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Executive Summary November 12, 2010

The Economy

While the tenor of the economic discourse remains quite pessimistic, the U.S. economy is continuing to show significant signs of progress.

One area where we're seeing that progress: unemployment. While the overall job market picture remains a concern, a couple positive signs have emerged since our last newsletter. First, the Labor Department announced that the private sector added 159,000 jobs in October, with one big source of the gains being the service sector. A solid increase in service-type jobs is a great sign, given the sector's huge role in the U.S. economy. It's a sign that firms may be getting more demand than expected, meaning the U.S. consumer may not be as tapped out as many have feared.

The report also showed that average hours worked and average hourly wages both increased.

The second piece of good labor market news came from the Labor Department's latest data on new claims for unemployment. New claims fell to 435,000 in the week ending Nov. 6, the lowest level in four months. And, the four-week moving average fell to its lowest level since the collapse of Lehman Brothers triggered the financial crisis in September 2008. Continuing claims for unemployment, both in terms of the weekly figure and the four-week moving average, also fell in the most recent weeks for which data was available.

Positive signs also continued to come from the manufacturing sector. Bears have been predicting that the strong manufacturing rebound we've seen over the past year-plus is headed for trouble, but the sector just keeps on growing. In October, the Institute for Supply Management's manufacturing index not only showed an expansion in the sector, but an acceleration of growth, as the index hit its highest level in five months. And while many had viewed a significant deceleration in new orders in September as reason for concern, ISM's new orders sub-index jumped back up in October to its highest level since May.

ISM's non-manufacturing index, meanwhile, showed accelerating growth in the service sector, another sign that U.S. demand and consumer spending may be higher than many have feared.

In the housing market, the National Association of Realtors said its Pending Home Sales Index, a forward-looking indicator, dipped 1.8% in September. Overall, a couple big factors -- the foreclosure moratorium and the expiration of the government's homebuyer tax credit program -- are making it difficult to get a true read on the housing market right now.

Finally, details are emerging about the Federal Reserve's latest quantitative easing plan. Under the program, the Fed will buy $600 billion in Treasuries through the first half of next year. The first phase of the program is expected to start today (Nov. 12), and involves the purchase of $105 billion of Treasury bonds through Dec. 9, Forbes reported. The impact of this new round of quantitative easing ("QE2") is of course being widely debated. It certainly would seem that all of the Fed's money printing will result in some long-term inflation, though to what extent remains to be seen.

The generally positive economic news has helped push the market higher since our last newsletter. The S&P 500 returned 2.5% for the fortnight, while the Hot List returned 8.7%. For the year, the portfolio has gained 13.4% vs. 8.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 173.3% vs. the S&P's 21.3% gain.

Hold The Froth

Given the market's recent turnaround and some sentiment statistics that are being highlighted in the media, you might think that investors are becoming pretty optimistic. The S&P 500 is up about 15% since Aug. 30, and the American Association of Individual Investors' weekly sentiment survey, which measures whether investors are bullish, bearish, or neutral on stocks for the next six months, has posted a bullish reading well above historical norms since early September.

But a recent fund flows report from Morningstar says there's more than meets the eye here. The report notes that AAII's survey uses a relatively small sample, and measures what investors say the will do rather than what they are actually doing. And, according to fund flow figures, investors in reality remain lukewarm on equities -- particularly U.S. equities.

According to Morningstar, investors withdrew about $6.3 billion from long-term U.S. stock mutual funds in October, while at the same time pouring more than $22 billion into bond funds. Some of the stock outflows were offset by flows into U.S. stock exchange-traded funds of about $3.5 billion, but overall the mutual fund and ETF U.S. stock figures combined were in the red. Investors were, however, quite bullish on foreign equities, pumping more than $9 billion into international stock ETFs and close to $6 billion into international stock mutual funds.

All of that makes for a broader picture that is far from frothy, particularly when it comes to U.S. stocks. Despite the fact that many high-quality U.S. stocks are trading at very attractive values -- and the fact that bond prices are very high and yields are very low -- investors are continuing to dump more cash into the perceived safety of bonds. That's kept a number of high-quality stocks -- like some of those in the Hot List -- selling at very attractive valuations.

