|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||November 9, 2012|
While the elections -- and their impact on how the U.S. will deal with the looming "fiscal cliff" -- were foremost on many investors' minds over the past two weeks, the economy was continuing to flash some positive signals.
The October jobs report, for example, was one of the best we've seen in a while, with 184,000 private sector jobs created during the month, according to the Labor Department. The unemployment rate rose slightly, to 7.9%, but that appeared to be because more people were looking for jobs -- the number of people not in the labor force declined by 369,000. The "U-6" rate (which unlike the headline number includes discouraged workers who've given up looking for work and part-time workers who can't get full-time jobs) declined slightly to 14.6%. That's still very elevated, but it's down from 16.0% last year at this time.
Manufacturing activity, meanwhile, increased for the second straight month in October, doing so at a slightly faster pace than it did in September, according to the Institute for Supply Management. The group's New Orders sub-index also increased at an accelerating rate, and the employment sub-index showed that employment conditions continue to improve. ISM's non-manufacturing index showed that the service sector also expanded in October, for the 34th straight month. Its employment sub-index indicated that hiring was improving for the third straight month, while its prices sub-index remained quite elevated -- a sign that inflationary pressures are something to keep an eye on.
The housing market is continuing to show signs of recovery. Home prices in 20 major cities rose on average by 0.9% in August, according to the latest S&P/Case-Shiller Home Price Indices data. Prices were up 2.0% over the year-ago period. While the market isn't booming, it has now been improving for several months, a great sign.
Housing was a major factor in a better-than-expected third-quarter gross domestic product report. GDP was up 2.0% for the quarter, showing that growth accelerated after the second quarter's 1.3% growth. Residential investment accounted for about a sixth of the increase, according to the Commerce Department. Government spending was also a big factor; it jumped nearly 10% in real terms during the quarter, driven by an increase in defense spending. The big driver behind the growth, however, was the U.S. consumer -- personal consumption expenditures accounted for about 70% of the GDP increase.
Speaking of consumers, the Commerce Department's latest monthly consumer data showed that disposable personal income increased 0.4% in September. But real disposable personal income actually declined, by less than 0.1%. Personal consumption expenditures, meanwhile, jumped 0.8%, or 0.4% in real terms. Of course, the data are somewhat of a double-edged sword -- increased spending boosts the economy, at least in the short term, but it seems that Americans are dipping into their savings in order to increase their spending. The personal savings rate fell from 3.7% in August to 3.3% in September, the third lowest monthly reading since the start of 2008.
Since our last newsletter, the S&P 500 returned -2.5%, while the Hot List returned -0.3%. So far in 2012, the portfolio has returned 8.8% vs. 9.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 146.0% vs. the S&P's 37.7% gain.
Peering over the Precipice
Following Tuesday's elections, stocks plummeted, with the Dow Jones Industrial Average posting its biggest loss of the year and the S&P 500 enduring its biggest decline in about five months. A number of factors sparked the plunge. Wall Street no doubt was disappointed that President Obama was re-elected instead of Mitt Romney, who was perceived to be more pro-business, and negative debt-related news coming out of Europe didn't help.
Perhaps the biggest reason for the sharp market declines, however, was the fact that the President/Senate/House dynamic was unchanged by the election. We still have a Democratic President and Senate, and a Republican House of Representatives, and, while some of the players have changed, the ideologies on both sides don't seem to have shifted much. With the "fiscal cliff" -- the combination of tax hikes and budget cuts that will go into effect in 2013 if no action is taken -- looming, confidence isn't too high that legislators will finally be able to reach a compromise and put the U.S. on a better fiscal path.
I for one am optimistic -- albeit very cautiously so -- that Congress and the President can get their acts together. But what if they don't? Based on how investors fled the market after the election, and the dire prognostications many pundits have been making, it's easy to think that falling off the cliff will mean disaster for the economy and market. And, no doubt, it would have some big short-term ramifications.
But a look at history shows that failure to avoid the cliff doesn't mean disaster. That's what O'Shaughnessy Asset Management, the firm headed by James O'Shaughnessy (one of the gurus upon whom I base my strategies) found in a recent study. Looking at data going back to 1926, OSAM looked at how the stock market has fared during times of varying tax levels, since tax increases are one of the biggest concerns surrounding the cliff. "Our analysis suggests that, across history, tax rates and changes to those rates generally have not meaningfully impacted equity returns," Travis Fairchild and Patrick O'Shaughnessy wrote in a paper detailing the study. The analysis included tax rates involved with dividends -- which are set to jump dramatically if we go off the cliff. "Surprisingly, dividend-paying stocks performed best when taxes were highest," Fairchild and O'Shaughnessy wrote.
