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Executive Summary July 10, 2009

The Economy

The past fortnight has been more of the same for the economy, featuring generally weak data sprinkled with a few signs of hope.

Unemployment continues to be at the forefront of the economic concerns. Last week, the government reported that 467,000 jobs were lost in June, which was up 45% from May's encouraging tally. That lifted the unemployment rate slightly, to 9.6%, the highest reading in more than a quarter-century. The silver lining was that the Labor Department also reported that new claims for unemployment dropped last week to their lowest level since January, though some of that appears to be due to the July 4 holiday and the timing of auto industry layoffs, according to the Associated Press.

Another sign of continued weakness came from the retail sector, as many firms reported rough same-store sales results for June. J.C. Penney's sales were down (compared to the year-ago month) more than 8%; Neiman Marcus' fell more than 20%; Limited Brands' declined 12%, and Gap's were down 10%. Even discount retailers, like Costco, posted declines, though bad weather seems to have played a role in those sales drops.

On the positive side, the decline in the manufacturing sector continues to slow. The Institute for Supply Management's manufacturing index rose for the sixth straight month in June, the group reported last week. The index now sits at about 45, which is getting closer and closer to the over-50 reading that would indicate the contraction has stopped and manufacturing is expanding again.

The residential real estate market is also continuing to show some signs of life. Pending home sales are showing a "sustained uptrend", the National Association of Realtors said last week, as they rose in May for the fourth straight month. That marked the first time in almost five years that pending sales rose for four consecutive months, the Realtor group reported, adding that the increases have come even as loan underwriting standards have toughened. The NAR's pending sales index remains below 2007 levels, however, and well below 2006 levels.

Leading indicators have also turned pretty positive, with the Conference Board's Leading Economic Index having increased sharply in the past two months. And Bloomberg's John Dorfman notes that Ned Davis research recently said all 12 of its leading indicators are now pointing toward a recovery.

Looking forward, perhaps the biggest economic issue now on the horizon is the potential of a second stimulus package. Economists are split on whether another government injection of cash is needed. Some, like Columbia Professor and Nobel Prize winner Joseph Stiglitz, say that more is needed. "The basic problem is that the first stimulus is not as big as it appears because of the offsetting reductions in state revenues," he recently told Fortune. "The states have balanced budgets, which means they have to reduce their expenditures or raise taxes, either of which has what I call a negative stimulus effect." Yale economist Robert Shiller has also said more stimulus is needed -- one of the reasons the Great Depression dragged on so long, he says, was that the government failed to provide enough stimulus to the economy because of inflation fears.

Others aren't so sure. Some say the problem isn't the size of the stimulus, but the fact that its poor design means it just isn't kicking in right away. And others say running up an already booming national debt would be a problem. "There's a concern among global investors that we're running these very large deficits," Moody's Mark Zandi told Fortune. "If they revolt, then interest rates rise, and you negate any benefit from another stimulus. It's just more prudent to wait another three, six months to see how things go."

Another issue that could soon come to the forefront: commercial real estate. Delinquency rates on commercial loans are now at 7% -- doubled what they were a year ago -- as the economy has scuffled, the Associated Press reported this week. Continued troubles in that market could be big trouble for commercial real estate owners, regional and local banks who made the loans, and investors who own commercial mortgage-backed securities.

Amid the continued economic struggles, the market has taken a step back over the past two weeks, with the S&P 500 falling 4.1%. The Hot List has also lost some ground, down 3.1%. For the year, the portfolio remains well ahead of the broader market, having gained 12.4% vs. the S&P's 2.3% loss. And since its inception -- now a full six years ago -- the portfolio is up 84.3% while the S&P is well in the red, down 11.8%.

Familiar Faces

The Hot List is adding four new stocks this week, though "new" may be something of a misnomer. Each of the additions -- oil services companies Lufkin Industries and BJ Services, women's clothing retailer The Dress Barn, and aerospace & defense firm Ceradyne -- have spent time in the portfolio earlier this year, with all posting gains and some, like Dress Barn (+70% in a three-month span) and BJ Services (+21% in two months) really helping bolster the Hot List's returns.

