|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||March 2, 2012|
A number of new reports are showing that the US economy continues to strengthen, though reminders remain about the headwinds it is facing.
Since our last newsletter, one of the most positive signs has come from the labor market. New claims for unemployment have remained around the 350,000 mark, and the four-week moving average has reached a four-year low. The four-week average is about 10% below where it was a year ago, and more than 46% lower than it was at the height of the Great Recession.
Manufacturing activity also continues to expand. The Institute for Supply Management's manufacturing index showed that the sector grew in January for the 31st straight month, though the rate of growth declined a bit. The index's employment and new orders sub-indices also decelerated a bit, but nevertheless remained comfortably in expansion territory. Industrial production, meanwhile was flat in January, according to a new report from the Federal Reserve. The report also showed that production increased much more significantly than initially thought in December, however, rising 1.0% rather than the 0.4% initially reported. A big part of the flat reading in January was due to utility output falling 2.5%, thanks to unseasonably warm temperatures.
Mixed news came on the housing front. On the positive side, existing home sales rose 4.3% in January, according to the National Association of Realtors, while pending home sales rose 2.0%. But home prices, which had seemed to have been moderating, fell in December and for the 4th quarter as a whole, according to new data from the S&P/Case-Shiller Housing Indices. The national index, as well as the 10 city and 20 city composite indices, all hit their lowest points since the housing crisis started in 2006. The national index fell 3.8% in the 4th quarter compared to the 3rd quarter, while the 10 city and 20 city composite indices both fell 1.1% in December versus November. The seasonally adjusted numbers weren't as bad as the headline figures, however, with the nationwide reading falling 1.7% in the 4th quarter versus the 3rd quarter, and the 10 city and 20 city indices both falling 0.5% in December versus November. All in all, the housing market remains fragile, as most signs of hope seem to be matched with equally significant causes for concern.
The other big headwind pushing against the US economy -- the European debt crisis -- also remains on investors' minds. Unemployment in the eurozone reach 10.7% in January, according to a new report, the high for the euro-era. And manufacturing activity for the region continued to contract in January, another report showed. It has now been in contraction mode since last July.
Since our last newsletter, the S&P 500 returned 1.2%, while the Hot List returned 3.3%. So far in 2012, the portfolio has returned 15.7% vs. 9.3% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 161.6% vs. the S&P's 37.4% gain.
The Bull Turns Three
The continued improvement in the US economy is helping push stocks higher as the bull market that began in March 2009 nears its three-year mark. The third year of the bull has been a weak one, marked, of course, by some wild volatility. Through the end of February, the S&P 500 had gained just 3.5% in its third year, after gaining more than 95% over the first two years.
So, as we enter the fourth year of the bull, what should we expect? Well, every bull is different, of course. But by examining the past, we can at least get an idea first of how many bulls have made it through a fourth year, and, second, how those that have made it that far have tended to fare.
With that in mind, I recently looked back at all of the bull markets since 1957, the year that the S&P 500 benchmark came into its current form. The current bull is the tenth bull market since then. For the previous nine, the average duration was right at 48 months -- four years. Five of the nine lasted longer than four years, and one -- the bull that ran from mid-1962 to early-1966 -- came within about three-and-a-half months of doing so. That gives us six past bulls whose fourth years we can examine.
Before doing that, however, let's take a quick look at how the current bull has fared so far compared to past bulls. In the nine previous bulls since 1957 (all of which lasted at least two years), the S&P made big gains in the first two years, on averaged jumping 52.1%. The current bull continued that trend in an even bigger way, jumping 95.1%.
But post-1957 bulls that made it through a third year gained an average of just 3.9% in their third years. The worst of those third years (in the 1974-1980 bull) involved a 7.0% loss, and the best (the 1982-1987 bull) involved a 13.4% gain -- in other words, it's quite common for a bull market to start strong before stalling a bit in its third year, which is just what happened this time around.
So, what tends to happen in the fourth year, for those bulls that make it that far? The six post-1957 bulls that did make it prior to this one gained an average of 13.2% -- not as dramatic as the gains of the first two years, but still very solid gains. The individual fourth years ranged from a high of 29.7% (the 1957-1961 bull) to a low of -0.4% (the 1990-2000 bull).
In examining past bull markets, I also came across a New York Times article written before the fourth year of the 2002-2007 bull offered some insight into what types of stocks tend to fare best as bull markets mature. "A study of bull markets going back to 1900 by Ned Davis Research ... showed that in the first third of bull markets, stocks that pay dividends tend to trail those that don't pay them," wrote the Times' Paul Lim. "In the middle third, the dividend payers lead slightly, but in the final third, dividend payers, on average, win handily." Ned Davis Research also found that larger stocks tend to dramatically cut the advantage that smaller stocks have on them in the latter stages of bull runs.
