|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||November 25, 2011|
The US economy is continuing to prove remarkably resilient, as it pushes forward through some very strong headwinds at home and abroad. Now, if only political leaders could get their act together the way that businesses have, the economy could really begin to gain some traction.
Since our last newsletter, several economic reports have continued to show that the economy is expanding. Industrial production, for example, increased by 0.7% in October, according to new data from the Federal Reserve. The manufacturing and mining sectors showed solid growth, gaining 0.5% and 2.3%, respectively, while the utility sector was basically flat for the month. Capacity utilization is now 10.5 percentage points above the 2009 low, though it remains 2.6 percentage points below the long-term historical average.
The American consumer, meanwhile, continues to show resilience. Retail and food service sales increased 0.5% in October, according to a new Commerce Department report. It was the 5th straight month that sales have increased. They reached a new all-time high, and now stand 19.5% above their 2009 low.
We also got some decent news from the housing sector. Housing starts were close to flat in October, according to new Commerce Department data, but building permits for new housing jumped 10.9% in the month. Permit issuance is now 17.7% above year-ago levels, while housing starts are 16.5% above their year-ago levels. The National Association of Realtors also reported that existing-home sales rose 1.4% in October, while total housing inventory dropped 2.2% as we continue to eat away at the huge overhang of supply caused by the housing bubble. Median home prices were down 4.7% from year-ago levels, however.
On the employment front, the data continues to be better than many have expected. Despite all of the worries about Europe and the U.S.'s own debt troubles, new claims for unemployment have now been below 400,000 for three straight weeks, the first time that has happened since April. They're still high by historical standards, but we're continuing to see slow improvement.
Finally, regional manufacturing reports are indicating that the sector has continued to grow in November. The Federal Reserve Bank of Philadelphia said its manufacturing index remained in positive territory for the second straight month, and its six-month indicator of future activity jumped sharply. And the New York Fed's manufacturing index edged slightly back into expansion territory after five straight months of contraction.
But while the fundamentals of the economy continue to improve, investors continue to focus on two broader issues: the European debt crisis and the U.S.' own debt issues. In Europe, the situation drags on, and questions have arisen not only about the debt problem itself, but also about the political will to fix it. In the U.S., meanwhile, politics continues to get in the way of solutions. In what sadly was not much of a surprise, the deficit (not-so) "super committee" failed to come to a compromise on a plan to cut the nation's deficit. By not reaching a deal before its deadline, the committee will trigger fairly drastic automatic spending cuts in defense and domestic programs. There is still hope that a more palatable resolution will be reached before the automatic cuts go into effect in 2013. Regardless, yet another failure of our elected leaders to put the country's needs above politics has unnerved investors and the market.
Since our last newsletter, the S&P 500 returned -5.5%, while the Hot List returned -6.8%. So far in 2011, the portfolio has returned -21.6% vs. -7.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 111.5% vs. the S&P's 16.1% gain.
New Research from a Market Guru
As Hot List readers know, our investment process is driven by data -- particularly long-term historical data. We don't invest based on short-term trends, the latest big macroeconomic headlines, or gut feelings on a particular day. History has shown that such emotional, short-term thinking is a recipe for failure. The gurus whose approaches inspired the Hot List, meanwhile, have proven that a rational, long-term, stick-to-the-numbers approach often leads to success in the market.
One of the gurus who has compiled the most data on long-term investment strategy is James O'Shaughnessy, whose book What Works on Wall Street forms the basis of two of my strategies. O'Shaughnessy recently released an updated version of that excellent book, and this one includes a plethora of new data on long-term stock returns and strategies. I'd like to share some of the more intriguing observations with you now.
For O'Shaughnessy, one of the biggest problems investors face is the tendency to focus on recent events. In the introduction to his book, he discusses how some began calling the "abysmal" returns of the past decade the "new normal", even though it wasn't that long ago that commentators were declaring that the Internet had ushered in a "new era" of perpetually rising stock returns -- a declaration that proved to be horribly wrong. "It seems that the one thing that doesn't change is people's reaction to short-term conditions and their axiomatic ability to perpetuate them far into the future," O'Shaughnessy writes.
