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Executive Summary January 31, 2014

The Economy

While the focus has been on emerging markets and the impact that the end to quantitative easing could have on them, the U.S. economy has continued to push forward over the past couple weeks.

Industrial production increased 0.4% in December, according to a new Federal Reserve report, and that was despite utility output -- which is usually tied to weather conditions -- falling 1.4%. Manufacturing output rose 0.4%, while mining output rose 0.8%. It was the fifth straight month of strong gains in overall industrial production.

In addition, financial data firm Markit reported that its preliminary services sector gauge hit a four-month high in January, Reuters said, another good sign.

Housing data was more mixed. New home sales declined 7.0% in December, according to the Census Bureau. But many analysts said that the extremely cold temperatures may have impacted home buying activity during the month, along with low supply levels -- only a five-month supply of new homes existed. Average sales prices were up 4.6% compared to the previous December.

While new sales declined, the National Association of Realtors said that existing home sales increased by 1.0% during the month. That put them 3.2% above year-ago levels. The median sales price was up 9.9% year-over-year.

Housing starts fell 9.8% in December, meanwhile, the Census Bureau reported, which may have been largely a snap-back decline after November's huge increase. They were still 4% above year-ago levels. Permit issuance for new construction fell 3.0%, but was more than 11% above its year-ago pace.

Overseas, the big news of course involved emerging markets, which were hit hard. The declines appeared to be the result of QE fears. In recent years, money flowed into EMs as the Federal Reserve's quantitative easing program sent investors on a quest for yield. Now, with the Fed beginning to taper its QE program -- it decided to cut the scale of its asset purchases by $10 billion for the second month in a row at its January meeting -- many fear that money will flow back out of EMs. Several EM central banks increased rates to try to stem the outflows -- Turkey even raised its benchmark one-week lending rate for banks to 10% from 4.5% -- but early indications were that the increases weren't helping much. And some feared the hikes could end up hurting growth in EMs.

Amid all that, markets have been jolted a bit. Since our last newsletter, the S&P 500 returned -2.8%, while the Hot List returned -4.7%. So far in 2014, the portfolio has returned -8.8% vs. -2.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 231.7% vs. the S&P's 79.3% gain.

Portfolio Update

It's been a rough fortnight for the Hot List, and for equities in general. As of late afternoon trading on Jan. 30, eight of the portfolio's ten holdings were in the red since our last newsletter, with two posting double-digit losses. HCI Group, the Florida property & casualty insurer, was down about 13%. Some of that was likely due to broader market weakness, but most seemed to be linked to news that HCI became the first admitted homeowners insurance carrier to provide flood insurance in Florida since significant changes to regulations occurred in 2012. Shares fell more than 10% the day after the announcement, so investors apparently weren't keen on the decision. HCI has done a great job growing in recent years, however, and its fundamentals are exceptional. It's still up about 30% since joining the Hot List in June.

CNOOC, the Chinese energy giant, was down about 12%. Its decline likely had more to do with the broader EM fears than HCI's declines did. But company specific factors were also involved. CNOOC said it will produce 422 million to 435 million barrels of oil equivalent in 2014, a 5.6% increase from a year earlier but short of expectations. The firm maintained its average annual production growth target from 2011 to 2015 of 6% to 10%, provided that key offshore projects start on time later this year or early next, but two analysts downgraded the stock after the output projection, Bloomberg reported.

The Hot List did have a couple nice winners, though. BofI (Bank of the Internet) was up 6%. The Fed's announcement about continuing its taper plan may have been at play, since less QE opens the door to higher rates, which mean better yield spreads and more profits for banks.

USANA Health Sciences also notched some solid gains, rising about 4%. Its shares had been hit quite hard earlier in the month in a guilt by association decline, after fellow multi-level marketer Nu Skin became the target of a Chinese regulatory investigation. USANA's gains over the past two weeks seems to be a typical bounce back following investor overreaction.

While January has been a tough month, the Hot List remains well ahead of the market over the long haul, and the recent declines are making for some good buying opportunities. In two weeks we'll rebalance the portfolio, at which point we'll see where my strategies are finding the best values.

Editor-in-Chief: John Reese

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Guru Spotlight: John Neff

Most investors wouldn't give a fund described as "relatively prosaic, dull, conservative" a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling -- so dazzling that Neff's track record may be the greatest ever for a mutual fund manager.

By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7 percent annual return, beating the market by an average of 3.1 percent per year. Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers -- an "investor's investor", if you will.

How did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a "contrarian" or "value investor", Neff writes in John Neff on Investing that, "Personally, I prefer a different label: 'low price-earnings investor.' It describes succinctly and accurately the investment style that guided Windsor while I was in charge."

To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren't expecting much from it. Much like David Dreman, the great contrarian guru who we examined a few newsletters back, Neff found that stocks with lower P/E ratios -- and lower expectations -- tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn't match investors' expectations.

To Neff, however, the P/E wasn't always a lower-is-better ratio. If investors knew that a firm was a dog, they'd rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40 and 60 percent of the market average.

While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate -- more than 20 percent -- could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7 and 20 percent per year, the kind of steady, unspectacular growth that could be sustained.

Sustainable growth also meant growth that was driven by sales -- not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7 percent per year, or at least 70 percent of EPS growth.)

One more key aspect of Neff's strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor's 3 percent per year market outperformance during his tenure came from dividends.

To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock's total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.

