Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary October 16, 2009

The Economy

The economic news hasn't changed much in the past two weeks, with continued small signs of improvement popping up against a broader backdrop of lingering problems and weakness.

The best example may involve unemployment. New jobless claims dropped for the fifth time in six weeks, according to data released Thursday, and the four-week average is now down to 531,500 -- the lowest level since January. The figure is now almost 20% below the highs it reached in April. Continuing claims, meanwhile, dropped below 6 million for the first time in more than six months.

But while those are good signs, the overall level of unemployment remains high. After declining for two straight months and four out of the last five, job cuts increased in September, the Labor Department reported earlier this month. The 263,000 jobs lost was a far cry from earlier this year, when the figure topped 600,000 throughout the first quarter, but it was still sobering news. The unemployment rate is now 9.8% -- the highest since 1983. In addition, average work week durations are at record lows, and the underemployment rate -- which factors in part-time workers who want, but can't find, full-time jobs -- is at 17%, CNNMoney reports.

But there are signs that the economy is continuing to recover -- a sentiment that most Federal Reserve members expressed in their September meeting, according to minutes released this week. For example, manufacturing numbers continue to improve. Thursday, the New York Fed reported that its manufacturing index nearly doubled in October, rising to its highest level since 2004. It was the third straight month the index indicated an expansion in manufacturing, the first time that has happened in almost two years. The Philadelphia Fed also said its manufacturing index, which measures activity in the mid-Atlantic region, was positive in October for the third straight month.

Two other key areas of the economy offered mixed signals this week. First, housing: While home sales and prices have shown signs of life in recent months, housing foreclosures remain high. They dropped 4% in September compared to August, but were still up almost 30% year-over-year, according to RealtyTrac. For the full third quarter, foreclosures were up 5% compared to the second quarter, though September marked the second straight month-over-month decline, the group said.

The other key area: consumer spending. Retail sales fell in September by 1.5%, the Commerce Department reported this week. But a large chunk of that was due to a big drop in auto sales, which was to be expected given that the government's Cash for Clunkers plan ended. Excluding auto sales, retail sales actually rose 0.5% for the month, a good sign in a country where consumer spending makes up about 70% of the economy.

Finally, we've embarked on earnings season, and thus far the third-quarter results have provided some encouragement. Several big financial firms have been posting strong numbers -- a good sign considering the mess the sector was last year at this time. JPMorgan Chase has reported $3.6 billion in profits for the quarter, while Goldman Sachs raked in about $3.2 billion. Citigroup even posted a $101 million profit, a year after it lost more than $2.8 billion. And chipmaker Intel, which some consider a bellwether for the technology sector, beat earnings and revenue estimates by wide margins, and issued greater than expected fourth-quarter revenue guidance.

On balance, the signs of economic improvement continued to outweigh the lingering concerns, helping send the market higher. For the first time in more than a year, the Dow Jones Industrial Average crossed the 10,000 mark. For the fortnight, the S&P 500 jumped 6.5%, while the Hot List was even better, gaining 10.0%. For the year, the portfolio is now up 49.8%, vs. 21.4% for the S&P. And since its July 2003 inception, the Hot List is far ahead of the index, having gained 145.7% compared to the S&P's 9.6% gain.

Don't Fight the Fed

As the market has kept rising in recent weeks, strategists have continued to debate whether stocks can keep climbing, or whether the rally is running out of steam. On the whole, the strategists I keep my eyes on have leaned toward the bullish side. Among them are some managers with excellent long-term track records, including Steven Leuthold, Liz Ann Sonders, Bob Doll, Jeremy Siegel, James O'Shaughnessy, Kenneth Fisher, and Anthony Bolton.

These top market minds have presented some strong arguments for why they remain high on stocks, and this week I'd like to focus on one of those points. It's one that's close to the heart of one of the gurus upon whom I base my Guru Strategies.

The argument involves interest rates. Currently, interest rates are at or near historic lows -- part of the Federal Reserves "quantitative easing" strategy for stabilizing the economy and keeping credit markets liquid. Now that the economy has shown signs of stabilizing, and improving, many have begun to wonder when the Fed will begin to tighten up its monetary policy.

