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Executive Summary January 22, 2010

The Economy

For anyone looking for a smooth, painless economic recovery, the last two weeks have provided a dose of reality.

The biggest piece of that reality check may be the job market. Earlier this month, the government announced that the unemployment rate remained at a very high 10% in December. And, while revised figures showed that the economy in November added jobs for the first time in almost two years, new figures showed that those slight gains reversed in December, with 85,000 jobs being shed.

In addition, new claims for unemployment increased 8% last week, and the four-week average rose for the first time since August.

New data also showed that retail sales were much weaker than expected in December, falling 0.3%. Analysts had been forecasting a 0.5% gain.

The market was also impacted by several big banks' earnings reports, which were mixed. Bank of America reported a $5 billion loss for the fourth quarter, though all but about $200 million of that was related to preferred dividends and payback of TARP funds. Wells Fargo, meanwhile, posted a $2.8 billion profit and said credit quality improved in the quarter. Goldman Sachs' earnings were close to $5 billion, but Citigroup lost almost $8 billion, setting aside more than $8 billion for consumer loan losses. The bottom line: The financial sector is miles ahead of where it was a year ago, but it's still unclear when many of these firms' balance sheets will be healthy.

The financial sector also got some big news on the regulatory front, with President Obama proposing new restrictions that would impact big banks. The regulations would limit the scope of financial institutions' endeavors, and also limit the amount of consolidation possible in the sector. That news shouldn't have come as a big surprise -- Obama and legislators have been talking financial sector reform for months now -- but it still drove the market lower.

Stepping back, however, the overall economic picture continues to be one of improvement. For starters, while unemployment figures have risen in the past week or two, the overall jobs picture is far better than it was a year ago. In the first three months of 2009, the economy was shedding an average of close to 700,000 jobs per month. Over the past three months, the average has been about a tenth of that, 69,000.

In addition, industrial production increased in December for the sixth straight month, with the December reading the highest monthly output of the year, according to Federal Reserve data. The same was true of capacity utilization, another sign that things are moving in the right direction.

And while retail sales fell in December, the U.S. consumer -- contrary to popular belief -- doesn't need to lead the recovery. Inventory replenishing has been a big factor in the recovery so far, and exports continue to be a big boost for the economy. AllianceBernstein Chief Economist Joseph Carson recently told CNNMoney.com that exports are now accounting for a record portion of U.S. manufacturing shipments, and that they are growing twice as much as the global average. Exports increased in November for the eighth straight month, according to the Census Bureau, reaching their highest level in a year. Growing middle classes in emerging market countries and the dollar's decline should make that export growth continue, Carson says, which will lead to job growth, and consumer spending gains, within the U.S.

The mixed economic news meant an up and down two weeks for stocks, with volatility returning to the market. The S&P 500 was in the red for the fortnight, losing 2.2%. The Hot List also lost some ground, falling 2.6%. So far in a young 2010, the portfolio remains ahead of the S&P, however, having gained 2.7% vs. the index's 0.1% gain. And since its July 2003 inception, the Hot List is now up 147.5%, far outpacing the S&P's 11.6% gain.

Quality Additions

The Hot List is selling four stocks in today's monthly rebalancing and replacing them with four new companies whose shares now get better ratings from my guru-based models. The four departing stocks -- Chevron, World Acceptance, Telvent GIT, and Oil States International -- on the whole performed well, with World Acceptance and Oil States posting double-digit gains, Telvent ending up in the black, and Chevron ending up slightly in the red.

The four newcomers come from a variety of industries. There's a telecom (Telefonica); a video game specialist (GameStop); a retail pharmacy giant (CVS); and a construction services firm (EMCOR Group). While these newbies come from very different segments of the market, they share at least one thing in common: All have demonstrated an excellent ability to grow earnings over the long haul -- even through one of the worst recessions in decades. EMCOR has upped EPS in each year since 2004 -- including 2008; CVS has increased earnings every year since 2002; and GameStop's streak goes back one year further, to 2001. All those firms also have very manageable debt/equity ratios that are well below their industry averages. (Telefonica, which had a slight dip in earnings last year but has otherwise been growing earnings since 2004, is a bit of a different story, since like most telecoms and utilities it carries significant debt.)

I mention this because the recession we're coming out of crushed the earnings of many companies. Even solid firms like Coca-Cola and Microsoft saw earnings dip in 2008, as overleveraged consumers dug in and closed their wallets. For a company to continue to grow earnings in such a climate was an impressive feat. During the recession and bear market, that type of quality was in many cases rewarded; while the S&P 500 fell 57% in the bear, CVS' shares, for example, fared almost 20 percentage points better.

