long haul. No fancy formulas, no insider knowledge -- just a straightforward assessment of a company's balance sheet.

His study turned quite a few heads on Wall Street. It focused on companies that had high book/market ratios -- i.e. the type of unpopular stocks whose book values (total assets minus total liabilities) were high compared to the value investors ascribed to them (their share price multiplied by their number of shares). These are stocks that have very low expectations.

Quite often, such firms have low book/market ratios because they are in financial distress, and investors wisely stay away from them. On certain occasions, however, high book/market firms may be good companies that are being overlooked by investors for one reason or another. These firms can be great investment opportunities, because their stock prices will likely jump once Wall Street realizes it's been shunning a winner.

Through his research, Piotroski developed a methodology to separate the solid but overlooked high book/market firms from high book/market ratio firms that were in financial distress. He found that this method, which included a number of balance-sheet-based criteria, increased the return of a high book/market investor's portfolio by at least 7.5 percentage points annually. Buying the high book/market firms that passed his strategy and shorting those that didn't would have produced an impressive 23% average annual return from 1976 and 1996.

Since I started tracking it in late February 2004, a 10-stock portfolio picked using my Piotroski-based model has been my most volatile strategy. It has a beta of 1.34, meaning it has been 34% more volatile than the broader market. At times, it has been far ahead of the S&P 500, but right now it's coming off a few rough years that have put it at the bottom of my 10-stock, monthly rebalanced Guru Strategy portfolios. Since inception, it has returned 45.4% versus 71.6% for the S&P. It has lagged the index in each of the last three years, but keep in mind that back in 2010, after a couple of mediocre years, the deep value strategy roared back, gaining more than 55% -- quadrupling the S&P and more than doubling the gains of my next best individual guru portfolio. Volatility is to be expected from a deep value strategy that often focuses on small caps, so I really wouldn't be surprised if the Piotroski model puts up some big bounce-back numbers over the next couple years.

It's also worth noting that when rebalanced annually -- the approach Piotroski took in his paper -- the Piotroski approach has been one of my best performers, producing 8.1% annualized returns vs. 5.2% for the S&P.

Let's take a look at how Piotroski's approach, and the model I base on it, work.

Diving into The Balance Sheet

Piotroski wasn't the first to study high book/market stocks. But his research took things a step further than many past studies. He noted that the majority of high book/market stocks ended up being losers, and that the success of high book/market portfolios was usually dependent on the big gains of a small number of winners. Much as low price/earnings ratio investors like John Neff used a variety of tests to make sure low P/E stocks weren't rightfully being overlooked because of poor financials, Piotroski sought to separate the high book/market winners from the high book/market losers.

The first step in this approach is, of course, to find high book/market ratio stocks. In his study, Piotroski focused on the stocks whose book/market ratios were in the top 20 percent of the market, so that's the figure I use.

That's the easy part. The harder part is determining whether investors are avoiding a low-B/M stock because it is in financial trouble, or whether the company is a solid one that is simply being overlooked. The Piotroski-based model looks at a variety of factors to determine this, including return on assets and cash flow from operations, both of which should be positive.

Piotroski also thought that good companies had cash from operations that was greater than net income. Such companies are making money because of their business -- not because of accounting changes, lawsuits, or other one-time gains.

Several of Piotroski's other financial criteria don't necessarily look for fundamental excellence, but instead for improvement. This makes a lot of sense; a company whose return on assets had declined from 10 percent to 1 percent and whose cash flow from operations had dwindled from $10 million to $10,000 would pass the above ROA and cash flow tests, for example, but it certainly wouldn't be the type of strong performer Piotroski was targeting. Looking at how a company's fundamentals had been changing allowed him to not only get an idea of the firm's financial position, but also of whether that position was improving or declining.

Among the other "change" criteria my Piotroski-based model examines are the long-term debt/assets ratio, which should be steady or declining; the current ratio (current assets/current liabilities), which should be steady or increasing; gross margin, which should be steady or rising; and asset turnover, which measures productivity by comparing how much sales a company is making in relation to the amount of assets it owns. (That should be steady or increasing).

As you can see, the Piotroski-based approach is a stringent one. Here are the stocks currently in its 10-stock, monthly rebalanced portfolio.