This week, Australia became the first major nation to raise interest rates, leading to speculation that others -- perhaps even the U.S. -- will soon follow. But it appears we're still a ways away from that. Yesterday, the latest inflation figures from the Labor Department showed that the consumer price index rose just 0.2% in September, and it remains 1.3% lower than year-ago levels. So despite all of the money the government has pumped into the economy, inflation is far from a problem right now. In addition, the difference between 10-year Treasury note rates and Treasury Inflation-Protected Securities -- a gauge of future inflation expectations -- remains in line with what the spread has been over the past five years, according to Bloomberg News.

What would continued low inflation mean for stock investors? It could mean a lot. As the great Martin Zweig astutely observed, interest rates and the stock market's direction tend to have a lot to do with each other.

In his book Winning on Wall Street, Zweig, whose approach is the basis for my Growth Investor model, offers this key maxim: Don't Fight the Fed. "In the stock market, as with horse racing, money makes the mare go," he wrote. "Monetary conditions exert an enormous influence on stock prices."

Zweig found that, generally, high rates or a rising trend in rates was a negative for the market, while low rates or a falling trend in rates was a positive. And right now, rates are low -- very low. For example, the prime rate -- the rate banks charge their best customers -- was at 3.25% in September. Prior to last December, it hadn't been below 4% since 1958. The federal funds rate, meanwhile (the rate at which banks lend money overnight to each other) was at 0.15% in September. Prior to last fall, its monthly reading had been below 1% only once in the previous 50 years. And the September discount rate (which the Fed charges banks looking to borrow from it) was also at all-time low levels, at just 0.5%. (All figures come from the Federal Reserve.)

Why are low rates better for stocks? There are a couple reasons. "First," Zweig said, "falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds." That appears to be what's happening now. As of yesterday, the 10-year Treasury note was yielding under 3.5%. While that's up from last fall, when investors flocked to the safety of T-bills amid the financial crisis, it's still far below historic norms. In fact, from 1959 through 2007, the monthly reading on 10-year T-bills was below 3.5% just once, in June 2003, according to the Federal Reserve.

In other words, if you want to find impressive returns in today's investment climate, stocks -- not bills or bonds -- are probably your best bet.

The other factor is that low or falling rates allow corporations to borrow money for less. "That reduces a major expense, especially for companies that are heavy borrowers such as airlines, public utilities, or savings and loans," Zweig wrote. And that means more profits for companies. "Wall Street loves the idea that future earnings will go up," Zweig says. "So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings."

Current rates are already so low that it's unlikely we'll see them decrease much more. But it seems likely that they'll stay low for a while. One reason is the low inflation readings I discussed earlier. Another is the sheer size of the government's efforts to stimulate the economy. One would think that, given the depth of the recession and the massive efforts to jumpstart the economy, the Fed will want to err on the side of caution and not jump the gun on rate increases, lest it risk another economic turn for the worse.

One important related factor in all of this involves the slow recovery many strategists and pundits are predicting for the U.S. economy. Many assume that a slow economic recovery would be a negative for stocks. But looked at through the interest rate lens, you can see that the opposite may well be true. If growth is indeed slower, the government will likely keep rates low, which could help boost stocks.

If we do go through a slow-growth environment, investors who can find those companies that are producing strong growth could really benefit. And that's what my models are designed to do -- find companies that are producing strong results, regardless of the economic climate.

Of course, the Fed and interest rates are just part of the investment landscape picture. Zweig's "don't fight the fed" maxim doesn't always work -- during last year's market collapse, rates were also quite low and the market kept falling while they were cut further. But then again, no one variable will always work; Zweig himself looked at a myriad of other factors. But the "don't fight the Fed" advice does have a good track record, and in a broader market context which includes strong valuations, an improving economy, and huge amounts of government aid designed to bolster the economy and markets, it's a key reason to be optimistic that stocks can continue to climb higher.

Editor-in-Chief: John Reese

Have Your Portfolio Managed Using the Validea Hot List

For the first time, you can now have your portfolio professionally managed using the Validea Hot List Strategy. Validea Capital Management's new Hot List model takes the time and effort out of following the Validea Hot List.

Get More Information!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

Guru Spotlight: Kenneth Fisher

For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.

But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.

While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.

Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.

It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.

So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 120.2% (13.4% annualized), while the S&P 500 has gained just 9.6% (1.5% annualized). That makes it one of my most successful long-term strategies.

Price-to-Sales and "The Glitch"

Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.

But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.

The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.

According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.

One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.

More than the PSR

While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.

Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year).

Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.