Throughout much of the market's recent rally, however, quality hasn't been rewarded as much as it normally would be. Junk stocks -- those with the worst fundamentals and balance sheets -- have led the rally. That's no surprise. Such stocks tend to get hit hardest during financial crises like the one we've just been through, since they are most likely to go out of business when times get very tough. Their stock prices plunge -- sometimes too far. When the fears subside and investors realize many of those "junk" stocks will survive, however, they pour back into the Armageddon-priced shares.

But such junk rallies don't last forever, and we've already begun to see a shift toward an environment in which quality is rewarded. That, too, shouldn't be a big surprise, according to some new data that comes in part from one of the gurus upon whose writings I base my investment models: James O'Shaughnessy. O'Shaughnessy's book What Works on Wall Street details his four-decade-plus study of stock returns and stock-picking strategies, which is one of the most extensive studies of its kind.

Just as his book examines what has worked on Wall Street over the long term, O'Shaughnessy's firm recently released details of a new study that examines what works in the second year of bull markets, a point we are fast approaching. In explaining the results of the study, Patrick O'Shaughnessy -- James' son -- says that the O'Shaughnessy's firm's research has found significant trends in the types of stocks that perform well during bear markets and at various stages of the ensuing bull markets. "While the particulars of each bear market are very different, the types of stocks that perform well at various stages surrounding the declines are somewhat consistent around all bear markets and quite consistent around severe bear markets like the one we've just seen", he writes.

In the first year following severe bear markets, O'Shaughnessy says, low-momentum stocks crush high-momentum stocks, just as we've seen in the junk rally that started last March. (My models reflected that, with the Momentum Investor approach ranking 2nd-worst of all my individual models, and none of 2009's four best strategies using momentum.) "During the nearly nine months since the March 9th market bottom, market trends have closely mirrored those of other severe bear markets," O'Shaughnessy says, adding that the underperformance of momentum strategies suggests not that such approaches are broken, but that "this year has just been more of the same."

Now, on to the part that is of greater immediate importance -- the second year bull market trends. According to O'Shaughnessy, bull markets' second years tend to demonstrate characteristics more consistent with long-term stock movements -- that is, stocks with stronger fundamentals tend to fare better. "The bizarre market dynamics from the first year of recovery subside in year two," O'Shaughnessy writes, "and the expected long-term advantage of buying stocks with our [fundamental] criteria returns."

That assessment bodes well for my fundamental-based Guru Strategies, and it got me thinking about how those strategies fared back in the second year of the last bull market, which ran from late 2002 into the fall of 2007.

The short answer to that question is, they fared quite well. From Oct. 1, 2003 (this is actually about a week shy of the one-year mark for that bull market, but I'm using Oct. 1 because I track my returns on a monthly basis) through the end of September 2004, the S&P 500 returned about 11.9%. That's a solid return, but less than half the almost 30% return it generated in the first year or so of the bull.

The seven original individual guru-based strategies I track on Validea.com, on the other hand, returned between 21.1% and 58.4% in that second year of the bull market; the average was about 38.9%. The Hot List also excelled, returning 57.1%. Quality and fundamentals, it seems, were indeed rewarded as the bull matured.

Now, I'm certainly not going to promise 50%+ returns for the Hot List in the second year of the bull market, which, hopefully, will begin on March 10 of this year. As the younger O'Shaughnessy noted, the particulars of bull markets can differ significantly, and the current environment certainly presents some unique challenges. Given how far many junk-type stocks have rallied, and given how much uncertainty remains for the economy and the stock market, however, I do think that a second year of a junk-led rally is unlikely.

What's more likely is that we will continue to see a shift back toward quality stocks -- those with strong earnings, low debt, high returns on equity -- and that quality stocks selling at attractive valuations will be of particular interest to investors. How quickly and when exactly such a transition unfolds is dependent on a myriad of factors, of course, and as with any market, there will be bumps in the road. But history has shown that eventually investors always do come back to quality. Over the long haul, that's where I think investors will have the most success, and it's why I'll continue to focus on the type of fundamentally sound, financially secure companies you'll find in the Hot List.
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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: World Acceptance Corp. (WRLD), Oil States International, Inc. (OIS), Chevron Corporation (CVX), Telvent Git, S.a (TLVT), .

The Keepers

6 stocks remain in the portfolio. They are: Itt Educational Services, Inc. (ESI), Tidewater Inc. (TDW), National-oilwell Varco, Inc. (NOV), Aeropostale, Inc. (ARO), Dresser-rand Group Inc. (DRC) and Fuqi International, Inc. (FUQI).

The Newbies

We are adding 4 stocks to the portfolio. These include: Cvs Caremark Corporation (CVS), Telefonica S.a. (Adr) (TEF), Emcor Group, Inc. (EME), Gamestop Corp. (GME), .

