Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary May 9, 2014

The Economy

While the recent GDP report showed that the economy barely grew at all in the first quarter, more recent data shows that the second quarter is a much better story.

In April, for example, the private sector added 273,000 jobs, according to the Labor Department. The unemployment rate fell from 6.7% to 6.3%, the lowest it has been since September 2008. The so-called "U-6" rate, which also includes part-time workers seeking full-time work and discouraged workers who have given up looking for a job, fell to 12.3%, the lowest it's been since November 2008.

The number of people not in the labor force, which had fallen by nearly 800,000 in the year's first three months, jumped by close to 1 million in April, however. Bears fixed on that, and it's true that that isn't a good sign. But it's also true that the not-in-the-labor-force number can be quite volatile, and is close to its December 2013 level, when the unemployment rate was nearly half a percentage point higher. In other words, while the April report may not have been as strong as the headline jobs-added number indicated, the general trend of improvement does seem to be continuing in the labor market, and that's a big positive.

The manufacturing sector, meanwhile, expanded in April for the 11th straight month, and did so at an accelerating pace for the third straight month, according to the Institute for Supply Management. The survey's New Orders sub-index remained at a very healthy level, and the Employment sub-index made a nice jump. The prices sub-index, which has been quite high, fell a bit to its lowest reading of 2014, which would seem to be a good sign inflation-wise.

The service sector also expanded in April at an accelerating rate, the 51st straight month that it has grown. The New Orders sub-index made a big jump, hitting its highest level since last September. The Employment sub-index fell a bit, but still indicated that employment conditions in the sector were improving. Respondents indicated a sharp jump in inventory, however, which is something to keep an eye on.

Personal income made another nice jump in March, rising 0.5%, according to a new government report. Real disposable personal income rose 0.3%. Consumers increased their spending rather sharply during the month, with real personal consumption expenditures jumping 0.7%, similar to what we saw in the March retail sales report. With spending outpacing income gains, the personal savings rate fell from 4.2% to 3.8%. That's on the low side, though not alarmingly so.

As for that first quarter GDP number, it was weak and may be headed lower upon revision -- subsequent reports in areas like construction spending and factory inventories were weaker than the government had assumed in the advance GDP report. Though disappointing, a good deal of the first quarter weakness seems to have been a result of bad weather, which at times significantly impacted production around the country. So the data is neither surprising nor too alarming, especially given that things seem to have picked up over the past month or two.

Since our last newsletter, the S&P 500 returned -0.2%, while the Hot List returned -1.9%. So far in 2014, the portfolio has returned -12.0% vs. 1.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 220.0% vs. the S&P's 87.5% gain.

Re-evaluating Value

Over the long-term, small-cap value stocks have well outperformed larger growth stocks. For decades, that notion has been a pretty widely known one in the investing world, thanks in large part to the research of highly regarded finance professors Kenneth French and Eugene Fama. Fama and French's research found, for example, that from 1927-2009, small value stocks beat large growth stocks by an average of more than five percentage points annually. In addition, large value stocks beat large growth stocks and small growth stocks by about two percentage points each annually.

That data would seem to indicate that simply buying stocks with low price/book ratios -- the metric Fama and French used to assess value -- should be a good investment strategy. And many analysts have supported the idea of such a strategy by contending that the market must reward investors who buy value stocks (which are often in some kind of distress) for taking on additional risk -- that, at least, is what efficient market hypothesis supporters usually say.

But new data -- from none other than Fama and French themselves -- seems to turn that notion on its head. In a working paper that was released last year, Fama and French analyzed historical stock returns again, this time adding in two new factors: profitability and investment intensity (the level of capital investment a company makes). While the paper didn't get a whole lot of attention, one of its initial findings appears to be quite significant: The profitability and investment factors made redundant the value factor. "In other words, value stocks -- defined as those with low price/book -- only beat growth stocks because they historically tended to be more profitable and less voracious users of capital," wrote Morningstar's Samuel Lee in a recent piece discussing Fama and French's new paper.

The redundancy of the value factor might seem to be contrary to what many of the value-focused gurus I follow preach. In reality, the takeaways from French and Fama's new data fit quite well in a several key ways with the gurus' teachings, and I think they are well worth touching on.

