|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||September 18, 2009|
After a lengthy period in which "good" news simply meant signs that economic activity was declining less quickly than it was before, we've now had several consecutive weeks in which the economic data has been genuinely improving.
Over the past fortnight, one of those data points involved industrial production. According to a new report from the Federal Reserve, industrial production jumped a higher-than-expected 0.8% in August. In addition, the Fed revised its July figures upward, from a 0.5% gain to a 1.0% gain. It marks the first time since late 2007 that industrial production has increased in back-to-back months, and the increases are the largest back-to-back gains since late 2005.
Following the encouraging manufacturing report that came in earlier this month -- which indicated that the U.S. manufacturing sector expanded in August for the first time in a year-and-a-half -- recent regional manufacturing reports are also coming in strong. The New York Federal Reserve reported this week that its measure of general business conditions rose more than 50% in September, reaching its highest level since November 2007. And the Philadelphia Federal Reserve reported that its manufacturing index more than tripled in September, marking the second straight month the index has indicated an expansion in the region.
The bad news: The Philadelphia data also showed that the prices manufacturers are paying to obtain materials is rising, while the prices they're receiving for their goods are plunging, a cause for concern.
There are other reasons to keep from getting too excited about the economy's early-stage rebound. The jobless rate -- though it is a lagging economic indicator -- remains troublingly high. The latest unemployment report from the government showed that the jobless rate rose in August to 9.7%, up from 9.4%, and that doesn't include people who have given up looking for jobs. With consumer spending making up two-thirds of the U.S. economy, a high jobless rate may be a barrier to a more robust recovery.
The job losses are lessening, however, according to the Labor Department's latest figures. About 216,000 jobs were lost in August -- the fewest in a year. But overall, the employment picture remains weak.
Housing data, meanwhile, has improved markedly in recent months -- something Warren Buffett cited this week in saying that the economy has leveled out. But the data released over the past two weeks was more mixed. Applications for building permits rose 2.7% in August, while housing starts rose 1.5%. But the increases were largely due to major gains in the multi-family homes category, which can be quite volatile, observers noted, making the long-term significance of the gains unclear.
Overall, however, the news was generally encouraging over the past two weeks -- Fed Chairman Ben Bernanke even said it is now likely that the recession is over. Another example of positive data: Retail sales surged 2.7% in August, the government reported, representing the biggest increase in some three years. And while a chunk of that increase was due to the government's "Cash for Clunkers" program, retail sales still jumped 1.1% excluding the auto rebate program -- almost three times what analysts had expected, the Associated Press reported.
In light of the upbeat economic news, stocks resumed their rise, which had been briefly interrupted in late August and early September. Since our last newsletter, the S&P 500 has gained 6.2%, while the Hot List has jumped 7.9%. For the year, the portfolio is now up 42.0%, far ahead of the S&P's 18.0% gain. And since its inception more than six years ago, the Hot List is up 132.8%, while the S&P has gained a mere 6.5%.
Stock Picking in The New Normal
As the economy continues to recover from one of the worst recessions in history, one term that has been popping up like wildfire is "the new normal". A number of strategists -- including some who are quite good at what they do, like PIMCO's Bill Gross and Mohamed El-Erian, as well as John Mauldin -- say that we're entering a new era, one in which the end of corporate and personal overleveraging will lead to slower-than-accustomed consumer spending and profit growth -- and, therefore, lower stock returns.
Whether they are right remains to be seen. While the "new normal" crowd's arguments can be persuasive, the U.S. economy and stock market have proven to be remarkably resilient over the past 200-plus years. Many times before investors have uttered the phrase "this time it's different", and many times they've been proven wrong as long-term trends reasserted themselves -- the late, great Sir John Templeton actually called that phrase "the four most dangerous words in investing".
What's crucial to remember here, however, is that the "new normal" that these strategists discuss is a reference to the broader economy and the broader stock market -- not individual companies or stocks. And, whatever the broader economy and market landscapes look like as we move forward, you can bet that there will still be plenty of companies that make plenty of money for their shareholders.
The trick, of course, is separating the companies that can do that from those that will fall by the wayside -- a process that is important in any environment, but which becomes critical in one in which growth is at a premium. Fortunately, that's exactly what my Guru Strategies are designed to do.
The approaches developed by the gurus aren't designed to snatch up hot stocks and ride waves of investor euphoria during good times. They are designed to search deep into companies' balance sheets and income statements, find the best companies out there, and buy their stocks when the price is right. And during what could be termed "stock-picker" environments, they have a good track record.
Take, for example, the bull market of 2002-2007. That rally began in October 2002, and by the end of 2003 the S&P 500 had surged almost 45%. In the ensuing years, however, the bull was much more subdued, with the S&P gaining 9% in 2004, 3% in 2005, 13.6% in 2006, and just 3.5% in 2007. That meant that from 2004 through 2007, the S&P gained an average of 7.3%, producing a total compound return of 32.0%. While those are decent profits, they're far from runaway gains.
The Hot List, in contrast, gained 23.5% in 2004, 14.5% in 2005, and 28.5% in 2006, before sustaining an 11.6% loss in 2007. That makes for an annualized gain of 12.6%, and a compound return of a little over 60%, nearly doubling the compound return of the S&P during that period of lower-than-average gains for the broader market.