In recent years, my Neff-inspired model has been very stringent, with very few companies passing all of its tests. In fact, currently the highest score any stock gets using the approach is an 81%. Here's a look at the stocks that currently make up my 10-stock Neff-based portfolio:

Amtrust Financial Services, Inc. (AFSI)
Anheuser-Busch InBev SA (BUD)
PennantPark Investment Corporation (PNNT)
American Equity Investment Life Holding Company (AEL)
CNOOC Limited (CEO)
Employers Holdings, Inc. (EIG)
PNC Financial Services Group, Inc. (PNC)
Oracle Corporation (ORCL)
Humana Inc. (HUM)

I began tracking my Neff-based portfolio at the start of 2004, and it's had some significant ups and downs. From its inception through 2007, the portfolio returned about 67%, about double the S&P 500's 32.4% return. The 2008 crash was especially hard on value stocks, however, and the Neff portfolio fell more than 48% for the year, about 10 percentage points behind the S&P. It bounced back strong in 2009, surging 45.4%, but has struggled over the past few years. All in all, it is averaging annualized returns of 3.6% since inception, lagging the S&P 500 by about 1.3 percentage points (through Jan. 28).

Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. Right now, it's heavily concentrated in the financial sector, with seven of its ten holdings being financials. Most of them are dirt-cheap thanks to lingering fears about the economy and financial sector. By treading into such unloved areas, a value-focused strategy can languish for lengthy periods of time, and the Neff-based portfolio has indeed struggled in recent years. But Neff succeeded by staying disciplined and focusing on value. We believe the Neff-inspired model is built on strong fundamental-focused value principles, so we'll do the same and stay the course. Over the long term, I think that should lead to some good results.

News about Validea Hot List Stocks

AGCO Corporation: (AGCO) : AGCO declared an increase of 10% in its quarterly dividend, beginning in the first quarter of 2014. The dividend increase will result in a quarterly dividend of $0.11 per common share.

HCI Group, Inc. (HCI) : HCI became the first admitted homeowners insurance carrier to provide flood insurance in the state of Florida since the advent of significant changes to flood insurance regulations occurred in 2012. The firm will offer the flood insurance only to those who also have homeowners policy with HCI. The company said its biggest goal was to help customers who were hit hardest by "hefty rate increases" under the National Flood Insurance Program. Investors didn't seem happy with the move. Shares fell 10.6% the day after the announcement.

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

HCI   |   TJX   |   USNA   |   LEA   |   LUKOY   |   HFC   |   CEO   |   BOFI   |   AGCO   |   AFOP   |  

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

The TJX Companies, Inc. (TJX) is the off-price apparel and home fashions retailer in the United States and worldwide. As of January 28, 2012, the Company operated in four business segments. It has two segments in the United States, Marmaxx (T.J. Maxx and Marshalls) and HomeGoods; one in Canada, TJX Canada (Winners, Marshalls and HomeSense) and one in Europe, TJX Europe (T.K. Maxx and HomeSense). As a result of the consolidation of the A.J. Wright chain, all A.J. Wright stores ceased operations by the end of February 2011. It completed the consolidation of A.J. Wright, converting 90 of the A.J. Wright stores to T.J. Maxx, Marshalls or HomeGoods banners and closed the remaining 72 stores, two distribution centers and home office. In December 2012, the Company acquired Sierra Trading Post, an off-price Internet retailer.

USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.

Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.

NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe, as well as Africa. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO and completed acquisition of CJSC Kama-Oil. In June 2013, it sold a 99.57% stake in Lukoil Odes'kyi NPZ PAT. The Company's major shareholder is NKO ZAO NRD with a stake of 91.60%. In December 2013, it consolidated a 100% stake in ISAB Srl.

HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.

CNOOC Limited is an investment holding company. The Company, along with its subsidiaries, is a producer of offshore crude oil and natural gas and an independent oil and gas exploration and production company. Its subsidiaries are engaged in exploration, development, production and sales of oil and natural gas. It has three segments: independent operations, operations under joint arrangement and trading business. The Company has four producing areas in offshore China, which include the Bohai Bay, Western South China Sea, Eastern South China Sea and East China Sea. It also has oil and gas assets in Indonesia, Iraq, Australia, Africa, North America and South America. As of December 31, 2012, its subsidiaries included CNOOC China Limited, CNOOC International Limited, China Offshore Oil (Singapore) International Pte Ltd and others.

BofI Holding, Inc. is a holding company for BofI Federal Bank, a diversified financial services company. The Bank operate its bank from a single location in San Diego, California, serving approximately 40,000 retail deposit and loan customers across all 50 states. As of June 30, 2012, it had total assets of $2,386.8 million, loans of $1,799.7 million, mortgage-backed and other investment securities of $483.0 million, total deposits of $1,615.1 million and borrowings of $547.2 million. It distributes its deposit products through a range of retail distributions channels, and its deposits consist of demand, savings and time deposits accounts. It distributes its loan products through its retail, correspondent and wholesale channels, and the loans it retains are primarily first mortgages secured by single family real property and by multifamily real property.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

Alliance Fiber Optic Products Inc. (AFOP) designs, manufactures and markets a range of fiber optic components, and integrated modules incorporating these components, for communications equipment manufacturers and service providers. The Company offers a range of products, including interconnect devices that are used to connect optical fibers and components, couplers and splitters that are used to divide and combine optical power, and dense wavelength division multiplexing (DWDM) devices that separate and combine multiple specific wavelengths. The Company's optical passive products include wavelength division multiplexing (WDM), coarse wavelength division multiplexers (CWDM) and DWDM components and modules that utilize thin film filter technologies to separate optical signals, variable attenuators, optical switches and other optical devices utilizing micro optic lensing technology including integrated electro-optical modules incorporating these products.

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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