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Executive Summary February 18, 2011

The Economy

The economic news has been mixed since our last newsletter, but overall the recovery keeps moving forward.

The employment picture continues to slowly but surely improve. The Labor Department's most recent employment report showed that the private sector added 50,000 jobs in January -- not exactly gangbusters growth. But the unemployment rate fell to 9.0%, and has now fallen 0.8 percentage points since November to reach its lowest level in almost two years. The so-called "U-6" unemployment rate -- which, unlike the headline number, includes workers who have given up looking for work -- fell by 0.6 percentage points, meanwhile, to 16.1%, its lowest level in nearly two years.

As happened in December, January's figures showed a significant drop in the unemployment rate, while a relatively small number of jobs were created. And, just as in December, that odd juxtaposition does not appear to be due to discouraged workers dropping out of the labor force and no longer being counted -- the U-6 figure is intended to pick them up, and it declined significantly, too. A big part of the reason for the discrepancy is that the "jobs created" figure comes from a survey of businesses; the unemployment rate is calculated using a survey of households. That creates inconsistencies. For example, the number of people who were self-employed jumped by 167,000 in January, but those jobs -- and other hirings at very new companies -- are unlikely to be included in the business survey that gives us the "jobs created" figure.

Overall, the bottom line is that the employment picture is continuing to show improvement. The weekly claims data also bears that out. The four-week moving average of new claims for unemployment is about 11% below where it was a year ago; the four-week moving average for continuing claims is down close to 20% over that time.

In the industrial and manufacturing arenas, meanwhile, we've gotten mixed news since our last newsletter. Industrial production fell 0.1% in January, according to a new Federal Reserve report, though the December figure was revised upward to a gain of 1.2% (up from 0.8%). A big part of the January decline was due to weather, as temperatures moved closer to normal, which decreased output from the utilities industry. Manufacturing production actually increased by 0.3%.

Early signs regarding February manufacturing are encouraging. The Philadelphia Federal Reserve's manufacturing index, which measures activity in the mid-Atlantic region, almost doubled in February, a great sign.

Last newsletter, I talked about how inflation had been rearing its head a bit. This week, the Labor Department announced that core inflation -- which does not include volatile food or energy prices -- was up 0.2% in January. While not an alarming number, it is the highest figure in several months. And, more importantly, the overall inflation number rose by 0.4% for the second straight month, thanks to a 0.5% increase in food prices and a 2.1% increase in energy prices. While they may not be included in the "core" figure, food and energy are certainly at the core of most consumers' expenses. Food and fuel prices that get too high would be a threat to the recovery.

For now, however, consumers are continuing to show resilience. After eclipsing their pre-recession high in December, retail and food services sales increased again in January, rising 0.3%, according to the Census Bureau. It was the seventh straight month retail and food sales have risen.

Overall since our last newsletter, the S&P has returned 2.5%, while the Hot List has returned 2.6%. For the year, the portfolio stands at 3.7% vs. 6.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 179.7% vs. the S&P's 34.0% gain.

Major Shakeup

On today's regularly scheduled rebalancing, the Hot List is selling off five of its holdings, and replacing them with five new stocks that now get higher scores from my Guru Strategies.

The departing stocks are mostly solid winners, including Atwood Oceanics (up about 18% through yesterday's close), Sanofi-Aventis (up about 16%), and Raytheon Company (up about 11%). Millicom International (down about 2%) and Ariad Pharmaceuticals (down about 6%) are also leaving the portfolio. The newcomers are a very diverse group, and include an oil driller (Ensco), yoga-focused retailer (lululemon), a for-profit education company (Lincoln Educational Services), and a couple tech stocks (Western Digital and Acme Packet).

Given the significant amount of changeover, I thought it would be a good time to review our rebalancing process. It's been about a year since we last examined the topic, which means we have another year worth of data and information to learn from.

