Executive Summary  |   Portfolio  |   Guru Analysis  |   Watch List

Executive Summary November 21, 2014

The Economy

After several weeks of very strong economic data, the news was more mixed over the past fortnight. But overall, the economy appears to be relatively healthy and continuing to improve.

New government data, for example, supported the solid ADP jobs data we discussed last newsletter. The Labor Department said the private sector added 209,000 jobs in October, with total nonfarm payrolls rising by 214,000. It also revised its August and September jobs-added figures to indicate a total of 31,000 more jobs were added in those months than previously thought. The unemployment rate fell to 5.8% in October, the lowest it has been since July 2008; the broader "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) fell three-tenths of a point to 11.5%, the lowest it has been since September 2008. The number of people not in the labor force also declined by more than 200,000.

New claims for unemployment, which had been falling to levels not seen in nearly a decade-and-a-half, rose slightly over the past couple weeks. But despite the minor increase, new claims remain about 13% below year-ago levels. Continuing claims are 19% below where they stood a year ago, and are at their lowest level since 2000.

Industrial production slipped 0.1% in October, meanwhile, according to a new Federal Reserve report. Manufacturing output rose 0.2%, the Fed said, but mining output fell 0.9% as oil prices continued to fall, impacting US oil shale operations. Utility output, which tends to be seasonally driven, also fell, declining 0.7%.

Housing starts fell slightly, by 2.8%, in October, according to the Census Bureau. They still stand 7.7% above year-ago levels, however. Permit issuance for new construction rose 4.8%, meanwhile, putting it about 2.7% above its year-ago pace.

Retail sales bounced back from a September decline, rising 0.3% in October, according to another government report. They are a solid 4.6% above year-ago levels.

Elsewhere, inflation was flat in October, according to the Labor Department. That put it just 1.7% ahead of its year-ago pace. Part of the reason is gas prices, which continue to deflate. As of Nov. 19, the price for a gallon of regular unleaded was just $2.86, according to AAA. That's down 25 cents over the past month. If you strip out food and gas prices, so-called core inflation was up 0.2% in October, however, according to the Labor Department.

Since our last newsletter, the S&P 500 returned 1.1%, while the Hot List returned 0.2%. So far in 2014, the portfolio has returned -12.5% vs. 11.1% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 218.5% vs. the S&P's 105.2% gain.

Staying Active

While 2014 has thus far turned out to be another good -- albeit very choppy -- year for stocks, it's been another rough one for mutual fund managers. As of late October, more than 75% of large-cap funds were lagging their benchmarks, according to Bloomberg (citing Morningstar data). Nearly 90% of mid-cap funds lagged their benchmarks, meanwhile, and about half of small-cap funds lagged theirs.

That's nothing new, of course. Numerous studies show that the vast majority of mutual funds fail to beat their benchmarks over the long term. Part of that is because of fees and trading costs. Part of it is due to plain old bad management -- buying high and selling low.

Of course, individuals don't do any better. I've often cited in these pages the data from Dalbar, Inc., which shows how individual investors continually underperform the broader market because they fall prey to the same behavioral biases that trip up the pros.

Given how much data shows that pros and amateurs alike fail to outperform the major benchmark indices, should anyone practice active management anymore? Or is passive index investing the only real way to go?

Well, I certainly believe that active management can be a very successful approach -- if it's truly active. The numbers bear that out.

Consider a study that Patrick O'Shaughnessy (the son of James O'Shaughnessy, one of the gurus upon whose writings I base my strategies) recently highlighted in a piece for the American Association of Individual Investors. "A study by Yale professor Martijn Cremers and BlackRock portfolio manager Antti Petajisto showed that being different is the way to win," he wrote. "They concluded that the best way to predict how a fund manager would perform is to look at how unique their portfolio is versus the index; the more unique, the higher the average excess returns. The authors coined the term 'active share' to measure a portfolio's uniqueness. Active share is a score between 0 and 100: A score of 100 means that the portfolio is entirely different than the index (no overlap in holdings), whereas a score of 0 indicates an index fund, meaning the fund has perfect holdings overlap with the market. The authors found that even though the average manager loses to the index, those with the highest active share (top 20%) have historically outperformed by 2.4% before fees and 1.13% after fees. The message is clear: If you want to beat an index, you have to be very different than the index."

