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Executive Summary July 2, 2015

The Economy

While chaos continues to reign overseas in the form of Greece's possible exit from the Eurozone, things remain quite solid on the economic homefront.

The private sector added 237,000 jobs in June, for example, according to payroll processor ADP. That's the highest monthly total in 2015. The Labor Department is scheduled to release its June jobs report today, and investors will no doubt be paying close attention to see if its numbers are in line with ADP's.

A separate Labor Department report shows that jobs are out there to be had. Job openings at the end of April jumped to the highest level since the department started tracking them in 2000, the report said.

Manufacturing growth picked up in June, meanwhile, with the Institute for Supply Management's manufacturing index showing that the sector expanded for the 30th straight month, doing so at its fastest pace since January. New orders growth ticked higher, and there was a nice pick-up in employment conditions in the sector, too.

Personal income jumped 0.5% in May, according to the Commerce Department.. Real disposable personal income rose 0.2%, while real personal consumption expenditures surged 0.6%, as the economy may now be realizing the positive effects -- namely, more disposable income for consumers -- of lower gas prices. That meant the personal savings rate fell from 5.4% to 5.1%, still a very respectable level.

The latest Consumer Price Index data seem to indicate that inflation has really started to pick up -- the CPI jumped 0.4% in May, the largest increase in about 2 years, according to the Labor Department. But the gain was driven almost entirely by rebounding gas prices. Excluding volatile gas and food prices, so-called "core inflation" rose just 0.1%.

More recently, gas prices have been leveling off, and remain well below year-ago levels. As of June 30, the average price for a gallon of regular unleaded was $2.77, according to AAA, up just slightly from $2.73 a month ago.Gas prices are down 25% from where they were a year ago.

Since our last newsletter, the S&P 500 returned -1.1%, while the Hot List returned 1.8%. So far in 2015, the portfolio has returned 12.2% vs. 0.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 262.9% vs. the S&P's 107.7% gain.

The Valuation Situation

It's been almost five months since we've looked at broader market valuation. Let's check back in and see where we stand.

As always, let's start with earnings. Using the S&P 500's July 1 late-afternoon price of 2,075, the index is trading for about 20.9 times trailing 12-month (TTM) as-reported earnings per share, up from 19.9 in February, when last we checked in.

Using projected operating earnings for the next year, the P/E is about 17.2, down from 17.5 in February. P/Es are significantly higher than they were a year or two ago, but these earnings-related valuations are far from exuberant; they're probably on the high side of the "fair value" range, particularly in a low-interest-rate environment.

The S&P's price/sales ratio, meanwhile, is 1.75, up from 1.65 when we last checked in, according to Morningstar.com. Its price/book ratio is 2.63, up a bit from 2.45 in February. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Dividend yields, meanwhile, remain attractive, and are right around where they were in February, at 2.2%.

One figure that remains quite high is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It is now 123.4%, down slightly from 123.9% in February, according to GuruFocus.com. That puts it in the "Significantly Overvalued" range, based on the site's analysis of historical data. The current figure is higher than the 2007 peak, but still well short of the 2000 bull market peak, when the ratio climbed to about 150%.

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 26.7, using Yale Economist Robert Shiller's earnings data. That's down from 27.5 in February, but well above the 16.6 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.5 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.

The Q ratio also indicates that the market is significantly overvalued. Based on a methodology developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. Using the most recent report, which came at the end of the first quarter, Doug Short of Advisor Perspectives (who writes a monthly update on the ratio) puts the Q at 1.08, down from 1.11 in February (and from 1.17 last August). That was 58% higher than the historical average using the arithmetic mean and 70% higher than the geometric mean. As has been the case for some time, the current Q indicates the market is significantly overvalued, but it's not nearly as high as it has gotten at some market tops.

(Bloomberg recently had a very interesting piece on the Q ratio, examining its usefulness -- or lack thereof -- as a timing tool, and its relevance today given how much our economy has shifted from a capital-intensive manufacturing one to a technology- and service-oriented one. I'd recommend anyone interested in market valuation read it.)

The big decline in oil prices over the past year has likely had some impact on valuations, as energy companies' earnings have tumbled while consumers for a long time were not fully redeploying money they were saving on gas into other areas of the economy. Still, based on the totality of all of the metrics we examined, the market certainly seems a bit overpriced. And that's fine. As I have noted before, by definition, there are going to be times when valuations are above their averages. But A) while elevated, the current valuations do not seem to indicate that the euphoria that can topple bull markets is present, and B) plenty of attractively valued individual stocks remain.

