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Executive Summary October 9, 2015

The Economy

While it is still faring well compared to the rest of the world, the US economy has flashed some warning signals over the past couple weeks.

One of those warning signals came in the September jobs report. The economy added 142,000 jobs during the month, the Labor Department said, and the August figure was revised lower, from 173,000 to 136,000. Both the August and September numbers were well below the 200,000-plus average we've seen over the past year or so. In addition average hourly wages dipped slightly in September vs. August. The unemployment rate held steady at 5.1%, the lowest it has been since April 2008. The reason that the unemployment rate dropped while job growth slowed was that the number of people not in the workforce jumped by 2.3 million during the quarter. When the labor force shrinks, a common refrain is that it's because workers are so discouraged that they have given up looking for jobs. But such workers should be included in the "U-6" rate, which unlike the headline number takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job -- and the U-6 fell to 10.0% in September, the lowest it has been since May 2008. A more likely explanation for the increase in people not in the labor force seems to be that more and more baby boomers are hitting retirement age.

The second bearish signal came in the form of manufacturing data. While the manufacturing sector expanded for the 33rd straight month, according to the Institute for Supply Management, it did so at the slowest pace in almost two-and-a-half years. New order growth was close to flat in September, and employment conditions improved minimally during the quarter, according to ISM. Customer inventories increased, while backlogs of orders fell fairly sharply.

Nevertheless, we also had some very good economic news. The service sector remained a bright spot, expanding in September for the 68th straight month, according to ISM. The rate of expansion wasn't as fast as it was in July or August, but it was still quite strong. New order growth slowed from August's stellar pace, but remained solid, and employment conditions also remained very strong.

New claims for unemployment also fell since our last newsletter, coming close to the 42-year low they hit back in July. They are 11.6% below year-ago levels. Continuing claims, the data for which lag new claims by a week, also fell since our last newsletter and are 8% below year-ago levels.

Personal income jumped 0.3% in August, meanwhile, according to the Commerce Department. Real disposable personal income rose 0.4%, while real personal consumption expenditures rose 0.4%. That meant the personal savings rate was 4.6%, down slightly from August's 4.7%.

Gas prices have continued to fall, though they appear to be leveling out more recently. A gallon of regular unleaded on average cost $2.31 as of October 8, down from $2.39 a month earlier, according to AAA. That's close to 30% below where it was a year ago.

Since our last newsletter, the S&P 500 returned 4.2%, while the Hot List returned 8.0%. So far in 2015, the portfolio has returned 2.2% vs. -2.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 230.4% vs. the S&P's 101.3% gain.

Portfolio Update

It has been a very nice fortnight for the Hot List, with several big winners pushing the portfolio back into the black for 2015. Since our last newsletter, seven of our holdings have gained ground and three have been in the red, with four of the winners posting double-digit gains. (Performance data as of mid-morning trading on October 8.)

The biggest winner: Zumiez Inc. (ZUMZ), the Washington State-based teen-focused specialty apparel retailer, which surged more than 21%. About half of that increase came after the firm announced that September same-store sales fell 1.8%, but far exceeded the -6.9% estimate from analysts, according to Thomson Reuters. Zumiez shares had been hit hard in September after a disappointing earnings report. But the Hot List saw it as a good value play late in the month, and so far the stock is paying off.

Just behind Zumiez was Universal Insurance Holdings (UVE), the small-cap insurer that offers homeowners insurance in Florida, North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland. UVE shares jumped 19% since our last newsletter. After a rough August, UVE was one of the market's best performers in September, as investors seemed to realize that they had been too hard on this strong performing business during the market swoon. The firm also announced in September a $10 million program to buy back its shares, which runs through the end of 2016, and that likely helped to boost shares as well.

A third big winner was Chart Industries (GTLS), which was up more than 17.5%. The strong performance from Chart, which makes engineered equipment for the industrial gas, energy, and biomedical industries, coincided with the broader market's rebound, and was likely thus a case of a small-cap getting hit too hard during the August declines and then snapping back as fears subsided. The company also announced that a subsidiary had received contracts in excess of $40 million from Magnolia LNG, which may well have heartened investors.

On the downside, athletic apparel retailer Foot Locker (FL) was our biggest loser, down 4.9%. Shares fell after a U.S. District Court ruled against Foot Locker in a case that involves claims related to the conversion of the company's pension plan in 1996 to a defined benefit plan with a cash balance formula. Foot Locker said it plans to appeal the decision.

The Hot List's strong performance over the past two weeks was very encouraging, and hopefully it is a sign of things to come as 2015 winds down. In two weeks, we will rebalance the portfolio, at which time we'll see which current holdings will continue to impress my guru-inspired strategies.