It's not unusual for previous Hot List stocks to be sold off and then re-enter the portfolio, though it's a bit unusual for all four of the stocks to be recent Hot List veterans. I think that's a good sign, though. Had these stocks left the portfolio because of deteriorating financials, it might have been a sign of a weakening economy. But it appears the reason behind their departures and returns were due to price, not any deterioration of their businesses. Their price gains earlier this year had made them less attractive values than some other stocks in the market, so the Hot List sold them. Now, during this recent minor pullback, their prices have come down to the point that the Hot List again sees strong potential in them.

Capitalizing on what are essentially inefficiencies in the market is exactly what the Hot List is designed to do. And while the overall guru-based system I use is a long-term one, this week's trades show that these strategies are also quite effective in taking advantage of inefficiencies in pricing over short-term periods.

Perhaps more importantly, the fact that we're seeing this sort of pattern in the market -- undervalued stocks gaining momentum, becoming less attractive values, falling back, and again becoming undervalued -- is a good sign. Last year's bursting of the equity bubble left stocks plummeting indiscriminately with no real sense of value. This year, particularly in the past few months, we're seeing signs that stocks are settling back into their usual patterns of short-term fluctuations -- and that means opportunities for investors.

Along the same lines, 2009 has also seen a return to discrimination among different types of stocks. Last year, just about every industry was in the red, and the best-performing sectors still lost close to 20%. So far this year, according to Morningstar, 22 industries are up more than 30%, while 21 are down more than 20%. In the style-box categories -- all of which were way down, within a fairly tight range, last year -- there's also been discrimination, with the results ranging from +10.6% to -9.9%.

Now, discrimination among sectors, industries, styles, and size doesn't mean all is well in the market, and, even within the first half of this year, investors tastes have swung pretty substantially (going from growth-focused in the first few months to value-focused in the last few, for example). But taken with some other signs, this discrimination starts to paint a picture of a market that is at least in the early stages of settling back into a more "normal" state. For example, in the past few months, we've seen value stocks roar back after a lengthy period of underperformance, just as they always have. And we've seen the market turn just after investor sentiment was reaching extreme lows, as it usually does. (Back on March 5, the American Association of Individual Investors' sentiment survey found that just 19% of respondents were bullish; four days later, a big rally began. On June 4, that figure was about 48%, the highest it had been in five months; since then, the market has scuffled.)

In addition, there has been a marked drop in volatility over the past month or two. The Chicago Board of Options Exchange Volatility Index (the VIX) has spent most of May, June, and July hovering in the high 20s and low 30s, its lowest level since before last fall's financial meltdown. (It actually climbed over 80 in the fall.)

Taken together, the value rebound, low-sentiment rebound (and subsequent higher-sentiment pullback), and dramatic decrease in volatility are signs of a market that is following historical trends, and showing signs of stabilization. Does that mean we're out of the woods yet? Of course not. Major issues remain with the economy, the stimulus plan (and, potentially, second stimulus plan) will have repercussions, and, in the shorter term, the upcoming round of earnings announcements will no doubt have a big impact on the market's direction. But the signs I mentioned above do indicate that the market is both battling back from serious troubles with some success, and exhibiting some of the behaviors and trends it has in the past -- it hasn't morphed into some completely new animal, as some feared it would.

Whatever the short term brings, I believe that over the long run, the market will continue to stabilize and function, in a broad sense, as it always has, rewarding patient, long-term, disciplined investors. And that means that valuations will remain key to posting good returns. Right now, both the broader market and individual stocks remain attractive. At the end of the second quarter, the 10-year price/earnings ratio of the S&P 500 was 15.75, which was still slightly below its long-term average. And James O'Shaughnessy notes that 15% of stocks in the index were trading below liquidation value toward the end of the quarter. The U.S. markets are also attractively valued compared to those of other nations. In late June, the U.S. had the eighth-lowest current P/E ratio of 20 major countries, at 14, according to Bespoke Investment Group. (The average for the 20 countries was 20.15.)

