|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||October 9, 2015|
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.
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.
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.
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:
MBIA Inc. (MBIA)
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)
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 email@example.com.
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