Portfolio Changes

Newcomers to the Validea Hot List

CVS Caremark Corporation (CVS): Based in Rhode Island, CVS is the nation's largest prescription medication provider, filling or managing more than a billion prescriptions a year. It has more than 7,000 CVS/pharmacy stores in 43 states, and is the nation's largest employer of pharmacists and nurse practitioners. Over the past year, the firm has taken in more than $97 billion in sales. It has a $47.7 billion market cap.

CVS gets strong interest from my Peter Lynch-based approach, and some interest from several other of my models. To see why the Lynch model is so high on it, scroll down to the "Detailed Stock Analysis" section below.

EMCOR Group, Inc. (EME): Based in Connecticut, this construction and facilities services firm does electrical, mechanical, lighting, air conditioning, heating, security, fire protection and power generation systems work for companies in a wide variety of industries. The $1.7 billion market cap company, which gained 15.6% while in the Hot List from Nov. 27-Dec. 24, has taken in close to $6 billion in sales in the past year.

EMCOR gets high marks from my Peter Lynch- and Joel Greenblatt-based models. The "Detailed Stock Analysis" section below explains why.

Telefonica (TEF): Based in Madrid, this telecom firm operates in 25 countries and has almost 270 million customers. Its main markets are Latin America and Europe. Over the past year, the $122 billion market cap firm has taken in almost $80 billion in sales.

Telefonica gets strong interest from my James O'Shaughnessy-based value strategy, and some interest from three of my other models. To see what the O'Shaughnessy approach likes about it, check out the "Detailed Stock Analysis" section below

GameStop Corp. (GME): The world's largest video game retailer, GameStop sells all sorts of Nintendo, Xbox, and PlayStation games and game units, as well as a variety of computer games. The Texas-based company has more than 6,000 stores in the U.S. and 17 other countries, operating under the GameStop, EB Games, and Electronics Boutique names. The firm has a $3.4 billion market cap, and has taken in more than $9 billion in sales over the past 12 months.

GameStop gets approval from my Peter Lynch- and Joel Greenblatt-based strategies. To find out why, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

ITT Educational Services (ESI): On Jan. 21, ITT announced fourth-quarter earnings of $93.7 million, or $2.56 a share, up 49% from the year-ago period as enrollment jumped more than 30%. Revenues increased 34% to $374.4 million. Both earnings and revenue beat analyst expectations.

For the full year, ITT's earnings were $300.3 million, or $7.92 per share, which also represented a 49% gain over 2008. Annual revenue jumped almost 30%. The firm said it expects 2010 earnings per share of between $10 and $10.50; analysts had been expecting $9.48, Reuters reported.

Dresser-Rand Group (DRC): A Dresser-Rand subsidiary has agreed to acquire Leading Edge Turbine Technologies in a deal valued at $35 million, the Houston Business Journal reports. Leading Edge specializes in the repair of industrial gas turbines and large utility steam turbine equipment. It is expected to add about $26 million to Dresser-Rand's bottom line in the 2009 fiscal year, the HBJ reported.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take an in-depth look at one of my individual Guru Strategies. 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

FUQI   |   ARO   |   EME   |   NOV   |   TEF   |   DRC   |   CVS   |   GME   |   ESI   |   TDW   |  

Fuqi International, Inc. (Fuqi) is a designer of precious metal jewelry in China, developing, promoting, and selling a range of products in the Chinese luxury goods market. The Company's products consist of a range of styles and designs made from gold and other precious metals, such as platinum and Karat gold (K-gold). The Company also produce jewelry items that contain diamonds and other precious stones on a custom-order basis. Its design database contains over 30,000 products. The Company operates through its wholly owned subsidiary Fuqi International Holdings Co., Ltd. (Fuqi BVI) and its wholly owned subsidiary, Shenzhen Fuqi Jewelry Co., Ltd. (Fuqi China). As of December 31, 2008, the Company had 69 jewelry retail counters and stores in China.

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.

EMCOR Group, Inc. (EMCOR) is an electrical and mechanical construction and facilities services company in the United States, Canada, the United Kingdom and in the world. The Company's segments include United States electrical construction and facilities services, United States mechanical construction and facilities services, United States facilities services, Canada construction and facilities services, United Kingdom construction and facilities services, and Other international construction and facilities services. The Company specializes in providing construction services relating to electrical and mechanical systems in facilities of all types and in providing services for the operation, maintenance and management of all aspects of such facilities (referred to as facilities services).