While "rebalancing" is often discussed as a way to maintain certain asset allocations within a multi-asset portfolio, it means something different for the Hot List, since the Hot List is an all-stock portfolio. For the Hot List, "rebalancing" entails two main things: 1.) ensuring that the portfolio includes only the stocks that best meet an underlying quantitative strategy, and 2.) bringing them back to target weights in this all-equity portfolio.

We've compiled a good amount of our own research on the topic after nearly eight years of running our model portfolios. What we've found is that, generally, a monthly rebalancing works best for our portfolios, particularly for the consensus-based Hot List. Using simple averages, the 14 ten-stock portfolios we track on Validea.com (12 individual guru portfolios, the Hot List, and our Top 5 Gurus portfolio) have returned an average of 10.68% per year since inception when rebalanced monthly (note: our "monthly" rebalancings are actually every 28 days). When rebalanced quarterly, the returns have been slightly lower, averaging 10.16% per year. And when rebalanced annually, the difference is much larger, with the average return being 7.43% per year. (All figures mentioned above and below are through Feb. 16.)

For our 20-stock portfolios, it's been a similar story. The monthly rebalanced portfolios have averaged 10.10% per year; the quarterly rebalanced versions have returned 9.97%; and the annually rebalanced portfolios have returned 6.84%.

For the Hot List, it's also been a similar story, with more of an edge going to the monthly rebalanced portfolios. The 10-stock version of the Hot List has returned 14.5% annualized when rebalanced monthly; 11.60% when rebalanced quarterly; and 10.20% when rebalanced annually. We also track a 20-stock version of the Hot List. Its monthly rebalancing has led to 12.20% annualized returns, while the quarterly and annual figures have been 10.40% and 9.1%, respectively.

Discipline Is Key

What do all of those numbers mean for your portfolio? Do they mean you should definitely use a monthly rebalancing period?

Not necessarily. While I think there's value in examining the numbers I laid out above, it's important to realize that they cover a period of about seven-and-a-half years, so there's certainly the chance that they could shift over longer periods.

In addition, different strategies may fare better with different rebalancing periods, and some of the gurus I follow use different rebalancing periods. Even within my models, there's wide variation. For example, while the Hot List clearly has performed best with a 10-stock, monthly rebalancing approach, my Joseph Piotroski-inspired model has generated annualized returns of 14.9% annualized using an annual rebalancing and 20-stock portfolio, well ahead of the 10.6% per year when using a 10-stock, monthly rebalancing approach. Some of the differences may be due to chance; some may be due to the specifics of the strategy.

There are other factors to consider, too. Transaction costs, tax implications, and even the simple issue of the time you have available to put into your rebalancings can be key issues.

So, what's the bottom line, then? To me, the key is picking a rebalancing period -- whatever it may be -- and sticking with it. A regularly scheduled rebalancing period of any length (within reason) helps you do something that most investors can't do if left to their own devices: keep emotion out of your buy and sell decisions. We humans are emotional creatures, and as such we're prone to a number of cognitive biases when it comes to stock investing. I've mentioned many of them -- hindsight bias, anchoring, over-optimism -- in past Hot Lists, and they will wreak havoc on your portfolio.

By following a disciplined rebalancing system, however, you keep those biases and your emotions at bay -- and as an investor, there may be no more important task. You buy and sell when your approach says it's time to buy or sell -- not when you read about a hot stock, or when your neighbor gives you a tip on a "sure thing", or when you get a feeling that the broader market is about to turn up or down. I believe that that sort of disciplined buying and selling at regular intervals has been a big reason that the Hot List has performed so well over the long haul, and I think it's an attribute of our system that will help us continue to outperform in years to come.
Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 5 stocks leave our portfolio. These include: Ariad Pharmaceuticals, Inc. (ARIA), Sanofi-aventis Sa (Adr) (SNY), Atwood Oceanics, Inc. (ATW), Raytheon Company (RTN) and Millicom International Cellular Sa (Usa) (MICC).