First, it's important to note that the value gauge French and Fama use is the price/book ratio, which is not one of the more used gauges by the gurus. In fact, in a research report earlier this year, James O'Shaughnessy's firm wrote that "Despite its popularity, we do not use price-to-book in [the] OSAM Value [composite] because of several problems with the factor." The price/book ratio "consistently has one of the lowest annualized returns of all value factors," O'Shaughnessy Asset Management said in the paper. "Also, in half of the time periods shown, price-to-book underperforms the market." While that particular paper was looking at the Canadian stock market, OSAM said the issue was not isolated to Canada. "In the U.S., price-to-book has been a very inconsistent value ratio with prolonged periods of underperformance," the group said. "From 1927 to 1963 the cheapest ten percent of stocks by price-to-book underperformed the U.S. market by an annualized 205 bps; and over the next 36 years by more than 200 bps." O'Shaughnessy, for the record, initially found the price/sales ratio to be the best value factor -- that's what I use in my O'Shaughnessy-based growth model, which has been one of my better performers over the long haul. (Today O'Shaughnessy actually uses a "value composite" that includes several value gauges, similar, in effect, to what the Hot List does.)

What I find interesting about OSAM's work in relation to Fama and French's work is that in almost all cases, the gurus upon whom I base my strategies used valuation metrics that focused on earnings, sales, or cash flow -- in other words, the concept of profitability was at work within the value metrics. The price/book ratio, in contrast, is based on the value of the company's assets, not its ability to generate profits -- and Wall Street is less concerned with what a company already is than with what it could grow into in the future. It's also worth noting that of the three guru-inspired models I run that do use the price/book ratio, two of them (the David Dreman and Benjamin Graham approaches) use other value metrics (the price/earnings, price/cash flow and price/dividend ratios for Dreman, and the P/E for Graham) as well. The one strategy that uses price/book (actually its inverse, the book/market ratio) as its sole valuation gauge -- the Joseph Piotroski-based approach -- includes among its other variables the return on assets rate and gross profit margin, both of which get at a firm's profitability, as well as cash flow from operations, which is designed to eliminate firms that are burning through cash. Those three variables jive quite well with the profitability and investment factors that French and Fama added to their analysis in their paper.

Then there's Warren Buffett. Of all of the guru-inspired strategies I use, the Buffett-based approach probably has the least stringent valuation measure -- it simply requires that the company's earnings yield be higher than the yield on long-term treasury bonds. It focuses a great deal on earnings persistence, return on equity, return on retained earnings, and return on capital -- profitability. In addition, it looks for companies that have good free cash flows, the idea being that that will weed out firms that require a high amount of capital investment. High profitability, low investment requirements -- that's exactly what French and Fama's study found made the value factor redundant.

So what does all this mean? Does it mean that value no longer matters? Most definitely not, in my opinion. Price is always important when you are buying anything, stocks included. As O'Shaughnessy's research has shown, a number of non-price/book ratio valuation metrics have been great ways to identify winning stocks throughout history (metrics like the Price/sales and price/earnings ratios).

Just as importantly, I think French and Fama's new research highlights the importance of using a well-rounded strategy that looks at a company and its shares from a number of different angles. Profitability, balance sheet, valuation -- you should consider all of those factors when analyzing a stock. As Kenneth Fisher, another of the gurus I follow, wrote, "Never assume you have found the one silver bullet." My Guru Strategies do not look for a silver bullet. Most of the strategies use between seven and 10 different variables; the Motley Fool-based approach uses no fewer than 17. And those are just individual models. With a consensus approach like the Hot List, which gets input from all 12 of my models, you're talking about putting a stock through dozens and dozens of financial and fundamental tests. Those that make the grade are thus some of the most fundamentally sound stocks in the market, showing strength across a number of different levels. Take Hot List newcomer NetEase, which is being added to the portfolio today. The $9-billion-market-cap tech firm has grown earnings at a 24% pace over the long term, and much more rapidly in the most recent quarter. It has no long-term debt and a 5.4 current ratio, indicating a very strong balance sheet, and it has been extremely profitable, averaging a 10-year return on equity north of 28% and a return on retained earnings over that period of more than 20%. All of that, and it trades for about 12 times earnings and has a free cash flow yield of close to 8%.

Of course that's no guarantee that the stock will be a huge winner for the portfolio. But over the long term, stocks with those kind of well-rounded fundamentals and financials tend to perform quite well. By investing in baskets of stocks like those, we stack the odds greatly in our favor over the long haul. The proof is in the pudding -- the Hot List's stellar long-term track record is in large part due to its deep, thorough fundamental analysis of companies and their shares. Moving forward, I'm confident that this approach will continue to pay off with returns well ahead of the market average.

Editor-in-Chief: John Reese

Have Your Portfolio Managed Using Validea's Investing System
Many users know about our research services but are unaware that money management services based on our system are also offered through a separate registered investment advisory firm, Validea Capital Management.

If you are thinking about switching advisors or no longer have the time or inclination to manage your investments yourself, find out more about Validea Capital, its portfolio offerings, and its performance below.
Request an Investment Consultation Today!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. The information above is not intended as personal investment advice and should not be interpreted as such.

