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Executive Summary October 29, 2010

The Economy

The financial news continues to be dominated by talk of quantitative easing, with the Federal Reserve dropping strong hints that a second round of "QE" is in the works. But while "QE2" has been filling the headlines, some encouraging economic signs have been popping up .

First, new claims for unemployment fell about 5% for the week ended Oct. 23, the Labor Department reported, reaching their lowest level in more than three months. In fact, with the exception of one week back in July, new claims were the lowest they've been since before the Lehman Brothers' collapse and financial crisis. Continuing claims, meanwhile, fell to their lowest level since November of 2008.

Third-quarter earnings results also offered some good news. As of Oct. 27, more than 80% of S&P 500 companies that had reported earnings had beaten estimates, according to Thomson Reuters. And while many investors have been concerned that profit growth has been driven by cost-cutting measures (which can't go on forever) rather than sales growth, a number of bellwether-type firms have reported strong sales increases for the quarter. Caterpillar Inc., for example, reported a 53% jump in revenue and sales, while tech giants Apple (+67%) and Google (+23%) also reported big revenue gains. Even some consumer discretionary-type retailers have been reporting solid demand -- Coach, for example, upped revenue by 20% in the third quarter.

Overall, retail sales increased 0.6% in September, according to the Census Bureau. In doing so, they reached their highest level since before the Lehman collapse.

Industrial production, meanwhile, declined slightly in September, according to the Federal Reserve, dipping 0.2%. It was the first time in more than a year that production had declined, though the dip was tempered by the fact that August's numbers were revised upward. Overall, that means industrial production remains right where it was back in July -- three straight months of steady numbers is not a great sign, but it's certainly not an uncommon occurrence even in good economic times.

As for the housing market, it offered some good news, with the National Association of Realtors announcing that existing-home sales jumped 10% in September. The overall housing picture remains cloudy, however; existing-home sales remain 19.1% below year-ago levels, but the year-ago figures are somewhat inflated because of the homebuyer tax credit program that many buyers were taking advantage of back then.

Finally, one factor to keep an eye on is the dollar. With all of the talk of more quantitative easing, the dollar has been declining. That has a number of different implications -- cheaper exports and costlier commodities, to name just two -- that could have a big impact on the economy. The size of the Fed's easing plan, which has yet to be announced, will of course have an impact on the dollar's movement.

The market digested all of this news with some ups and downs over the past fortnight, with the S&P 500 returning 0.9%, and the Hot List returning -0.2%. For the year, the portfolio stands at 4.3% vs. 6.2% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 151.4% vs. the S&P's 18.3% gain.

To Ease Or Not To Ease

While some very positive economic signs, like the unemployment claim declines and the consumer spending increase, have popped up recently, the main focus of many investors and the media continues to be "QE2".

To be sure, another round of easing would be a big event, so it's worth taking a look at what it might involve. First off, to be clear, the Fed has not officially said it will engage in more easing. But it and its chairman, Ben Bernanke, have dropped some pretty strong hints that it will do so. Bernanke said earlier this month, for example, that "there would appear -- all else being equal -- to be a case for further action" by the Fed.

With nominal interest rates already near zero, the "further action" would likely come in the form of more asset purchases by the Fed. The group's first round of QE already called for the purchase of $300 billion in long-term Treasuries, close to $200 billion in federal agency debt, and up to $1.25 trillion in agency-guaranteed mortgage-backed securities (with the agencies in question being Fannie Mae, Freddie Mac, and Ginnie Mae).

The goals of such an asset-purchase program would be two-fold, according to a recent paper published by the Federal Reserve Bank of St. Louis: to decrease long-term interest rates, which, in turn, would spur demand. Sounds good in theory. But in practice, there are some big questions.

Perhaps the foremost is whether such a plan really addresses the root of the issue. Since March 2009, the Fed has been buying assets not with proceeds from the sale of other assets, but by creating new deposits -- essentially, by printing money. And there already seems to be plenty of money in the financial system, thanks to the first round of QE, government bailouts, and stimulus efforts. The issue, rather, is the velocity of that money, which hasn't gotten back to pre-financial-crisis levels. Essentially, banks are sitting on piles of cash rather than lending it out, while many corporations, feeling uncertain about where we're headed, are sitting on their own piles of cash rather than investing it in ways that could grow their businesses.

So, will more QE really increase the velocity of money and spur more demand? Well, I'm not going to try to play economic forecaster. But I think it is worth noting that one of the QE side effects that many see as a concern -- significant inflation -- actually is a reason to be bullish on stocks. History has proven that over the long run stocks are a far better inflation fighter than just about any other investment; because they essentially are pieces of a business, they are able to draw on increasing revenue streams as prices rise. Bonds, bills, and even gold can't do that.

For long-term investors, what may be even more important to focus on is that plenty of companies are already generating demand for their products and services, without the aid of more easing from the Fed. In fact, many put up very respectable sales gains throughout the "Great Recession", despite all of the economic turmoil.

