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Executive Summary April 15, 2011

The Economy

Rising fuel prices and the aftermath of the tragedy in Japan have dampened confidence, but they don't seem to have made a big impact on the U.S. economy, with activity continuing to expand across several sectors and the unemployment rate continuing to edge downward.

Since our last newsletter, the Institute for Supply Management reported that the manufacturing sector expanded in March for the 20th straight month despite all of the concerns about the Middle East and Japan. The rate of expansion was down fractionally from February, but still faster than any other month since May 2004.

The non-manufacturing (or service) sector also expanded again in March for the 16th consecutive month, according to ISM. That growth was reflected in the strong jobs data for March. The private sector added 230,000 jobs during the month, the Labor Department reported, with 199,000 coming from the service sector.

With employers stepping up their hiring -- in February, businesses posted the largest number of job openings since September 2008, other Labor Department data showed -- unemployment continues to edge lower, with the jobless rate falling from 8.9% to 8.8% in March. The rate has now declined in four straight months, falling a full percentage point from its November 2010 level. The broader, so-called "U-6" measure of unemployment (which, unlike the headline number, includes those who have given up looking for a job) also fell again in March. At 15.7%, it's now at its lowest point in two years, though still significantly higher than pre-recession levels.

With more Americans employed, consumer spending also keeps rising. Retail and food service sales rose 0.4% in March, according to the Commerce Department, the ninth straight month they've increased. The figure is 7.1% above its year-ago level, and 16% above the December 2008 recessionary low.

Overseas, things have continued to be more eventful than they've been at home. The ongoing turmoil in Libya has kept oil prices volatile, as they briefly climbed above $110 a barrel recently before dropping back down. Gas prices remain quite elevated, though reports this week that gas prices for the summer "will jump 40% " were misleading. Yes, the Energy Information Administration is expecting prices to be $3.86 on average in the U.S. for the April-September period, which is 40% above last summer's prices. But most of those gains have already occurred -- per-gallon gas prices averaged $3.79 as of April 11, according to the EIA. And in March, when consumers were still increasing their spending, prices were between $3.50 and $3.60 a gallon. That's not to say that rising gas prices aren't a threat to the economic recovery; just realize that the EIA is not forecasting a 40% increase on current gas prices this summer.

The Japan situation also continues to weigh on markets. The Japanese government this week raised its assessment of the severity of the nuclear problems, which is of course something that bears watching. It's still far too early to gauge what the overall damage to the country and its economy will be.

Also impacting the market have been interest rate hikes in Europe and in China. The Chinese government increased rates for the second time this year last week, and officials said it will likely make two more rate hikes in the second quarter. In Europe, meanwhile, where inflation has been climbing, the European Central Bank starting increasing rates this week. The latest U.S. inflation report is due out today, and it will be interesting to see if core inflation begins to accelerate. Food and gasoline prices have surged in recent months (though food prices finally declined in March for the first time since last June, according to the United Nations' Food and Agriculture Organization), but core inflation has remained moderate.

Overall for the fortnight, the S&P returned -0.9%, while the Hot List returned 3.3%. For the year, the portfolio stands at 9.8% vs. 4.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 196.4% vs. the S&P's 31.4% gain.

Stocks: Cheap, or Pricey?

If you're a regular Hot List reader, you know that the Guru Strategies that drive the Hot List portfolio tend to have a distinct value bias. Whether it's deep value strategies like my Benjamin Graham- and Warren Buffett-inspired models, or growth-oriented strategies that include key value components (like my Peter Lynch- or James O'Shaughnessy-based approaches), these methods put a major emphasis on the price you're paying for a stock.

The issue of value is one that's gotten quite a bit of attention lately, particularly when it comes to the broader market's overall valuation. As an asset class, are stocks cheap, or are they pricey? That's the question on many investors' minds, and, depending on whom you ask, you'll get some wildly divergent opinions.

Those on the "pricey" side of the debate include top value strategist Jeremy Grantham and Yale economist and noted bubble-spotter Robert Shiller. In January, with the S&P 500 trading fairly close to its current level, Grantham said that the index was about 40% overvalued.