A Winner

The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach is has helped it rebound from a tough 2008 and remain far ahead of the broader market since its inception, and it's why I expect it to continue to produce solid returns over the long run.

Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio. As you'll see, it's particularly high on oil firms right now -- an interesting trend given that, in his September column for Forbes, Fisher himself said fossil fuels aren't leaving the energy landscape anytime soon, and recommended that investors dedicate a sizeable chunk of their portfolios to fossil fuel stocks.

Oil States International, Inc. (OIS)

Frontier Oil Corporation (FTO)

Sierra Wireless, Inc. (SWIR)

Schnitzer Steel Industries, Inc. (SCHN)

General Dynamics Corporation (GD)

Chevron Corporation (CVX)

Aeropostale, Inc. (ARO)

World Fuel Services Corporation (INT)

National Presto Industries Inc. (NPK)


News about Validea Hot List Stocks

Chevron Corp. (CVX): Chevron said on Oct. 8 that it expects third-quarter earnings to be significantly higher than the second quarter, due to higher crude oil prices and gains from asset sales and tax items, the Associated Press reported. The company didn't offer a specific estimate for third-quarter earnings, which are due on Oct. 30. Earnings were $1.75 billion, or 87 cents per share, in the second quarter.

Aeropostale (ARO): The teen clothing retailer reported that sales jumped 19% in September vs. a year ago, beating estimates, according to Investor's Business Daily. Aeropostale also raised Q3 earnings per share guidance.

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

INT   |   RS   |   MELI   |   BRP   |   ARO   |   CVX   |   FTO   |   HUM   |   VIT   |   BAP   |  

World Fuel Services Corporation is engaged in the marketing and sale of marine, aviation and land fuel products and related services on a worldwide basis. The Company operates in three segments: marine, aviation and land. In its marine segment it offers fuel and related services to maritime customers, including international container and tanker fleets, commercial cruise lines and time-charter operators. In its aviation segment, it offers fuel and related services to major commercial airlines, second and third-tier airlines, cargo carriers, regional and low-cost carriers, corporate fleets, fractional operators, private aircraft, military fleets. In its land segment, it offers fuel and related services to petroleum distributors operating in the land transportation market. In June 2008, it acquired certain assets of Texor Petroleum Company, Inc. In April 2009, the Company acquired the Henty Oil Group of Companies.

Reliance Steel & Aluminum Co. is a metals service center company. The Company's network of metals service centers operates more than 200 locations in 38 states, Belgium, Canada, China, Mexico, Singapore, South Korea and the United Kingdom. Through this network, it provides metals processing services and distributes a line of more than 100,000 metal products, including alloy, aluminum, brass, copper, carbon steel, titanium, stainless steel and specialty steel products, to more than 125,000 customers in a range of industries. Many of the Company's metals service centers process and distribute only specialty metals. Reliance Steel & Aluminum Co. delivers products from facilities located across the United States and Canada. In March 2009, New Wave Holdings Ltd. completed the sale of the entire 30% interest in Reliance Pan Pacific Pte. Ltd. (RPP) held by its wholly owned subsidiary, Manufacturing Network Pte Ltd, to the Company.

MercadoLibre, Inc. hosts an online platform in Latin America, called MercadoLibre and located at www.mercadolibre.com. The Company has e-commerce operations in Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay and Venezuela. In addition, it also operates online trading platforms in Costa Rica, the Dominican Republic and Panama. MercadoLibre has two principal services: The MercadoLibre marketplace and The MercadoPago online payments solution. The MercadoLibre marketplace is a fully automated, topically arranged online trading service. The MercadoPago online payments solution is an integrated online payments solution. During the year ended December 31, 2008, visitors to its Website were able to browse an average of over 2.5 million total listings on any given day in over 2,000 different product categories. At December 31, 2008, the Company had over 33.7 million confirmed registered MercadoLibre users.

Brasil Telecom Participacoes S.A. is a provider of telecommunications services in Region II in Brazil. The Company offers integrated telecommunications services, which includes fixed-line and mobile telecommunications services, data transmission services (including broadband access services), Internet service provider (ISP) services and other services, for residential customers, small, medium and large companies, and governmental agencies. The Company provided services, which include Fixed-Line Telecommunications Services, Mobile Telecommunications Services, Data Transmission Services and other services.

