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Executive Summary March 30, 2012

The Economy

Having climbed up to a higher level over the past few months, the economy seems to be sitting relatively comfortably on a plateau for the moment, hopefully recharging for its next move upward.

New claims for unemployment continue to come in well below the 400,000 mark that proved so tough to break through for so long. In the week ending March 24, 359,000 new claims were filed (seasonally adjusted), according to the Labor Department, representing a slight decrease since our last newsletter and the lowest level in nearly four years. Continuing claims (which run one week behind new claims) also fell, and are more than 11% below year-ago levels.

Industrial production, meanwhile, was flat in February, according to a new report from the Federal Reserve, but January's figure was revised upward to a 0.4% gain (from a previous reading of no change).

The housing sector continues to struggle, though things are much better than they were a year ago. Housing starts fell 1.1% in February, according to the Commerce Department, but remained about 35% above year-ago levels. Privately-owned housing units authorized by building permits rose 5.1%, and are about 34% above year-ago levels. Pending and existing home sales both slipped a bit in February, meanwhile, according to the National Association of Realtors. Pending sales (a forward-looking indicator based on contract signing) fell 0.5% and existing sales (which are completed transactions) fell 0.9%, the group said. But pending sales remain 9.2% above the year-ago level and existing sales are 8.8% above their year-ago level.

A revised gross domestic product report was also released this week, and it showed that GDP growth was 3.0% in the fourth quarter of 2011. That's not gangbusters growth, but it's solid, and reaffirms some of the improving data we've seen in recent months.

Gas prices, meanwhile, remain a concern. A gallon of regular unleaded gas averaged $3.92 as of March 29, up from $3.72 a month ago, according to AAA. So far the rising cost of fuel doesn't seem to have derailed the improving economy. But at some point, it could pose a danger.

Since our last newsletter, the S&P 500 returned 0.0%, while the Hot List returned 0.5%. So far in 2012, the portfolio has returned 20.7% vs. 11.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 172.9% vs. the S&P's 40.3% gain.

Sentimental Thoughts

The stock market has made an impressive turnaround in 2012, bouncing back from a very volatile -- and eventually flat -- 2011 with some strong gains in this year's first quarter. The rebound has been heartening for investors and kind to the Hot List, with the portfolio up 20.7%. But it also has some saying that sentiment has shifted too far to the bullish side too quickly. Top U.K. fund manager Neil Woodford recently referred to a "wave of optimism" that has swept across global equity markets, and advised caution, for example. Others say that valuations have become stretched. With that in mind I thought it would be a good time to review just where market sentiment does stand by looking at a number of commonly used gauges.

One of the most often referred to sentiment trackers is the American Association of Individual Investors' weekly sentiment survey, which asks respondents whether they are bullish, bearish, or neutral on how the broader stock market will fare over the next 6 months. The survey began in mid-1987, and since then the average bullish reading has been 39%; the average bearish reading has been 30%; and the average neutral reading has been 31%.

Since the start of 2012, however, the bullish reading on the survey has been no lower than 42.38%, and as high as 51.64%. The bearish readings, meanwhile, have been no higher than 29.00%, and as low as 17.16%. Those aren't overwhelming outliers -- for some perspective, during the tech bubble the bullish reading sometimes rose above 70%, and the bearish readings sometimes dipped into single digits -- but they do seem to be an indication that sentiment has shifted significantly to the bullish side.

But while the AAII sentiment survey is certainly an interesting one, there are several factors that make me question just how accurately it reflects overall investor optimism or pessimism. For one thing, AAII tends to provide some very good, value-focused, long-term investing commentary and advice. Because of that it seems reasonable to infer that many -- though certainly not all -- of its readers have a value-focused, long-term approach to investing, and thus are more likely to be bullish for good, quality reasons like valuation than because of a follow-the-crowd attitude.

Secondly, the AAII survey does not take into account magnitude of the respondents' bullishness or bearishness. So, to use a somewhat oversimplified example, if 6 respondents say they are bullish and 4 say they are bearish, that would make for a 60% bullish rate -- and that sounds like sentiment is very positive. But what if each of the 6 bulls is only very, very slightly optimistic on stocks, while each of the 4 bears is extremely pessimistic about the market. When you take the magnitude of the 10 respondents' answers into consideration, it would be difficult to say that the group as a whole is very bullish, as the 60% bullish rate indicates.

