|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||August 20, 2010|
While the pundits and many investors have focused on the negatives, several positive signs have emerged in the economy since our last newsletter -- offering indications that the recent slowdown wasn't the start of another recession, but instead part of the normal fluctuations seen in most recoveries.
One of the positives: Industrial production jumped 1.0% in July, according to new Federal Reserve data. That followed a decrease of 0.1% in June, which many had pointed to as a sign that the recovery was in trouble. But the July number was strong -- since industrial production turned positive in July 2009, only three months have featured a bigger gain. Industrial production now stands at its highest mark since October 2008; the same goes for capacity usage, which hasn't declined in 13 months.
Mixed news came from the manufacturing sector, where a deceleration in growth had recently raised fears among many investors. On the positive side, the New York Federal Reserve announced that its regional manufacturing index rose in August. And, the sub-index for employment nearly doubled from July, while the employee workweek index turned positive after being negative in July.
The Philadelphia Federal Reserve's manufacturing index, which covers the middle Atlantic region, turned negative, however, for the first time in 13 months. The index's employment component also declined.
A major problem for the economy remains unemployment, and there was bad news this week on that front. The government announced that in the most recent week, new claims for unemployment rose to their highest level in nine months. While weekly data can be quite volatile, that certainly isn't good news.
Since our last newsletter, the Federal Reserve has also announced its plan to use proceeds from its mortgage-backed securities portfolio to buy up Treasury bonds. The move was a sign that the Fed sees the recovery as weaker than previously hoped. That didn't help skittish investors, who have been piling into Treasuries -- and out of stocks -- for some time. (This week, the yield on the 10-year Treasury fell to about 2.6%, down from about 2.9% a month ago and 3.5% a year ago.) Investors are piling into other bonds, too. According to the Investment Company Institute, bond funds took in more than $7 billion in the most recent week for which data is available; investors removed $1.43 billion from equity funds, meanwhile.
Against a backdrop of low rates and crowded bond funds, the stocks of many financially sound companies look particularly attractive. And the majority of firms continue to beat expectations in both earnings and revenue. In the second quarter, about 66% of firms beat earnings estimates, while about 63% beat revenue estimates, according to Bespoke Investment Group. Dealmaking activity has also been better, with big names like Dell and BHP Billiton making headlines with proposed takeovers. That's a sign that companies have cash to spend -- according to FactSet Research, publicly traded firms in the U.S. have more than $2 trillion in cash and short-term investments on their balance sheets.
While corporations have a lot of cash on hand, a big question for the U.S.' service-driven economy is whether consumers will spend enough to spur growth. Reports from some big consumer stocks were mixed in the past week -- Wal-Mart, Home Depot, and Target all posted strong second-quarter profit figures, but their sales numbers weren't great.
A consumer spending boost could come from the real estate market, however. Mortgage refinancings surged 17% in the most recent week, the Mortgage Bankers Association reported, reaching their highest level in over a year. Economists from Morgan Stanley estimate that, if 50% of mortgages in mortgage-backed bonds are refinanced, $46 billion a year would be freed up for consumers, according to The Wall Street Journal. On the downside, a wave of refinancings could hamper the mortgage-backed-security market, which is still recovering from the 2008 crisis.
Despite some positives that emerged for the economy, fear seemed to win out for the fortnight. The S&P returned -4.5%, while the Hot List returned -6.4%. For the year, the portfolio stands at -9.9% vs. -3.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 117.2% vs. the S&P's 7.5% gain.
The Unemployment Question
One of the reasons fear continues to have the edge in the market is the employment situation. And make no bones about it -- while encouraging signs have been sprinkled here and there in recent months, the overall employment situation is not good. The unemployment rate is close to 10% -- and that doesn't include those who've gotten discouraged and have stopped looking for work, or those whose benefits have run out.
Last newsletter, I looked at how the current recovery compared to past recoveries in terms of manufacturing and gross domestic product. This week, I thought it would be good to take a look at how it compares to past recoveries in terms of unemployment.
To do so, let's look at two of the past recessions most often compared to the recent one -- the one that occurred in 1973-75, and the "double-dip" recession that occurred in 1980-82.