All of this isn't to say you should expect 13% to 14% returns from the market in the coming year; as I noted above, while that has been the average, the individual fourth years have returned anywhere from 0% to almost 30%. This one might even be beyond that range, on one side or the other.
But I think there are two broader takeaways that are important here. The first is that just because a bull is entering its fourth year, it doesn't mean that it's getting long in the tooth and is nearing an end. Indeed, of the last five bulls, two have lasted just over five years, one lasted more than six years, and another lasted nearly ten years (the fifth, from 1987-1990, lasted about two-and-a-half years).
The other key takeaway is that in most bulls, after an initial junk rally, market-wide gains become less dramatic and fundamentals tend to win out. In addition to the data from Ned Davis Research I mentioned above, James O'Shaughnessy's firm has also done some extensive work into what types of stocks fare best at various stages of bulls. It found that generally, choosing stocks based on the fundamentals it examines -- book/price ratios, shareholder yield (which is dividend yield plus share buyback yield), and momentum -- has resulted in underperformance of the broader market in the first year of bulls, and then outperformance in the second and third years. The implication is that lower-quality stocks get pounded during bear markets, and then experience a big bounce-back early in the bull that follows as fears subside; then, the bull matures and fundamentals start to win out again. While O'Shaughnessy's firm didn't include research on fourth years of bulls, it stands to reason that fundamentals would fare well in a bull that continues to mature beyond a third year.
That bodes well for the Hot List as this bull's fourth year approaches. It is driven by a wide array of fundamentals, from valuation ratios like the price/book, price/sales, and price/earnings ratios to return on equity and capital to dividend yield and relative strength. Of course, there's no guarantee this bull will last another year. But given that overall valuations remain reasonable, and that the economy is continuing to show resilience, I think things are shaping up well as we approach the bull's third birthday, and I think the Hot List is well positioned to take advantage.
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.
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."
O'Shaughnessy has revamped his strategies over the years, most recently in his new, updated version of What Works on Wall Street (which I reviewed in the Nov. 25, 2011 edition of the Hot List). I've chosen not to tinker with my O'Shaughnessy-based models, however, given the exceptional performance they've had over the long term. The models discussed here are thus based on O'Shaughnessy's 1996 version of What Works on Wall Street.
So, let's start with the value stock strategy. O'Shaughnessy's 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 very solid performer since its inception back in 2003, with my 10-stock O'Shaughnessy-based portfolio gaining 145.0% (10.9% annualized) since inception, while the S&P 500 has gained just 37.2% (3.7% annualized; figures through Feb. 28).
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 portfolio made up of growth and value stocks can vary over time. For a long time, the portfolio has been leaning strongly to the growth side. But it's begun to shift back toward a neutral stance in 2012, with six of its holdings chosen using the growth method and four picked with the value model. Here's a look at the portfolio's holdings:
CACI -- CACI International Inc. (Growth)
ROST -- Ross Stores, Inc. (Growth)
TJX -- The TJX Companies, Inc. (Growth)
AZN -- AstraZeneca PLC (Value)
CSTR -- CoinStar, Inc. (Growth)
BP -- BP Plc (Value)
PBR -- Petroleo Brasileiro (Value)
MDF -- Metropolitan Health Networks (Growth)
STO -- Statoil ASA (Value)
ABC -- AmerisourceBergen Corp. (Growth)
Not Just 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
Tech Data Corp. (TECD): On Feb. 28, Tech Data said fourth-quarter net income fell 30% thanks to the cost of closing down its operations in Brazil and Colombia, the Associated Press reported. Excluding the costs of shutting down its Brazil and Colombia operations, earnings per share were $1.75, which beat analysts' expectations of $1.59 per share. Revenue was about flat at $7.11 billion; analysts had expected $7.16 billion, AP reported.
Ternium SA (TX): Ternium reported net income attributable to shareholders of $104.7 million, or 53 cents per American depositary share, up from $77.5 million, or 39 cents, a year earlier, according to Bloomberg. The earnings of 53 cents per ADR included a 25 cent foreign-exchange loss, a big reason why the firm fell short of analysts estimates of 59 cents a share, Bloomberg reported. Earnings before interest, taxes, depreciation and amortization rose to $369.6 million, which topped analysts' estimates of $315.8 million. Ternium also said it expects operating income to be lower this quarter than it was last quarter, with shipments remaining "relatively stable" and costs rising.
The Next Issue
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