|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||June 26, 2009|
The economy remains weak, but the nature of the debate on where we stand continues to shift significantly. Whereas a couple months ago the issue was whether we were headed for a depression, most talk now is focusing on whether we're seeing real economic improvement, or whether things are just deteriorating less quickly than they were before.
That shift is in and of itself is somewhat encouraging, a sign that we've moved past the worst of (or perhaps even the majority of) the financial crisis. The numbers appear to back that up. Over the past three months, spreads on investment grade corporate bonds have been almost cut in half, while junk bond spreads are about half what they were back in December. And my colleague John Markman recently noted that the cost of credit default swaps -- which gives an indication of how risky investors think bonds are -- have plunged in recent months.
Interestingly, Markman says the biggest reason for the credit thaw may be the bankruptcies of Chrysler and General Motors. Investors had been worried that the government would strip bondholders of their rights in those proceedings; when the government kept bondholders at the head of the line, however, a sense of relief came over investors -- a sense of relief so strong that the bond market is essentially signaling that the credit crisis is over, Markman says.
Now, with the credit crisis (hopefully) having shifted to the rearview mirror, the focus is on whether or not the economy is, in fact, improving. Some, including Warren Buffett and Yale economist Robert Shiller, say they haven't seen those "green shoots" that everyone seems to be talking about; others, including Federal Reserve Chairman Ben Bernanke and top strategist Liz Ann Sonders, say the shoots are real.
Whether things are actually improving or simply getting worse more slowly, the bottom line is that there is a way to go before the economy is back on track. While a number of economic indicators have been giving off signs of hope, they're still well below healthy levels. The junk bond yield spread I mentioned earlier, for example, has come down significantly from where it was a few months ago, but is still at a level associated with recessions, strategist John Mauldin recently noted. The same can be said for manufacturing numbers. They've jumped this year, but the Institute for Supply Management's manufacturing index is still at levels that indicate a contraction.
The housing market also provides some good news/bad news data. The good news: Existing home sales rose 2.4% in May, according to the National Association of Realtors, and the average sale price increased almost 4%. The bad news: The number of sales is still down more than 15% from 2007 levels, and the average sale price is still down more than 20% from then.
Perhaps the biggest economic concern, however, is unemployment, with new claims unexpectedly jumping last week to their highest level in more than a month and the most recent data on continuing claims also showing a continued rise. The June unemployment rate will be announced next Thursday, and investors will no doubt be looking to see where the figure goes following May's 9.4% reading, which was the highest in more than a quarter-century.
Now, some good signs. First off, durable goods orders -- expected to decline -- increased almost 2% last month, the second month in a row they've risen. Within that figure was a jump of nearly 8% in new machinery orders. That type of capital spending indicates that companies are seeing better times ahead. The Federal Reserve, meanwhile, stated this week that household spending -- the biggest part of the U.S. economy -- has shown signs of stabilizing. And a five-year Treasury auction yielded more demand than expected yesterday -- The Wall Street Journal noted that "both Treasury and Agency debt issues saw increasing demand from foreign investors, as the U.S. begins to look less risky despite daunting fundamental challenges ahead."
The Inflation Question
Of course, one potential threat that continues to linger somewhere down the road is inflation. David Dreman, the great contrarian investor who inspired one of my Guru Strategies, said this week that he is "terrified" of bonds right now because he thinks we're going to see very serious inflation. Another top strategist, Steven Leuthold, also said he is very worried about a debasing of the dollar, and is focusing in large part on overseas opportunities because of that.
Others, however, don't share their concerns. Alan S. Blinder, a professor of economics and public affairs at Princeton University who also served as vice chairman of the Federal Reserve, wrote in the New York Times last week that as long as banks hoard cash and limit the amount of credit they're issuing, inflation isn't a problem; the money the government has been pumping into financials isn't getting into the system. Blinder points to something I touched on in our last Hot List: He says that the recent surge in Treasury yields is due more to a bounce off historical lows than a sign of inflation. And the small spread between the rate on nominal Treasury debt and the rate on Treasury Inflation-Protected Securities indicates that investors aren't yet worrying about inflation, he says.
Robert Shiller, meanwhile, says inflation concerns should be put on the back burner, and that more stimulus should be on the front burner. Shiller says that inflation concerns during the Great Depression kept the government from adding more stimulus to the economy, which dragged out the Depression. Shiller says the recent surge in confidence hasn't been matched by real improvement in the economy, and that the government must capitalize on that confidence surge while it still can to try to grow some real "green shoots".
With much disagreement over where things stand, and are headed, investors have been cautious since our last Hot List. The S&P 500 is down 2.6%, and the portfolio has fallen 6.0%. For the year, however, the Hot List remains well in the black, up 15.8%, while the S&P has gained just 1.9%. And, since its inception almost six years ago, the portfolio is up nearly 90% vs. an 8% loss for the S&P.