The former ended in March of 1975, at which time the unemployment rate was 8.6%. (All figures are from the U.S. Labor Department.) Unemployment actually continued to rise for two months after the recession technically ended, peaking at 9.0% in May 1975.
Six months after that peak, in November 1975, unemployment remained elevated -- it was 8.3%. Nine months after, it was at 7.7% A year after the May '75 peak, it remained much higher than normal, at 7.4%. By May 1977 -- a full two years after unemployment had peaked -- it still stood at 7.0%. It wasn't until the second half of that year that it finally fell below 7%.
How about the recession that ended in November 1982? Unemployment peaked at 10.8% in November of 1982. Six months after the unemployment peak, the rate stood at 10.1% -- still extremely high. Nine months after the peak, it was at 9.5%. By November 1983 -- a year after peaking -- it had fallen substantially, but was still elevated, at 8.5%. Two years later, it was still higher than we're accustomed to, at 7.2%.
Now, on to the current rebound. Unemployment hit its high of 10.1% back in October of 2009. Six months later, it was at 9.9%; nine months later -- in July (the most recent data available) -- it was 9.5%.
So, a quick recap:
6 months after peak: 8.3%
9 months after peak: 7.7%
12 months after peak: 7.4%
24 months after peak: 7.0%
6 months after peak: 10.1%
9 months after peak: 9.5%
12 months after peak: 8.5%
24 months after peak: 7.2%
6 months after peak: 9.9%
9 months after peak: 9.5%
12 months after peak: N/A
24 months after peak: N/A
As you can see, in the current recovery, employment has rebounded a bit more slowly than it did following its 1975 and 1982 peaks. Both those recoveries saw the unemployment rate drop 0.7 percentage points in the first six months, and another 0.6 percentage points in the next three months; the current recovery involved corresponding drops of 0.2 points and 0.4 points, respectively.
That difference, however, isn't jaw-dropping; in fact, I don't think it's significant enough to draw any real conclusions from -- and I certainly don't think it's a big enough difference to indicate that "this time it's different", as some pundits say.
To me, the bigger point to take from those sets of numbers is that following very difficult recessions, the employment picture doesn't snap back overnight. In the case of both the 1973-75 and 1980-82 recessions, unemployment peaked shortly after the recession ended, and then made its way downward slowly. As you can see from the figures above, the unemployment rate was still quite elevated even two years after the recessions were over.
What's also very important to note is that in both those two-year periods following the 1975 and 1982 unemployment peaks, the market gained ground despite unemployment remaining elevated.
A Not-So-New Normal?
These figures also put the "New Normal" concept that many on Wall Street have embraced in a different context. As you probably know, part of the "New Normal" theory is that we are going to see an extended period of high unemployment. But there's a crucial piece of the New Normal theory that seems to get distorted. While the media has made it seem like an "extended period" could be a decade or two (or more), some of the New Normal's staunchest proponents haven't been nearly as dire.
Bond giant PIMCO, for example, has been at the forefront of the New Normal prognostications, and its chief, Mohamed El-Erian, has said the New Normal will be a 3- to 5-year phenomenon. We're almost two years into the alleged "New Normal" right now, meaning that -- if you buy the New Normal argument -- there's somewhere around 2 years left. The point: When you look at the time it took for unemployment to get back to moderate levels after the 1973-75 and 1980-82 recessions, the notion that unemployment will remain elevated for a couple more years hardly seems "new" at all.
All of this isn't to downplay to severity of the current employment situation, or to cast aside the very real, very awful impact that the U.S.'s employment troubles are having on millions of Americans. But as an investor, it's important to separate the emotional impact of high unemployment figures from the reality of the investing environment. And the reality is that it can take quite a while for unemployment to fall significantly following tough recessions -- and that the stock market can post big gains even during those lingering periods of elevated unemployment. That doesn't mean the market is going to take off today or next week; what it means is that the lingering high unemployment numbers aren't unprecedented, and they aren't in and of themselves reason to avoid stocks. Indeed, with valuations reasonable and many firms sporting exceptional balance sheets, earnings and revenue growth, and profit margins, there are plenty of reasons for long-term investors to be bullish.