Perhaps the most significant limitation to the AAII survey, however, is that it measures how investors say they are feeling, not what they are actually doing with their money. It's easy to read an online survey, consider things for a moment and have some optimistic feelings, and click the bullish button; it's another to actually take your hard-earned money and put it in the market, particularly when there are as many fears and concerns hanging over the financial world as there are right now.

To get a sense of what investors are actually doing with their money, the best place to go is fund flow reports. Lipper provides some that are particularly useful, because they include flows to both mutual and exchange-traded funds. In the first two months of 2012, Lipper's data shows that investors put a net of $39.3 billion into stock and mixed equity mutual funds, and $29.9 billion into exchange-traded stock and mixed equity funds. The $22.5 billion injected into mutual funds in February was the biggest inflow in a year (though far from an astronomical amount during bullish periods).

But there are a couple of details within the numbers that indicate investors are not exactly hog-wild on equities. For one thing, flows into bond funds continue to outpace flows into stock funds. While a total of $69.2 billion flowed into mutual and exchange-traded stock and mixed equity funds in January and February, even more -- $72.3 billion -- flowed into bond funds, which is somewhat remarkable given how low bond yields are right now.

In addition, of the $69.2 billion that flowed into stock and mixed equity funds in January and February, nearly half of it -- $32.9 billion -- was on the "mixed equity" side of the equation, meaning it went into funds that invest not only in stocks but in other assets as well. Only $1.8 billion went into U.S. domestic stock funds over the two months; about a quarter -- $17.5 billion -- went into world stock funds. In other words, investors were collectively putting only moderate amounts of money into funds that focus primarily on stocks, and almost no money into funds that primarily focus on U.S. stocks.

Even some news stories that on the surface seem to indicate a strong bullishness aren't quite what they seem. One that I recently read had the headline, "Hedge Funds Capitulating Buy Most Stocks Since 2010". The word "capitulating", to me, indicates a total throwing in of the towel in order to join the bull run. The article focuses on an index used by the International Strategy & Investment Group to assess how bullish hedge funds are. That index, the article states, rose to 48.6 recently, making its biggest increase in nearly two years. Sounds very bullish, but the article goes on to explain that a reading of 50 indicates hedge funds are "deploying a 'normal' ratio of long to short investments". So despite the recent rise, the index is still showing that hedge funds are underinvested in equities compared to historical norms.

It's a similar story with some of the recent consumer confidence numbers. One article I read this week heralded, "Consumer Confidence Stays Near 4-Year High," which makes it sound as though people are really feeling quite good about things. But the reality is that confidence has been so low for the last four years that being "high" for that period is far, far from being truly confident. The Conference Board's Consumer Confidence Index is at 70.2 -- far above its October level of 39.8, and nearly three times where it was in early 2009. But it is still nowhere near its historical norm -- in a recent piece for Advisor Perspectives, Doug Short noted that the current level is barely above the average for the past five recessions, which is 69.4. Bloomberg's Consumer Comfort Index is painting a similar picture, coming in at -34.7 in March, well below the -15.2 average since its 1985 inception. Basically, while the economy is improving, Americans still feel like it's a recession.

So, with consumer confidence still quite low and data showing that hedge, mutual, and exchange-traded fund flows have been perhaps moderately bullish on the whole, why all the fear about the market's recent rise? It seems that any time the stock market goes on a nice month or two run these days, people get very worried -- even when, as is the case now, the run is supported by solid improvement in the economy.

The reason, I believe, is something that Matthew Craft of the Associated Press touched on in a recent column. "Every comparison to 2008, even a comparison that's supposedly good, stirs memories of 2008," Craft wrote. "For some people, it rekindles the fear of losing a job or a house. For others, years of retirement savings swallowed by a plunging stock market."