The Fallen

As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: Trueblue Inc (TBI), Foot Locker, Inc. (FL), Hollyfrontier Corp (HFC), Dorman Products Inc. (DORM), Hyster-yale Materials Handling Inc (HY) and Cnooc Ltd (Adr) (CEO).

The Keepers

4 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Valero Energy Corporation (VLO), Smith & Wesson Holding Corp (SWHC) and Bofi Holding, Inc. (BOFI).

The Newbies

We are adding 6 stocks to the portfolio. These include: Bed Bath & Beyond Inc. (BBBY), Robert Half International Inc. (RHI), Anika Therapeutics, Inc. (ANIK), Drew Industries, Inc. (DW), Northrop Grumman Corporation (NOC) and Netease, Inc (Adr) (NTES).

Portfolio Changes

Newcomers to the Validea Hot List

Bed Bath & Beyond Inc. (BBBY): This New Jersey-based home goods and furnishings retailer ($12 billion market cap) has stores in the U.S., Canada, and Mexico, and has taken in about $11.5 billion in sales in the past 12 months. It gets some interest from my Warren Buffett-inspired strategy, in part because it has upped EPS in all but one year of the past decade. Bed Bath & Beyond also gets strong interest from my Peter Lynch-based model. To read more about it, check out the "Detailed Stock Analysis" section below.

Northrop Grumman Corporation (NOC): One of the country's largest defense contractors, this Virginia-based firm is involved in the aerospace, electronics, information systems, and technical services arenas, serving government and commercial customers across the globe. Its products include unmanned aircraft systems, B-2 stealth bombers, the James Webb space telescope, radar systems, 911 public safety systems, and cybersecurity solutions, to name just a few.

Grumman has a $26 billion market cap, and gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about it, see the "Detailed Stock Analysis" section below.

Drew Industries Inc. (DW): Indiana-based Drew is a supplier to the recreational vehicle and manufactured homes industries. Through its subsidiaries, Lippert Components, Inc. and Kinro, Inc., it produces a range of components, including windows, doors, chassis, chassis parts, bath and shower units, axles, upholstered furniture, awnings and slide-out mechanisms for RVs. It also makes components for modular housing, truck caps and buses, and for trailers used to haul boats, livestock, equipment, and cargo.

Drew ($1.2 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. To read more about it, check out the "Detailed Stock Analysis" section below.

NetEase, Inc. (NTES): This $9-billion-market-cap Chinese tech firm offers a number of popular online games, including World of Warcraft, as well as e-mail services, advertising services and web portals. It's been a rapid grower, increasing EPS at a 24% rate over the long haul and revenues at a 23% rate.

NetEase gets high marks from my Peter Lynch- and Warren Buffett-based models. For more on its fundamentals, see the "Detailed Stock Analysis" section below.

Anika Therapeutics: This Massachusetts-based firm develops therapeutic products for tissue protection, healing and repair based on hyaluronic acid, a naturally occurring polymer found throughout the body that enhances joint function and coats, protects, cushions and lubricates soft tissues. Shares have bucked the downward biotech tend this year, thanks to better than expected first quarter earnings and the FDA's approval of Monovisc, its single injection treatment for osteoarthritis knee pain.

Anika gets strong interest from my Peter Lynch-, Motley Fool-, and Martin Zweig-based models. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

Robert Half International (RHI): California-based RHI, founded in 1948, was the world's first specialized staffing firm, and today is its largest. It offers professional consulting and staffing services, and is the parent company of Protiviti, a global consulting firm that helps companies solve problems in finance, technology, operations, governance, risk and internal audit. RHI has staffing and consulting operations in more than 400 locations across the globe.

RHI ($6.2 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. For more on its fundamentals, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

BofI Holding (BOFI): BofI reported record third fiscal quarter net income of $14.6 million, an increase of 40.5% over net income of $10.4 million for the quarter ended March 31, 2013. Earnings attributable to BofI's common stockholders were $1.00 per diluted share, up 44.6% from $0.74 per diluted share for the third quarter a year earlier. Core earnings, which exclude the after-tax impact of gains and losses associated with the firm's securities portfolio, increased 47.1% to $15.0 million.

HollyFrontier (HFC): HollyFrontier reported first quarter net income attributable to stockholders of $152.1 million or $0.76 per diluted share, down from $333.7 million or $1.63 per diluted share for the year-ago quarter, principally reflecting lower first quarter refining margins. The firm said that refined product margins, although lower than the first quarter of 2013, showed nice improvement versus the back half of 2013.

