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Executive Summary | Portfolio | Guru Analysis | Watch List |
| Executive Summary | April 29, 2011 |
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The Economy
The U.S. economy is continuing its recovery, though some of the past week's economic reports show that it's having to push through some significant headwinds. One of those reports came from the Commerce Department, which said that gross domestic product grew just 1.8% in the first quarter, slowing significantly from the 3.1% pace seen in last year's fourth quarter. A big piece of the slowdown in growth was a slowdown in consumer spending, which, after rising 4.0% in the fourth quarter of last year, increased 2.7% in the first quarter. Still, the decline was more of a reflection of the prior quarter's strength than the first quarter's weakness -- the 2.7% gain was better than every other quarter of the recovery so far. Other factors contributing to the slowdown were an upturn in imports and a sharp decline in government spending, which was down more than 5% from the previous quarter. The big rise in oil prices during the first quarter no doubt had an effect on GDP, and it led to significant inflation. The price index for gross domestic purchases (which reflects the prices U.S. consumers pay) rose 3.8% in the first quarter, the sharpest increase since the financial crisis hit. Excluding food and energy, prices rose 2.2%. Another somewhat disappointing report came from the Labor Department, which said that new applications for unemployment rose about 6% in the most recent week (ending April 23), reaching their highest level in three months. Still, new claims are some 35% below their recession-era highs. There's been positive news in the past couple weeks, too. Industrial production increased 0.8% in March, for example, according to the latest figures from the Federal Reserve, and reached its highest point since the Lehman Brothers collapse and financial market implosion in the fall of 2008. Regional manufacturing reports for April, meanwhile, have generally been solid. The New York Federal Reserve's index showed that manufacturing activity expanded at an accelerating pace in New York, with the April reading marking the index's highest point in a year. The Federal Reserve Bank of Philadelphia said its index, which covers parts of New Jersey, Pennsylvania, and Delaware, showed expansion for the month, but at a much slower pace than in March. That may be more of a reflection on the strength of the March numbers, which were the highest in 27 years, than an indication of weakness in April, however. The Kansas City Fed, which covers several Midwestern states, and Richmond Fed, which covers several mid-Atlantic and Southern states, also both reported slowdowns in manufacturing growth in April, but still remained comfortably in expansion territory. The housing market, meanwhile, continues to struggle. Both a 10-city and 20-city indices of home prices fell 0.2% in February, according to the S&P/Case-Shiller Home Price Indices. The 20-city index was down 3.3% over the past year, and the 10-city index was down 2.6%. The 20-city index is just about at its April 2009 trough level, and the 10-city is 1.5% above its low. Preliminary March figures from the National Association of Realtors were more encouraging, however. The group said existing-home sales bounced back from a disappointing February, rising 3.7% in March. And the median price of those homes rose 2.2%. Finally, a few big pieces of news came from the Federal Reserve this week. First, the Fed announced that it would end its $600 billion bond-purchasing "QE2" program in June, as expected. Then, in the first-ever press conference held by a Federal Reserve Chairman after a Federal Open Market Committee meeting, Ben Bernanke said the Fed will nevertheless continue monetary policy easing efforts going forward after June. That commitment to a loose money policy -- at least in the short term -- has kept the dollar falling in recent weeks, as expectations of significant inflation are growing. As for the markets, since our last newsletter, the S&P 500 returned 3.5%, while the Hot List returned 2.3%. So far in 2011, the portfolio is up 12.4% vs. 8.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 203.3% vs. the S&P's 36.0% gain. Staying Disciplined -- In Good Times and Bad Despite all of the economic challenges the U.S. is dealing with, stocks have continued their strong performance in the first four months of 2011, pushed higher by the resilience of the economy and the low-interest-rate environment the Federal Reserve continues to provide. The Hot List has fared even better, picking up a number of bargains that have netted big gains in relatively short periods. Oil services firm Atwood Oceanics gained 17.7% during a one-month stint in the portfolio; Tractor Supply Company jumped 18.1% in its one-month stay; and current holdings Sanofi-Aventis and OpenTable are up about 18% and 23%, respectively, in their brief month-and-a-half-long stints in the portfolio (through Wednesday). The Hot List's strong start to 2011 has pushed its long-term track record even further ahead of the S&P 500. Since its July 2003 inception, the portfolio has now averaged annualized gains of 15.6%, during a period in which the S&P 500 has gained just 4.0% per year (through Wednesday). The strong year-to-date performance has been nice, but this week I'd like to talk a little about what happens when things don't go so well. And, if you're