Editor-in-Chief: John Reese

Guru Spotlight: Peter Lynch

Choosing the greatest fund manager of all-time is a tough task. John Templeton, Benjamin Graham, John Neff -- a number of investors have put up the types of long-term track records that make it difficult to pick just one who was "The Greatest".

If you were to rank Peter Lynch at the top of the list, however, you'd probably find few would disagree with you. During his 13-year tenure as the head of Fidelity Investments' Magellan Fund, Lynch produced a 29.2 percent average annual return -- nearly twice the 15.8 percent return that the S&P 500 posted during the same period. According to Barron's, over the last five years of Lynch's tenure, Magellan beat 99.5 percent of all other funds. If those numbers aren't impressive enough, try this one: If you'd invested $10,000 in Magellan the day Lynch took the helm, you would have had $280,000 on the day he retired 13 years later.

Just like investors who entrusted him with their money, I, too, owe a special debt of gratitude to Lynch. When I was trying to find my way in the stock market many years ago, Lynch's book One Up On Wall Street was a big part of what put me on the right track. Lynch didn't use complicated schemes or highbrow financial language in giving investment advice; he focused on the basics, and his common sense approach and layman-friendly writing style resonated not only with me but with amateur and professional investors all over, as evidenced by its best-seller status. The wisdom of Lynch's approach so impressed me that I decided to try to computerize the method, the first step I took toward developing my Guru Strategy computer models.

Just what was it about Lynch's approach that made him so incredibly successful? Interestingly, a big part of his approach involved something that is not at all exclusive to being a renowned professional fund manager: He invested in what he knew. Lynch believed that if you personally know something positive about a stock -- you buy the company's products, like its marketing, etc. -- you can get a beat on successful businesses before professional investors get around to them. In fact, one of the things that led him to one of his most successful investments -- undergarment manufacturer Hanes -- was his wife's affinity for the company's new pantyhose years ago.

But while his "buy-what-you-know" advice has gained a lot of attention over the years, that part of his approach was only a starting point for Lynch. What his strategy really focused on was fundamentals -- that's why I was able to computerize it -- and the most important fundamental he looked at was one whose use he pioneered: the P/E/Growth ratio.

The P/E/Growth ratio, or "PEG", divides a stock's price/earnings ratio by its historical growth rate. The theory behind this was relatively simple: The faster a company was growing, the more you should be willing to pay for its stock. To Lynch, PEGs below 1.0 were signs of growth stocks selling on the cheap; PEGs below 0.5 really indicated that a growth stock was a bargain.

To show how the P/E/G can be more useful than the P/E ratio, Lynch has cited Wal-Mart, America's largest retailer. In his book "One Up On Wall Street", he notes that Wal-Mart's P/E was rarely below 20 during its three-decade rise. Its growth rate, however was consistently in the 25 to 30 percent range, generating huge profits for shareholders despite the P/E ratio not being particularly low. That also proved another one of Lynch's tenets: that a good company can grow for decades before earnings level off.

The PEG wasn't the only abbreviation Lynch popularized within the stock market lexicon. His strategy is often used as a primary example of "GARP" -- Growth At A Reasonable Price -- investing, which blends growth and value tenets. While some categorize Lynch as a growth investor because his favorite type of stocks were "fast-growers" -- those growing earnings per share at an annual rate of at least 20 percent -- his use of PEG as a way to make sure he wasn't paying too much for growth really makes him a hybrid growth-value investor.

One Size Doesn't Fit All

One aspect of Lynch's approach that makes it different from those of other gurus I follow is his practice of evaluating different categories of stocks with different variables. His favorite category, as I noted, was "fast-growers". These companies were growing earnings at a rate of 20 to 50 percent per year. (Lynch didn't want growth rates above 50 percent, because it was unlikely companies could sustain such high growth rates over the long term).

The other two main categories of stocks Lynch examined in his writings were "stalwarts" and "slow-growers". Stalwarts are large, steady firms that have multi-billion-dollar sales and moderate growth rates (between 10 and 20 percent). These are usually firms you know well -- Wal-Mart and IBM are current examples of "stalwarts" based on that definition. Their size and stability usually make them good stocks to have if the market hits a downturn, so Lynch typically kept some of them in his portfolio.

"Slow-growers", meanwhile, are firms with higher sales that are growing EPS at an annual rate below 10 percent. These are the types of stocks you invest in primarily for their high dividend yields.

One way Lynch treated slow-growers and stalwarts differently from fast-growers involved the PEG ratio. Because slow-growers and stalwarts tend to offer strong dividend yields, Lynch adjusted their PEG calculations to include dividend yield. For example, consider a stock that is selling for $30, and has a P/E ratio of 10, EPS growth of 12 percent, and a 3 percent yield. To find the PEG, you'd divide the P/E (10) by the total of the growth rate and yield (12+3=15). That gives you 10/15=0.67, which, being under 1.0, indicates that the stock is indeed a good value.