The flight to bonds is also an indication that there's still plenty of dry powder available to push stocks higher. As the economy continues to rebound over the long haul -- and I believe it will continue to rebound -- fears should subside, and investors who've been waiting on the sidelines or diving into bonds will likely turn their attention back to stocks. And as that happens, those who've been staying disciplined and scooping up these stock market bargains should reap some nice rewards.

Looking North - New Validea Canada Site

For the past seven-plus years, we've been allowing the Hot List and our other model portfolios to roam the U.S. stock market universe, looking for the best opportunities they can find. While many investors and funds limit their stock-picking by market capitalization, growth/value distinction, or industry, we let the Hot List and our other portfolios roam the entire U.S. market -- the more areas of the market you allow yourself to go, the more good opportunities you can find.

In that same sort of spirit, we've recently added a whole new set of opportunities to our universe, with the launch of our sister web site, Validea Canada.

With Validea Canada, we've created a site that uses the same guru-inspired models you've seen on Validea.com to analyze more than 1,000 securities that trade on Canadian exchanges. This new product is the first of its kind in the Canadian market and will allow investors to uncover opportunities using tools that were previously unavailable to Canadian investors. The site offers the same analytical tools found on Validea.com, including:

  • The Guru Analysis feature for analyzing individual stocks;

  • Model portfolios based on each of my individual guru-based models, as well as two consensus-based portfolios;

  • The Guru Stock Screener, which allows you to see all of the stocks that pass a particular strategy or multiple strategies;

  • The Advanced Guru Stock Screener, which lets you find Guru Strategy-approved stocks that also meet your own fundamental criteria or industry/sector desires;

  • A Canadian Hot List portfolio, which tracks the ten Canada-traded stocks my models are highest on.

  • (Just to avoid any confusion, Validea Canada is a separate site from Validea.com. The Hot List portfolio you've been following here will continue to invest only in U.S.-traded stocks, while the Validea Canada site will focus only on Canada-traded securities.)

    The launch of Validea Canada comes at a good time for our neighbors to the north. First off, Canada's economy was not hit as hard as the U.S. during the "Great Recession". Canada didn't have the same subprime-mortgage woes the U.S. experienced, and no Canadian banks needed government capital injections amid the global financial crisis.

    Canada has also posted impressive growth during its recovery -- real gross domestic product increased at a 4.9% annualized rate in the fourth quarter of last year and a 5.8% annualized rate in this year's first quarter, before slowing to 2.0% in the second quarter. The Canadian economy has also posted a very strong job market rebound, and Canada's housing market is in solid shape.

    Canada and its businesses and stocks have also benefited from a strong Canadian dollar, which has risen to about parity with the U.S. dollar over the past couple years while also gaining significant ground on other currencies, including the Euro. And, while Canada's economy is tied strongly to the U.S. economy, the country's vast array of natural resources -- particularly oil and metals -- also allow it to benefit from growth in emerging markets, while having a government that is much more stable and proven than those of many emerging countries.

    Despite its many strengths, however, Canada's economy has flown largely under the radar. While investors have been turning to international stocks rather than U.S. stocks, they are keying on popular, fast-growing emerging markets -- not old, developed markets like Canada. And that's creating a lot of bargains in the Canadian market. Several dozen stocks currently get approval from one or more of my Guru Strategies.

    As a current subscriber to Validea.com, I'd like to offer you the chance to sign up for Validea Canada at a discount of more than 40% off our regular prices. Our normal rates for the Canadian site are $49.95 for a monthly plan, $129.95 for a quarterly plan, or $449.95 for an annual subscription. But as a current Validea.com subscriber, you can sign up for a monthly plan for just $29.95, a quarterly plan for just $74.95, or an annual plan for just $269.95. If you are interested in a free trial to Validea Canada, please click here.

