|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||December 11, 2009|
Aided by a strong continued tailwind of government assistance, the economy has been pushing forward for the past few months, and it has kept on showing progress -- albeit slow progress -- in recent weeks.
Among the positive signs of the past fortnight was the November jobs report, which showed that unemployment dipped from 10.2% in October to 10.0% last month. Of course, that's still extremely high, but the fact that the jobless rate dropped for just the second time in 19 months offered some hope that things are moving in the right direction.
Another encouraging sign was the latest manufacturing numbers, which showed that the sector expanded for the fourth consecutive month, according to the Institute for Supply Management. The manufacturing data showed that new orders are increasing at an accelerating rate, a very good sign. The ISM's non-manufacturing (services) index fell, however, indicating a slight contraction after two months of expansion. New orders increased for the sector, however, a silver lining. The manufacturing sector tends to go into downturns earlier than the services sector and emerge earlier, the group's chairman told Bloomberg.
Housing also continues to improve, though the overall picture remains far from healthy. Foreclosure activity dipped 8% in November, falling for the fourth straight month, according to RealtyTrac -- though the rate remains almost 20% higher than it was a year ago. The National Association of Realtors' Pending Home Sales Index also increased again in November, the group reported, the ninth straight month it has risen -- a record. A big reason for the record run has been the government's first-time homebuyer tax credit.
And that brings us back to the government, which is where the big economic news occurred this past fortnight. Earlier I mentioned how the government's efforts have provided a major tailwind for the economy in recent months. Well, now it appears that that tailwind, in some shape or form, will remain in place for close to another year, at least.
That's because this week, Treasury Secretary Timothy Geithner told Congressional leaders that the Obama Administration was extending the $700 billion Toxic Asset Relief Plan through Oct. 3, 2010. While Geithner said that the TARP program will be wound down, and that the move is more of a precaution to guard against unforeseen potential problems, it nevertheless means that the U.S. economy will continue to have some strong government backing for close to another year.
The other big TARP-related development this week was the news that the Obama Administration is now expecting the final cost of the bailout to be about $200 billion less than previously projected -- and that led President Obama to say more funding could be available for his jobs program. As I wrote last newsletter, it's not unusual for the job market to be one of the final pieces of a recovery to fall into place. But it would certainly be nice to see improvement in that area sooner rather than later, both to put more Americans back to work (and spending money), and to engender confidence about the broader economy.
Finally, the dollar continues to be a key factor in the market's movements. Good days for the dollar usually have meant bad days for the market, and bad days for the dollar have meant good days for the market. Thursday, we got new data showing that the weaker dollar has bolstered exports and lowered the trade deficit, helping drive stocks higher. The dollar's direction going forward is definitely something to keep an eye on.
As all of this has unfolded since our last newsletter, stocks have moved slightly higher, with the S&P 500 gaining 1,0%. The Hot List has lost 1.4%, but still remains far ahead of the market for 2009, having gained 38.1% compared to the S&P's 22.0% gain. And since its July 2003 inception, the 10-stock portfolio is up 126.5%, while the S&P has gained just 10.2%.
Searching for High-Quality, as Always
As hard as it might have been to believe back in the first two months of the year, 2009 has turned out to be an exceptional bounce-back year for the stock market. As of this writing, the S&P 500 is up almost 63% since its March low, and the Nasdaq Composite is up almost 73%.
As you probably know, a good portion of those gains have been driven by so-called "junk" stocks, which were pounded amid apocalyptic fears last fall, only to bounce back once the fears of flat-out doom alleviated. In a recent New York Times column, Mark Hulbert highlighted some data that showed how significant the junk rally has been. According to Ford Equity Research, Hulbert wrote, stocks in the bottom fifth of the 4,000 the group tracks in terms of "quality" (based on size, debt level, earnings history and industry stability) returned an average of 152% from the beginning of March to the end of November; stocks in the highest quintile averaged a 66% gain. The disparity is the greatest over the first nine months of any bull market since 1970, the first year for which Ford has such ratings, Hulbert says.
Now, however, a number of the gurus I follow are saying the junk rally has run its course, and that higher-quality stocks are the place to be going forward. Among them is Jeremy Grantham, who has one of the best track records of any investor I know, having called the 2000 crash, the '08 meltdown, and the '09 rally. Now, Grantham tells the Times that "it's almost a certain bet that high-quality blue chips will outperform lower-quality stocks over the longer term."