While I don't believe Grantham has divulged the exact details of his fair-market calculation, one valuation metric he relies heavily on, according to a 2010 article in Advisor Perspectives, is one that has been popularized by Shiller (though it was actually pioneered by the late, great Benjamin Graham, one of the gurus upon whom I base my models). The variable goes by a number of different names -- the Shiller P/E, the 10-year P/E, the CAPE (Cyclically Adjusted P/E) -- but essentially it compares the S&P's price to its average earnings over the past ten years, with some adjustments for inflation. The theory: Comparing price to earnings for the past ten years smoothes out anomalous one-year earnings results that pop up in any given year. Shiller's latest calculations (which are available on his Yale web page) show that, as of the beginning of April, the 10-year P/E for the S&P was 23.47 -- some 45% or so above the long-term average of 16.

Others point to different numbers that paint a strikingly different picture. Wharton professor and author Jeremy Siegel, for example, said not long ago that stocks were still historically cheap. Based on 2011 earnings projections, he said, the S&P 500 was trading about 13% below where it would be with a modest 15 P/E multiple, according to Reuters. What's more, Siegel said that one must take interest rates into account when determining the market's value. During lower-interest-rate periods (when stocks have less competition from fixed-income assets), investors are willing to pay more for stocks -- he said that historically, if you exclude periods in which rates were above 8%, the average P/E for stocks is 19. That would mean the market was about 43% below average valuation.

Siegel and others say that, while looking at one year of earnings can be misleading, looking at 10 years' worth of earnings can also be misleading. In a recent New York Times article that looked at the Shiller P/E, Siegel said that keeping earnings from the financial crisis -- a "once-in-a-75-year event" -- in the assessment of the market's 10-year P/E "doesn't seem to be realistic."

So, two of the market's top minds offer staggeringly different views that stocks are either 45% overvalued, or 43% undervalued -- and we're only talking about earnings-related valuation metrics. There are, of course, other metrics, like the price/sales and price/book ratios, that can provide other takes on the market's valuation. Right now, according to Morningstar, the S&P 500's components on average are trading for 1.3 times sales, for example, not bad at all. That's actually below the 1.5 upper limit my James O'Shaughnessy-based model uses when examining individual stocks, and in the "good value" range my Kenneth Fisher-based model uses.

The S&P also appears reasonably valued if you use a metric that Peter Lynch used to analyze individual stocks: the P/E/Growth ratio. Using 2010 earnings, the S&P is currently trading for 15.7 times operating earnings, and 17.0 times as-reported earnings. Based on an average of the 3, 4 and 5 year EPS growth rates, the index's earnings grew at a 22% pace. For both operating and as-reported earnings, those figures make for a P/E/G below 1.0, which would be considered attractive by my Lynch-based model.

If we use the S&P 500's projected 2011 earnings, the P/E/Gs are also attractive. Using Standard & Poor's operating earnings projection of $96.99 for 2011, we get a P/E/G of 0.86; using S&P's as-reported earnings projection of $97.26, we get a P/E/G of 0.53. Both those figures would come in under the Lynch model's 1.0 target.

Of course, you could look at S&P earnings or sales from a variety of other periods to determine a P/E/G or a price/sales ratio -- three-year average earnings or sales, five-year average earnings or sales, etc. And, often, you'll find divergent stories of what the market's valuation is. To me, the bottom line is thus this: When it comes to analyzing the stock market's valuation, there's no one metric that you should always rely on, no silver bullet that will tell you just how cheap or expensive stocks are.

Oh, one more thing, just to further muddy the waters: Just because the broader market appears expensive doesn't mean it won't rise. For example, back in the early 1990s, the 10-year P/E climbed above 16 (its current historical average) just four months into a bull market that ended up lasting nearly a full decade. When it crossed that level, the S&P was priced around 372; if you'd sold out of stocks then, and waited to buy back in until the next time the 10-year P/E was below 16, you'd have had to wait until November 2008, when the index was at about 883. That's an annualized gain of about 5% per year that you'd have missed out on by shunning stocks (and certainly more than that if you'd picked good stocks) -- not great, but hardly the disastrous returns you might expect for a period when stocks were usually trading for between 20 and 45 times trailing 10-year earnings.