Individual stocks look even better. Each of the firms added to the Hot List this week gets approval from three of my best-performing long-term strategies -- those I base on the writings of Benjamin Graham, Kenneth Fisher, and Peter Lynch. They have strong balance sheets and impressive fundamentals, and by focusing on those types of well-rounded stocks, I expect the portfolio will continue to take advantage of the opportunities the market gives it and post some strong gains over the long haul.
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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Genesco Inc. (GCO), World Fuel Services Corporation (INT), Netease.com, Inc. (Adr) (NTES) and Net17 1 Ueps Technologies Inc (UEPS).

The Keepers

6 stocks remain in the portfolio. They are: Pfizer Inc. (PFE), Jos. A. Bank Clothiers, Inc. (JOSB), Frontier Oil Corporation (FTO), Oil States International, Inc. (OIS), Chevron Corporation (CVX) and Fuqi International, Inc. (FUQI).

The Newbies

We are adding 4 stocks to the portfolio. These include: The Dress Barn, Inc. (DBRN), Bj Services Company (BJS), Ceradyne, Inc. (CRDN) and Lufkin Industries, Inc. (LUFK).

Portfolio Changes

Newcomers to the Validea Hot List

Lufkin Industries (LUFK): Based in Lufkin, Texas, Lufkin designs, engineers, manufactures, sells, installs and services oil field equipment and power transmission products for energy firms around the world.

Lufkin is a small cap, with a market cap of $578 million, but it has taken in more than $750 million in sales in the past year. It gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based models. To see why, check out the "Detailed Stock Analysis" section below.

The Dress Barn (DBRN): This New York state-based clothing retailer posted a 70% gain while in the Hot List from Jan. 23 until the portfolio sold it on April 17, and then gained another 4.6% while in the portfolio from mid-May to mid-June. It's dipped since then, and my Peter Lynch-, Benjamin Graham-, and Kenneth Fisher-based models think the $819 million small-cap is again a good buy.

Dress Barn operates more than 800 stores in 46 states under the "dressbarn" name, as well as close to 700 more stores under the "maurices" name. It specializes in apparel for women age 35 to 55, and, while it's a small-cap, it has taken in almost $1.5 billion in sales over the past 12 months. To find out why my models like the stock, see the "Detailed Stock Analysis" section below.

BJ Services (BJS): Another familiar face to the Hot List, this Houston-based oil services firm gained more than 21% while in the portfolio for a two-month stint earlier this year. It provides field development and production enhancement services to the energy industry, with particular expertise in shale fracturing for oil and gas firms trying to tap into shale oil and gas wells. BJ also deals with industrial chemicals and commissioning, and inspection of refineries, pipelines and offshore platforms. It has more than 18,000 employees across 50 countries, and over the past year it has taken in more than $5.3 billion in sales. The firm has a $3.6 billion market cap.

Like Lufkin and Dress Barn, BJ Services gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based models. To see why, check out the "Detailed Stock Analysis" section below.

Ceradyne Inc. (CRDN): Yet another winner from earlier in the year whose recent price drop has made it a buy is this Costa Mesa, Calif.-based firm. It produces advanced technical ceramic products and components for the defense, industrial, automotive, nuclear, electronic and medical industries, with products ranging from body armor to tools used in oil drilling to dental abutments and crowns. Ceradyne has a market cap of about $414 million, and it has taken in close to $600 million in sales in the past year.

Like all three of the other stocks added to the portfolio this rebalancing, Ceradyne's strong fundamentals earn it approval from the strategies I base on the writings of Peter Lynch, Benjamin Graham, and Kenneth Fisher. To see why, scroll down to the "Detailed Guru Analysis" section below.

News about Validea Hot List Stocks

Frontier Oil Corporation (FTO): On July 1, Reuters reported that Frontier said the crude oil run rates at its El Dorado refinery in Kansas increased from 118,600 barrels per day in May to 132,000 barrels per day in June. The May figures were impacted by a weather-related power outage. The firm's Cheyenne, Wy., refinery utilization fell slightly to 41,500 bpd in June from 43,900 in May, Reuters said.