It makes sense. On a gross return basis, a "closet indexer" -- a fund or portfolio that largely mirrors its benchmark's holdings -- should perform like the benchmark index, because their holdings are so similar. Factor in fees and trading costs, and their net returns are likely to lag those of the benchmark. To offset the fees and costs, a fund has to beat a benchmark on a gross basis, and to beat it, the fund has to be different from it. (If you're managing your own portfolio, you don't have to deal with management fees, but trading costs can certainly still be a drag on performance. So if you are "closet indexing", with your portfolio, the same logic holds.)

The outperformance of funds with high active share also makes sense on an intuitive level because stocks that aren't in the major benchmark indices tend to be flying under the radar and getting a lot less attention from Wall Street than those that aren't in the major benchmarks. That means such stocks provide opportunities for significant mispricings, and fundamental-focused investors can exploit those inefficiencies.

So, what is the Hot List's active share rate? Currently, it's quite high. Only one of its holdings -- Valero Energy -- is a member of the S&P 500, the benchmark we use.

To see if this is typical or anomalous, I looked at what the portfolio's active share percentage has been at a few different points over the past couple years. I found that, while our active share at times has been lower than its current level, it has generally been quite high: Six months ago, in May 2014, four of the Hot List's ten holdings were in the S&P 500; six months prior to that, in November 2013, only one of the ten was in the S&P; and six months before that, in May 2013, only three of its ten holdings were S&P members.

Given that my models often key on smaller and mid-cap stocks (as I discussed in one of last month's newsletters), I thought it would be interesting to also see how the Hot List's active share score looks when using the Russell 2000 index (which is composed of 2,000 smaller US stocks) as a benchmark. While the portfolio's active share doesn't appear quite as high on that basis, it is still pretty high: On average, only four of the Hot List's ten holdings were Russell 2000 members in those same four months that I examined above.

Size Matters

When it comes to constructing a portfolio that's different from a benchmark, size can certainly play a big role. The more holdings you have, the more likely it is that your returns are going to start to resemble broader market indices. Mutual funds that hold several hundred stocks must start to look quite a bit like their benchmarks.

Because it only holds 10 stocks, that's not an issue for the Hot List. But in a concentrated portfolio with high active share, the difficulty is that your returns fairly often will veer quite sharply from the broader market or your benchmark -- and not always in a positive way. That's been the case with the Hot List this year. In such times, you can't take solace in the idea that, "Well, it's been a tough stretch for everyone," the way that you could if you were closet indexing and your benchmark was down a lot, too.

We don't have a problem with that. After years of studying history's best investors and all sorts of academic research, we are confident that a concentrated portfolio of 10 stocks can do very well over the long haul, with the price being that there will be a lot of short-term ups and downs. Given the rewards, we are content to pay that price. (Incidentally, recent research from Patrick O'Shaughnessy supported this belief. He took a look at how different sized portfolios of the cheapest value stocks would have fared over the past 50 years or so. O'Shaughnessy found that the best returns came from a five-stock portfolio; the best risk-adjusted returns came from a 15-stock portfolio.)

It's important to remember, however, that most investors probably don't have the stomach to deal with concentrated funds with high active share. Joel Greenblatt, another of the gurus upon whom I base a strategy, told WealthTrack last week that he abandoned a highly concentrated approach that had been extremely successful for him for one that involves investing in a few hundred stocks on the long side and a few hundred stocks on the short side. The reason: Most clients just can't handle big swings in performance that come with a concentrated portfolio, he said. They will bail on a good strategy if it is struggling in the short term, which defeats the purpose of following it to begin with. A broader portfolio decreases short-term volatility.

In the end, I think investors should focus on the best opportunities in the market based on fundamentals and financials. But it's not always as simple as loading up your portfolio with a small number of the most fundamentally and financially sound stocks. There's a real-world, practical aspect of investing that you have to deal with, too. Going after only the best of the best -- a very limited number of the absolute most fundamentally and financially sound stocks -- often means having high active share and returns that differ significantly from the market or a benchmark. You thus have to know yourself, to understand how much of the bad times you can handle and how you'll respond when things get tough. If you don't have good answers to those questions, the specific stock-picking strategy used may well become moot. As Greenblatt so wisely said, "The best strategy for most people is the one they can stick with."

Editor-in-Chief: John Reese

Have Your Portfolio Managed Using Validea's Investing System
Many users know about our research services but are unaware that money management services based on our system are also offered through a separate registered investment advisory firm, Validea Capital Management.