When it comes to individual stocks, there's also no silver valuation bullet. I believe that's part of what makes the Hot List so successful -- by using a dozen different proven strategies, it looks at a myriad of valuation measures, from P/E ratios to price/sales ratios to dividend yield to price/book ratios and beyond. In doing so, it offers a more comprehensive look at a stock's valuation.

Take, for example, Hot List newcomer AstraZeneca, which is being added to the portfolio this rebalancing. AstraZeneca trades for just 8.8 times trailing 12-month earnings, 7.1 times projected 12-month earnings, and at a P/E/G ratio of just 0.7. Plus, it's yielding over 6% (remember, dividend yield is a valuation ratio -- it's essentially the inverse of the price/dividend ratio). That's four different metrics, all saying the same thing: AstraZeneca's stock is a bargain.

Overall, I think the various valuation measures show that the market remains at least reasonably valued. But more importantly, numerous bargains in individual stocks like AstraZeneca are out there. The Hot List will continue to key on them as we move deeper into what so far has been a solid 2011.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 2 stocks leave our portfolio. These include: Western Digital Corp. (WDC) and Tractor Supply Company (TSCO).

The Keepers

8 stocks remain in the portfolio. They are: Pre-paid Legal Services, Inc. (PPD), Skechers Usa, Inc. (SKX), Aeropostale, Inc. (ARO), Sanofi-aventis Sa (Adr) (SNY), Gamestop Corp. (GME), Acme Packet, Inc. (APKT), Bridgepoint Education, Inc. (BPI) and Opentable Inc (OPEN).

The Newbies

We are adding 2 stocks to the portfolio. These include: Astrazeneca Plc (Adr) (AZN) and Zhongpin Inc. (HOGS).

Portfolio Changes

Newcomers to the Validea Hot List

AstraZeneca PLC (AZN): Based in London, AstraZeneca is one of the world's largest drugmakers. The $68-billion-market-cap firm is active in more than 100 countries, and makes a variety of well-known medications, including Crestor, Symbicort, and Nexium.

AstraZeneca gets strong interest from my Peter Lynch-, Warren Buffett-, and James O'Shaughnessy-based models. See the "Detailed Stock Analysis" section below to learn more about the stock.

Zhongpin Inc. (HOGS): This China-based meat and food processing firm is a small-cap ($528 million), but it has taken in close to a billion dollars in sales over the past year. It specializes in pork and pork products, and vegetable and fruits.

Zhongpin gets strong interest from my Peter Lynch- and James O'Shaughnessy-based models. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

News about Validea Hot List Stocks

OpenTable Inc. (OPEN): The restaurant reservation upstart has kept up its strong momentum since joining the portfolio last month. It's up about 19% in that brief period.

Sanofi-Aventis (SNY): Sanofi said it has completed its takeover of biotechnology firm Genzyme Corp., a deal worth about $20.1 billion, Reuters reports. The acquisition gives Sanofi access to Genzyme's business of treating rare diseases, and is expected to help the company combat sales erosion from drugs facing cheap generic competition. Sanofi is using the proceeds of its $7 billion notes offering, about $7 billion raised through its U.S. commercial paper program, a drawing of $4 billion on a bridge facility and available cash to finance the deal, according to Reuters.

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

ARO   |   BPI   |   HOGS   |   AZN   |   APKT   |   PPD   |   OPEN   |   SNY   |   GME   |   SKX   |  

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aropostale merchandise through its e-commerce Website, www.aeropostale.com. During the fiscal year ended January 30, 2010 (fiscal 2009), the Company launched P.S. from Aeropostale, which offers casual clothing and accessories focused on elementary school children between the ages of 7 and 12. During fiscal 2009, the Company completed the closure of its 14 store Jimmy'Z concept. Jimmy'Z Surf Co., Inc., a wholly owned subsidiary of Aeropostale, Inc., was a contemporary lifestyle brand targeting young women and men aged 18 to 25.

Bridgepoint Education, Inc. (Bridgepoint) is a accredited provider of postsecondary education services. The Company offers associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. It delivers its programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2009, it offered approximately 1,150 courses, 60 degree programs and 125 specializations and concentrations. As of December 31, 2009, it had 53,688 students enrolled in its institutions, 99% of whom were attending classes online.