    If you're enjoying and finding value in your subscription to Validea.com, I'd encourage you to give Validea Canada a look. And if you have any questions about the site, feel free to contact us at hotlist@validea.com.
    Editor-in-Chief: John Reese

    Validea Capital Management - Private Portfolio Management Based on Strategies of Legends

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    ** 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: Martin Zweig

    If you've been a Hot List reader for any significant amount of time, you know that my Guru Strategies have a distinct value bias. The majority of these models -- ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy -- are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.

    But that doesn't mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we'll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock's earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently -- and that their growth was coming from the right sources.

    Zweig's thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.

    Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotlights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls. He even owns the "sperm" costume from Woody Allen's film Everything You Always Wanted to Know About Sex. His collecting interests also span the historic (several old stock certificates, including one signed by Commodore Vanderbilt) as well as the nostalgic (like the two old-fashioned gas pumps that are almost identical to those he'd seen at the nearby Mobil station while growing up in Cleveland), Financial World has reported.

    Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:

    Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.

    Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).

    Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.

    Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.

    While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)

    In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not cost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.

    Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).

    Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.

    There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).

    Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 7.3% per year while the S&P 500 has gained just 2.7% per year.

    The model tends to choose stocks from a variety of areas. Currently, my 10-stock Zweig-based portfolio's holdings range from retailers to tech firms to healthcare companies to auto parts firms:

    Jos. A. Bank Clothiers (JOSB)
    Apple Inc. (AAPL)
    Lululemon Athletica (LULU)
    Capella Education Company (CPLA)
    Neogen Corporation (NEOG)
    LKQ Corporation (LKQX)
    Universal American Corporation (UAM)
    Deckers Outdoor Corporation (DECK)
    World Acceptance Corporation (WRLD)
    HealthSpring Inc. (HS)

    As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.

    What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.

    News about Validea Hot List Stocks

    Eli Lilly & Co. (LLY) : Lilly announced on Nov. 8 that it will spend up to $800 million to buy Avid Radiopharmaceuticals, a development-stage company that has made an agent that could help diagnose Alzheimer's disease, the Associated Press reported. Avid has no products currently on the market, but is seeking FDA approval for Florbetapir, an injectable agent used to detect amyloid plaque in the brain, which is an indicator of Alzheimer's, AP stated. Lilly will pay $300 million upfront for Avid and as much as $500 million more if Florbetapir meets certain regulatory and commercial goals. Avid also is developing diagnostic agents used to combat other ailments like Parkinson's disease and diabetes, according to AP.

    China Automotive Systems (CAAS): China Automotive announced third-quarter profit and revenue that beat analysts' expectations. Revenue for the period jumped 17.6% from the year-ago quarter, to $76.1 million, beating analysts' estimates of $75.8 million. Net income fell 4.7% from the year-ago quarter, however, due to a lower noncash gain on the value of a derivative, the Associated Press reported. But the profit results ($8.2 million, or 26 cents a share) still beat analysts' expectations of 23 cents per share.

    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

    CAAS   |   LLEN   |   WRLD   |   SNY   |   GME   |   DLTR   |   WDC   |   LLY   |   CCME   |   HS   |  

    China Automotive Systems, Inc. (China Automotive) is a holding company and has no significant business operations or assets other than its interest in Great Genesis Holdings Limited (Genesis). Through Genesis, the Company manufactures power steering systems and other component parts for automobiles. All operations are conducted through eight Sino-foreign joint ventures in China and a wholly owned subsidiary in the United States. The Company has business relations with more than 60 vehicle manufacturers, including FAW Group and Dongfeng Auto Group, automobile manufacturers in China; Shenyang Brilliance Jinbei Co., Ltd., light vehicle manufacturer in China; Chery Automobile Co., Ltd, state-owned car manufacturer in China, and Xi'an BYD Auto Co., Ltd and Zhejiang Geely Automobile Co., Ltd., car manufacturers.