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aeropostale merchandise through its e-commerce Website, www.aeropostale.com. As of January 31, 2009, it operated 914 stores, consisting of 874 Aeropostale stores in 48 states and Puerto Rico, 29 Aeropostale stores in Canada, and 11 Jimmy'Z stores in 10 states. The Company locates its stores primarily in shopping malls, outlet centers and, to a much lesser degree, lifestyle and off-mall shopping centers. The Company has developed a new retail store concept called P.S. from Aeropostale, which will offer casual clothing and accessories focusing on elementary school children between the ages of seven and 12. It offers a focused collection of apparel, including graphic t-shirts, tops, bottoms, sweaters, jeans, outerwear and accessories.

Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates, and provides administrative, financial, management and technology support to the United States and International subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining operations of coal and other minerals, power generation and energy services. Exploration and production (upstream) operations consist of exploring for, developing and producing crude oil and natural gas, and also marketing natural gas. Refining, marketing and transportation (downstream) operations relate to refining crude oil into finished petroleum products; marketing crude oil and the many products derived from petroleum, and transporting crude oil, natural gas and petroleum products by pipeline, marine vessel, motor equipment and rail car. In April 2009, Reliance Industries Limited bought back Chevron Corporation's 5% stake in Reliance Petroleum Limited.

Frontier Oil Corporation (Frontier) is an independent energy company engaged in crude oil refining and the wholesale marketing of refined petroleum products. The Company operates refineries (the Refineries) in Cheyenne, Wyoming and El Dorado, Kansas with a total annual average crude oil capacity of approximately 182,000 barrels per day (bpd). Frontier's Cheyenne Refinery has a permitted crude oil capacity of 52,000 bpd on a 12-month average. The Company markets its refined products primarily in the eastern slope of the Rocky Mountain region, which encompasses eastern Colorado (including the Denver metropolitan area), eastern Wyoming and western Nebraska (the Eastern Slope). The Cheyenne Refinery has a coking unit, which allows the refinery to process amounts of heavy crude oil for use as a feedstock. During the year ended December 31, 2008, heavy crude oil constituted approximately 76% of the Cheyenne Refinery's total crude oil charge.

Humana Inc. (Humana) is a health and supplemental benefits company. The Company is a full-service benefits solutions company, offering an array of health and supplemental benefit plans for employer groups, government benefit programs and individuals. The Company operates in two segments: Government and Commercial. The Government segment consists of beneficiaries of government benefit programs, and includes three lines of business: Medicare, Military and Medicaid. The Commercial segment consists of members enrolled in its medical and specialty products marketed to employer groups and individuals. On October 31, 2008, the Company acquired PHP Companies, Inc. (doing business as Cariten Healthcare). On August 29, 2008, the Company acquired Metcare Health Plans, Inc. On May 22, 2008, it acquired OSF Health Plans, Inc. On April 30, 2008, the Company acquired UnitedHealth Group's Las Vegas, Nevada individual SecureHorizons Medicare Advantage health maintenance organization (HMO) business.

VanceInfo Technologies Inc. is an information technology (IT) service provider and one of the offshore software development companies in China. The Company's range of IT services includes research and development services (R&D services), enterprise solutions, application development and maintenance (ADM), quality assurance and testing, as well as globalization and localization. It provides these services primarily to corporations headquartered in the United States, Europe, Japan and China, targeting industries, such as technology, telecommunications, financial services, manufacturing, retail and distribution. The Company operates a range of offshore development centers in China (CDCs). Its major clients include Microsoft, IBM, Huawei, TIBCO, and a European mobile handset manufacturer. In July 2009, the Company acquired the operating subsidiaries of TP Corporation Limited (TP), a provider of customer relationship management (CRM) solutions and call center services.

Credicorp Ltd. (Credicorp) is a financial services holding company. The Company operates primarily through its four principal subsidiaries: Banco de Credito del Peru (BCP), Atlantic Security Holding Corporation (ASHC), El Pacifico-Peruano Suiza Compania de Seguros y Reaseguros (PPS) and Grupo Credito S.A (Grupo Credito). Credicorp is engaged principally in commercial banking (including trade finance, corporate finance and leasing services), insurance (including commercial property, transportation and marine hull, automobile, life, health and pension fund underwriting insurance) and investment banking (including brokerage services, asset management, and trust, custody and securitization services, and trading and investment). The Company conducts its commercial banking and investment banking activities primarily through BCP, ASHC and its pension fund business through Prima AFP. Credicorp's insurance activities are conducted through PPS.

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.

Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.

Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.