But while many investors are assuming that the poor performance of stocks during the 2000s is the start of a new era of poor returns, O'Shaughnessy says history shows something entirely different. He looks at the worst rolling ten-year returns for equities since 1900; the period ending in February 2009 was the second-worst over that span, with 10 other 10-year spans ending in 2008, 2009, or 2010 cracking the top 50 (his data goes through 2010).
What did he find? Well, he found that equity returns following those awful 10-year periods tended to be outstanding. In the year following the 50 worst 10-year periods, stocks averaged a real return of 20.47%. The average three-year real compound return following the bad decades was 14.53%; the average five-year compound return was 15.78%, and the average ten-year compound return was 14.55%.
Since stocks bottomed in early 2009, we've seen that pattern play out, to an even greater degree. The S&P 500 gained 68.57% in the first year after its March 9, 2009 bottom; it averaged 39.68% gains in the first two years. (These S&P figures are before inflation is factored in, but the main idea should hold true.)
"Historically, we have always seen reversion to the mean," O'Shaughnessy explains. "After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average." Why is that? O'Shaughnessy astutely notes that it's largely about valuation -- stocks get overvalued after good decades, and undervalued after bad decades.
Undervaluation is certainly what appears to have happened after the 2008-09 market crash. And nearly three years later, even after stocks have risen significantly, valuations remain attractive. Sentiment, however, remains low, which is not surprising after having had two big market crashes in a decade. With all of the negative headlines, it's hard to stay focused on the valuations, but O'Shaughnessy's research shows that that's what good investors have to do.
A New Valuation Equation
That brings us to another very interesting new piece of O'Shaughnessy's research. In past editions of What Works on Wall Street, he found that, when it comes to valuation, the price/sales ratio (PSR) was the best predictor of future performance. That's why the growth model I base on his writings requires that a stock have a PSR below 1.5.
In the book's updated version, however, O'Shaughnessy taps into expanded historical data that leads him to a different conclusion. Using return data from 1964 through 2009, he looks at how stocks that were in the top decile based on a number of valuation metrics have fared historically. Here are the average annual compound returns for some of the more popular measures:
Top Decile Based On
Enterprise Value/EBITDA -- 16.58%
Price/earnings -- 16.25%
Price/operating cash flow -- 16.25%
Buyback Yield -- 15.81%
Shareholder Yield -- 15.56%
Price/book value -- 14.53%
PSR -- 14.49%
Dividend Yield -- 13.30%
(A few definitions may be necessary here: Enterprise value is equal to common equity at market value, plus debt, minority interest, and preferred equity at market value, and minus associate company at market value and all cash and cash equivalents; EBITDA is earnings before interest, taxes, depreciation, and amortization; buyback yield is the change, percentage-wise, between the amount of shares outstanding now and a year ago; shareholder yield is buyback yield plus dividend yield.)
Of course, raw returns aren't everything; risk is also a big factor to consider, so O'Shaughnessy looks at factors like standard deviation of returns, biggest annual declines, percentage of years in which returns were positive, and consistency of returns. One measure that takes into account both risk and return is the Sortino ratio. Here's a look at how the various valuation metrics stacked up on that basis.
Top Decile Based On
Enterprise Value/EBITDA --0.50
Shareholder Yield -- 0.47
Price/earnings -- 0.46
Price/operating cash flow -- 0.45
Buyback Yield -- 0.44
Dividend Yield -- 0.31
Price/book value -- 0.30
PSR -- 0.29
So, which valuation does O'Shaughnessy recommend? None, in a manner of speaking. As the data above shows, the higher-returning strategies aren't always the best when you factor in risk. On top of that, different approaches fare better in different environments. So O'Shaughnessy decided to find out how stocks that had the best composite valuation based on a number of metrics fared.