Owens Corning (OC)
Era Group Inc. (ERA)
Transocean Ltd. (RIG)
GulfMark Offshore, Inc. (GLF)
Vodafone Group Plc (VOD)
BHP Billiton plc (BBL)
United Microelectronics Corp. (UMC)
Marchex, Inc. (MCHX)
Companhia Paranaense de Energia (ELP)
AGCO Corporation (AGCO)

News about Validea Hot List Stocks

CTC Media (CTCM): On Sept. 29 CTC shares tumbled 23% on news that proposed amendments to Russia's "On Mass Media" law passed second and third readings in the lower house of the Russian parliament, TheStreet reported. The legislation would limit the direct or indirect foreign ownership of Russian mass market businesses, according to CTC Media. If the law passes it will take effect on Jan. 1, 2016, and would make it so non-Russian people and companies can't own more than 20% of Russian mass media firms, TheStreet 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

LQDT   |   VLO   |   AGCO   |   SIMO   |   JLL   |   CTCM   |   ANIK   |   OVTI   |   PJC   |   RGR   |  

Liquidity Services, Inc. is an auction marketplace for surplus and salvage assets. The Company enables buyers and sellers to transact in an automated online auction environment offering over 500 product categories. The Company's marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with digital images and other relevant product information. It organizes its products into categories across industry verticals, such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware and specialty equipment. It's online auction marketplaces are www.liquidation.com, www.govliquidation.com, www.govdeals.com and www.liquibiz.com. It also operates a wholesale industry portal www.goWholesale.com. In July 2012, the Company acquired GoIndustry-DoveBid plc. In November 2012, the Company acquired National Electronics Service Association.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

Silicon Motion Technology Corporation (SMTC) is a holding company. The Company's operations are conducted through Silicon Motion, Inc. (SMI Taiwan), a wholly owned subsidiary located in Taiwan and FCI, Inc. (FCI), a wholly owned subsidiary of SMTC, located in Korea. The Company is a fabless semiconductor company that designs, develops and markets, high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. SMTC designs, develops and markets high performance, low-power semiconductor products for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products. Its product offerings address three main markets: mobile storage, multimedia SoCs and mobile communications markets. On October 25, 2011, its subsidiary FCI acquired BTL System, Inc.

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.

CTC Media, Inc. operates three Russian television networks CTC, Domashny and Peretz. CTC network offers entertainment programming targeted at 6-54 year-old viewers. Domashny network targeted at 25-59 year-old female viewers. Peretz focusing primarily on edgy and comedy programming. Starting January 2013 CTC targets 10 to 45 year-old viewers and Peretzl focuses on 25 to 49 year-old viewers. As of December 31, 2012, approximately 100 million people were within the coverage of CTC's signal, approximately 63 million people are within the coverage of Domashny's signal, and approximately 61 million people are within the coverage of Peretz's signal. . It also operates Channel 31, a television network in Kazakhstan, and a television channel in Moldova, each offering entertainment programming. In addition, it has in-house production operations focused on series, sitcoms and shows. During 2012, its signals are converted to MPEG-4.

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

OmniVision Technologies, Inc. (OmniVision) designs, develops and markets integrated and semiconductor image-sensor devices. The Company's main products, image-sensing devices, which the Company refers to as CameraChip image sensors, capture an image electronically and is used in a number of consumer and commercial mass-market applications. The Company's CameraChip image sensors are manufactured using the complementary metal oxide semiconductor (CMOS), fabrication process and are single-chip solutions that integrate several distinct functions, including image capture, image processing, color processing, signal conversion and output of a fully processed image or video stream. The Company has also integrated its CameraChip image sensors with wafer-level optics, which the Company refers to as CameraCubeChip imaging devices. The Company's CameraCubeChip imaging device is a small footprint, total camera solution.

Piper Jaffray Companies is an investment bank and asset management firm, serving the needs of corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The Company operates in two segments: Capital Markets and Asset Management. The Capital Markets segment provides investment banking and institutional sales, trading and research services for various equity and fixed income products. The Asset Management segment includes traditional asset management activities and related services. The Company markets the investment banking and institutional securities business under Piper Jaffray name. Its asset management business is marketed under Advisory Research, Inc. In July 2013, Piper Jaffray Companies announced that it has completed its purchase of Seattle-Northwest Securities Corporation. In July 2013, the Company announced that it has completed its purchase of Edgeview Partners L.P.

Sturm Ruger & Co Inc, formerly Sturm, Ruger & Company, Inc., is engaged in the design, manufacture, and sale of firearms to domestic customers. The Company operates in two segments: firearms and investment castings. The firearms segment manufactures and sells rifles, pistols, revolvers, and shotguns principally to a select number of licensed independent wholesale distributors primarily located in the United States. The investment castings segment manufactures and sells steel investment castings. The Company offers products in four industry product categories, which include rifles, shotguns, pistols, and revolvers. The Company's firearms are sold through independent wholesale distributors, principally to the commercial sporting market. The Company's customers include Jerry's/Ellett Brothers, Davidson's, Sports South and Lipsey's.

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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