Take a look at the three new additions this week to the Hot List. One, World Acceptance Corp., is a financial that actually grew revenues by 18.4% in 2008, while also upping earnings. It followed that by upping revenues by 13.3% in 2009, and by 12.4% in its fiscal 2010 (which ended at the end of March). In the first half of fiscal 2011, its revenues rose another 12%. (The firm has also upped earnings per share in each year of the past decade.)

Another Hot List newcomer, Eli Lilly, also upped revenues in 2008 and 2009, and it is on pace to do so again in 2010. And the third newbie, China MediaExpress, has been raking in the sales -- revenues more than doubled in the first quarter of 2010, and then nearly tripled in the second quarter.

Companies like these show that there are firms that will find a way to generate demand -- and profits -- through even the toughest times. While much of the financial world continues to key on QE2 and other macroeconomic factors, good investors will focus on trying to identify these types of companies, and snatch them up when their shares are cheap. Right now, we are finding plenty such bargains in the market, and over the long haul I'm confident they'll help the Hot List continue its stellar long-term performance.

Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: Jos. A. Bank Clothiers, Inc. (JOSB), Research In Motion Limited (Usa) (RIMM) and Aeropostale, Inc. (ARO).

The Keepers

7 stocks remain in the portfolio. They are: Western Digital Corp. (WDC), Sanofi-aventis Sa (Adr) (SNY), China Automotive Systems, Inc. (CAAS), Healthspring, Inc (HS), Gamestop Corp. (GME), Dollar Tree, Inc. (DLTR) and L&l Energy, Inc. (LLEN).

The Newbies

We are adding 3 stocks to the portfolio. These include: Eli Lilly & Co. (LLY), World Acceptance Corp. (WRLD) and China Mediaexpress Holdings Inc (CCME).

Portfolio Changes

Newcomers to the Validea Hot List

Eli Lilly & Co. (LLY): Based in Indiana, this 134-year-old pharmaceutical maker's products are marketed in 143 countries around the globe. Among its most well-known products: anti-depressant/neuropathic pain fighter Cymbalta, erectile dysfunction drug Cialis, and Prozac.

Lilly ($40 billion market cap) gets approval from my Peter Lynch- and Joel Greenblatt-inspired strategies. To read more about it, check out the "Detailed Stock Analysis" section below.

World Acceptance Corp. (WRLD): Based in Greenville, S.C., World Acceptance ($670 million market cap) specializes in small, short-term loans, and has close to 1,000 offices in the southern and central U.S., and Mexico. Its loans are generally under $3,000 and have durations of less than 24 months, and much of its business comes from repeat customers.

World Acceptance gets approval from my Peter Lynch-, Warren Buffett-, and James O'Shaughnessy-based models. See the "Detailed Stock Analysis" section below to learn more about the stock.

China MediaExpress Holdings Inc. (CCME): This China-based firm operates a television advertising network on inner-city passenger buses in China. Its network includes digital televisions that show ads on more than 21,000 buses, many of which travel through some of China's most populous regions.

China MediaExpress' shares have been hot lately, just about doubling since mid-September. My models think the firm's fundamentals show it has more room to run -- it gets approval from my Joel Greenblatt-based model and the model I base on the writings of Motley Fool creators Tom and David Gardner. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

News about Validea Hot List Stocks

HealthSpring Inc. (HS): HealthSpring announced on Oct. 28 that profits grew 27% in the third quarter vs. the year-ago period. Earnings per diluted share were $0.95 while revenue was $725.2 million. Analysts had predicted earnings of $0.83 on revenue of $737 million, according to the Nashville Business Journal. The firm cited "continued favorable trends in our Medicare Advantage medical expenses and better than expected Part D membership growth and pharmacy rebates" as reasons for the profit gains.

Sanofi-Aventis (SNY): Sanofi has announced that it will acquire all outstanding shares of BMP Sunstone Corporation, a Chinese specialty pharmaceutical maker, for about $520.6 million on a fully diluted basis. The acquisition will be structured as a merger of Sunstone and a wholly-owned subsidiary of Sanofi. The price per share -- $10 -- represents a 30% premium above the closing price of Sunstone's shares on Oct. 27.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. 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

HS   |   WDC   |   CCME   |   CAAS   |   WRLD   |   LLEN   |   LLY   |   SNY   |   GME   |   DLTR   |  

HealthSpring, Inc. (HealthSpring) is a managed care organization with a primary focus on Medicare, the federal government-sponsored health insurance program for United States citizens aged 65 and older, qualifying disabled persons and persons suffering from end-stage renal disease. As of December 31, 2009, the Company operated coordinated care Medicare Advantage plans in Alabama, Florida, Illinois, Mississippi, Tennessee, and Texas. As of January 1, 2010, it also commenced operations of Medicare Advantage plans in three counties in Northern Georgia. As of December 31, 2009, the Company's Medicare Advantage plans had over 189,000 members. The Company also offers prescription drug benefits in accordance with Medicare Part D to its Medicare Advantage plan members, in addition to providing other medical benefits (MA-PD) plans. It also offers prescription drug benefits nationally on a stand-alone basis in accordance with Medicare Part D (PDP).