He found that combining value metrics could produce even better results. An approach that incorporated the price/book, price/earnings, price/sales, EBITDA/EV, and price/cash flow ratios as well as buyback yield was a top performer, for example. To do this, he ranked all stocks by percentile in each of those categories, with those with the worst of a particular ratio (say, the PSR) getting 1, and those with the best getting 100. Then he simply added up the six scores, and split the results into deciles. He found that stocks in the top decile based on those six factors historically averaged a compound annual return of 17.30%, with a Sortino ratio of 57 -- much better than any of the individual metrics.
O'Shaughnessy's finding about multiple valuation metrics being used in concert is significant, but it doesn't surprise me. In a sense, it's the same general approach we use with the Hot List. Because a number of different strategies go into the Hot List's stock-selection method, so too do a number of different valuation metrics. Current Hot List holding Forest Laboratories, for example, gets approval from my Joel Greenblatt-based approach in part because of its strong earnings yield (which is essentially the inverse of the Enterprise value/EBITDA ratio), strong interest from my Benjamin Graham-based model in part because of its strong P/E and price/book ratios, and strong interest from my Peter Lynch-based model in part because of its strong yield-adjusted P/E-to-growth ratio. As I've noted before, stocks that are strong across a variety of different valuation metrics and fundamentals tend to perform well over time, and O'Shaughnessy's exceptional research is more proof of that.
Finally, I'd like to leave you with a brief summary of some of the keys to investing success that O'Shaughnessy references in the final chapter of his book. Some of these should look very familiar, as they are right in line with the tenets we use to manage the Hot List.
Always Use Strategies: "You'll get nowhere buying stocks just because they have a great story," O'Shaughnessy writes. These stocks usually come with huge price tags, and usually go down in flames. "You must avoid them," he says. "Always think in terms of overall strategies and not individual stocks."
Ignore the Short Term: "When you look only at how your investment portfolio has performed for the last quarter, year, and three- and five-year period, you are looking at a tiny snapshot of time," he writes, saying that that snapshot can be very misleading. He recommends focusing on rolling returns vs. a benchmark over time.
Use Only Strategies Proven Over The Long Term: O'Shaughnessy says to make sure you use an approach that has proven its worth over several different market environments. Short-term performance, or even the fact that a strategy might make intuitive sense, are no match for a long-term track record. "Stocks change. Industries change," he says. "But the underlying reasons certain stocks are good investments remain the same. Only the fullness of time reveals which are the most sound."
Invest Consistently: "If you use even a mediocre strategy consistently, you'll beat almost all investors who jump in and out of the market, change tactics in midstream, and forever second-guess their decisions," O'Shaughnessy writes.
Always Bet With The Base Rate: "Base rates are essentially the odds of beating the market over the time period you plan to invest," O'Shaughnessy says. "If you pay attention to the odds, you can put them on your side."
Never Use The Riskiest Strategies: O'Shaughnessy says to always focus on strategies with the highest risk-adjusted returns.
Always Use More Than One Strategy: O'Shaughnessy says that combining strategies that focus on different types of stocks (i.e., growth, value, large-cap, small-cap, geographic regions) can allow you to do much better than the broader market while not taking on more risk.
Use Multifactor Models: "You should always make a stock pass several hurdles before investing in it," O'Shaughnessy says. I couldn't agree more -- all of my models use multiple variables, and most use at least four or five.
To paraphrase Warren Buffett, investing is simple, but it's not easy. It's simple because we know what we need to do -- buy stock in good companies selling at good prices. And gurus like O'Shaughnessy have shown us strategies that identify good companies, and attractively priced shares. The hard part -- and O'Shaughnessy stresses this in his book -- is sticking to your strategy when times get tough. A bad quarter or half-year or year can wreak havoc on investors' psyches, particularly in today's world of 24-hour financial news, when we are continually reminded of every potential danger or negative in the market and economy.
