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|Executive Summary||May 9, 2014|
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.
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.
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).
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).
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).
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.
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