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Executive Summary April 2, 2010

The Economy

While questions linger about the housing and job markets, the economy continues to improve both at home and abroad, with data from around the globe giving evidence of a sustained rebound.

Yesterday, the Institute for Supply Management announced that its manufacturing index rose for the eighth straight month in March -- and it did so at the fastest pace in almost six years. New orders and production numbers both showed accelerating growth, and the group's employment index indicated job growth in the manufacturing sector for the fourth straight month. The ISM report also showed that manufacturers were increasing inventories in March for the first time after 46 months of liquidation, "perhaps signaling manufacturers' willingness to increase inventories based on expected levels of activity," an ISM official said. The manufacturing numbers indicated that the broader economy grew for the 11th consecutive month.

In other parts of the world, manufacturing data was also strong. In China, two reports showed strong improvements in the sector after somewhat disappointing results in February, according to MarketWatch. Japan's biggest manufacturers, meanwhile, reported being their least pessimistic since 2008. And Germany, the U.K., India, South Korea, Turkey, the Czech Republic and others "are rolling along," MarketWatch reported, noting that "even in the housing-bust countries of Ireland and Spain, factory output is starting to edge higher."

That's very good news, because a couple other areas -- housing and employment -- aren't looking as good. Existing home sales dipped 0.6% compared to January, the National Association of Realtors reported last week, though they remain about 7% above year-ago levels. The S&P Case/Shiller home price index rose, meanwhile, on a seasonally-adjusted basis, according to its most recent report. But that data is from January, so it is a couple months behind. And this week, one of the index's founders, Robert Shiller, told Bloomberg news that he thinks there is a "50/50" chance of a double-dip in the housing market recovery.

A big question is whether private investors will be willing to step in to the mortgage-backed security market, after the Federal Reserve this week ended its $1.25 trillion effort to snatch up MBSs. Many are expecting mortgage rates will climb as a result, which would be a headwind for the housing market.

In terms of employment, meanwhile, signals are mixed. New claims for unemployment reached their lowest point since August 2008 in the week ending March 27, and the four-week moving average also fell. Continuing claims also fell to their lowest level in more than a year.

But job-watching firm Challenger, Gray & Christmas reported that the number of planned job cuts announced in March jumped to more than 67,000 after coming in around 42,000 in February, mostly because of government cuts, CNNMoney reported. Still, the March figure is less than half of what it was a year ago, and economists are expecting today's Labor Department jobs report to show that the economy gained 184,000 jobs in March, according to CNNMoney. The market will no doubt be watching that report closely.

The market took all of this in stride, with the S&P 500 returning 1.1% since our last newsletter, and the Hot List returning 1.0%. The portfolio is now up 9.1% for the year vs. 5.6% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 162.9% vs. the S&P's 17.8% gain.

Onward and Upward

With its strong performance in the first quarter of 2010, the Hot List has now wiped away all of its 2008 losses. Through March 31, the portfolio's 47% gain last year and 8% gain thus far in 2010 put it up about 3% since the start of 2008. So while many expected the bear market and near-collapse of the economy to leave investors playing catch-up for years -- or even a decade -- the Hot List has wiped out all of 2008 and early 2009's losses in a matter of a little over a year. (It still has about 5 percentage points to make up if you go back to October 2007, when the bear started.) I think that shows what a disciplined approach can do in combination with an economy and stock market that have, throughout history, proven to be much more resilient than many believe them to be.

Moving forward, I think that stocks are well positioned for more gains, though of course there's always the possibility of road bumps in the short term (including the housing and job market issues referenced above). And they look particularly attractive compared to their main competitor, bonds.

Since our last newsletter, even the man known as the "Bond King" -- PIMCO's Bill Gross -- has said stocks look better than bonds, for the next few months, at least. I'll go with the stock market," he told CNBC when asked which asset class -- stocks or bonds -- was likely to outperform over the next three months. He added that the bond market faces headwinds from the new healthcare bill, which will add to a U.S. deficit that has been ballooning.

In addition, this past week, Bloomberg reported that the S&P 500 had hit its lowest valuation compared to junk bonds in more than two years. The lowest-rated debt was yielding 3.24 percentage points more than the S&P's earnings yield, which is well below the 22-year average of 5.93 percentage points, according to Bloomberg. That bodes well for stocks -- it would seem likely that the spread would return to historical norms, and that would likely involve some combination of rising stock prices (and the S&P's earnings yield falling) and rising yields.