Here's what OSAM did: It separated all years from 1926-2011 into three categories -- high, middle, low -- based on the average effective tax rate for a family earning $250,000. It found that in the one-third of years with the lowest effective tax rate, the S&P 500 gained just 3.7% annualized, and produced an average dividend yield of 3.7%. In the third of years with the highest tax rate, the index gained 11.3% annualized, with a yield of 4.5%. In the middle third of years, it gained 13.9%, and yielded 3.3%.
The group also looked at how the market performed during the 10 years when taxes increased the most from the prior year, and the 10 years when taxes decreased the most. On average, in the year after the 10 highest increases occurred, stocks gained 8.4%; the average three-year annualized return was 7.9%, and the average five-year annualized return was 15.7%. Following the largest decreases, one-year returns averaged 13.0%; three-year annualized returns were 8.4%; and five-year annualized returns averaged 13.4%. "Put simply," Fairchild and O'Shaughnessy wrote, "large tax increases or decreases have not foretold doom or boom for equity returns."
OSAM found a similar situation with dividends. The outperformance of high-dividend stocks was basically the same, on average, during periods when dividends were taxed as regular income, periods when dividends were exempt from taxation, and periods when dividends were taxed at 15%. They found just one example of a dividend tax increase in the neighborhood of what the fiscal cliff could cause (1954-55), and found that high-dividend stocks outperformed following that increase as well.
Fairchild and O'Shaughnessy say they aren't arguing that large tax hikes are good for stocks, or that there is a causal relationship between high taxes and strong dividend stock returns. "But it does contradict the projections of those calling for a sell off in dividend-paying stocks as the fiscal cliff nears," they say, adding that they think valuation declines in high-dividend stocks "should be short-term and unsustainable" and would likely lead to a big buying opportunity. They say now is not a time to panic, and that what should drive stock returns in the future is the quality of companies and the price of their shares -- not tax rates. I wholeheartedly agree.
But What About Obama?
For those concerned with the loss of the Presidential candidate who was presumed to be more business-friendly, history paints a similar picture. While the Republican party is generally considered to be more business and market friendly than the Democratic party, the market has actually performed significantly better with Democratic Commanders-in-Chief in charge. Since 1901, the market has averaged 12.1% annual returns under Democratic Presidents, and just 5.1% under Republican Presidents, according to S&P Capital IQ. GDP and corporate profits have also fared better under Democratic Presidents than Republicans.
Of course, there are plenty of examples of Republican Presidents whose terms involved strong market gains. The market averaged nearly 11% annual returns during President Eisenhower's eight years, and more than 10% annually during President Reagan's two terms. And Democratic Presidents have seen sub-par markets, with both John F. Kennedy and Jimmy Carter in office while the market posted annualized returns of less than 7% (all those figures according to Bloomberg Financial Markets data, via The New York Times).
So what does all of that mean? Are Democrats better stewards of the economy and financial markets than Republicans? Trying to answer such a question is nearly impossible. For one thing, no two Democrats are the same, and no two Republicans are the same (no matter what one party will try to tell you about the other). Often, in fact, a President's actions will play against stereotypes. Kennedy, a Democrat, oversaw sharp tax cuts for high-income Americans during his tenure, while the first President Bush raised taxes during his. Clinton's actions showed far more fiscal conservativeness than those of the second President Bush, as he balance the budget while Bush spent far beyond the nation's means.
In addition, a President needs to have a friendly enough Congress to carry out his plans. And, if that's the case, the impact of those plans may not be felt immediately. Some policies championed by one President may not have their full effect until a new President is in office, making it very hard to judge the cause-and-effect relationship a President's policies have on the economy and market?
Even if you could judge the impact of a President's policies on the market with a great degree of accuracy, I'm not sure you'd find much of a pattern. Economic and financial cycles are simply more powerful than any one elected official, and perhaps even more powerful than Congress and the President combined. Does anyone, for example, really believe that the Internet bubble would not have burst, and the country not gone through a recession, had Clinton been able to serve a third term? Would the housing crisis have been averted if John Kerry won the Presidency in 2004? Could John McCain have stopped the financial crisis in its tracks if he captured the White House in '08? I find any of those scenarios highly unlikely. The forces at play were simply too great.