Western Digital Corporation (WD) designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufacturers (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. Its hard drives are used in desktop computers, notebook computers, and enterprise applications such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Its hard drives are used in CE applications, such as digital video recorders (DVRs), and satellite and cable set-top boxes (STBs). It also sells its hard drives as stand-alone storage products by integrating them into finished enclosures, embedding application software and offering the products as WD-branded external storage appliances for personal data backup and portable or expanded storage of digital music, video and other digital data.

China MediaExpress Holdings, Inc. (CME), through contractual arrangements with Fujian Fenzhong Media Co., Ltd. (Fujian Fenzhong), operates the television advertising network on inter-city express buses in China. The Company and its subsidiaries and variable interest entity (VIE) are engaged in the operation of mobile television advertising networks on passenger buses travelling on highways in the People's Republic of China. The Company does not conduct any substantive operations of its own, but conducts it primary business operations through Fujian Fenzhong, a VIE of a wholly owned subsidiary, Fujian Across Express Information Technology Co, Ltd. (Across Express). On October 15, 2009, CME acquired all of the issued and outstanding capital stock of Hong Kong Mandefu Holding Limited (the HKMDF), its subsidiary and VIE, and as a result, HKMDF became its direct wholly owned subsidiary.

China Automotive Systems, Inc. (China Automotive) is a holding company and has no significant business operations or assets other than its interest in Great Genesis Holdings Limited (Genesis). Through Genesis, the Company manufactures power steering systems and other component parts for automobiles. All operations are conducted through eight Sino-foreign joint ventures in China and a wholly owned subsidiary in the United States. The Company has business relations with more than 60 vehicle manufacturers, including FAW Group and Dongfeng Auto Group, automobile manufacturers in China; Shenyang Brilliance Jinbei Co., Ltd., light vehicle manufacturer in China; Chery Automobile Co., Ltd, state-owned car manufacturer in China, and Xi'an BYD Auto Co., Ltd and Zhejiang Geely Automobile Co., Ltd., car manufacturers.

World Acceptance Corporation is engaged in the small-loan consumer finance business, offering short-term small loans, medium-term larger loans, related credit insurance and ancillary products and services to individuals. The Company offers standardized installment loans of between $300 and $4,000 through 990 offices in South Carolina, Georgia, Texas, Oklahoma, Louisiana, Tennessee, Illinois, Missouri, New Mexico, Kentucky, Alabama and Mexico as of March 31, 2010. The Company serves individuals with limited access to consumer credit from banks, savings and loans, other consumer finance businesses and credit card lenders. In the United States offices, the Company also offers income tax return preparation services and access to refund anticipation loans through a third party bank to its customers and others. During the fiscal year ended March 31, 2010 (fiscal 2010), the Company opened 48 offices.

L & L Energy, Inc. (L & L) is engaged in the businesses of coal mining, coal washing, coal coking and coal wholesaling. The Company's operations are conducted in Yunnan and Guizhou provinces in the southwest region of the People's Republic of China. As of April 30, 2010, the Company had three operating subsidiaries: KMC, which has coal wholesale operations and Ping Yi Coal Mine (mining operations PYC); two coal mining operations (DaPuAn Mine and SuTsong Mine), including DaPuAn's coal washing operations (the 2 Mines or LLC), and L&L Yunnan Tianneng Industry Co. Ltd. (including Hong Xing coal washing and ZoneLin coking operations) (TNI).

Eli Lilly and Company discovers, develops, manufactures, and sells products in one business segment, pharmaceutical products. The Company also has an animal health business segment. It manufactures and distributes its products through facilities in the United States, Puerto Rico, and 17 other countries. Its products are sold in approximately 128 countries. The Company's products include Neuroscience products, Endocrinology products, Oncology products, Cardiovascular products, Animal health products, and other pharmaceuticals. In the United States, Eli Lilly and Company distributes pharmaceutical products principally through independent wholesale distributors, with some sales directly to pharmacies. In July 2010, the Company acquired Alnara Pharmaceuticals, Inc.

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. The Company is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, the Company specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company.

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 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

Dollar Tree, Inc. (Dollar Tree) is an operator of discount variety stores offering merchandise at the fixed price of one dollar. At January 30, 2010, the Company operated 3,806 discount variety retail stores. Approximately 3,650 of these stores sell substantially all items for one dollar or less. The remaining stores, operating as Deal$, sell items for one dollar or less but also sell items for more than one dollar. Dollar Tree's stores operate under the names of Dollar Tree, Deal$ and Dollar Bills.

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.


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