Another difference: For slow-growers, Lynch wanted a high yield, and the model I base on his approach requires dividend yield to be higher than the S&P average and greater than 3 percent.

Beyond The PEG

The PEG wasn't the only variable Lynch applied to all stocks. For fast-growers, stalwarts, and slow-growers alike, he also looked at the inventory/sales ratio, which my Lynch-based model wants to be declining, and the debt/equity ratio, which should be below 80%. (For financial companies, it uses the equity/assets ratio and return on assets rates rather than the debt/equity ratio, since financials typically have to carry a lot of debt as a part of their business.)

The final part of the Lynch strategy includes two bonus categories: free cash flow/price ratio and net cash/price ratio. Lynch loved it when a stock had a free cash flow/price ratio greater than 35 percent, or a net cash/price ratio over 30 percent. (Lynch defined net cash as cash and marketable securities minus long term debt). Failing these tests doesn't hurt a stock, however, since these are only bonus criteria.

A Market-Beater

Over the long term my Lynch-inspired model has had its ups and downs, but if you've stuck with it, it's paid off. Overall since I started tracking it in July 2003, the portfolio has averaged annualized returns of 8.6%, easily beating the 5.8% annualized return for the S&P 500 (all performance figures are through Oct. 7). The 20-stock Lynch-inspired portfolio I track has been one of my best performers, gaining 13.0% annualized since its mid-2003 inception.

Here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:

Maiden Holdings (MHLD)
Sanderson Farms (SAFM)
HCI Group (HCI)
WSFS Financial Corporation (WSFS)
Moelis & Co. (MC)
TriCo Bancshares (TCBK)
AVX Corporation (AVX)
Heritage Insurance Holdings (HRTG)
Zumiez (ZUMZ)

News about Validea Hot List Stocks

Zumiez Inc. (ZUMZ): Zumiez announced that September same-store sales fell 1.8%, but that far exceeded the -6.9% estimate from analysts, according to Thomson Reuters. The big beat was part of why shares surged 21% since our last newsletter.

Foot Locker (FL): A U.S. District Court ruled against Foot Locker in a case that involves claims related to the conversion of the company's pension plan in 1996 to a defined benefit plan with a cash balance formula. Foot Locker said it plans to appeal the decision.

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

UVE   |   FL   |   GTLS   |   BOFI   |   HRTG   |   SAFM   |   WETF   |   TRV   |   ZUMZ   |   MMI   |  

Universal Insurance Holdings, Inc. (UIH), with its wholly owned subsidiaries, is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. The Company's offers homeowners' insurance through the Insurance Entities, Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC). Substantially all aspects of insurance underwriting, distribution and claims processing are performed by the Company's subsidiaries. UPCIC, a wholly owned subsidiary of the Company, is a writer of homeowners insurance in Florida and has commenced its operations in North Carolina, South Carolina, Hawaii, Georgia, Massachusetts, Maryland, Delaware, and Indiana. APPCIC, also a wholly owned subsidiary, writes homeowners multi-peril insurance on Florida homes valued in excess of $1 million, which are limits and coverages currently not targeted through its affiliate UPCIC.

Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailer whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction and SIX:02, as well as the retail stores of Runners Point Group, including Runners Point and Sidestep. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., and the direct-to-customer subsidiary of Runners Point Group, which sell to customers through their Internet and mobile sites and catalogs. As of January 31, 2015, the Company operated 3,423 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand. As of January 31, 2015, the Company operated a total of 78 franchised stores, of which 31 are in the Middle East, 27 in Germany and Switzerland, and 20 in the Republic of Korea.

Chart Industries, Inc. (Chart) is a diversified manufacturer of engineered equipment engineered equipment for the industrial gas, energy, and biomedical industries. The Company's equipment and engineered systems are used for low-temperature and cryogenic applications. It operates through three segments: Energy & Chemicals (E&C), Distribution & Storage (D&S) and BioMedical. Its products include vacuum insulated containment vessels, heat exchangers, cold boxes and other cryogenic components. Its E&C and D&S segments manufacture products used in energy-related and industrial applications, such as the separation, liquefaction, distribution and storage of hydrocarbon and industrial gases. Through its BioMedical segment, it supplies cryogenic and other equipment used in the medical, biological research and animal breeding industries. The Company, through Thermax, Inc., provides cryogenic fluid vaporizers utilized in industrial gas, petro-chemical and liquefied natural gas applications.