If you are thinking about switching advisors or no longer have the time or inclination to manage your investments yourself, find out more about Validea Capital, its portfolio offerings, and its performance below.
Request an Investment Consultation Today!

** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. The information above is not intended as personal investment advice and should not be interpreted as such.

The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Omnivision Technologies, Inc. (OVTI), Anika Therapeutics, Inc. (ANIK), Lannett Company, Inc. (LCI) and Monster Beverage Corp (MNST).

The Keepers

6 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Valero Energy Corporation (VLO), Credit Acceptance Corp. (CACC), Jones Lang Lasalle Inc (JLL), Zumiez Inc. (ZUMZ) and Amtrust Financial Services Inc (AFSI).

The Newbies

We are adding 4 stocks to the portfolio. These include: Middleby Corp (MIDD), Universal Insurance Holdings, Inc. (UVE), Foot Locker, Inc. (FL) and Piper Jaffray Companies (PJC).

Portfolio Changes

Newcomers to the Validea Hot List

Foot Locker (FL): This specialty athletic retailer operates nearly 3,500 stores in 23 countries in North America, Europe, Australia, and New Zealand, offering athletic footwear and apparel.

Foot Locker ($8 billion market cap) gets strong interest from my James O'Shaughnessy-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

Piper Jaffray Companies (PJR): Piper Jaffray is an investment bank and asset management firm serving corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The company operates in two segments: Capital Markets and Asset Management. It has a $900 million market cap.

Piper gets strong interest from my Peter Lynch-based model and high marks from several other strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

The Middleby Corporation (MIDD): This commercial cooking equipment manufacturer was a pretty amazing growth story 10 to 15 years ago -- from 1998 to late-2002, Middleby more than doubled its market share in the U.S. commercial cooking equipment market, from 11% to 26%, according to U.S. Business Review. That helped the stock become one of the best-performing stocks of the 2000s, with its shares jumping about 1,700%. Growth has slowed, of course, but it's still strong (23% over the long term), and my Warren Buffett-based model is high on the mid-cap ($5 billion). For more on Middleby, see the "Detailed Stock Analysis" section below.

Universal Insurance Holdings, Inc. (UVE): Universal is a vertically integrated insurance holding company involved in insurance underwriting, distribution and claims. Its subsidiaries offer homeowners insurance in Florida, North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland.

Universal ($650 million market cap) gets strong interest from my Motley Fool-based model, inspired by an approach outlined by Fool co-creators Tom and David Gardner. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

News about Validea Hot List Stocks

Monster Beverage Corp. (MNST): Monster reported third-quarter earnings of $121.6 million, or 70 cents per share, beating analyst expectations of 68 cents per share, the Associated Press reported. Monster said revenues were $636 million, short of the $641.7 million analysts expected. Shares jumped nearly 8% the day after the announcement. That may have been due to Credit Suisse raising the company's price target and EPS estimates, TheStreet.com reported. CS increased the price target for Monster to $115 from $98, and increased annual EPS estimates to $2.62 from $2.50 for fiscal 2014, $3.03 (from $2.95) for fiscal 2015, and $3.49 (from $3.46) for fiscal 2016, TheStreet said. Credit Suisse said it raised the estimates because of Monster's better than expected operating margins. Through Nov. 19, Monster shares were up 12.7% since joining the portfolio four weeks ago, and the Hot List is taking the profits and selling the stock on today's rebalancing.

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

VLO   |   JLL   |   UVE   |   ZUMZ   |   AFSI   |   CACC   |   FL   |   PJC   |   AGCO   |   MIDD   |  

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

Jones Lang LaSalle Incorporated (Jones Lang LaSalle), is a financial and professional services firm specializing in real estate. Jones Lang LaSalle has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries. The Company offers integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients. It delivers an array of Real Estate Services (RES) across its three geographic business segments: the Americas, Europe, Middle East and Africa (EMEA), and Asia Pacific. LaSalle Investment Management, a wholly owned member of the Jones Lang LaSalle group that consists of its fourth business segment, is a diversified real estate investment management company. In July 2014, Jones Lang LaSalle Inc acquired CLEO Construction Management (CLEO), a construction project management services firm that specializes in medical facilities.