investing in the stock market, there will be times when things don't go well. Even the greatest investors in the world have all had market-lagging years, and years when they've flat out lost a lot of money. Peter Lynch, for example, compiled one of the greatest fund-management track records of all time at Fidelity, beating the S&P by about 14 percentage points per year over a 13-year period. But in 1981, his Magellan fund got walloped, losing 22.6% while the S&P lost just 5%. Warren Buffett's Berkshire Hathaway has crushed the S&P over the past four decades or so, but it, too, has had years when it lagged by a wide margin. In 1999, its shares fell nearly 20% while the S&P gained 21%. That's a 41-percentage-point underperformance by the man who is perhaps the greatest investor in history. John Neff, meanwhile, beat the S&P by an average of more than 3 percentage points over a three-decade period while heading the Windsor Fund, a remarkable long-term track record. But he, too, had years when he fell far behind the broader market -- like 1989, when Windsor gained 15% and the S&P rose more than 31%. The Hot List is no different. While its performance this year and over the long term have both been excellent, it hasn't been perfect. Last year it lagged slightly, and back in 2007 it lost 11.6% while the S&P rose 3.5%. But after those years, we continued to stick to a disciplined stock-picking approach -- a lesson that many of the gurus I follow preached -- and it paid off. In the next two years after 2007, the portfolio outperformed the S&P by nearly 20 percentage points, making up all the ground it had lost in 2007, and more. And after lagging slightly last year, we stayed disciplined, and the portfolio has so far quickly wiped out the slight lead the S&P had on it in 2010. Discipline is so crucial because no strategy -- even one as successful as the Hot List -- will beat the market every year. Part of the reason is that there are simply too many factors that go into stock prices to come up with an approach that will win in every climate. But part is because logically, it just can't happen. To understand what I mean, let's turn to Joel Greenblatt, whose Little Book that Beats the Market is the basis for one of my best-performing Guru Strategies. Greenblatt's "magic formula" crushed the market over a 17-year period, but he is quick to point out that it had many years -- and even back-to-back-to-back years -- when it lagged. And that's what happens -- what has to happen -- with a good strategy, he says. "If the magic formula worked all the time, everyone would probably use it," he explains. "If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain-prices stocks selected by the magic formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the magic formula would be ruined!" Instead, what happens is that good strategies have bad years, and many investors lack the discipline to stick with them, and bail on the approach. That leaves good stocks on sale at bargain prices, and disciplined investors can snatch them up. And, eventually, the market realizes the bargains that exist, and many of the stocks take off. Those who stuck with the strategy during the down year(s) often end up quickly making up any ground they'd lost. That's what happened with the Hot List after 2007, and, so far, it's what we're seeing after 2010. The bottom line is that, whatever the Hot List does in the coming months, we'll keep on managing the portfolio with the same disciplined approach we always have. Hopefully, that will mean continued gains and outperformance in the remaining two-thirds of 2011. But even if it doesn't, I'm confident that this disciplined approach will continue to yield excellent results over the longer term. |
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Guru Spotlight: James O'Shaughnessy To say that James O'Shaughnessy has written the book on quantitative investing strategies might be an exaggeration -- but not much of one. Over the years, O'Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor's Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds. In addition to finding out how certain strategies had performed in terms of returns over the long term, O'Shaughnessy's study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns -- what he called his "United Cornerstone" strategy. The United Cornerstone approach, the basis for my O'Shaughnessy-based Guru Strategy, is actually a combination of two separate models that O'Shaughnessy tested, one growth-focused and one value-focused. His growth method -- "Cornerstone Growth" -- produced better returns than his "Cornerstone Value" approach, and was a little more risky. The Cornerstone Value strategy, meanwhile, produced returns that were a bit lower, but with less volatility. Together, they formed an exceptional one-two punch, averaging a compound return of 17.1 percent from 1954 through 1996, easily beating the S&P 500s 11.5 percent compound return during that time while maintaining relatively low levels of risk. That 5.6 percent spread is enormous when compounded over 42 years: If you'd invested $10,000 using the United Cornerstone approach on the first day of the period covered by O'Shaughnessy's study, you'd have had almost $7.6 million by the end of 1996 -- more than $6.6 million more than you'd have ended up with if you'd invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not -- as efficient market believers suggest -- move in a "random walk," but instead, as O'Shaughnessy writes, with a "purposeful stride." Two-In-One