|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||June 21, 2013|
While the market has been rattled by concerns about central bank policy (when will the Fed start to taper?) and headwinds overseas (is China's housing market about to burst?), the U.S. economy has been hanging in there with signs of slow, steady progress.
The resurgent housing market continues to be the biggest bright spot. Housing starts rose 6.8% in May, according to a new government report, and now stand about 27% above their year-ago level. Permit issuance for new home construction fell 3.1%, but remained about 20% above its year-ago pace. In addition, the National Association of Realtors reported that existing home sales rose 4.2% in May, putting them more than 15% above where they stood last May. Prices also continue to climb -- the median sales price for the month was 15.4% above the year-ago level.
Retail and food service sales also increased in May, according to the Commerce Department. They rose 0.6%, boosted by a big increase in auto sales. Overall retail and food service sales are about 5% higher than they were a year ago, a solid year-over-year improvement indicating that the U.S. consumer continues to be more resilient than many had expected.
Industrial production was flat in May, a new report from the Federal Reserve showed. Manufacturing activity did increase, though only slightly, by 0.1%. Mining activity jumped 0.7%. Those gains were offset by a 1.8% decline in utility output. Utility output is often a factor of weather and thus quite volatile, however.
In the job market, new claims for unemployment are pretty close to where they were at the time of our last newsletter two weeks ago. They are about 8% below year-ago levels. Continuing claims edged slightly downward since our last newsletter, and are almost 11% below year-ago levels. The labor market improvement, though slow, thus continues, a good sign. But there is a caveat, and it's one we haven't looked at before. While the weekly unemployment claims and monthly jobs data continue to show job growth and a decrease in unemployment, the number of American workers going on disability leave continues to rise. There are many reasons behind the staggering increase in disability claims over the past decade or two; the topic is too vast to dissect here, but NPR's Chana Joffe-Walt gives an excellent, in-depth report on the topic here. A key takeaway is that in many cases, unemployed workers may essentially be getting shifted from one form of government assistance (unemployment) to another (disability).
The issue is thus a very important one to consider when examining the overall jobs and economic pictures. For example, the economy added 593,000 jobs during the first five months of 2013, according to Labor Department data. But for every 7 Americans who got a job, one was added to the disability rolls. This is an issue we'll keep an eye on going forward.
Elsewhere, new data confirms that inflation remains tame, despite the best efforts of the Federal Reserve. The Consumer Price Index did rise in May for the first time since February (and only the second time since October) but the gain was just 0.1%. That made for a year-over-year gain of just 1.4%, well below the Fed's target.
Data like that would seem to support the idea that the Fed is not going to be ending its quantitative easing efforts anytime soon. But that hasn't stopped rampant speculation from occurring as to when the Fed will begin to taper its bond buying programs, with many fearing it will be sooner rather than later. That speculation has been a big driver in the market's struggles over the past few weeks. So too has been data coming out of China. One report showed that Chinese manufacturing slowed in June to its lowest level in nine months. In addition, interbank lending rates jumped sharply in China, with seven-day repurchase rates rising to the highest level since at least March 2003, according to Bloomberg, and one-day rates rising by an "unprecedented" 527 basis points. Those are signs that Chinese banks are growing more wary of lending to each other, a likely byproduct of fears about a potential housing bubble in the Asian giant. When it comes to both the China situation and the Fed situation, however, the moving parts are abundant, and it is extremely difficult to tell how things will unfold, and at what pace they will unfold. That makes it extremely difficult -- and risky -- to try to base investment decisions on what you think might happen in either situation.
Amid all this, since our last newsletter the S&P 500 returned -2.1%, while the Hot List returned -2.6%. So far in 2013, the portfolio has returned 19.4% vs. 11.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 223.7% vs. the S&P's 58.8% gain.
The concerns I touched on above have made for rough seas for stocks in general, as well as for the Hot List portfolio, over the past fortnight. Not surprisingly, the concerns about the global economy and global demand have hit cyclical types of stocks particularly hard. With the models driving the portfolio having made some big moves into the oil and gas industries recently -- areas they see as full of longer-term value -- our performance has been negatively impacted. As is often the case with value stocks, the values don't always get recognized right away. And in this case the global economic fears have kept pushing some of these Hot List stocks downward. As of mid-afternoon trading on June 20, shares of oil refiner HollyFrontier were down about 10% since our last newsletter. Fellow refiner Valero Energy's shares were down about 7%, and Royal Dutch Shell and Chevron had also slid a bit.
Interestingly, more consumer-oriented stocks in the portfolio actually did quite well. Shares of kitchen and home goods chain Williams-Sonoma were up more than 4%, while those of nutritional supplement product company USANA Health Sciences continued to excel, rising more than 5%. That put shares of USANA up a total of 108% since the start of its six-month stint in the portfolio. The stock continues to get strong scores from many of my models, so as of now it is a strong contender to remain in the portfolio. We'll see just what happens to it and the Hot List's other holdings when we rebalance the portfolio two weeks from now.
Guru Spotlight: Peter Lynch
Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".
If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.
Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.
Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.
But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.
The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.
To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.
The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.
One Size Doesn't Fit All
One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).
The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.
"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.
One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.
Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.
Beyond The PEG
The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)
The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.
Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. This year, it's been a particularly strong performer, with my 10-stock Lynch-based portfolio gaining 27.9% to nearly double the S&P 500. Overall since I started tracking it in July 2003, the portfolio has averaged annualized returns of 8.7%, easily beating the 5.0% annualized return for the S&P 500 (all performance figures are through June 19). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 14.7% annualized over that period.
Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:
Bridgepoint Education Inc. (BPI)
HCI Group (HCI)
Enstar Group (ESRG)
Volterra Semiconductor Corporation (VLTR)
Green Dot Corporation (GDOT)
East West Bancorp (EWBC)
Wuxi Pharmatech Inc. (WX)
AutoNavi Holdings Limited (AMAP)
Humana Inc. (HUM)
United Overseas Bank Ltd. (UOVEY)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success, and it's one that is particularly relevant given the portfolio's rough recent run: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do when the market gets volatile. But Lynch said it's critical to stay disciplined: "The real key to making money in stocks," he once said, "is not to get scared out of them".
News about Validea Hot List Stocks
Chevron Corporation (CVX): Chevron has entered into an agreement with Iraq's regional Kurdish government that gives it the right to explore the Qara Dagh block located southeast of Irbil. Financial details weren't disclosed, Zacks Investment Research said. The block is about 330 square miles in size.
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 firstname.lastname@example.org.
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