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Executive Summary November 23, 2012

The Economy

While Superstorm Sandy has dealt the U.S. economy some short-term blows, it appears that the country's broader, overall economic engine is continuing to push forward.

Industrial production, for example, fell 0.4% in October, according to a new Federal Reserve report. (All month-over-month changes cited here are seasonally adjusted; year-over-year figures are not.) But Sandy negatively impacted the figure by nearly a full percentage point, the Fed said, meaning that production would have been solidly positive if not for the storm's short-term impact. Manufacturing production was down 0.9%, the Fed said, though when Sandy's impact was taken into account, it was about flat for the month.

Retail sales, meanwhile, fell 0.3% in October, according to the Commerce Department. But Sandy's impact on that figure, which the department said could not be quantified, is not known. It stands to reason, however, that with major metropolitan areas like New York basically shutting down for long periods, the impact was a negative one.

One area of the economy that we know is continuing to improve is the housing market. Existing home sales increased 2.1% in October over September, according to the National Association of Realtors, and are now 17.8% above their year-ago level. Median sales prices were up slightly for the month, and are now about 11% above the year-ago level.

Housing starts also increased in October, according to the Commerce Department. They rose 3.6%. Permit issuance for new home building fell, however, by 2.7%. Both permit issuance and housing starts remain far ahead of where they were a year ago.

Sandy has made the labor market picture tough to discern, meanwhile, as new claims for unemployment spiked two weeks ago thanks to the storm, and then fell rather sharply this week.

Since our last newsletter, the S&P 500 returned -0.2%, while the Hot List returned 2.4%. So far in 2012, the portfolio has returned 12.5% vs. 10.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 154.3% vs. the S&P's 39.0% gain.

Checking In On Valuations

From the U.S. elections to the "fiscal cliff" drama to the continued periodic debt crisis flare-ups in Europe, a number of major macroeconomic factors have been impacting stocks over the past couple months. Investors have largely focused on these sort of macro developments, jumping into stocks when hopeful signs emerge and bailing when fears rise.

Of course, great investors like Warren Buffett or Joel Greenblatt or Kenneth Fisher don't make such macro-driven, emotional decisions, so we don't either. We focus on facts and figures and long-term data. With that in mind, I think it's a good time to check in on where we stand with the broader market's valuation, and with the valuation of some Hot List stocks.

We'll start with the broader market, and earnings. Using the S&P 500's price of about 1,390 (which is where the index stood in mid-afternoon trading on Nov. 21), the index is trading for about 15.9 times trailing 12-month (TTM) as-reported earnings per share, and about 14.2 times TTM operating EPS. Those figures are just a shade lower than where they were when last we looked at broader market valuation back in late August.

Using projected earnings for the next year, the operating figure is about 12.7, down from 13.1 in late August, and the as-reported figure is 14.1, down from August's 14.4, according to S&P data. All in all, these short-term earnings figures paint a picture of a market that is pretty fairly valued, and perhaps a bit undervalued.

The S&P's price/sales and price/book ratios, meanwhile, remain right where they were back in August. The index trades for about 2.0 times book value, according to Morningstar. 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 S&P's current price/sales ratio of 1.3, also according to Morningstar, is higher than the historical average cited by Comstock and Ned Davis. But it doesn't seem astronomical -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

As for dividend yields, they continue to look pretty solid. The S&P is yielding about 2.2%, well above the 1.66% yield on 10-year Treasury bonds. That's historically rare.

One figure that has improved since August is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It has fallen to 89.5% (from 97.7%), according to GuruFocus.com. That puts it at the top end of the "Fair Valued" range, (90% to 115%), based on the site's analysis of historical data; back in August it was in the "Modestly Overvalued" range.

The 10-year cyclically adjusted price/earnings ratio remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 20.9, using Yale Economist Robert Shiller's earnings data. That's down from 21.9 in August. It's still well above the 16.5 historical average (which dates back to 1871). But 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 18.3. (The distinction is significant because 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).

Tobin's Q also indicates that the market is significantly overvalued. 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. As of the most recent report, which came at the end of the second quarter, the Q ratio was 0.92. Since then, stocks have gained about 2%, so using today's market prices the current ratio would be slightly higher. That makes it significantly higher than the historical average is 0.7 using the arithmetic mean and 0.65 using the geometric mean, according to Doug Short of Advisor Perspectives. As has been the case for some time, the current Q indicates the market is significantly overvalued, but not nearly as high as it has gotten at some market tops.

Since we last looked in August, the valuation picture has thus gotten a little better overall. Conflicting metrics remain -- Tobin's Q shows the market to be significantly overvalued, for example, while several other metrics show it to be fairly valued or undervalued. All in all, I'd say the broader market remains somewhere near the fair value range.