He's not alone. Donald Yacktman, whose exceptional track record has made him a finalist for Morningstar's fund manager of the decade honor, recently told Bloomberg that the best values he's finding in the market involve businesses that are "very high quality", not the junk-type stocks that led the rally earlier this year. James O'Shaughnessy, one of the gurus upon whose writings I base a strategy, told Barron's last month that he thinks stocks could return 15% annually for the next five years, with the junk rally ending and high-quality stocks taking the lead. And Joel Greenblatt, another guru who inspired one of my models, told Yahoo! TechTicker that his "magic formula" approach seems to be finding more values in high-quality stocks than in junk-type stocks.
If these gurus are right -- and their track records show that they are right a lot more than most -- it bodes well for the Hot List. My models are designed to find the highest of the high-quality stocks in the market, those with the strongest balance sheets and best fundamentals.
Take, for example, current Hot List pick National Oilwell-Varco. The Houston-based oil services company gets approval from two of my strategies, my Benjamin Graham-based value model and my James O'Shaughnessy-inspired growth model. To pass these two very different approaches, Varco has to have:
- a pristine balance sheet (its 2.1 current ratio and greater than 6-to-1 net current assets/long-term debt ratio earn approval from the Graham approach);
- a long history of earnings growth (it has increased per-share earnings in each of the past six years, which my O'Shaughnessy model likes);
- solid valuations (its 1.3 price/sales ratio meets the O'Shaughnessy model's standards, and its 1.23 price/book ratio and a three-year price/earnings ratio of 11.8 pass the Graham model's tests);
- and, on top of all that, strong momentum (its relative strength of 74 passes muster with the O'Shaughnessy approach.
All of those are hallmarks of a quality stock selling at an attractive price, the type of stock that should excel if the market does turn back to high-quality companies like Grantham, O'Shaughnessy, and others believe.
And if junk stocks continue to outperform high-quality stocks as a group? Well, that doesn't mean poor returns for the Hot List. Just look at this year. The portfolio is up about 20 percentage points on the broader market in '09, and all of that outperformance (and a bit more, since the portfolio was actually slightly lagging the S&P in early March) has come since the March low. And the Hot List has achieved that outperformance by focusing on firms with the strongest fundamentals -- low debt, strong growth, etc.
That strong performance amid a junk-driven market is, to me, another sign that the highest of the high-quality stocks are the place to focus over the long haul. Yes, junk rallies will happen from time to time, but they are by definition driven mostly by emotion, not fundamentals, making them very hard to time. History, and the Hot List, have proven, however, that stocks with excellent fundamentals will more often than not excel over the long haul, and the last several months have shown that they can do quite well even in a junk-led market. Those high-quality firms are thus the types of stocks on which we'll continue to focus, both in the short term and over the long haul.
Guru Spotlight: Joel Greenblatt
Anyone who has ever put cash in the market knows that making money in stocks is hard. But what a lot of investors don't realize is that while it is difficult, it doesn't have to be complicated. You don't need incomprehensible, esoteric formulas and you don't need to spend every waking hour analyzing stocks -- Joel Greenblatt has proved that.
Back in 2005, Greenblatt created a stir in the investment world with the publication of The Little Book that Beats The Market, a concise, easy-to-understand bestseller that showed how investors could produce outstanding long-term returns using his "Magic Formula" -- a purely quantitative approach had just two variables: return on capital and earnings yield.
Greenblatt's back-testing found that focusing on stocks that rated highly in those areas would have produced a remarkable 30.8 percent return from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that period. Greenblatt also posted impressive numbers in his money management experience, with his hedge fund, Gotham Capital, producing returns of 40 percent per year over a span of more than two decades.
Written in an extremely layperson-friendly manner, Greenblatt's "Little Book" -- it's only 176 pages long and small enough to fit in your jacket pocket -- broke investing down into terms even an elementary schooler could understand. In fact, Greenblatt said he wrote the book as a way to teach his five children how to make money for themselves. Using several simple analogies, he explains a variety of stock market principles. One of these he often returns to involves Jason, a sixth-grade classmate of Greenblatt's youngest son who makes a bundle selling gum to fellow students. Greenblatt uses Jason's business as a jumping off point to explain issues like supply, demand, taxation, and rates of return.
In reality, the "Magic Formula" is less about magic than it is about simple, common sense investment theory. As Greenblatt explains, the two-step formula is designed to buy stock in good companies at bargain prices -- something that other great value investors, like Warren Buffett, Benjamin Graham, and John Neff also did. The return on capital variable accomplishes the first part of that goal (buying good companies), because it looks at how much profit a firm is generating using its capital. The earnings yield variable, meanwhile, accomplishes the second part of the task -- buying those good companies' stocks on the cheap. The earnings yield is similar to the inverse of the price/earnings ratio; stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.