Pfizer Inc. (PFE): On June 30, Pfizer announced that it has discontinued a late-stage study of its cancer drug Sutent as an treatment for colon cancer because the drug has not been effective enough, the Associated Press reported. Pfizer said there were no safety issues with the drug, which is approved for to treat advanced kidney cancer and gastrointestinal cancer.

In addition, Pfizer also has offered solutions to the European Commissions concerns about the firm's planned $68 billion takeover of Wyeth, Reuters reported. The commission, which had been concerned that the merger would be competitive, said it extended the deadline for its review of the deal to July 20 from July 6, according to Reuters.

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

JOSB   |   OIS   |   FTO   |   FUQI   |   CRDN   |   LUFK   |   DBRN   |   BJS   |   PFE   |   CVX   |  

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, retailer and direct marketer (through stores, catalog and Internet) of men's tailored and casual clothing and accessories. It sells all of its products exclusively under the Jos. A. Bank label through its 460 retail stores (as of January 31, 2009, which includes seven outlet stores and 12 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. Its products are targeted at the male career professional and emphasize the Jos. A. Bank brand of tailored and casual clothing and accessories. The Company's products, which range from the original Jos. A. Bank Executive collection to the more luxurious Jos. A. Bank Signature collection to the exclusive Jos. A. Bank Signature Gold collection. Jos. A. Bank operates through two segments: Stores and Direct Marketing.

Oil States International, Inc. (Oil States) through its subsidiaries, is a provider of specialty products and services to oil and gas drilling and production companies worldwide. The Company operates in a number of oil and gas producing regions, including the Gulf of Mexico, United States onshore, West Africa, the North Sea, Canada, South America and Southeast and Central Asia. Its customers include many of the national oil companies, major and independent oil and gas companies and other oilfield service companies. Oil States operates in three principal business segments: offshore products, tubular services and well site services. The Company's well site services segment includes the accommodations, rental tools and drilling services businesses. On February 1, 2008, Oil States purchased all of Christina Lake Enterprises Ltd., the owners of an accommodations lodge (Christina Lake Lodge) in the Conklin area of Alberta, Canada.

Frontier Oil Corporation (Frontier) is an independent energy company engaged in crude oil refining and the wholesale marketing of refined petroleum products. The Company operates refineries (the Refineries) in Cheyenne, Wyoming and El Dorado, Kansas with a total annual average crude oil capacity of approximately 182,000 barrels per day (bpd). Frontier's Cheyenne Refinery has a permitted crude oil capacity of 52,000 bpd on a 12-month average. The Company markets its refined products primarily in the eastern slope of the Rocky Mountain region, which encompasses eastern Colorado (including the Denver metropolitan area), eastern Wyoming and western Nebraska (the Eastern Slope). The Cheyenne Refinery has a coking unit, which allows the refinery to process amounts of heavy crude oil for use as a feedstock. During the year ended December 31, 2008, heavy crude oil constituted approximately 76% of the Cheyenne Refinery's total crude oil charge.

Fuqi International, Inc. (Fuqi) is a designer of precious metal jewelry in China, developing, promoting, and selling a range of products in the Chinese luxury goods market. The Company's products consist of a range of styles and designs made from gold and other precious metals, such as platinum and Karat gold (K-gold). The Company also produce jewelry items that contain diamonds and other precious stones on a custom-order basis. Its design database contains over 30,000 products. The Company operates through its wholly owned subsidiary Fuqi International Holdings Co., Ltd. (Fuqi BVI) and its wholly owned subsidiary, Shenzhen Fuqi Jewelry Co., Ltd. (Fuqi China). As of December 31, 2008, the Company had 69 jewelry retail counters and stores in China.

Ceradyne, Inc. develops, manufactures and markets advanced technical ceramic products, ceramic powders and components for defense, industrial, automotive/diesel and commercial applications. The Company's products include lightweight ceramic armor for soldiers and other military applications; ceramic industrial components for erosion and corrosion resistant applications; ceramic powders, including boron carbide, boron nitride, titanium diboride, calcium hexaboride, zirconium diboride, and fused silica, which are used in manufacture of armor and a range of industrial products and consumer products; evaporation boats for metallization of materials for food packaging and other products; reduced friction, ceramic diesel engine components; functional and frictional coatings primarily for automotive applications; translucent ceramic orthodontic brackets, and ceramic-impregnated dispenser cathodes for microwave tubes, lasers and cathode ray tubes.