Finally, MarketWatch's Mark Hulbert also offered an interesting take on why bonds might be headed for trouble. Hulbert discusses the bond prognosis of Dan Seiver, a top bond strategist who has been on target with his bond predictions over the past couple years. The reasons Seiver thinks bonds are going to fall further are in line with what I anticipate. Writes Hulbert, "The economic recovery is gathering steam; government deficits are larger than even the pessimists were predicting a couple of years ago that they would be -- and getting worse; the government's bond rating is in danger; inflation will continue to worsen; the dollar will continue to lose value; the Federal Reserve eventually will have to end its quantitative easing; and the demographic trend towards an increasing proportion of society in retirement will overwhelm Social Security, Medicare and other government programs." All of that would figure to push bond prices lower, and yields higher.

What's really interesting about Hulbert's piece is his discussion of why so many smart bond market investors might not be acknowledging these issues. He points to a study done by Stefano DellaVigna, an assistant professor of economics at University of California at Berkeley, and Joshua Pollet, an assistant professor of finance at Michigan State University, that focuses on how investors deal with assessing longer-term issues.

The study showed that "very few of us are able to focus on events many years into the future, even when those phenomena are quite predictable and are sure to have a large impact on our investments," Hulbert explains. He compares the phenomenon to the old adage about the frog who, when thrown into boiling water, immediately jumps out; but when put into a pot of water that is gradually heated to boil, the frog won't have the impetus to jump out until it's too late.

While the macro factors -- rising debt, potential inflation, changing demographics that will lead to more debt problems -- seem to bode ill in general for bonds, I think stocks have some good tailwinds behind them. The economy is in the early stage of a pretty strong recovery, even if the media doesn't want to believe that recovery is real; valuations aren't nearly what they were a year ago, but they aren't bad; and companies have used the financial crisis as a way to streamline their operations and become more efficient. All of that should help the broader market going forward, and investors who focus on the stocks of strong companies selling at attractive prices -- like the Hot List does -- should continue to do particularly well over the longer term.

Editor-in-Chief: John Reese

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Guru Spotlight: Benjamin Graham

Today, many investors look to Warren Buffett for advice about the stock market and the economy. But before he became one of the world's richest men and greatest investors, there was someone whose investment advice Buffett himself cherished: Benjamin Graham. And Buffett was far from alone. Known as "The Father of Value Investing", Graham inspired a number of famous "sons" -- Mario Gabelli, John Neff, John Templeton, and, most famously, Buffett, are all Graham disciples who went on to their own stock market greatness.

So, just who was Graham? Born in England in 1894 as Benjamin Grossbaum (his family later changed its surname to Graham during World War I, when German names were viewed with suspicion), Graham built his reputation -- and fortune -- by using an extremely conservative, low-risk approach to investing. To him, preserving one's original capital was every bit as important as netting big gains, and two factors from his early years may show why. The first was Graham's own family's fall from financial comfort to poverty not long after his father died when he was nine. The second involved his first major business venture, an investment firm he founded with Jerome Newman. Just three years after opening, the stock market crash of 1929 and the Great Depression arrived, and Graham's clients, like just about everyone else, were hit hard, according to Graham biographer Janet Lowe. Graham worked without compensation for five years until his clients' fortunes were fully restored.

Having lived through both his own family's financial troubles and the market crash, it's no surprise that the strategy Graham laid out in his classic book The Intelligent Investor was a conservative, loss-averse approach. To Graham, an investment wasn't something that could be turned into quick, easy profits; anything that offers such "easy" rewards also comes with substantial risk, and Graham abhorred risk. True "investment", he wrote, deals with the future "more as a hazard to be guarded against than as a source of profit through prophecy."

In terms of specifics, Graham's approach limited risk in a number of ways, and my Graham-based model lays out several of those methods. For example, one key criterion is that a firm's current ratio -- that is, the ratio of its current assets to its current liabilities -- is at least two, showing that the firm is in good financial shape. The approach also targets financially sound firms by requiring that long-term debt not exceed long-term assets. Two other criteria the Graham method uses to find low-risk plays: the price/earnings ratio and the price/book ratio. Graham wanted P/E ratios to be no greater than 15 (and, as another signal of his conservative style, he used three-year average earnings rather than trailing 12-month earnings, to ensure that one-year anomalies didn't skew the ratio). For the price/book ratio, he used a more unusual standard: He believed that the P/E ratio multiplied by the P/B ratio should be no greater than 22.