To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.
The slightly unconventional ways in which Greenblatt calculates earnings yield and return on capital also involve some good common sense -- and are particularly interesting given the recent credit crisis. For example, in figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: These parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.
In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This give the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. In the past few months, we've seen how misleading conventionally derived P/E ratios and earnings yields could be, since earnings had been propped up by the use of huge amounts of debt. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.
In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.
We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years, and its underlying model has factored into our Hot List selections for the past two years or so. So far, the model has been an exceptional performer. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has fallen 12.9%, but the portfolio has gained 35.3 percent. This year has been its best. Year-to-date, the portfolio is up 51.4% vs. the S&P's 22.0% gain.
One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.
Here's a look at the current holdings of my Greenblatt-based portfolio:
ITT Educational Services (ESI)
Apollo Group (APOL)
Dresser-Rand Group (DRC)
GameStop Corp. (GME)
Amedisys, Inc. (AMED)
Chicago Bridge & Iron Company N.V. (CBI)
LHC Group (LHCG)
Deluxe Corporation (DLX)
AmSurg Corp (AMSG)
"Magic"? Or Discipline?
While Greenblatt's methodology is completely quantitative, one of the most important aspects of his approach is psychological -- and it's something that I believe is critical to keep in mind in the current financial climate. To Greenblatt, the hardest part about using the Magic Formula isn't in the specifics of the variables; it's having the mental toughness to stick with the strategy, even during bad periods. If the formula worked all the time, everyone would use it, which would eventually cause the stocks it picks to become overpriced and the formula to fail. But because the strategy fails once in a while, many investors bail, allowing those who stick with it to get good stocks at bargain prices. In essence, the strategy works because it doesn't always work -- a notion that is true for any good strategy.
News about Validea Hot List Stocks
National Oilwell Varco (NOV): Varco announced on Dec. 8 that it has acquired two Asian companies that serve the oil and gas industries, Hochang Machinery Industries Co. Ltd., which has facilities in South Korea, and South Seas Inspection Pte. Ltd, of Singapore.
The Hochang purchase is an effort to strengthen the fabrication capabilities of Varco's rig technology segment, the Associated Press reported, while the South Seas acquisition was designed to build its petroleum services and supplies segment. The purchases totaled about $160 million in cash, AP said.
Chevron Corp. (CVX): On Dec. 5, Chevron said its Australian subsidiary has reached an agreement with the Tokyo Electric Power Co. to deliver 4.1 million tons of liquefied natural gas per year for up to 20 years from the Wheatstone field in northwestern Australia, MarketWatch reported. The deal was worth A$90 billion, according to Reuters.
Under the agreement, Tokyo Electric will also acquire 15% of Chevron's equity stake in Wheatstone field licenses, MarketWatch stated, and an 11.25% stake in natural gas processing facilities that will be developed on shore.
Chevron also said it will stop supplying 1,100 independently owned fuel filling stations in Delaware, Indiana, Kentucky, North Carolina, New Jersey, Maryland, Ohio, Pennsylvania, South Carolina, Virginia, West Virginia, Washington, D.C., and parts of Tennessee by the middle of 2010, according to Reuters. The stations account for 8 percent of U.S. sales volume. The decision was part of Chevron's review of its global downstream operations, Reuters reported.
Aeropostale (ARO): On Dec. 2, Aeropostale reported third-quarter earnings of $62.6 million, or 92 cents per share, up about 47% from the year-ago period. Analysts on average had been expecting earnings of 91 cents per share, Reuters reported. The firm also said it expects fourth-quarter profit to be between $1.20 to $1.24 per share, the Associated Press stated, while analysts predict a profit of $1.22 per share. And Aeropostale reported that sales in stores open at least one year rose 7% in November, missing analysts' estimates of 7.7%, AP stated.
On Dec. 7, Aeropostale also announced that it will up its share repurchase plan by $250 million, bringing to $290 million the total amount at its disposal to buy back shares, MarketWatch reported.
The Next Issue
The next issue of the Hot List will be published on Thursday, Dec. 24, one day earlier than usual due to the Christmas holiday. The portfolio will be rebalanced at that time. If you have any questions, please feel free to contact us at firstname.lastname@example.org.
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