The Keepers

5 stocks remain in the portfolio. They are: Telefonica S.a. (Adr) (TEF), Aeropostale, Inc. (ARO), Tower Group, Inc. (TWGP), Gamestop Corp. (GME) and Dollar Tree, Inc. (DLTR).

The Newbies

We are adding 5 stocks to the portfolio. These include: Western Digital Corp. (WDC), Lincoln Educational Services Corporation (LINC), Acme Packet, Inc. (APKT), Lululemon Athletica Inc. (LULU) and Ensco Plc (ESV).

Portfolio Changes

Newcomers to the Validea Hot List

Ensco Plc (ESV): This London-based firm provides offshore drilling services to the petroleum industry. Its fleet includes eight ultra-deepwater semi-submersible rigs, as well as 40 premium "jackup rigs" that are located in several different regions around the world.

Ensco, which has a $7.7 billion market cap, gets strong interest from the models I base on the writings of Peter Lynch and the late, great Benjamin Graham. To read more about it, check out the "Detailed Stock Analysis" section below.

lululemon athletica inc. (LULU): This Vancouver-based firm makes clothing for a variety of athletics, focusing largely on technical athletic apparel for yoga, running, and dancing. It has more than 100 stores across Canada, the U.S., Australia, and Hong Kong.

lululemon, which has a market cap of about $4.3 billion, gets strong interest from the model I base on the writings of Tom and David Gardner, the creators of The Motley Fool investment web site, as well as my Momentum Investor model. The "Detailed Stock Analysis" section below has more on the stock.

Western Digital Corp. (WDC): This California-based firm is a leader in the hard drive and digital storage business. The 40-year-old company has a market cap of about $7.8 billion, and has raked in close to $10 billion in sales in the past year. It gets approval from my Peter Lynch-based model, and high marks from a couple of my other strategies. For more on the stock, see the "Detailed Stock Analysis" section below.

Lincoln Educational Services Corporation (LINC): Lincoln offers high school graduates and working adults various degree and diploma programs. The New Jersey-based small-cap ($350 million) has seen its earnings surge in recent years, as the weak jobs market has sent many job-seekers back to school for more education or training.

Acme Packet (APKT): Located in Bedford, Mass., Acme offers session border control solutions that enable the delivery of interactive communications -- voice, video and multimedia sessions -- and data services across IP network borders. The firm has a $4.7 billion market cap.

Acme gets solid scores from two of my growth approaches, my Martin Zweig-inspired model and my Motley Fool-based strategy. Read more about its fundamentals in the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Atwood Oceanics (ATW): Shares of Atwood, which two weeks ago announced fourth-quarter earnings that beat expectations, continued to make some big gains. They appeared to get a boost from the announcement of a big merger between fellow oil service firms Ensco and Pride International. As of yesterday's close, ATW shares had gained more than 18% since the portfolio picked up the stock on Jan. 21. The big gain made Atwood's shares less attractive, and the portfolio is selling the position today and taking the profits.

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

ARO   |   LINC   |   WDC   |   TEF   |   APKT   |   TWGP   |   LULU   |   ESV   |   GME   |   DLTR   |  

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aropostale merchandise through its e-commerce Website, www.aeropostale.com. During the fiscal year ended January 30, 2010 (fiscal 2009), the Company launched P.S. from Aeropostale, which offers casual clothing and accessories focused on elementary school children between the ages of 7 and 12. During fiscal 2009, the Company completed the closure of its 14 store Jimmy'Z concept. Jimmy'Z Surf Co., Inc., a wholly owned subsidiary of Aeropostale, Inc., was a contemporary lifestyle brand targeting young women and men aged 18 to 25.