Listen, in the short term, there's no doubt that the emotions raised by the fiscal cliff issue can and probably will have a significant impact on the stock market. We've already seen that. But the point is that investing is about the long term. And there's little evidence showing that an election, or the sort of tax hikes involved in the fiscal cliff, will lead to a long-term destruction of wealth for investors.
Regardless of what policy actions our leaders take (or don't take) in the next four years, good companies should continue to make money, and if their shares are reasonably priced, then many of those stocks will rise. New technologies, and perhaps new industries altogether, will arise and possibly have more impact on markets than any President or Congress could. (Consider, for example, whether any elected official or body has had more of an impact on the market than the invention of the automobile, or of the personal computer.) Companies will take advantage of new, blossoming markets overseas. Cyclical forces beyond the reach of any President will continue to play out. And investors who focus on strong companies with attractively valued shares should continue to fare well over the long haul, even if there are significant bumps in the road over the short term.
Guru Spotlight: Martin Zweig
Generally, my Guru Strategies have a distinct value bias. The majority of these models -- ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy -- are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.
But that doesn't mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we'll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock's earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently -- and that their growth was coming from the right sources.
Zweig's thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.
Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotlights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls.
A Serious Strategy
Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:
Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.
Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).
Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.
Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.
While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)
In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not cost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.
Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).
Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.
There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).
Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired 10-stock portfolio has been a very strong performer since its July 2003 inception, returning 87.3%, or 7.0% per year, while the S&P 500 has gained just 39.4%, or 3.6% per year (through Nov. 7). This year has been a difficult one for the portfolio, which is down about 2% while the S&P is up about 11%. But its stellar long-term track record indicates that it should bounce back strong.
The model tends to choose stocks from a variety of areas -- it goes where the growth is. Here are the portfolio's current holdings:
Altisource Portfolio Solutions S.A. (ASPS)
Fred's, Inc. (FRED)
Monster Beverage Corp. (MNST)
MWI Veterinary Supply (MWIV)
Syntel, Inc. (SYNT)
Triumph Group Inc. (TGI)
World Acceptance Corp. (WRLD)
LKQ Corporation (LKQ)
Nu Skin Enterprises, Inc. (NUS)
Duff & Phelps Corp. (DUF)
As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.
What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.
News about Validea Hot List Stocks
The TJX Companies Inc. (TJX): For the four-week period ended October 27, consolidated same-store sales at TJX rose 7.0% vs. the previous year, Zacks Equity Research reported, citing higher customer traffic in the U.S., Europe, and Canada. Total sales were up 11.0%. TJX also raised its third-quarter and full-year outlooks. The firm expects adjusted earnings of about 63 cents per share in the third quarter, up from the higher end of the 56 to 59 cents per share range. It expects adjusted earnings of $2.46 to $2.49 per share for the fiscal year.
SolarWinds Inc. (SWI): On Oct. 25, SolarWinds announced third-quarter diluted third-quarter earnings per share of $0.29, up from $0.28 in the year-ago period. Total revenue was a record $71.7 million, up from $53.9 million a year earlier. The firm also said it was raising its full-year 2012 guidance, according to Reuters.
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.
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.
Validea is not registered as a securities broker-dealer or investment advisor either with the U.S. Securities and Exchange Commission or with any state securities regulatory authority. Validea is not responsible for trades executed by users of this site based on the information included herein. The information presented on this website does not represent a recommendation to buy or sell stocks or any financial instrument nor is it intended as an endorsement of any security or investment. The information on this website is generic by nature and is not personalized to the specific situation of any individual. The user therefore bears complete responsibility for their own investment research and should seek the advice of a qualified investment professional prior to making any investment decisions.
Performance results are based on model portfolios and do not reflect actual trading. Actual performance will vary based on a variety of factors, including market conditions and trading costs. Past performance is not necessarily indicative of future results. Individual stocks mentioned throughout this web site may be holdings in the managed portfolios of Validea Capital Management, a separate asset management firm founded by Validea.com founder John Reese. Validea Capital Management, which is a separate legal entity and an SEC registered investment advisory firm, uses, in part, the strategies on the web site to select stocks for its clients.