BofI Holding, Inc. (BofI) is the holding company for BofI Federal Bank (the Bank). The Bank is a diversified financial services company. The Bank provides consumer and business banking products through its branchless, distribution channels and affinity partners. The Bank has deposit and loan customers across the nation, including consumer and business checking, savings and time deposit accounts and financing for single family and multifamily residential properties, small-to-medium size businesses in target sectors, and selected specialty finance receivables. The Bank distributes its deposit products through a range of retail distribution channels, and its deposits consist of demand, savings and time deposits accounts. The Bank distributes its loan products through its retail, correspondent and wholesale channels, and the loans the Bank retains are primarily first mortgages secured by single family real property and by multifamily real property.

Heritage Insurance Holdings, Inc. (Heritage Insurance), formerly Heritage Insurance Holdings, LLC, is a property and casualty insurance holding company. The Company is engaged in providing personal and commercial residential insurance. Through Its subsidiary, Heritage Property & Casualty Insurance Company (Heritage P&C), it provides personal residential insurance for single-family homeowners and condominium owners, rental property insurance and commercial residential insurance in the state of Florida. The Company is vertically integrated and control or manage all aspects of insurance underwriting, actulato analysis, distribution and claims processing, and adjusting. It has approximately 207,000 personal residential policies in force and approximately 2,400 commercial residential policies in force.

Sanderson Farms, Inc. is a poultry processing company which is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared chicken items. In addition, the Company is engaged in the processing, marketing and distribution of prepared chicken through its wholly owned subsidiary, Sanderson Farms, Inc. (Foods Division). It produces a range of processed chicken products and prepared chicken items. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, and casual dining operators in the south-eastern, south-western, north-eastern and western United States and to customers who resell frozen chicken into export markets. During the fiscal year ended October 31, 2013 (fiscal 2013), it processed 452 million chickens, or over 3.0 billion dressed pounds.

WisdomTree Investments, Inc. is an asset management company that focuses on exchange-traded funds (ETFs). The Company's family of ETFs includes fundamentally weighted funds that track its own indexes, funds that track third party indexes and actively managed funds. The Company distributes its ETFs through all major channels within the asset management industry, including brokerage firms, registered investment advisers, institutional investors, private wealth managers and discount brokers. Most of its index-based funds employ a fundamental weighted investment methodology, which weights securities on the basis of factors, such as dividends or earnings, whereas most other ETF industry indexes use a capitalization weighted methodology. In addition, it also offers actively managed ETFs, which are ETFs that are not-based on a particular index but rather are actively managed with complete transparency into the ETF's portfolio on a daily basis.

The Travelers Companies, Inc. is a holding company. Through its subsidiaries, the Company is engaged in providing a range of commercial and personal property and casualty insurance products and services to businesses, Government units, associations and individuals. The Company has three operating segments: Business and International Insurance segment, Bond & Specialty Insurance segment and the Personal Insurance segment. Business and International Insurance segment offers a range of property and casualty insurance and insurance related services to its customers, primarily in the United States, as well as in Canada, the United Kingdom, the Republic of Ireland and throughout other parts of the world. Bond & Specialty Insurance segment provides surety, crime, management and professional liability coverages, and related risk management services. Personal Insurance segment includes a range of property and casualty insurance covering individuals' personal risks.

Zumiez Inc. is a multi-channel specialty retailer of apparel, footwear, accessories and hardgoods. As of January 31, 2015, the Company operated 603 stores; 550 in the United States, 35 in Canada and 18 in Europe. The Company operates under the names Zumiez and Blue Tomato. Additionally, it operates e-commerce websites at www.zumiez.com and www.bluetomato.com. In apparel the Company offers t-shirts; baseball tees; hoodies and sweatshirts; tank tops; shorts; board shorts; joggers; shirts; jackets; jeans and pants; sweaters, and snow outerwear. The Company offers accessories, including hats, socks, watches, sunglasses, jewelry, backpacks, beanies, belts, wallets, underwear and bags. In addition it also offers cameras and tech; headphones; home; travel gear; hacky sacks; shoe laces; digital video discs (DVDs), scarves and gloves.

Marcus & Millichap, Inc. is a brokerage firm specializing in commercial real estate investment sales, financing, research and advisory services. The Company also offers market research, consulting and advisory services to developers, lenders, owners and investors. It also offers two services to its clients: commercial real estate investment brokerage and financing. The Company divides the commercial real estate market into three segments by investment: Private client segment, which include properties with prices under $10 million; Hybrid segment, which include properties with prices equal to or over $10 million and less than $20 million, and Institutional segment, which include properties with prices of $20 million and above. As of December 31, 2014, the Company had nearly 1,500 investment sales and financing professionals in 78 offices in the United States and Canada that provide investment brokerage and financing services to sellers and buyers of commercial real estate.

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.