Lufkin Industries, Inc., is a supplier of oil field and power transmission products. The Company is divided into two operating segments: Oil Field and Power Transmission. Through its Oil Field segment, the Company manufactures and services artificial reciprocating rod lift equipment and related products, which are used to extract crude oil and other fluids from wells. Through its Power Transmission segment, the Company manufactures and services high-speed and low-speed increasing and reducing gearboxes for industrial applications. In January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfil contractual obligations and close all trailer facilities. In March 2009, the Company acquired International Lift Systems, LLC (ILS), a manufacturer of artificial lift systems serving oil and gas companies. In July 2009, the Company acquired Rotating Machinery Technology, Inc.

The Dress Barn, Inc. operates women's apparel specialty stores, principally under the names dressbarn, dressbarn woman and maurices. As of July 26, 2008, the Company operated 1,503 stores in 48 states and the District of Columbia, including 656 dressbarn Combo stores (a combination of its dressbarn and dressbarn woman brands), 677 maurices stores, 134 dressbarn stores and 36 dressbarn woman stores. Its dressbarn stores are typically operated as Combo stores, offering both dressbarn and larger-sized dressbarn woman merchandise. The Dress Barn, Inc. also operates stand-alone dressbarn and dressbarn woman stores in certain markets. Its dressbarn brands cater to 35 to 55 year-old women, sizes 4 to 24. The dressbarn stores offer in-season and casual fashion located primarily in convenient strip shopping centers in major trading and markets and surrounding suburban areas. As of July 26, 2008, the Company operated 1,503 stores in 48 states.

BJ Services Company is a provider of pressure pumping and oilfield services for the petroleum industry. Pressure pumping services consist of cementing and stimulation services used in the completion of new oil and natural gas wells and in remedial work on existing wells, both onshore and offshore. Oilfield services include casing and tubular services; precommissioning, maintenance and turnaround services in the pipeline and process business, including pipeline inspection; chemical services; completion tools, and completion fluids. The Company conducts its operations through four segments: U.S./Mexico Pressure Pumping Services; Canada Pressure Pumping Services; International Pressure Pumping Services, and Oilfield Services Group. On May 21, 2008, the Company acquired Innicor Subsurface Technologies Inc.

Pfizer Inc. (Pfizer) is a research-based, global pharmaceutical company. The Company discovers, develops, manufactures and markets prescription medicines for humans and animals. It operates in two business segments: Pharmaceutical and Animal Health. Pfizer also operates several other businesses, including the manufacture of gelatin capsules, contract manufacturing and bulk pharmaceutical chemicals. In June 2008, Pfizer completed the acquisition of all remaining outstanding shares of common stock of Encysive Pharmaceuticals, Inc. through a merger of Pfizer's wholly owned subsidiary, Explorer Acquisition Corp., with and into Encysive. In June 2008, it also completed the acquisition of Serenex, Inc., a biotechnology company with a Heat Shock Protein 90 development portfolio. In January 2008, the Company completed the acquisition of Coley Pharmaceutical Group, Inc., a company whose area of capability is immunotherapy with emphasis on Toll-like receptor research and development.

Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates, and provides administrative, financial, management and technology support to the United States and International subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining operations of coal and other minerals, power generation and energy services. Exploration and production (upstream) operations consist of exploring for, developing and producing crude oil and natural gas, and also marketing natural gas. Refining, marketing and transportation (downstream) operations relate to refining crude oil into finished petroleum products; marketing crude oil and the many products derived from petroleum, and transporting crude oil, natural gas and petroleum products by pipeline, marine vessel, motor equipment and rail car. In April 2009, Reliance Industries Limited bought back Chevron Corporation's 5% stake in Reliance Petroleum Limited.

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.


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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.