Guru Spotlight: James O'Shaughnessy
To say that James O'Shaughnessy has written the book on quantitative investing strategies might be an exaggeration -- but not much of one. Over the years, O'Shaughnessy has compiled an anthology of research on the historical performance of various stock selection strategies rivaling that of just about anyone. He first published his findings back in 1996, in the first edition of his bestselling What Works on Wall Street, using Standard & Poor's Compustat database to back-test a myriad of quantitative approaches. He has continued to periodically update his findings since then, and today he also serves as a money manager and the manager of several Canadian mutual funds.
In addition to finding out how certain strategies had performed in terms of returns over the long term, O'Shaughnessy's study also allowed him to find out how risky or volatile each strategy he examined was. So after looking at all sorts of different approaches, he was thus able to find the one that produced the best risk-adjusted returns -- what he called his "United Cornerstone" strategy.
The United Cornerstone approach, the basis for my O'Shaughnessy-based Guru Strategy, is actually a combination of two separate models that O'Shaughnessy tested, one growth-focused and one value-focused. His growth method -- "Cornerstone Growth" -- produced better returns than his "Cornerstone Value" approach, and was a little more risky. The Cornerstone Value strategy, meanwhile, produced returns that were a bit lower, but with less volatility. Together, they formed an exceptional one-two punch, averaging a compound return of 17.1 percent from 1954 through 1996, easily beating the S&P 500s 11.5 percent compound return during that time while maintaining relatively low levels of risk. My O'Shaughnessy-based model also has a very strong track record; in fact, in 2010 it's been one of my best performers, gaining nearly 7% while the S&P 500 is down about 2%.
That 5.6 percent spread is enormous when compounded over 42 years: If you'd invested $10,000 using the United Cornerstone approach on the first day of the period covered by O'Shaughnessy's study, you'd have had almost $7.6 million by the end of 1996 -- more than $6.6 million more than you'd have ended up with if you'd invested $10,000 in the S&P for the same period! That seems powerful evidence that stock prices do not -- as efficient market believers suggest -- move in a "random walk," but instead, as O'Shaughnessy writes, with a "purposeful stride."
The Two-Pronged O'Shaughnessy Attack
Let's start with O'Shaughnessy's value stock strategy. His Cornerstone Value approach targeted "market leaders" -- large, well-known firms with sales well above those of the average company -- because he found that these firms' stocks are considerably less volatile than the broader market. He believed that all investors-even the youngest of the bunch -- should hold some value stocks.
To find these firms, O'Shaughnessy required stocks to have a market cap greater than $1 billion, a number of shares outstanding greater than the market mean, and trailing 12-month sales that were at least 1.5 times the market mean.
Size and market position weren't enough to make a value stock attractive for O'Shaughnessy, however. Another key factor that was a great predictor of a stock's future, he found, was cash flow. My O'Shaughnessy-based value model calls for companies to have cash flows per share greater than the market average.
O'Shaughnessy found that, when it came to market leaders, another criterion was even more important than cash flow: dividend yield. He found that high dividend yields were an excellent predictor of success for large, well-known stocks (though not for smaller stocks); large market-leaders with high dividends tended to outperform during bull markets, and didn't fall as far as other stocks during bear markets. The Cornerstone Value model takes all of the stocks that pass the four aforementioned criteria (market cap, shares outstanding, sales, and cash flow) and ranks them according to dividend yield. The 50 stocks with the highest dividend yields get final approval.
The Cornerstone Growth approach, meanwhile, isn't strictly a growth approach. That's because one of the interesting things O'Shaughnessy found in his back-testing was that all of the successful strategies he studied -- even growth approaches -- included at least one value-based criterion. The value component of his Cornerstone Growth strategy was the price/sales ratio, a variable that O'Shaughnessy found -- much to the surprise of Wall Street -- was the single best indication of a stock's value, and predictor of its future.