Is the new normal that Gross and others are predicting really ahead of us? I don't know for sure. But if it is, and growth really does become harder to come by, one group that could feel the effects is index fund investors. Index funds do, of course, have some great benefits, including low fees and low levels of effort in terms of maintaining a portfolio. But if a new normal of lower growth does set in, such broader indexes likely won't produce the kind of returns many investors are used to.
If they are willing to take on a bit of extra risk and put in a bit of extra effort, however, I believe investors will be able to find plenty of opportunities even if such a new normal does set in. To do so, a disciplined, thorough approach to stock-picking will be required, one that looks deep into companies' balance sheets and fundamentals to find the firms that are likely to thrive while others struggle. That's just what the strategies that make up the Hot List are designed to do, which is why I'm confident the portfolio will continue to generate strong returns even if the "new normal" many envision becomes a reality.
Guru Spotlight: Peter Lynch
Picking the greatest mutual 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.
Lynch's fame goes beyond his success in the market. His quick wit and "everyman" approach have made him a favorite in the media, long since he retired nearly two decades ago. But make no mistake: Much like Warren Buffett, Lynch's true appeal comes not from his sense of humor or ability to relate to the average period -- it comes from that impeccable track record.
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
While Lynch applied different criteria to his different stock categories, the PEG wasn't the only criterion he applied to all stocks. He also made an astute observation about inventory, which can be applied not only to fast-growers but other firms as well. He viewed it as a red flag when inventory increased more quickly than its sales. (Inventory piling up indicates the products aren't as in-demand as the company had hoped.) My Lynch-based model thus likes the inventory/sales ratio to stay the same or decrease from year to year, but will allow for an increase of up to 5 percentage points if all other financials are in order.
Another crucial variable Lynch applied to all categories of stocks: the debt/equity ratio. He liked firms to be conservatively financed, and the model I base on his writings requires firms to have debt/equity ratios no greater than 80 percent.
There is an exception to this test, however: For financial firms, debt is often a required part of business. Recognizing this, Lynch didn't apply the debt/equity ratio to financials. Instead, he looks at how a company's equity compares to its assets for a sign of financial health, and at how much of a return it is generating on those assets for a sign of its profitability.
The model I base on Lynch's writings calls for financial firms to have an equity/assets ratio of at least 5 percent, and a return on assets of at least 1 percent.
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.
Using these fundamental tests, the Validea Lynch-based portfolio has put together a strong track record. Since its inception more than six years ago, it has gained 81.1% percent, while the S&P 500 has gained just 6.5%. The portfolio really excelled in 2003, 2004, 2005, and 2006, before stumbling on tough times in 2007 and 2008, along with the rest of the market. But it has had an exceptional 2009, gaining 47.2%, more than doubling the S&P 500's return for the year.
Now, here's a look at the stocks that currently make up my 10-stock Lynch-based portfolio:
Molina Healthcare, Inc. (MOH)
China Digital TV Holding Co., Ltd. (STV)
Nasdaq QMX Group, Inc. (NDAQ)
Humana Inc. (HUM)
Comtech Telecommunications Corp. (CMTL)
SonoSite, Inc. (SONO)
Administaff, Inc. (ASF)
Amerigroup Corporation (AGP)
Energy Recovery, Inc. (ERII)
Discover Financial Services (DFS)
The Stomach's The Key
While it's not a quantitative factor, there is another part of Lynch's strategy that was a critical part of his success: Don't bail when things get bad.
Lynch recognized that the stock market was unpredictable in the short term, even to the smartest investors. In fact, he once said in an interview with American television station PBS that putting money into stocks and counting on having nice profits in a year or two is like "just like betting on red or black at the casino. ... What the market's going to do in one or two years, you don't know."
Over the long-term, however, good stocks rise like no other investment vehicle, something Lynch recognized. His philosophy: Use a proven strategy and stay in the market for the long term and you'll realize those gains; jump in and out and there's a good chance that you'll miss out on a chunk of them.
That, of course, is particularly hard to do at times like this, when the market has plummeted. But the fear and anxiety investors feel after such a plunge make it more important than ever to heed Lynch's advice: "The real key to making money in stocks," he once said, "is not to get scared out of them."
News about Validea Hot List Stocks
General Dynamics (GD): The Air Force has awarded a contract worth almost $50 million to a unit of General Dynamics for specialized research on several programs related to survivability, the Associated Press reported on Sept. 15. GD will conduct research and use advanced state-of-the-art material technologies or applications in several programs areas, the government said. AP also reported on the same day that General Dynamics received at least five other military contracts totaling at least $54.6 million.
Chevron Corp. (CVX): On Sept. 16, Chevron announced Korea Gas Corp. has agreed to buy 1.5 million tons of liquefied natural gas a year from Chevron over 15 years -- the largest long-term LNG deal ever signed between Australia and South Korea, the Associated Press reported. The gas will come from the Gorgon gas field, which Chevron and joint venture partners ExxonMobil Corp. and Royal Dutch Shell recently announced will be developed off the northwest Australian coast, according to AP. The price of the deal was not announced, but Australian Broadcasting Corp. radio reported an estimated price of 30 billion Australian dollars ($26 billion), AP stated.
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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