But history has shown that sticking with fundamental-focused strategies with good track records -- even when it seems the whole world is running away from stocks -- is a recipe for success. And making emotional decisions based on today's headlines or your gut feelings is a recipe for failure. That's why we'll continue to stick with the Hot List, even during a rough year like this one has been. Over the long haul, the strategies that underlie the portfolio have been exceptionally successful -- both for us and for the gurus who developed them. Even if it ends up lagging the S&P 500 this year, the Hot List will still have beaten the index 67% of the years since its inception, and it's done so by a huge margin -- the portfolio's gains are more than six-fold the S&P's gains since inception. I'm confident that by continuing to focus on fundamentals and staying disciplined, the portfolio will bounce back strong.
As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Asiainfo-linkage, Inc. (ASIA), Telecom Argentina S.a. (Adr) (TEO), Bank Of The Ozarks, Inc. (OZRK) and Stamps.com Inc. (STMP).
6 stocks remain in the portfolio. They are: Forest Laboratories, Inc. (FRX), Petroleo Brasileiro Sa (Adr) (PBR), Aeropostale, Inc. (ARO), Ternium S.a. (Adr) (TX), Capella Education Company (CPLA) and Bridgepoint Education, Inc. (BPI).
We are adding 4 stocks to the portfolio. These include: Kulicke And Soffa Industries Inc. (KLIC), Interpublic Group Of Companies, Inc. (IPG), World Acceptance Corp. (WRLD) and Astrazeneca Plc (Adr) (AZN).
Newcomers to the Validea Hot List
AstraZeneca PLC (AZN): Based in London, AstraZeneca is one of the world's largest drugmakers. The $57-billion-market-cap firm is active in more than 100 countries, and makes a variety of well-known medications, including Crestor, Symbicort, and Nexium.
AstraZeneca gets strong interest from my Peter Lynch-, David Dreman-, and James O'Shaughnessy-based models. See the "Detailed Stock Analysis" section below to learn more about the stock.
Kulicke and Soffa Industries (KLIC): This firm designs, manufactures and sells capital equipment and expendable tools used to assemble semiconductor devices, including integrated circuits (IC), high and low powered discrete devices, light-emitting diodes (LEDs), and power modules.
It gets strong interest from my Peter Lynch- and Kenneth Fisher-based models. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
World Acceptance Corp. (WRLD): Based in Greenville, S.C., World Acceptance ($936 million market cap) specializes in small, short-term loans, and has close to 1,000 offices in the southern and central U.S., and Mexico. Its loans are generally under $3,000 and have durations of less than 24 months, and much of its business comes from repeat customers.
World Acceptance gets approval from my Peter Lynch- and Warren Buffett-based models and my Momentum Investor strategy. See the "Detailed Stock Analysis" section below to learn more about the stock.
Interpublic Group of Companies, Inc. (IPG): This New York City-based firm is an organization of advertising agencies and marketing services companies. It has a market cap of about $4 billion, and in the past year has taken in nearly $7 billion in sales.
Interpublic gets strong interest from my Joel Greenblatt- and Peter Lynch-based models. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.
News about Validea Hot List Stocks
Aeropostale, Inc. (ARO): The teen retailer announced that it has signed a licensing agreement with FiBA Group to open about 30 stores in Turkey over the next five years. The first store is scheduled to open in summer 2012.
Ternium SA (TX): Shares of the steelmaker fell sharply last week on news that it is in talks to buy a stake in industry rival Usiminas, according to Reuters. Brazilian magazine Exame reported that Ternium has offered 40 reais a share for the combined stake that Brazilian conglomerates Camargo Correa and Grupo Votorantim have in Usiminas, Reuters stated, which would be a 72% premium on Usiminas shares as of Wednesday. Investors seemed very leery of the deal's potential benefits, as Ternium shares fell 18% last Thursday on the news.
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 firstname.lastname@example.org.
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