Craft says that's what behavioral finance experts believe, and I'm with them. He interviewed psychiatrist Richard Peterson, who explained how traumatic memories get "seared in the brain", and can be easily irritated. "News that reminds people of the financial crisis -- debt problems in Europe, a sudden swing in the market -- sets off the same emotions of fear or anger," Craft writes. "Getting your fear button pushed that often is exhausting, Peterson says. People eventually tune out to save their sanity."

Meir Statman, a professor of finance at Santa Clara University in California and a leading expert in behavioral finance, offered a similar take. "Fear is still with us," said Statman, who has collaborated on research papers with Kenneth Fisher, one of the gurus upon whom I base my strategies. "We live as if it's still 2008."

Statman says a couple of phenomena appear to be at work. One is the tendency for investors (and people in general) to take an event and uses it as the basis for understanding everything else. "We look at something and ask, 'What is this similar to?'" he says. Usually, people use recent events as their point of reference, but Statman thinks many investors are now using the 2008 crisis as their baseline because it feels closer. "I think that what's vivid in people's minds is not last year but 2008," he said.

Statman says people are also falling prey to "confirmation bias" -- the process in which we look for data that supports our initial belief and cast aside information that contradicts it. "If you have evidence that goes against your beliefs, you dismiss it," he says. That's what the "doom and gloom" crowd appears to be doing, he says. So rather than looking at the rising market and acknowledging that it is supported by reasonable valuations and an improving economy, they see the rise as a sign that sentiment has gotten too high -- like it did before the tech bubble burst in 2000 and the housing bubble burst a few years back.

To me, the bottom line is that collectively, investors are far from overly optimistic right now. Yes, there may be a short-term shift to the moderately bullish side, but behind that lies a thick wall of worry and, for many, downright fear. And from an investor's point of view, that's good news. It means that there's probably a bit of a disconnect between reality and perception, and within that disconnect is where value exists. It will probably take a while longer for investors to get over their fears, given the severity of the 2008 crisis and the Great Recession, so more bumps in the road lie ahead. But at some point investors will move past those traumatic days of 2008 and 2009, and, as more and more of them return to the market, those who have had the discipline and courage to invest over the past couple years should really reap some nice rewards.
Editor-in-Chief: John Reese

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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.

The Details

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 four years or so. So far, the model has been a strong performer, with some big ups and downs. Since we began tracking our 10-stock Greenblatt-based portfolio in late 2005, the S&P 500 has gained just 11.1%; the Greenblatt-based portfolio has gained about 46% -- that's 6.2% annualized, vs. 1.7% annualized for the S&P. The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009, vs. 23.5% for the S&P. It beat the market slightly in 2010, had a rough 2011 (losing 15.3%), and has lagged so far this year. Greenblatt stresses that the strategy won't beat the market every month or even every year, however, which is important to remember. Over the long haul, though, it should produce excellent returns.

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. Among the holdings are four firms from the much-maligned for-profit education industry, a sign of how the strategy isn't afraid to head into rough waters to find bargains.

Bridgepoint Education Inc. (BPI)
Apollo Group Inc. (APOL)
ITT Educational Services (ESI)
GT Advanced Technologies Inc. (GTAT)
Strayer Education Inc. (STRA)
C&J Energy Services Inc. (CJES)
Iconix Brand Group, Inc. (ICON)
VAALCO Energy, Inc. (EGY)
AmSurg Corp (AMSG)
PDL BioPharma, Inc. (PDLI)

"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

Northrop Grumman Corporation (NOC): Grumman has been awarded a $334 million firm-fixed-price contract from the U.S. Air Force to provide Large Aircraft Infrared Countermeasure (LAIRCM) systems and support. Grumman will deliver the missile defense system and provide associated support to the Air Force beginning immediately and continuing through April 2014.

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

FRX   |   CSH   |   CSTR   |   CACI   |   NOC   |   TJX   |   BPI   |   AAP   |   ASPS   |   BODY   |  

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. The Company offers secured non-recourse loans, commonly referred to as pawn loans. The Company also offers unsecured consumer loans. Its consumer loan portfolio includes short-term loans, which include single payment loans (that are commonly referred to as payday loans) and line of credit products; longer-term multi-payment installment loans; and credit services and participation interests in receivables acquired from a third-party lender through the micro line of credit (MLOC) channel. It operates in two segments: retail services and e-commerce. Through the credit services organization programs (the CSO programs), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization or credit access business on behalf of consumers.