Here are the current holdings of the 10-stock Graham portfolio:

Sanofi-Aventis SA (SNY)
Northwest Pipe Company (NWPX)
Tidewater Inc. (TDW)
Ensco PLC (ESV)
National Oilwell-Varco (NOV)
Noble Corporation(NE)
Triumph Group (TGI)
JAKKS Pacific (JAKK)
Apogee Enterprises (APOG)

Two types of stocks that you won't find in the Graham portfolio are technology and financial firms. Graham excluded tech stocks from his holdings because they were too risky, and, while they're not as risky today, I do the same. Financial stocks, meanwhile, aren't explicitly excluded from my Graham model. But because of the low-debt requirements in this strategy, it's nearly impossible for a financial firm to garner approval.

Since I started tracking my Guru Strategies almost six years ago, the performance of my Graham-based model has been rather remarkable. Even though the strategy Graham outlined is now more than 60 years old, it just keeps on working. Through March 31, the 10-stock Graham-based portfolio is up 179.1% since its July 2003 inception, making it my best performer. That's a 16.5% annualized return in a period in which the S&P 500 has gained just 2.4% per year. The model's strict balance sheet criteria helped it avoid big losers in 2008, as the portfolio lost less than half of what the broader market lost, and it has rebounded big in 2009 and 2010, gaining 31.4% in '09 and close to 10% this year (through March 31).

Those figures are a great demonstration of how successful stock investing doesn't need to be incredibly complex or cutting-edge. You don't need fancy theories or gimmicks; you just need to focus on good companies whose stocks are selling at good values. Do that, and you should produce some strong results of your own.

News about Validea Hot List Stocks

Ares Capital Corporation (ARCC): On April 1, Ares announced that it has completed its merger with Allied Capital Corporation, making it the largest business development company by market capitalization and total portfolio companies under management. Ares now has about $12 billion in estimated committed capital under management. Allied Capital stockholders received the right to 0.325 shares of Ares common stock for each Allied common stock share held immediately prior to the merger. That results in about 58.5 million newly issued shares of Ares common stock, Ares stated.

Jos. A. Bank Clothiers (JOSB): The Maryland-based retailer reported on March 31 that its fiscal 2009 profit (for the year ending Jan. 31) rose 22% to $71.2 million, or $3.84 per share, the Baltimore Business Journal reported. Revenues were a record $770.3 million, up 11%. The results beat analysts' expectations of $3.70 in EPS and $753 million in revenue, sending Bank's shares up almost 6% for the day.

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.

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   |   ESI   |   EME   |   SNY   |   ARCC   |   BCO   |   AMED   |   TGI   |   RTN   |   JOSB   |  

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 Aeropostale merchandise through its e-commerce Website, www.aeropostale.com. As of January 31, 2009, it operated 914 stores, consisting of 874 Aeropostale stores in 48 states and Puerto Rico, 29 Aeropostale stores in Canada, and 11 Jimmy'Z stores in 10 states. The Company locates its stores primarily in shopping malls, outlet centers and, to a much lesser degree, lifestyle and off-mall shopping centers. The Company has developed a new retail store concept called P.S. from Aeropostale, which will offer casual clothing and accessories focusing on elementary school children between the ages of seven and 12. It offers a focused collection of apparel, including graphic t-shirts, tops, bottoms, sweaters, jeans, outerwear and accessories.

ITT Educational Services, Inc. (ITT/ESI) is a provider of postsecondary degree programs in the United States. As of December 31, 2009, the Company offered master, bachelor and associate degree programs to approximately 80,000 students. As of December 31, 2009, it had 125 locations (including 121 campuses and four learning sites) in 38 states. All of its institutions are authorized by the applicable education authorities of the states, in which they operate, and are accredited by an accrediting commission recognized by the United States Department of Education (ED). It designs its education programs, after consultation with employers and other constituents, to help graduates prepare for careers in various fields involving their areas of study. On June 10, 2009, it acquired Daniel Webster College (DWC). DWC offers programs of study at the master, bachelor and associate degree levels both in residence and through distance education.