Universal Insurance Holdings, Inc. (UIH) is a vertically integrated insurance company. The Company's insurance products are offered to the Company's customers through Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC), (collectively the Insurance Entities). Substantially all aspects of insurance underwriting, distribution and claims processing are covered through the Company's subsidiaries. Blue Atlantic Reinsurance Corporation (BARC), a wholly owned subsidiary of UIH, is a reinsurance intermediary broker. The Insurance Entities generate revenues primarily from the collection of premiums. Universal Risk Advisors, Inc. (URA), the Company's managing general agent, generates revenue through policy fee income and other administrative fees from the marketing of the Insurance Entities' insurance products through its distribution network of independent agents.

Zumiez Inc. (Zumiez) is a specialty retailer of action sports related apparel, footwear, equipment and accessories operating under the Zumiez brand name. As of January 28, 2012, the Company operated 434 stores in the United States and 10 stores in Canada. In addition, the Company operates a Website that sells merchandise online. At January 28, 2012, its stores averaged approximately 2,900 square feet. Its apparel offerings include tops, bottoms, outerwear and accessories, such as caps, bags and backpacks, belts, jewelry and sunglasses. Zumiez's footwear offerings primarily consist of action sports related athletic shoes and sandals. Its equipment offerings, or hardgoods, include skateboards, snowboards and ancillary gear, such as boots and bindings. The Company also offers a selection of other items, such as miscellaneous novelties.

Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four business segments: small commercial business, specialty program and personal lines reinsurance. The Company transacts business through 11 insurance company subsidiaries: Technology Insurance Company, Inc. (TIC), Rochdale Insurance Company (RIC), Wesco Insurance Company (WIC), Associated Industries Insurance Company, Inc. (AIIC), Milwaukee Casualty Insurance Company (MCIC), Security National Insurance Company (SNIC), AmTrust Insurance Company of Kansas, Inc. (AICK) and AmTrust Lloyd's Insurance Company of Texas (ALIC). In December 2013, the Company announced that it its wholly owned subsidiary completed the acquisition of Sagicor Europe Limited. In January 2014, the Company acquired Insco Dico Group.

Credit Acceptance Corporation (Credit Acceptance) is a provider of auto loans to consumers. The Company offers auto loans and related products and services to consumers through its network of Dealer-Partners. It refers to dealers who participate in the Company's programs as Dealer-Partners. Credit Acceptance has two programs: the Portfolio Program and the Purchase Program. Under the Portfolio Program, it advances money to Dealer-Partners (referred to as a Dealer Loan) in exchange for the right to service the underlying Consumer Loans. Under the Purchase Program, Credit Acceptance buys the Consumer Loans from the Dealer-Partners (referred to as a Purchased Loan) and keeps all amounts collected from the consumer. Dealer Loans and Purchased Loans are collectively referred to as Loans.

Foot Locker, Inc. is a global retailer of athletic shoes and apparel. As of August 02, 2014, the Company operated 3,460 stores, including 74 franchised stores. The Company operates in two segments. 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, Sidestep and Run2. The Direct-to-Customers segment operates the websites for eastbay.com, final-score.com, eastbayteamsales.com, ccs.com, as well as websites aligned with the brand names of its store banners (footlocker.com, ladyfootlocker.com, kidsfootlocker.com, champssports.com, footaction.com, and six02.com). Additionally, this segment includes the direct-to-customer subsidiary of Runners Point Group, which operates the websites for runnerspoint.com, sidestep-shoes.com, and sp24.com.

Piper Jaffray Companies is an investment bank and asset management firm, serving the needs of corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The Company operates in two segments: Capital Markets and Asset Management. The Capital Markets segment provides investment banking and institutional sales, trading and research services for various equity and fixed income products. The Asset Management segment includes traditional asset management activities and related services. The Company markets the investment banking and institutional securities business under Piper Jaffray name. Its asset management business is marketed under Advisory Research, Inc. In July 2013, Piper Jaffray Companies announced that it has completed its purchase of Seattle-Northwest Securities Corporation. In July 2013, the Company announced that it has completed its purchase of Edgeview Partners L.P.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

The Middleby Corporation (Middleby) through its operating subsidiary Middleby Marshall Inc. (Middleby Marshall) and its subsidiaries, is engaged in the design, manufacture, marketing, distribution, and service of a line of cooking and warming equipment used in all types of commercial restaurants and institutional kitchens, and food preparation, cooking and packaging equipment for food processing operations. The Company operates in two segments: the Commercial Foodservice Equipment Group and the Food Processing Equipment Group. In April 2014, Middleby Corporation acquired assets of Processing Equipment Solutions, Inc. In September 2014, Middleby Corporation acquires Concordia Coffee Company, Inc.

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.