|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||March 5, 2010|
Despite a rough stretch of winter weather that was expected to put a damper on the recovery, new data has been showing that, while not without problems, the economy continues to improve.
One indication of continued growth comes from manufacturers. The Institute for Supply Management's latest Report on Business indicated that the U.S. manufacturing sector expanded in February for the seventh straight month, and that the broader economy grew for the tenth straight month. In addition, the group's manufacturers' employment index showed expansion for the third straight month. "With these levels of activity, manufacturers are seemingly willing to hire where they have orders to support higher employment," said an ISM official.
ISM's non-manufacturing, or service, index also showed growth in February, the second straight month it has increased.
Another good sign was that, despite the trying weather conditions, consumers opened up their wallets at retailers in February. A Thomson Reuters survey showed that same-store retail sales jumped 4% during the month (compared to the year-ago period), the sixth straight monthly increase, and the biggest in more than two years.
Of course, not all the economic news has been positive. The latest data from the housing market, for example, was weak. The National Association of Realtors' latest figures show that existing home sales dropped 7.2% in January compared to the prior month, and pending home sales fell 7.6%. The Realtors group said bad weather was partly to blame for the declines. Compared to a year ago, however, existing sales are up 11.5% and pending sales are up 12.3%.
Then there's the employment picture. Overall, the job market remains fairly weak, with the economy losing more jobs than it gained again in February, according to two reports released this week. But the data also showed that job losses are continuing to slow. According to CNNMoney, Automatic Data Processing reported that the private sector job losses were 20,000 for the month, the best figure in two years. Challenger, Gray & Christmas reported, meanwhile, that about 42,000 jobs were cut, the lowest figure in its monthly report in about three-and-a-half years.
Another sign of hope in the jobs market comes from Intuit's Small Business Employment Index, a new survey that monitors activity at companies with fewer than 20 employees, which, according to Intuit, comprise 87 percent of the total U.S. private employer base. The group said that its index rose slightly in February, continuing an upward trend that started in mid-2009. An economist who helped create the index said small businesses generally start hiring sooner than larger firms, and called the upward trend "very heartening".
Finally, there's been a lot of talk about interest rates. The Federal Reserve recently upped the Discount Rate, the first time it has done so in more than three-and-a-half years. Some worried that would be a precursor to soon-to-follow hikes in the Federal Funds rate, and trouble for stocks. But it's important to note that the Discount Rate is essentially an emergency rate at which banks can borrow money from the Fed. And, now that the worst of the financial crisis has past and the economic recovery is moving forward, it's no surprise that the Fed is upping the rate. As Charles Schwab's Liz Ann Sonders noted this week, "The treatment prescription for an emergency room patient in severe distress is entirely different than the treatment prescription for a patient that's in the recovery room." And, right now, the patient that is the U.S. economy appears to be out of the emergency room and in recovery. Sonders is one of several top strategists who have said they believe the Fed will hold off on hiking the Fed Funds rate for some time (the Fed itself continues to say it will keep the rate low for an extended period), until the economy is strong enough to handle such increases.
All in all, it hasn't been a particularly eventful fortnight for the stock market, with the S&P 500 returning 1.5% since our last newsletter. The Hot List, meanwhile, has returned 4.1%, and is now up 4.3% for the year vs. 0.7% for the S&P. Since its inception in July 2003, the portfolio has gained 151.4%, while the S&P is up just 12.2%.
Old Principles, New Features
Since our last newsletter, we've added a couple new premium features to Validea.com, and I wanted to take some time to explain these new tools, and how I think they relate to broader investment strategy. The features, part of our new Validea Professional product, include Trade Alerts, Stock Reports, and industry- and country-based portfolios. These features will be free to Validea.com subscribers until the official launch of Validea Professional on March 15th. After that, subscriptions will be limited to the first 250 people, in order to keep the ideas within this new product exclusive. You can access Validea Professional here .
Trade Alerts, developed after extensive historical testing, are issued when my Guru Strategies issue a series of high-conviction signals that have tended to lead to strong performance in the past. For instance, on Feb. 26, a Trade Alert was issued on aerospace & defense firm AAR Corp. The alert was triggered because AAR was receiving strong scores from my Benjamin Graham-, Peter Lynch-, and James O'Shaughnessy-based models. Our testing shows that when these strategies have demonstrated a similar level of interest in a stock in the past, the stock has on average returned 39.3% in the following three-month period, and that the trade has made money 91% of the time.
The Trade Alerts section of the Validea Professional site lists all open trade alerts, the expected end date for the buy signal, as well as historical performance data for that particular alert signal.
I want to be clear that, while we're calling these "Trade Alerts", they are not short-term, market-timing instruments. The 14 open alerts as of Thursday had expected end dates that were all between approximately three months and six months after their start dates. And, because they are based on interest from my Guru Strategies, they are triggered when a stock has certain fundamental characteristics -- it's not a charting or technical analysis approach.