    L & L Energy, Inc. (L & L) is engaged in the businesses of coal mining, coal washing, coal coking and coal wholesaling. The Company's operations are conducted in Yunnan and Guizhou provinces in the southwest region of the People's Republic of China. As of April 30, 2010, the Company had three operating subsidiaries: KMC, which has coal wholesale operations and Ping Yi Coal Mine (mining operations PYC); two coal mining operations (DaPuAn Mine and SuTsong Mine), including DaPuAn's coal washing operations (the 2 Mines or LLC), and L&L Yunnan Tianneng Industry Co. Ltd. (including Hong Xing coal washing and ZoneLin coking operations) (TNI).

    World Acceptance Corporation 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 990 offices in South Carolina, Georgia, Texas, Oklahoma, Louisiana, Tennessee, Illinois, Missouri, New Mexico, Kentucky, Alabama and Mexico as of March 31, 2010. The Company serves individuals with limited access to consumer credit from banks, savings and loans, other consumer finance businesses and credit card lenders. In the United States offices, the Company also offers income tax return preparation services and access to refund anticipation loans through a third party bank to its customers and others. During the fiscal year ended March 31, 2010 (fiscal 2010), the Company opened 48 offices.

    Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. The Company is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, the Company specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company.

    GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

    Dollar Tree, Inc. (Dollar Tree) is an operator of discount variety stores offering merchandise at the fixed price of one dollar. At January 30, 2010, the Company operated 3,806 discount variety retail stores. Approximately 3,650 of these stores sell substantially all items for one dollar or less. The remaining stores, operating as Deal$, sell items for one dollar or less but also sell items for more than one dollar. Dollar Tree's stores operate under the names of Dollar Tree, Deal$ and Dollar Bills.

    Western Digital Corporation (WD) designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufacturers (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. Its hard drives are used in desktop computers, notebook computers, and enterprise applications such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Its hard drives are used in CE applications, such as digital video recorders (DVRs), and satellite and cable set-top boxes (STBs). It also sells its hard drives as stand-alone storage products by integrating them into finished enclosures, embedding application software and offering the products as WD-branded external storage appliances for personal data backup and portable or expanded storage of digital music, video and other digital data.

    Eli Lilly and Company discovers, develops, manufactures, and sells products in one business segment, pharmaceutical products. The Company also has an animal health business segment. It manufactures and distributes its products through facilities in the United States, Puerto Rico, and 17 other countries. Its products are sold in approximately 128 countries. The Company's products include Neuroscience products, Endocrinology products, Oncology products, Cardiovascular products, Animal health products, and other pharmaceuticals. In the United States, Eli Lilly and Company distributes pharmaceutical products principally through independent wholesale distributors, with some sales directly to pharmacies. In July 2010, the Company acquired Alnara Pharmaceuticals, Inc.

    China MediaExpress Holdings, Inc. (CME), through contractual arrangements with Fujian Fenzhong Media Co., Ltd. (Fujian Fenzhong), operates the television advertising network on inter-city express buses in China. The Company and its subsidiaries and variable interest entity (VIE) are engaged in the operation of mobile television advertising networks on passenger buses travelling on highways in the People's Republic of China. The Company does not conduct any substantive operations of its own, but conducts it primary business operations through Fujian Fenzhong, a VIE of a wholly owned subsidiary, Fujian Across Express Information Technology Co, Ltd. (Across Express). On October 15, 2009, CME acquired all of the issued and outstanding capital stock of Hong Kong Mandefu Holding Limited (the HKMDF), its subsidiary and VIE, and as a result, HKMDF became its direct wholly owned subsidiary.

    HealthSpring, Inc. (HealthSpring) is a managed care organization with a primary focus on Medicare, the federal government-sponsored health insurance program for United States citizens aged 65 and older, qualifying disabled persons and persons suffering from end-stage renal disease. As of December 31, 2009, the Company operated coordinated care Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas. As of January 1, 2010, it also commenced operations of Medicare Advantage plans in three counties in Northern Georgia. As of December 31, 2009, the Company's Medicare Advantage plans had over 189,000 members. The Company also offers prescription drug benefits in accordance with Medicare Part D to its Medicare Advantage plan members, in addition to providing other medical benefits (MA-PD) plans. It also offers prescription drug benefits nationally on a stand-alone basis in accordance with Medicare Part D (PDP).

    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.