Let's start with O'Shaughnessy's value stock strategy. His Cornerstone Value approach targeted "market leaders" -- large, well-known firms with sales well above those of the average company -- because he found that these firms' stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch -- should hold some value stocks. To find these firms, O'Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean. Size and market position weren't enough to make a value stock attractive for O'Shaughnessy, however. Another key factor that was a great predictor of a stock's future, he found, was cash flow. My O'Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average. O'Shaughnessy found that, when it came to market leaders, another criterion was even more important than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks); large market-leaders with high dividends tended to outperform during bull markets, and didn't fall as far as other stocks during bear markets. The Cornerstone Value model takes all of the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval. The Cornerstone Growth approach, meanwhile, isn't strictly a growth approach. That's because one of the interesting things O'Shaughnessy found in his back-testing was that all of the successful strategies he studied -- even growth approaches -- included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O'Shaughnessy found -- much to the surprise of Wall Street -- was the single best indication of a stock's value, and predictor of its future. The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company's last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period. The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O'Shaughnessy, is the combination of high relative strengths and low P/S ratios. By targeting stocks with high relative strengths, you're looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive. "This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings," O'Shaughnessy wrote, referring to some of history's well-known momentum-driven, overpriced stocks. "It forces you to buy stocks just when the market realizes the companies have been overlooked." To apply the RS criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, P/S ratio) and ranks them by RS. The top 50 stocks then get final approval. The Growth/Value Investor model I base on O'Shaughnessy's two-pronged approach has been a very solid performer since its inception back in 2003, with my 10-stock O'Shaughnessy-based portfolio gaining 121.8% (10.8% annualized) since inception, while the S&P 500 has gained just 35.5% (4.0% annualized; figures through April 27). The O'Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction, meaning the portion of the portfolio made up of growth and value stocks can vary over time. As it has for some time now, the portfolio is currently finding more buys using the growth approach, which is responsible for picking eight of the stocks in the 10-stock portfolio. It's also finding a lot of strong picks in two areas in particular: retail and healthcare. Here's a look at the portfolio's holdings (growth/value distinction in parentheses): ROST -- Ross Stores, Inc. (Growth) HS -- HealthSpring, Inc. (Growth) TJX -- The TJX Companies, Inc. (Growth) INT -- World Fuel Services Corporation (Growth) SNY -- Sanofi-Aventis SA (Value) AZN -- AstraZeneca PLC (Value) HOGS -- Zhongpin Inc. (Growth) CHSI -- Catalyst Health Solutions, Inc. (Growth) AAP -- Advance Auto Parts, Inc. (Growth) BIG -- Big Lots, Inc. (Growth) Not Just Numbers O'Shaughnessy is a pure quant, but you should be aware that some of his most critical lessons are less about specific criteria and numbers than they are about the general mindset an investor must have. Perhaps more than anything else, O'Shaughnessy believes in picking a good strategy and sticking with it -- no matter what. In What Works on Wall Street, he writes that in order to beat the market, it is crucial that you stay disciplined: "[C]onsistently, patiently, and slavishly stick with a strategy, even when it's performing poorly relative to other methods." The reason involved human emotions, which cause many investors to bail on a good approach and jump onto hot stocks or strategies that are often overhyped and overpriced. "We are a bundle of inconsistencies," he writes, "and while that may make us interesting, it plays havoc with our ability to invest our money successfully. Disciplined implementation of active strategies is the key to performance." Wise words, whether you follow O'Shaughnessy's approach or another proven method. News about Validea Hot List Stocks Pre-Paid Legal Services (PPD): Pre-Paid announced first-quarter net income of $16.8 million, or $1.72 per diluted share, down from $18.8 million, or $1.87 per diluted share, in the year-ago quarter. Membership revenues fell 4% to $102.5 million. Skechers USA Inc. (SKX): Skechers announced first-quarter net income of $11.8 million, or 24 cents per share, down from $56.3 million, or $1.15 per share, in the year-ago period. Revenue fell 3 percent to $476.2 million. Weakening demand for the firm's toning shoes were a reason for the declines, the Associated Press reported, adding that analysts had expected earnings of 31 cents per share, according to FactSet, on revenue of $465.2 million. Shares fell 7.5% Wednesday on the news, but the stock was still in the black since being added to the portfolio last month. 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. |
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