Looking at individual stocks, numerous bargains are out there. Take Hot List newcomer Main Street Capital Corporation, which gained 7.5% during a previous stint in the portfolio back in August. Main Street has been posting impressive growth in recent years, yet it trades for just 8.3 times trailing 12-month earnings and 1.7 times book value. In addition, it comes with a stellar 6.1% dividend yield. Another Hot List newbie, Russian oil power Lukoil, trades for 5.7 times TTM earnings, 0.38 times sales, and 0.67 times book value. It also comes with a solid 3.8% dividend yield.

Do both of these firms have some questions and issues surrounding them? Surely. Main Street is a small-cap financial, the sort of stock that would be particularly sensitive to short-term mood swings of macro-focused investors. Lukoil is another economically sensitive firm, and is from a country whose government isn't the most reliable or stable.

But that's what value investing is about -- buying shares of good companies whose shares aren't getting the love they should because of other investors' fears. And history shows that time and time again, those fears cause investors to overreact and undervalue these types of companies. That can make for a bumpy ride in the short term, but over the long term taking advantage of those undervalued bargains is a winning strategy -- from Benjamin Graham more than half a century ago to gurus like Warren Buffett and Joel Greenblatt today, that's what history has shown. And going forward, I see no reason why the success of long-term, value-focused investing won't continue.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Nu Skin Enterprises, Inc. (NUS), Solarwinds Inc (SWI), World Acceptance Corp. (WRLD), Northrop Grumman Corporation (NOC) and Mwi Veterinary Supply, Inc. (MWIV).

The Keepers

5 stocks remain in the portfolio. They are: Ross Stores, Inc. (ROST), The Tjx Companies, Inc. (TJX), Guess?, Inc. (GES), Autoliv Inc. (ALV) and Hollyfrontier Corp (HFC).

The Newbies

We are adding 5 stocks to the portfolio. These include: Western Digital Corp. (WDC), Lukoil (Adr) (LUKOY), Hibbett Sports, Inc. (HIBB), Main Street Capital Corporation (MAIN) and Vale Sa (Adr) (VALE).

Portfolio Changes

Newcomers to the Validea Hot List

Main Street Capital Corporation (MAIN): This Houston-based investment firm offers long-term debt and equity capital to lower middle-market companies (usually those with annual revenues between $10 million and $150 million) and debt capital to middle-market firms. Its investments usually support management buyouts, recapitalizations, growth financings, refinancings and acquisitions of companies that operate in diverse industry sectors. Being a small-cap financial ($950 million market cap), it is more susceptible to volatility, particularly in today's environment. But the stock trades for just 8.3 times trailing 12-month earnings, and comes with a handsome 6.1% dividend yield. It gets approval from my Peter Lynch-based model, and from the model I base on the writings of Tom and David Gardner of The Motley Fool. To read more about it, see the "Detailed Stock Analysis" section below.

Lukoil OAO (LUKOY): Russia-based Lukoil ($52 billion market cap) is the world's largest privately owned oil and gas company based on proved oil reserves, and is responsible for about 17% of Russian crude oil production. Its products are sold in Russia and former USSR republics, as well as Europe, Asia, and the U.S.

Lukoil gets approval from my James O'Shaughnessy-, Joseph Piotroski-, and Peter Lynch-based models. To read more about it, scroll down to the "Detailed Stock Analysis" section below.

Western Digital Corp. (WDC): This California-based firm is a leader in the hard drive and digital storage business. The 40-year-old company has a market cap of about $8.3 billion, and has raked in close to $14 billion in sales in the past year. It gets approval from my Peter Lynch- and Kenneth Fisher-based models. For more on the stock, see the "Detailed Stock Analysis" section below.

Hibbett Sports Inc (HIBB): This footwear, athletic equipment, and apparel products retailer operates out of small to mid-sized markets predominantly in the Southeast, Southwest, Mid- Atlantic and the Midwest. It gets approval from my Peter Lynch- and Warren Buffett-based models. For more on the stock, see the "Detailed Stock Analysis" section below.

Vale SA (ADR) (VALE): This Brazil-based metals and mining company operates in more than 38 countries, including mineral exploration activities in 21 countries. It gets approval from my Peter Lynch- and James O'Shaughnessy-based models. For more on the stock, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Ross Stores Inc. (ROST): Ross' net income rose 11% in the third quarter and revenue was up 10%, the company said on Nov. 15, matching analysts' expectations, the Associated Press reported. Ross said it was maintaining its fourth-quarter earnings guidance, which appeared to disappoint investors, however, as shares fell more than 5% during the day of the announcement. They quickly regained all the lost ground though.