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

ANIK   |   VLO   |   SWHC   |   DW   |   RHI   |   NOC   |   NTES   |   BBBY   |   BOFI   |   AGCO   |  

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

Smith & Wesson Holding Corporation (Smith & Wesson) is a manufacturer of firearms. The Company manufactures a range of handguns, modern sporting rifles, hunting rifles, black powder firearms, handcuffs, and firearm-related products and accessories for sale to a range of customers, including gun enthusiasts, collectors, hunters, sportsmen, competitive shooters, individuals desiring home and personal protection, law enforcement and security agencies and officers, and military agencies in the United States and globally. It sells its products under the Smith & Wesson brand, the M&P brand, the Thompson/Center Arms brand, and the Performance Center brand. The Company manufactures its firearm products at its facilities in Springfield, Massachusetts and Houlton, Maine. In May 2014, the Company through Deep River Plastics LLC, subsidiary purchased substantially all of assets of Tri Town Precision Plastics Inc.

Drew Industries, is a supplier of components for recreational vehicle (RVs) and manufactured housing. The Company operates in two segments: the RV products segment (RV Segment), and the manufactured housing products segment (MH Segment). The Company's operations are conducted through its wholly owned subsidiaries, Lippert Components, Inc. and its subsidiaries (Lippert) and Kinro, Inc. and its subsidiaries (Kinro), each of which has operations in both the RV Segment and the MH Segment. During the year ended December 31, 2012, the RV Segment accounted for 87% of net sales and the MH segment accounted for 13% of net sales. In February 2014, the Company's wholly-owned subsidiary, Lippert Components, Inc has acquired Innovative Design Solutions, Inc. (IDS). In March 2014, the Company's subsidiary Lippert Components, Inc, completed the acquisition of certain assets and the business of Star Design, LLC.

Robert Half International Inc. provides specialized staffing and risk consulting services. The Company operates in three segments: temporary and consultant staffing, permanent placement staffing, and risk consulting and internal audit services. The Company, through its Accountemps, Robert Half Finance & Accounting, and Robert Half Management Resources divisions, is a specialized provider of temporary, full-time, and project professionals in the fields of accounting and finance. OfficeTeam specializes in skilled temporary administrative support personnel. Robert Half Technology provides information technology professionals. Robert Half Legal provides temporary, project, and full-time staffing of attorneys and specialized support personnel within law firms and corporate legal departments. The Creative Group provides project staffing in the advertising, marketing, and Web design fields. Protiviti is a global business consulting and internal audit firm.

Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business. In September 2012, it acquired M5 Network Security Pty Ltd. In February 2014, Northrop Grumman Corp completed the acquisition of Qantas Defence Services Pty Limited.

NetEase, Inc. is a holding company. The Company is an Internet technology company. The Company operates in three segments: Online Game Services, Advertising Services and E-mail, Wireless Value-added Services and Others. The Company provides its Internet and wireless value-added applications, services and technologies and advertising services to Guangzhou NetEase and Guangyitong Advertising and they operate the NetEase Websites and the online advertising business. Guangzhou NetEase has two majority-owned subsidiaries, Youdao Computer (a search business operator) and Wangyibao (the operator of its Wangyibao payment system). Through its subsidiaries and contracts with its affiliates Guangzhou NetEase, Guangyitong Advertising and Shanghai EaseNet and their respective shareholders, it operates an interactive online community in China and is a provider of Chinese language content and services through its online games, Internet portal and wireless value-added services businesses.

Bed Bath & Beyond Inc. is a chain of retail stores, operating under the names Bed Bath & Beyond (BBB), Christmas Tree Shops (CTS), Harmon and Harmon Face Values (Harmon), buybuy BABY and World Market or Cost Plus World Market (World Market). In addition, it is a partner in a joint venture, which operates three stores in the Mexico City market under the name Bed Bath & Beyond. The Company sells a range of domestics merchandise and home furnishings. Domestics merchandise includes categories, such as bed linens and related items, bath items and kitchen textiles. Home furnishings include categories, such as kitchen and tabletop items, fine tabletop, basic housewares and general home. During fiscal year ended March 2, 2013 (fiscal 2012), the Company opened a total of 38 stores, including 12 BBB stores throughout the United States and Canada, five CTS stores, one Harmon store and 18 buybuy BABY stores, and six World Market stores throughout the United States and closed one BBB store.

BofI Holding, Inc. is a holding company for BofI Federal Bank, a diversified financial services company. The Bank operate its bank from a single location in San Diego, California, serving approximately 40,000 retail deposit and loan customers across all 50 states. As of June 30, 2012, it had total assets of $2,386.8 million, loans of $1,799.7 million, mortgage-backed and other investment securities of $483.0 million, total deposits of $1,615.1 million and borrowings of $547.2 million. It distributes its deposit products through a range of retail distributions channels, and its deposits consist of demand, savings and time deposits accounts. It distributes its loan products through its retail, correspondent and wholesale channels, and the loans it retains are primarily first mortgages secured by single family real property and by multifamily real property.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

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.