EMCOR Group, Inc. is an electrical and mechanical construction and facilities services company. It has six segments: United States electrical construction and facilities services, which involves systems for electrical power transmission and distribution, premises electrical and lighting systems, low-voltage systems, such as fire alarm, security and process control, voice and data communication, and fiber optic lines); United States mechanical construction and facilities services, which involves systems for heating, ventilation, air conditioning, refrigeration and clean-room process ventilation, fire protection, plumbing, process and high-purity piping, water and wastewater treatment, and central plant heating and cooling; United States facilities services; Canada construction and facilities services; United Kingdom construction and facilities services, and other international construction and facilities services. In February 2010, the Company acquired Scalise Industries.

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. The Company is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, the Company 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 in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines.

Ares Capital Corporation (Ares Capital) is a specialty finance company, which is a closed-end, non-diversified management investment company. Ares Capital's investment objective is to generate both current income and capital appreciation through debt and equity investments. It invests in United States middle-market companies. It invests primarily in first and second lien senior loans and mezzanine debt, which in some cases includes an equity component like warrants. First and second lien senior loans generally are senior debt instruments that rank ahead of subordinated debt of a given portfolio company. Its investments have ranged between $10 million and $100 million each, although the investment sizes may be more or less than the targeted range. The Company's investment adviser is Ares Capital Management LLC.

The Brink's Company (Brink's) is a provider of secure transportation, cash logistics and other security-related services to banks and financial institutions, retailers, government agencies, mints, jewelers and other commercial operations worldwide. The Company's international network serves customers in more than 50 countries and employs approximately 59,400 people. Its operations include approximately 875 facilities and 10,500 vehicles. 71% of its revenues are from outside North America. The Company has two segments: International and North America. International operations has three regions: Europe, Middle East and Africa (EMEA); Latin America, and Asia Pacific. North American operations include 181 branches in the United States and 52 branches in Canada. Brink's EMEA operates 258 branches in 22 countries. Its main operations are in France, the Netherlands and Germany. The Company's other security services include security and guarding.

Amedisys, Inc. (Amedisys) is a provider of home health services to the chronic, co-morbid, aging American population. The Company operates in two segments: home health and hospice segments. The Company's home health agencies deliver a range of services in the homes of individuals who may be recovering from surgery, have a chronic disease or disability or terminal illness and need assistance with the essential activities of daily living. Its typical home health patient is Medicare eligible, approximately 83 years old, takes approximately 12 different medications on a daily basis and has co-morbidities. Its hospice agencies provide palliative care and comfort to terminally ill patients and their families. As of December 31, 2009, it owned and operated 521 Medicare-certified home health agencies and 65 Medicare-certified hospice agencies in 40 states within the United States, the District of Columbia and Puerto Rico.

Triumph Group, Inc. (Triumph) designs, engineers, manufactures, repairs, overhauls and distributes aircraft components, such as hydraulic, mechanical and electromechanical control systems, aircraft and engine accessories, structural components and assemblies, non-structural composite components, auxiliary power units (APUs), avionics and aircraft instruments. The Company offers a variety of products and services to the aerospace industry through two groups of operating businesses: Triumph Aerospace Systems Group and Triumph Aftermarket Services Group. In March 2009, it acquired Merritt Tool Company, Inc., Saygrove Defence & Aerospace Group Limited, the aviation segment of Kongsberg Automotive Holdings ASA and The Mexmil Company, LLC. In March 2010, the Company announced the acquisition of Fabritech, Inc., a component manufacturer and repair station for critical military rotary-wing platforms.

Raytheon Company, together with its subsidiaries, develops products, services and solutions in defense markets; sensing, effects, command, control, communications and intelligence (C3I), and mission support, as well as the cybersecurity and homeland security markets. The Company serves both domestic and international customers, principally as a prime contractor on a portfolio of defense and related programs for government customers. It operates in six business segments Integrated Defense Systems (IDS), Intelligence and Information Systems (IIS), Missile Systems (MS), Network Centric Systems (NCS), Space and Airborne Systems (SAS) and Technical Services (TS). In October 2009, the Company acquired BBN Technologies Corp. and related entities.

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, retailer and direct marketer (through stores, catalog and Internet) of men's tailored and casual clothing and accessories. It sells all of its products exclusively under the Jos. A. Bank label through its 460 retail stores (as of January 31, 2009, which includes seven outlet stores and 12 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. Its products are targeted at the male career professional and emphasize the Jos. A. Bank brand of tailored and casual clothing and accessories. The Company's products, which range from the original Jos. A. Bank Executive collection to the more luxurious Jos. A. Bank Signature collection to the exclusive Jos. A. Bank Signature Gold collection. Jos. A. Bank operates through two segments: Stores and Direct Marketing.

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.