The Cornerstone Growth model allows for smaller stocks, using a market cap minimum of $150 million, and requires stocks to have price/sales ratios below 1.5. To avoid outright dogs, the strategy also looks at a company's last five years of earnings, requiring that its earnings per share have increased each year since the first year of that period.
The final criterion of this approach is relative strength, the measure of how a stock has performed compared to all other stocks over the past year. A key part of why the growth stock model works so well, according to O'Shaughnessy, is the combination of high relative strengths and low P/S ratios. By targeting stocks with high relative strengths, you're looking for companies that the market is embracing. But by also making sure that a firm has a low P/S ratio, you're ensuring that you're not getting in too late on these popular stocks, after they've become too expensive. "This strategy will never buy a Netscape or Genentech or Polaroid at 165 times earnings," O'Shaughnessy wrote, referring to some of history's well-known momentum-driven, overpriced stocks. "It forces you to buy stocks just when the market realizes the companies have been overlooked."
To apply the RS criterion, the Cornerstone Growth model takes all the stocks that pass the three growth criteria I mentioned (market cap, earnings persistence, P/S ratio) and ranks them by RS. The top 50 stocks then get final approval.
The Growth/Value Investor model I base on O'Shaughnessy's two-pronged approach has been a solid performer since its inception back in 2003, with my 10-stock O'Shaughnessy-based portfolio gaining 67.8% (7.6% annualized) since inception, while the S&P 500 has gained just 9.4% (1.3% annualized).
The O'Shaughnessy-based portfolio will pick stocks using both the growth and value methods I described above. It picks whatever the best-rated stocks are at the time, regardless of growth/value distinction, meaning the portion of the portfolios made up of growth and value stocks can vary over time. Currently, the strategy is finding more buys using the growth approach, which is responsible for picking eight of the stocks in the 10-stock portfolio. Here's a look at the 10-stock portfolio's holdings (growth/value distinction in parentheses):
ROST -- Ross Stores, Inc. (Growth)
HS -- HealthSpring, Inc. Growth)
JOSB -- Jos. A. Bank Clothiers (Growth)
INT -- World Fuel Services Corporation (Growth)
WRLD -- World Acceptance Corp. (Growth)
PSMT -- PriceSmart, Inc. (Growth)
MWIV -- MWIV Veterinary Supply Inc. (Growth)
ABC -- AmerisourceBergen Corporation (Growth)
JNJ -- Johnson & Johnson (Value)
CVX -- Chevron Corporation (Value)
Beyond The Numbers
O'Shaughnessy is a pure quant, but you should be aware that some of his most critical lessons are less about specific criteria and numbers than they are about the general mindset an investor must have. Perhaps more than anything else, O'Shaughnessy believes in picking a good strategy and sticking with it -- no matter what. In What Works on Wall Street, he writes that in order to beat the market, it is crucial that you stay disciplined: "[C]onsistently, patiently, and slavishly stick with a strategy, even when it's performing poorly relative to other methods."
The reason involved human emotions, which cause many investors to bail on a good approach and jump onto hot stocks or strategies that are often overhyped and overpriced. "We are a bundle of inconsistencies," he writes, "and while that may make us interesting, it plays havoc with our ability to invest our money successfully. Disciplined implementation of active strategies is the key to performance." Wise words, whether you follow O'Shaughnessy's approach or another proven method.
News about Validea Hot List Stocks
Jos. A. Bank Clothiers (JOSB): Bank's shares underwent a 3-for-2 split on Aug. 18. Each shareholder of record as of July 30, 2010 was to receive one additional share of common stock for every two shares then owned. The company said it was recognizing the increase in the value of its shares since its last stock dividend, which was due primarily to growth in sales, earnings and cash flows. It also said the split should enhance the firm's liquidity by making shares available to more investors.
Ross Stores (ROST): On Aug. 19, Ross reported net second-quarter income of $129.3 million ($1.07 per share), up 25% from $103.4 million ($0.82 per share) in the year-ago period. The company said the higher earnings were driven in large part by leaner inventory, according to Reuters, which added that the per-share profit was in line with analysts' expectations. Sales increased 8% to $1.91 billion.
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 firstname.lastname@example.org.
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