Lincoln Educational Services Corporation is a provider of career-oriented post-secondary education. As of December 31, 2009, the Company operated 43 campuses in 17 states. It offers recent high school graduates and working adults degree and diploma programs in five areas of study health sciences, automotive technology, skilled trades, hospitality services and business and information technology. For the year ended December 31, 2009, the Company's health science program, its automotive technology program, its skilled trades program, its hospitality services program and its business and information technology program accounted for approximately 37%, 31%, 13%, 10%, and 9%, respectively, of its average enrollment. The Company had 29,340 students enrolled as of December 31, 2009 and its average enrollment for the year ended December 31, 2009 was 27,808 students.

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.

Telefonica SA (Telefonica) together with its subsidiaries and investees operates in the telecommunications, media and contact center industries. Telefonica basic purpose is the provision of all manner of public or private telecommunications services, including ancillary or complementary telecommunications services or related services. The Company operates in three business areas: Telefonica Spain, Telefonica Latin America and Telefonica Europe. During the year ended December 31, 2009, Telefonica Moviles Espana, SAU, a wholly owned subsidiary of the Company completed the sale of its 32.18% stake in Medi Telecom, SA. In January 2010, the Telefonica Group, through its wholly owned subsidiary, Telefonica Europe plc completed the acquisition of JAJAH.

Acme Packet, Inc., incorporated on August 3, 2000, provides session border controllers (SBCs) that enable service providers, enterprises, government agencies and contact centers to deliver interactive communications, such as voice, video and other real-time multimedia sessions, across Internet protocol (IP) network borders. The Company's Net-Net product supports a range of communications applications at multiple network border points and also supports service architectures, such as IP Multimedia Subsystem (IMS). The Company's Net-Net family of products consists of the Net-Net OS software platform, the 2600, 3800, 4250, 4500 and 9200 platforms; 4500 Advanced Telecommunications Computing Architecture blade (ATCA blade); and Element Management System (EMS), Session Analysis System (SAS), and Route Manager Central (RMC), management applications. On April 30, 2009, the Company acquired Covergence Inc.

Tower Group, Inc. (Tower), through its subsidiaries, offers a range of commercial, personal and specialty property and casualty insurance products and services to businesses in various industries and to individuals. The Company operates in three segments: Brokerage Insurance, Specialty Business and Insurance Services. On February 5, 2009, Tower acquired CastlePoint Holdings, Ltd. (CastlePoint). On February 27, 2009, the Company and its subsidiary, CastlePoint, completed the acquisition of HIG, Inc. (Hermitage), a property and casualty insurance holding company. On October 14, 2009, the Company completed the acquisition of the renewal rights to the workers compensation business of AequiCap Program Administrators, Inc. (AequiCap), an underwriting agency. On November 13, 2009, it acquired Specialty Underwriters Alliance, Inc. (SUA). In July 2010, Tower Group, Inc. acquired the Personal Lines Division of OneBeacon Insurance Group, Ltd.

lululemon athletica inc. is a designer and retailer of technical athletic apparel primarily in North America. Its yoga-inspired apparel is marketed under the lululemon athletica brand name. The Company offers a line of apparel and accessories, including fitness pants, shorts, tops and jackets designed for athletic pursuits, such as yoga, running and general fitness. As of January 31, 2010, its branded apparel was principally sold through 124 stores that are primarily located in Canada and the United States. As of January 31, 2010, its retail footprint included 45 stores in Canada, 70 stores in the United States and nine franchise stores in Australia.

Ensco plc, formerly Ensco International plc (Ensco), is an offshore contract drilling company. As of February 15, 2010, Ensco's offshore rig fleet included 42 jackup rigs, four ultra-deepwater semisubmersible rigs and one barge rig. Additionally, it had four ultra-deepwater semisubmersible rigs under construction. Ensco's operations are concentrated in the regions of Asia Pacific, which includes Asia, the Middle East and Australia, Europe and Africa, and North and South America. It operates under four segments: Deepwater, Asia Pacific, Europe and Africa, and North and South America. Each of the four operating segments provides one service, contract drilling. Ensco engages in the drilling of offshore oil and natural gas wells by providing its drilling rigs and crews under contracts with international, government-owned and independent oil and gas companies.

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.

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.