National Oilwell Varco, Inc. (NOV) is a provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The Company operates in three segments. The Rig Technology segment designs, manufactures, sells and services systems for the drilling, completion and servicing of oil and gas wells. The Petroleum Services & Supplies segment provides a variety of consumable goods and services used to drill, complete, remediate and workover oil and gas wells, service pipelines, flowlines and other oilfield tubular goods. The Distribution Services segment provides maintenance, repair and operating (MRO) supplies, and spare parts to drill site and production locations worldwide. In April 2009, NOV acquired ASEP Group Holding B.V. and Anson Limited.In December 2009, National-Oilwell Varco, Inc. acquired Hochang Machinery Industries Co., Ltd. and South Seas Inspection (S) Pte. Ltd.

Telefonica, S.A. (Telefonica), together with its subsidiaries and investees, operates in the telecommunications, media and contact center industries. The Company is also involved in the media and contact center activities through investments in Telefonica de Contenidos and Atento. The Company operates in three business areas: Telefonica Spain, Telefonica Europe and Telefonica Latin America. In Latin America, Telefonica provides service to more than 158 million customers in Brazil, Argentina, Chile and Peru, and has substantial operations in Colombia, Ecuador, El Salvador, Guatemala, Mexico, Morocco, Nicaragua, Panama, Puerto Rico, Uruguay and Venezuela. In Europe, it has operating companies in the United Kingdom, Ireland, Germany, Czech Republic and Slovakia. On April 3, 2008, Vivo Participacoes, S.A. completed the acquisition of 53.90% of Telemig Celular Participacoes, S.A. In December 2009, the Company acquired JAJAH.

Dresser-Rand Group Inc. is the global supplier of custom-engineered rotating equipment solutions for the applications in the oil, gas, petrochemical and process industries. The products and service applications include oil and gas production; high-pressure field injection, gas lift, and enhanced oil recovery; natural gas processing; gas liquefaction; gas transmission and storage; refining; petrochemical production; and general industrial markets, such as paper, steel, sugar, distributed power and United States Navy. The Company operates globally with manufacturing facilities in the United States, France, United Kingdom, Germany, Norway, China and India. It operates a range of products and clients to the global client base in over 140 countries from the global locations in 18 United States states and 26 countries. The Company operates in two business segments: new units, and aftermarket parts and services.

CVS Caremark Corporation (CVS Caremark) is a provider of prescriptions and related healthcare services in the United States. It is a pharmacy services company and drives value for its customers through its approximately 6,900 CVS/pharmacy and Longs Drug retail stores; CVS Caremark's pharmacy benefit management, mail order and specialty pharmacy division, Caremark Pharmacy Services; its retail-based health clinic subsidiary, MinuteClinic, and Its online pharmacy, CVS.com. The Company operates in two business segments: Pharmacy Services and Retail Pharmacy. October 20, 2008, CVS Caremark acquired Longs Drug Stores Corporation, which includes 529 retail drug stores (the Longs Drug Stores) and RxAmerica LLC (RxAmerica), which provides pharmacy benefit management services, and certain other related assets.

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 31, 2009, the Company operated 6,207 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. During the fiscal year ended January 31, 2009, GameStop operated its business in four segments: United States, Canada, Australia and Europe. On April 5, 2008, GameStop acquired Free Record Shop Norway AS. In July 2008, the Company purchased certain assets and Website operations from The Gamesman Limited, a video game and entertainment software retailer, including eight stores in New Zealand. On November 17, 2008, GameStop France SAS, a wholly owned subsidiary of the Company, acquired SFMI Micromania SAS.

ITT Educational Services, Inc. (ITT/ESI), is a provider of postsecondary degree programs in the United States based on revenue and student enrollment. As of December 31, 2008, the Company offered master, bachelor and associate degree programs to approximately 62,000 students. As of December 31, 2008, it had 105 institutes and nine learning sites located in 37 states. All of its institutes 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). During the year ended December 31, 2008, the Company began its operations at eight new institutes. As of December 31, 2008, the Company offered 33 degree programs in various fields schools of study: information technology (IT); electronics technology; drafting and design; business; criminal justice, and health sciences.

Tidewater Inc. provides offshore supply vessels and marine support services to the offshore energy industry through the operation of offshore marine service vessels. As of March 31, 2008, the Company had a total of 430 vessels, of which 10 were operated through joint ventures, 61 were stacked and 11 vessels withdrawn from service. The Company provides services supporting all phases of offshore exploration, development and production, including towing of and anchor handling of mobile drilling rigs and equipment; transporting supplies and personnel necessary to sustain drilling, workover and production activities; assisting in offshore construction activities, and a variety of specialized services, including pipe laying, cable laying and three-dimensional (3-D) seismic work. The Company operates in two segments: United States and International.

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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