Coinstar, Inc. (Coinstar) is a provider of automated retail solutions, which offers convenient products and services. the Company's offerings in automated retail include its Redbox business, where consumers can rent or purchase movies and video games from self-service kiosks (Redbox segment), and its Coin business, where consumers can convert their coin to cash or stored value products at self-service coin counting kiosks (Coin segment). Its New Ventures business (New Ventures segment) is focused on identifying, evaluating, building, and developing self-service concepts in the marketplace. On June 9, 2011, the Company completed the sale transaction of the Money Transfer Business to Sigue Corporation (Sigue).

CACI International Inc (CACI) along with its wholly owned subsidiaries and joint ventures, is an international information systems, high technology services, and professional services corporation. It delivers professional services and information technology solutions to its clients, primarily the United States government. Other customers include state and local governments, commercial enterprises and agencies of foreign governments. The Company operates two units: domestic operations and international operations. CACI delivers professional services and information technology (IT) solutions to its clients. Its services are primarily targeted to the areas of defense, intelligence, homeland security and IT modernization. In November 2010, the Company acquired TechniGraphics, Inc. and Applied Systems Research Inc. In July 2011, it acquired Pangia Technologies, LLC. In September 2011, CACI acquired Paradigm Holdings, Inc. In October 2011, the Company acquired Advanced Programs Group, LLC.

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.

The TJX Companies, Inc. (TJX) is an off-price apparel and home fashions retailer in the United States and worldwide. The Company operates multiple off-price retail chains in the United States, Canada and Europe. As of January 29, 2011, TJX operated five business segments: three in the United States and one in each of Canada and Europe. Each of its segments has its own administrative, buying and merchandising organization and distribution network. Of the United States-based chains, T.J. Maxx and Marshalls , referred to as Marmaxx, are managed together and reported as a single segment and HomeGoods and A.J. Wright each is reported as a separate segment. Outside the United States, its chains in Canada are managed together, and its chains in Europe are managed together. Thus, Canada is reported as a segment and Europe is reported as a segment.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Advance Auto Parts, Inc. (Advance) is a specialty retailer of automotive aftermarket parts, accessories, batteries and maintenance items primarily operating within the United States. The Company operates in two segments: Advance Auto Parts (AAP), and Autopart International (AI). Its stores carry an extensive product line for cars, vans, sport utility vehicles and light trucks. The Company serves both do-it-yourself (DIY), and do-it-for-me (Commercial), customers. Its Commercial customers consist primarily of delivery customers for whom the Company delivers product from its store locations to it Commercial customers' places of business, including independent garages, service stations and auto dealers.

Altisource Portfolio Solutions S.A.( Altisource), together with its subsidiaries, is a provider of services focused on technology-enabled, knowledge-based functions related to real estate and mortgage portfolio management, asset recovery and customer relationship management. The Company operates in three segments: Mortgage Services, Financial Services and Technology Services. In April 2011, the Company acquired Springhouse, LLC (Springhouse). In July 2011, the Company acquired the assembled workforce of a sub-contractor (Tracmail) in India.

Body Central Corp. is a specialty retailer of young women's apparel and accessories operating retail stores in the South, Mid-Atlantic and Midwest regions of the United States. In addition, the Company operates a direct business through its e-commerce Website, www.bodyc.com, and Body Central catalog. It operates specialty apparel stores under the Body Central and Body Shop banners. It targets women in their late teens and twenties from diverse cultural backgrounds who seek the latest fashions and a flattering fit. Its stores feature a variety of tops, dresses, bottoms, jewellery, accessories and shoes sold primarily under Body Central and Lipstick labels. As of January 1, 2011, it had 209 stores located in fashion retail venues across 23 states in the South, Mid-Atlantic and Midwest. Its average store size is 4,300 square feet. During the fiscal year ended January 2, 2010 (fiscal 2010), the Company opened 27 stores. From fiscal year 2009 through January 1, 2011, it closed 13 stores.

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.

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