Zhongpin Inc. is principally engaged in the meat and food processing and distribution business in the People's Republic of China (the PRC). At December 31, 2009, the Company's product line included 358 meat products, including chilled pork, frozen pork and prepared meats, and 34 vegetable and fruit products, that are sold on a wholesale basis and on a retail basis through an exclusive network of showcase stores, network stores and supermarket counters. Its eight processing plants are located in Henan, Jilin and Sichuan provinces and in Tianjin in the PRC, have an aggregate processing capacity of approximately 1,504.9 metric tons per day or approximately 541,760 metric tons on an annual basis for chilled and frozen pork. Its three prepared pork products facilities are located in Henan province. Its one vegetable and fruits processing plant is located in Henan province. All of its products are sold under the Zhongpin brand name.

AstraZeneca PLC (AstraZeneca) is a biopharmaceutical company. The Company focuses on the discovery, development and commercialization of prescription medicines for six areas of healthcare. Its six areas of healthcare includes cardiovascular, gastrointestinal, infection, neuroscience, oncology, and respiratory and inflammation. The Company's products include Crestor, Nexium, Synagis, Seroquel, Arimidex and Symbicort. The Company owns and operates a range of research and development (R&D), production and marketing facilities worldwide.

Acme Packet, Inc., incorporated on August 3, 2000, provides session border controllers (SBCs) that enable service providers, enterprises, government agencies and contact centers to deliver interactive communications, such as voice, video and other real-time multimedia sessions, across Internet protocol (IP) network borders. The Company's Net-Net product supports a range of communications applications at multiple network border points and also supports service architectures, such as IP Multimedia Subsystem (IMS). The Company's Net-Net family of products consists of the Net-Net OS software platform, the 2600, 3800, 4250, 4500 and 9200 platforms; 4500 Advanced Telecommunications Computing Architecture blade (ATCA blade); and Element Management System (EMS), Session Analysis System (SAS), and Route Manager Central (RMC), management applications. On April 30, 2009, the Company acquired Covergence Inc.

Pre-Paid Legal Services, Inc. designs, underwrites and markets legal expense plans. The Company's life events legal plans (referred to as Memberships) provide for a range of legal services.The identity theft related benefits include a credit report and related instructional guide, a credit score and related instructional guide, credit report monitoring with daily online and monthly offline notification of any changes in credit information and identity theft restoration services. As of December 31, 2009, the Company had 1,547,585 Memberships in force with members in all 50 states, the District of Columbia and the Canadian provinces of Ontario, British Columbia, Alberta and Manitoba. Approximately 90% of such Memberships were in 29 states and provinces.

OpenTable, Inc. (OpenTable) provides solution that forms an online network connecting reservation-taking restaurants and people who dine at those restaurants. Its solutions include its Electronic Reservation Book (ERB), for restaurant customers and www.opentable.com, a restaurant reservation Website for diners. The OpenTable network includes approximately 12,000 OpenTable restaurant customers spanning all 50 states, as well as select markets outside of the United States. During the year ended December 31, 2009, the Company seated an average of approximately four million diners per month. Restaurants pays OpenTable an one-time installation fee for onsite installation and training, a monthly subscription fee for the use of its software and hardware and a fee for each restaurant guest seated through online reservations.

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. It is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, it specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company. In February 2011, the Company acquired BMP Sunstone Corp. In April 2011, the Company acquired Genzyme Corporation.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

Skechers U.S.A., Inc. (Skechers) design and market Skechers-branded contemporary footwear for men, women and children under several lines. addition to Skechers-branded lines, the Company also offers several designer, fashion and street-focused footwear lines for men, women and children. These lines are branded and marketed separately from Skechers and appeal to specific audiences. Its brands are sold through department stores, specialty stores, athletic retailers, and boutiques as well as catalog and Internet retailers. Along with wholesale distribution, its footwear is available at its e-commerce Website and its own retail stores. Skechers operates 90 concept stores, 92 factory outlet stores and 37 warehouse outlet stores in the United States, and 22 concept stores and five factory outlets internationally. The Company operates in four reportable segments: domestic wholesale sales, international wholesale sales, retail sales, and e-commerce sales.

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.

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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.