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

MAIN   |   HIBB   |   WDC   |   VALE   |   LUKOY   |   HFC   |   GES   |   ALV   |   ROST   |   TJX   |  

Main Street Capital Corporation is a United States-based principal investment firm that primarily provides long-term debt and equity capital to lower middle market companies. The Firm targets investments associated with ownership transitions, recapitalizations, strategic acquisitions, business expansion and other growth initiatives for later stage businesses. In addition to providing companies with necessary capital, Main Street provides management with expertise in corporate finance, operations and growth strategy implementation.

Hibbett Sports, Inc. owns and operates sporting goods stores in small to mid-sized markets predominantly in the Southeast, Southwest, Mid- Atlantic and the Midwest. The companys stores provide footwear, athletic equipment, and apparel products to individual customers as well as for school, athletic, and youth programs through educational institutions and youth associations.

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), which manufactured hard drives.

Vale SA (Vale) is a Brazil-based metals and mining company. The Company services are divided into four segments: Bulk Material, including the extraction of iron ore, manganese and ferroalloys, as well as pellet production; Basic metals, comprising the production of non-ferrous minerals, including nickel, copper and aluminum; Fertilizers, including the production of potash, phosphate and nitrogen; and Logistic services, including cargo transportation for third parties divided into rail transport, port and shipping services. Additionally, Vale is active in investments in joint ventures and associate in other businesses. The Company operates in more than 38 countries, including mineral exploration activities in 21 countries. As of December 31, 2011, the Company operated through 18 subsidiaries and three jointly-controlled entities, incorporated in Brazil, Peru, Indonesia, Chile, Australia, Austria, Canada, Colombia, Switzerland, Mozambique, New Caledonia, Oman, Singapore and the USA.

NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. As of December 31, 2011, the Company's major shareholder was ING Bank (Eurasia) ZAO with a stake of 75.93%.

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.

Guess?, Inc. (GUESS?) designs, markets, distributes and licenses apparel and accessories for men, women and children. The Company operates in five: Europe, North American Retail, Asia, North American Wholesale and Licensing. Its products are sold through retail, wholesale, e-commerce and licensing distribution channels. The lines include full collections of clothing, including jeans, pants, skirts, dresses, shorts, blouses, shirts, jackets, knitwear and intimate apparel. It also grant licenses to manufactures and distributes a range of products, including eyewear, watches, handbags, footwear, kids' and infants' apparel, leather apparel, swimwear, fragrance, jewelry and other fashion accessories. In fiscal 2012, it, along with its distributors and licensees, opened 224 stores in all concepts combined outside of the United Sates and Canada, which consisted of 120 stores in Europe and the Middle East, 89 stores in Asia and 15 stores in the combined area of Central and South America.

Autoliv, Inc. (Autoliv) is a holding company. Autoliv is the supplier of automotive safety systems, with a range of product offerings, including modules and components for passenger and driver-side airbags, side-impact airbag protection systems, seatbelts, steering wheels, safety electronics, whiplash protection systems and child seats, as well as night vision systems, radar and other active safety systems. Autoliv has two main operating segments: airbags/seatbelt (including restraint electronics) products and active safety electronics products. In addition, in April 2010, Autoliv Inc.'s Automotive Holding AS increased its stake in Norma AS from 51% to 93.74%. Additionally, Skandinaviska Enskilda Banken AB and ING Luxembourg SA sold their 6.67% and 10% stake, respectively, held in Norma AS. In November 2011, the Company acquired the airbag cushion cut&sew assets from Milliken. In June 2012, the Company sold its subsidiary Autoliv Mekan AB to Verktygs Allians i Hassleholm AB.

Ross Stores, Inc., along with its subsidiaries, operates two brands of off-price retail apparel and home fashion stores. As of January 28, 2012, the Company operated a total of 1,125 stores, of which 1,037 were Ross Dress for Less (Ross) locations in 29 states, the District of Columbia, and Guam, and 88 were dd's DISCOUNTS stores in seven states: 48 in California, 19 in Texas, 12 in Florida, four in Arizona, two in Georgia, two in Nevada, and one in Maryland. Ross focuses on customers primarily from middle income households, while dd's DISCOUNTS focuses on customers from more moderate income households. During the fiscal year ended January 28, 2012 (fiscal 2012), it opened 59 new Ross stores and closed ten existing stores. During fiscal 2011, it opened 21 new dd's DISCOUNTS stores. The average approximate dd's DISCOUNTS store size is 23,900 square feet. In April 2011, it purchased a 449,000 square foot warehouse for packaway storage in Riverside, California.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office.

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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