Stocks & the "New Normal"
The big question hovering over the investment world right now involves what the stock market will look like once the economy does get back on its feet. After a decade or two in which businesses and consumers ramped up their use of leverage to unsustainable levels, the economy is now going through a massive deleveraging. When it's over, what will the corporate profit picture look like? Will consumer spending get back up to previous levels, or will part of the consumer pullback be permanent? How long will it take for home values to get back to their highs? How much of an impact will new government involvement in the financial world have on businesses and consumers, both in terms of regulatory overhauls and tax rates?
I don't profess to know the answer to those questions; some of the brightest economic minds disagree on every one of those very complex issues.
What I do believe, however, is that whatever the "new normal", as many are calling it, looks like, stocks will remain the best long-term investment vehicle. Stocks have outperformed bonds, bills, and any other investment class for the past two-plus centuries not because of chance, but because of the underlying nature of our economy and investment system. Stock investors are rewarded over the long term with better rates of return because they take on more short-term risk than, say, bondholders, whose nominal rates of return are generally fixed -- that's the equity risk premium you often hear about.
In addition, stocks, unlike bonds, bills, or gold, also have the ability to produce increasing earnings streams. In a system in which the government has essentially factored a couple percentage points of annual inflation into the economy, that is a key advantage for stocks.
Yes, the issues I mentioned above -- different levels of leverage, government intervention, etc. -- will most likely have an impact on our investment world. The equity risk premium may rise or fall a bit, and corporate profits and consumer spending may do the same. But as of now, I see no reason to believe that stocks will lose their general long-term advantages over other asset classes.
I'm not the only one thinking that way. Many of the gurus upon whose approaches I base my models have been quite bullish lately. In his latest market commentary, for example, James O'Shaughnessy writes that even after their recent run-up, "we continue to believe that over the next three, five, and ten years, equities will be the best performing asset class and that investors need to take the opportunity the market has given them".
In fact, O'Shaughnessy sees a market that is conforming to historical trends, not one breaking away from them. Value stocks have whipped back into shape in recent months while momentum stocks have faltered -- periods generally "aligned with recessionary inflection points where stock leadership changes dramatically," he writes. "These periods are unpredictable, but not unexpected."
Another guru who is bullish on stocks for the long haul: David Dreman. As I noted above, Dreman said this week that he is "terrified" of bonds because he expects extreme inflation. He's high on stocks, though (I've noted in past newsletters that Dreman's own research found that, when inflation is factored in, stocks are far and away the best long-term investment vehicle). "Probably the two worst investments over the past two, three years have been stocks and real estate," Dreman told Reuters. "They could be the best investments two or three years out."
Another bullish guru: Kenneth Fisher. Fisher has been very high on stocks in recent months -- and he doesn't appear to think that we're headed for some world-changing new era of investing. In fact, on his firm's web site, a column written by a member of Fisher's editorial team this month says that a good way for investors to lose out is to think that "It's different this time." According to the analyst, these are the "most expensive words in the English language, folks will always believe it's different this time -- but it never is."
Finally, there's Warren Buffett. While Buffett did say this week that he has yet to see those supposed "green shoots" in the economy, he has done nothing to back away from his previous bullish long-term statements about U.S. stocks.
What Buffett did say is that it will take the economy time -- perhaps a lot of time -- to recover, and I agree. The economy is working through problems that were many years in the making, and they won't be fixed overnight. But the ship will be righted, and, while the process will take time, I don't believe it will result in any permanent damaging of equities as an asset class.
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:
Lufkin Industries, Inc. (LUFK)
Oil States International, Inc. (OIS)
Frontier Oil Corporation (FTO)
Pfizer Inc. (PFE)
L.B. Foster Company (FSTR)
Ceradyne, Inc. (CRDN)
Applied Industrial Technologies (AIT)
The Timken Company (TKR)
Ladish Co., Inc. (LDSH)
Genesco Inc. (GCO)
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 60 years old, it just keeps on working. My 10-stock Graham-based portfolio is up over 144% since its July 2003 inception, making it my best performer. That's a 16.2% annualized return in a period in which the S&P 500 has lost an average of 1.4% 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-time this year, gaining 26.4% compared to 1.9% for the S&P.
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
Pfizer Inc. (PFE) : On June 25, Pfizer said the Phase III clinical trial of its oncology drug Sutent showed the product was effective in slowing the progression of pancreatic neuroendocrine tumors, a type of pancreatic cancer, Reuters reported. Sutent is already approved to treat advanced kidney cancer and GIST, a type of gastrointestinal cancer.
Oil States International (OIS): On June 17, Oil States said one of its subsidiaries is teaming with Brazilian company Uniao Engenharia Fabricacao e Montagem Ltda. to provide deep water production and subsea pipelines to Brazil's expanding offshore construction industry, the Associated Press reported. The venture will be called Oil States-Uniao S.A.
The Next Issue
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