The second feature, Stock Reports, offer the same in-depth, guru-strategy-based analysis of a particular stock that you'll see on Validea.com or in the Hot List. But in addition, these reports combine the hundreds of data points that my models analyze to give each stock a simple letter grade, ranging from A to F. We've found that historically, stocks receiving an "A" grade have significantly outperformed the market over time.
The final Validea Professional feature -- the region and industry portfolios -- is particularly interesting given the current market environment. In 2008, equities were pummeled across the board; in 2009, the broad sense of relief that the financial crisis had passed and that another depression had been averted sent most stocks surging upward. But as we move deeper into 2010, many top strategists are saying that making profits in the market will be more about good old stock-picking than macro trends.
I tend to agree, and we're already seeing evidence of this. According to Morningstar, as of Thursday, the 20 best-performing industries so far in 2010 had returned between 10% and 32%; the 20 worst performers were down between 7% and 57%. Within the best performing industry, radio broadcasting, 6 of the 22 stocks were down at least 16%, while 9 were up at least 11%. And of 27 stocks in the worst-performing industry (reinsurance), 7 had gained 6% or more (and as much as 26.2%), while 9 were in the red (by as much as 21.6%).
More often than not, that's going to be the case -- something that may have been easy to lose sight of given what has been an unusually macro-driven past couple of years. In any region, country, sector, or industry, you're going to get some good companies, and some bad ones. Similarly, you're going to find some stocks that are good buys, and others that aren't. So while at any given time you can read stories about how Chinese stocks are the place to be, or how commodity stocks are going to take off, or how European stocks should be avoided, don't fall prey to such generalizations when it comes to building your portfolio.
My industry and region portfolios are examples of why good stock-picking within an industry or region is as important, if not more important, than the industry or region you pick. These portfolios hold only the 10 highest-rated stocks in their particular industry or region, according to my Guru Strategies. I started tracking them in late 2006, and since then the majority of them have significantly outperformed the S&P 500 and MSCI EAFE. For example, 5 of the 7 regional portfolios are generating positive annualized returns in a period in which the S&P and MSCI EAFE have both been losing more than 7% annually. Several of the regional portfolios have also outperformed their respective market indices by wide margins. The China portfolio, for example, is up about 47% since inception, during which time the Hang Seng Index is barely in the black and the Shanghai Stock Exchange Composite Index is up less than 20%.
To be sure, specific economic conditions always vary from country to country or industry to industry, and looking at a region or area of the market that you think is particularly strong can be a good jumping off point. But in the end, the tenets of good business and good investing cross borders and industries. And that means that, whatever region or industry you're looking at, companies that have such characteristics as long-term track records of increasing earnings, strong returns on equity, good profit margins, and low debt and healthy balance sheets tend to do better than those that don't. And the stocks of such companies, if bought at attractive prices relative to underlying fundamentals, tend to perform better than others over the long haul. Those are the beliefs that the gurus I follow -- from Benjamin Graham more than half a century ago to investors like Joel Greenblatt in this century-- espoused, and they are tenets that investors should keep in mind, no matter what region or industry they are keying in on.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world -- just look at all the hubbub surrounding the release of his latest shareholder letter this past week. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples.
In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price: Is It Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my new book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
A Strong Rebounder
My Buffett-based 10-stock portfolio is well ahead of the S&P 500 since its December 2003 inception. Where the model has really excelled, however, is coming out of downturns. In 2004, as we were emerging from the lengthy recession associated with the tech stock bust, the Buffett portfolio surged 37.3%, more than quadrupling the S&P's 9% gain. In addition, after struggling in 2007 and 2008 amid the latest recession and bear market, the portfolio bounced back strong in 2009 -- very strong. It gained 50.3%, more than doubling the gains of the broader market. And it's faring well out of the gate in 2010.
This strong performance out of downturns is no surprise, given Buffett's penchant for pouncing on good, beaten down stocks, which usually abound during tough times as investors let fear get the best of them. (One of Buffett's mantras is that investors "should try to be fearful when others are greedy and greedy only when others are fearful.")
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
News about Validea Hot List Stocks
Triumph Group Inc. (TGI): On March 1, Triumph Group said it had acquired Fabritech Inc., an Illinois-based firm that repairs and makes parts for military helicopters, the Associated Press reported. Financial terms of the deal were not disclosed, but the new company is expected to add $25 million in revenue for fiscal 2011 and will immediately add to profits, AP reported. The business will operate as Triumph Fabrications-St. Louis and will be part of Triumph Aftermarket Services Group, according to AP.
Aeropostale Inc. (ARO): Aeropostale announced on March 3 that its 3-for-2 stock split on shares of its common stock, which will be effected in the form of a stock dividend, will become effective on March 5, 2010. The previously announced split affects shareholders of record at the close of business on February 24, 2010. The additional shares were to be distributed to shareholders on or about March 4, 2010, the company said. The Hot List has owned shares of Aeropostale since Nov. 27, 2009.
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 email@example.com.
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.