Take Hot List newcomer Santander Consumer USA Holdings, a consumer finance company focused on vehicle finance and personal lending products. The firm has a 29% return on equity, 24% pre-tax profit margins, and 28% long-term revenue growth. Despite those tremendous fundamentals, the stock trades for less than 10 times earnings and less than 5 times cash flow, both of which are in the market's cheapest 20% of stocks.

As long as fundamentally sound stocks like Santander are out there, we will continue to buy them. And one of the beauties of using a quantitative screening system like the Hot List is that we can scan through thousands of stocks in a matter of seconds to find those types of stocks. With so many potential opportunities so easily accessible, we can almost always find enough attractively priced, financially sound companies to fill out a portfolio. As of July 2, for example, the 10 stocks in the Hot List traded at an average P/E of 12.8 and had long-term EPS growth rates over 20%. Those are the types of stocks that should fare well over the long term, regardless of what the short-term broader market valuation situation is.

Editor-in-Chief: John Reese

The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Universal Insurance Holdings, Inc. (UVE), Trueblue Inc (TBI), Silicon Motion Technology Corp. (Adr) (SIMO), Jones Lang Lasalle Inc (JLL), .

The Keepers

6 stocks remain in the portfolio. They are: Sasol Limited (Adr) (SSL), Sanderson Farms, Inc. (SAFM), Chart Industries, Inc. (GTLS), Amtrust Financial Services Inc (AFSI), Lumber Liquidators Holdings Inc (LL) and Heritage Insurance Holdings Inc (HRTG).

The Newbies

We are adding 4 stocks to the portfolio. These include: Credit Acceptance Corp. (CACC), World Acceptance Corp. (WRLD), Marcus & Millichap Inc (MMI), Santander Consumer Usa Holdings Inc (SC), .

Portfolio Changes

News about Validea Hot List Stocks

Jones Lang LaSalle (JLL): JLL announced that it has entered into an agreement to acquire LodgeTax, a national leader in hotel real estate tax services and consulting. JLL said the acquisition will allow it to strategically expand its hospitality platform to provide real estate tax consulting services to its clients across the country. The acquisition is scheduled to close within the coming weeks, subject to customary closing conditions. Terms were not disclosed.

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

AFSI   |   HRTG   |   GTLS   |   SAFM   |   LL   |   SSL   |   WRLD   |   SC   |   CACC   |   MMI   |  

Amtrust Financial Services, Inc. is an insurance holding company. Through its wholly owned subsidiaries, the Company provides specialty property and casualty insurance focusing on workers' compensation and commercial package coverage for small business, specialty risk and extended warranty coverage, and property and casualty coverage for middle market business. The Company operates through three segments. The Small Commercial Business segment provides workers' compensation and commercial package and other property and casualty insurance products. The Specialty Risk and Extended Warranty segment provides coverage for consumer and commercial goods and custom designed coverages, such as accidental damage plans and payment protection plans. The Specialty Program segment provides workers' compensation, package products, general liability, commercial auto liability, excess and surplus lines programs and other specialty commercial property and casualty insurance.

Heritage Insurance Holdings, Inc. (Heritage Insurance), formerly Heritage Insurance Holdings, LLC, is a property and casualty insurance holding company. The Company is engaged in providing personal and commercial residential insurance. Through Its subsidiary, Heritage Property & Casualty Insurance Company (Heritage P&C), it provides personal residential insurance for single-family homeowners and condominium owners, rental property insurance and commercial residential insurance in the state of Florida. The Company is vertically integrated and control or manage all aspects of insurance underwriting, actulato analysis, distribution and claims processing, and adjusting. It has approximately 207,000 personal residential policies in force and approximately 2,400 commercial residential policies in force.

Chart Industries, Inc. (Chart) is a diversified global manufacturer of engineered equipment engineered equipment for the industrial gas, energy, and biomedical industries. Chart's equipment and engineered systems are primarily used for low-temperature and cryogenic applications. The Company operates in three segments: Energy & Chemicals (E&C), Distribution & Storage (D&S), and BioMedical. The Company's products include vacuum insulated containment vessels, heat exchangers, cold boxes and other cryogenic components. The Company's E&C and D&S segments manufacture products used primarily in energy-related and industrial applications, such as the separation, liquefaction, distribution and storage of hydrocarbon and industrial gases. Through its BioMedical segment, it supplies cryogenic and other equipment used in the medical, biological research and animal breeding industries.

Sanderson Farms, Inc. is a poultry processing company which is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared chicken items. In addition, the Company is engaged in the processing, marketing and distribution of prepared chicken through its wholly owned subsidiary, Sanderson Farms, Inc. (Foods Division). It produces a range of processed chicken products and prepared chicken items. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, and casual dining operators in the south-eastern, south-western, north-eastern and western United States and to customers who resell frozen chicken into export markets. During the fiscal year ended October 31, 2013 (fiscal 2013), it processed 452 million chickens, or over 3.0 billion dressed pounds.

Lumber Liquidators Holdings, Inc. (Lumber Liquidators) is a retailer of hardwood flooring, and hardwood flooring enhancements and accessories in North America. The Company's product categories include Solid and Engineered Hardwood; Laminate; Bamboo, Cork and Vinyl Plank, and Moldings and Accessories. The Company sells its products primarily to homeowners or to contractors on behalf of homeowners. The Company offers wood flooring under18 brand names, led by Bellawood, a collection of solid and engineered hardwood flooring, bamboo flooring, moldings and accessories. The Company also offers a range of flooring enhancements and installation accessories, including moldings, noise-reducing underlay and tools. It offers around 400 different flooring product stock-keeping units. As of February 23, 2015, Lumber Liquidators operated around 354 stores located in 46 states of the United States and nine store locations in Canada.

Sasol Limited (Sasol) is a South Africa-based international integrated energy and chemicals company. The Company develops and commercializes technologies, builds and operates facilities to produce a range of product streams, including liquid fuels, high-value chemicals and low-carbon electricity. The Company's operations are organized into three focused business clusters: South African Energy Cluster; International Energy Cluster and Chemical Cluster. The South African Energy Cluster is involved in coal mining, gas production, synfuels manufacturing and oil refining. The International Energy Cluster manages the Company's oil and gas business outside South Africa. The Chemical Cluster is involved in making polymers, solvents, olefins and surfactants and other chemicals.

World Acceptance Corporation operates a small-loan consumer finance business in fourteen states and Mexico. The Company is engaged in the small-loan consumer finance business, offering short-term small loans, medium-term larger loans, related credit insurance and ancillary products and services to individuals. The Company offers standardized installment loans of between $300 and $4,000 through 1,271 offices in Alabama, Georgia, Illinois, Indiana, Kentucky, Louisiana, Mississippi, Missouri, New Mexico, Oklahoma, South Carolina, Texas, Tennessee, Wisconsin and Mexico as of March 31, 2014. The Company serves individuals with limited access to consumer credit from banks, credit unions, other consumer finance businesses and credit card lenders. In the United States offices, the Company also offers income tax return preparation services to its customers and others.

Santander Consumer USA Holdings Inc. is a holding company. The Company is a specialized consumer finance company focused on vehicle finance and unsecured consumer lending products. The Company offers various auto financing products and services to Chrysler customers and dealers under the Chrysler Capital brand. These products and services include consumer retail installment contracts and leases, as well as dealer loans for inventory, construction, real estate, working capital and revolving lines of credit. The Company also originates vehicle loans through a Web-based direct lending program, purchases vehicle retail installment contracts and services automobile and recreational and marine vehicle portfolios for other lenders. Its products and services include vehicle finance, and origination and servicing.

Credit Acceptance Corporation (Credit Acceptance) is a provider of financing programs to automobile dealers that enable them to sell vehicles to consumers. The Company's financing programs are offered through a nationwide network of automobile dealers; from repeat and referral sales generated by customers, and from sales to customers responding to advertisements for it products. The Company has two programs: the Portfolio Program and the Purchase Program. Under the Portfolio Program, it advances money to dealer (Dealer Loan) in exchange for the right to service the underlying consumer loans. Under the Purchase Program, the Company buys the consumer loans from the dealer (Purchased Loan) and keeps all amounts collected from the consumer. Its target market is independent and franchised automobile dealers in the United States. It provides dealers the ability to offer vehicle service contracts to consumers through its relationships with third-party providers (TPPs).

Marcus & Millichap, Inc. is a brokerage firm specializing in commercial real estate investment sales, financing, research and advisory services. The Company also offers market research, consulting and advisory services to developers, lenders, owners and investors. It also offers two services to its clients: commercial real estate investment brokerage and financing. The Company divides the commercial real estate market into three segments by investment: Private client segment, which include properties with prices under $10 million; Hybrid segment, which include properties with prices equal to or over $10 million and less than $20 million, and Institutional segment, which include properties with prices of $20 million and above. As of December 31, 2014, the Company had nearly 1,500 investment sales and financing professionals in 78 offices in the United States and Canada that provide investment brokerage and financing services to sellers and buyers of commercial real estate.

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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