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|Executive Summary||April 30, 2010|
A lot has happened in the financial world over the past fortnight -- namely Europe's big debt problems coming to a head and Goldman Sachs' brass getting grilled on Capitol Hill. But amid the hoopla, the U.S. economy is continuing to show signs that it has stabilized and is in recovery mode.
One of the big pieces to the recovery puzzle has been corporate earnings. With close to half the companies in the S&P 500 having reported, first-quarter operating earnings have been on average 76% higher than they were a year ago (and it's worth noting that the spread between operating and as-reported earnings was about 10% as of April 20, nowhere near the huge spreads seen during the writeoff-marred financial crisis). If that continues, it would be the greatest year-over-year increase on record, according to Standard & Poor's, the Associated Press reported this week.
Part of the reason for the corporate rebound is the government -- near-record-low interest rates, bailouts, and stimulus funding have all played big roles in helping corporate America. But another key reason is the U.S. consumer, who has been surprising many of those who thought they were tapped out. Last newsletter I discussed how retail sales posted a big surprise gain in March, and there are signs the gains will continue. The Conference Board reported this week that its Consumer Confidence Index jumped more than 10% in April, reaching its highest level since September 2008. (It's important to keep in mind, however, that the April reading -- 57.9 -- is still well below the 90 reading that signifies a stable economy.)
Another sign consumers are spending: The most recent U.S. trade data from the Census Bureau shows that imports jumped 1.6% in February. Exports also rose slightly, also a good sign.
The increased demand indicates that the recovery may be entering self-sustaining mode. While cost-cutting drove bottom-line growth in the earlier parts of the turnaround, top-line growth in the last two quarters (including the current one) has beaten consensus estimates by a greater amount than bottom-line growth has beaten estimates, something strategist Liz Ann Sonders -- who called both the start of the recession and the turnaround -- noted this week. "That tells you we are two quarters past the point where it was really all about cost-cutting and very little about top-line sales growth," Sonders said in an interview. "Certainly the estimates out through the rest of 2010 reflect a very strong environment for top-line growth, not just bottom-line growth." If that does indeed transpire, hiring should pick up (as it did in March). And more jobs means more people with money to spend -- and thus a self-sustaining recovery that can withstand the withdrawal of government support for the economy.
Speaking of government support, questions continue to hover over the housing market, with many fearing that we're headed for the second leg of a double-dip in home prices as government incentive programs wind down. But the most recent housing data hasn't been bad -- in fact, the National Association of Realtors reported last week that existing-home sales rose almost 7% in March, and now stand more than 16% above their year-ago levels. The Commerce Department also reported that new-home sales jumped 27% in March, the biggest gain in almost 50 years.
And while some recent headlines referenced the "fourth straight month" of home price declines, they don't tell the whole story. Yes, the most recent S&P/Case-Shiller readings (which are for the month of February) showed that a 20-city index of home prices fell for the fourth straight month. But those numbers weren't seasonally adjusted. The seasonally-adjusted figures show that prices fell in February by less than a tenth of a percent, and that the dip was the first monthly decline since May 2009. It was also the first time since late 2006 that monthly home prices came in above the year-ago levels, a good sign.
Residential construction has also been picking up, with building permits and housing starts both up in March.
All of that being said, a huge question for the economy and market remains what will happen when the government's support of the housing market comes to an end. The homebuyer tax credit programs are set to expire at the end of April, though other programs -- including Fannie Mae's "seller assistance" incentive for properties in foreclosure -- remain.
Finally, another big question for the economy and stock market is how the European debt crisis will impact the U.S. Greece, Portugal, and Spain all had their debt ratings cut this week, and some fear the same fate awaits more nations in the Euro zone.
For now, however, the continued signs of economic progress at home and low interest rate environment (which the Federal Reserve has indicated will continue) have somewhat counterbalanced the negatives in the market and economy. The S&P 500 has returned -0.4% since our last newsletter, while the Hot List has returned -3.0%. That means the portfolio is up 10.7% in 2010 vs. 8.2% for the S&P, and since its July 2003 inception the Hot List has gained 166.7%, while the index is up just 20.6%.
The Gloomy Bull
Stocks are up close to 80% off their March 2009 lows, the economy is showing clear signs of recovery, and companies are posting strong earnings and in many cases sporting solid balance sheets. But you probably wouldn't know it if you listen to the financial news or read what the pundits have to say. As my colleague Jon Markman said this past week, this may well be "the most morose bull market in history".
When it comes to individual investors, several numbers bear that out. First off, there's the American Association of Individual Investors' sentiment survey. The latest survey shows that the eight-week moving average of investors who say they are bullish is at about 41%, only slightly higher than the historical average (since mid-1987) of 39% -- but much lower than levels that have been reached in past bull markets. In fact, since the March 2009 market low, the highest eight-week average bullish reading has been 43%. In the two previous bull markets, the figure at times climbed above 50%, and even above 60% on occasion.
And, while stocks have been soaring, individual investors have by no means been pumping money into the market. According to another AAII survey, individual investors had about 59% of the portfolios in stocks as of the end of March, a bit below the 60% historical average (since late 1987).
More striking are fund flow figures, some of which MarketWatch's Mark Hulbert recently highlighted. Hulbert noted that, according to TrimTabs Investment Research, a total of $601.6 billion of new money was invested in open-end mutual funds and exchange-traded funds in the past year. Almost three-quarters of that -- $440 billion -- went into bond funds; about $105 billion, or 18%, went into international stocks; and about $53 billion, or 9%, went into hybrid and commodity funds.
That leaves a mere $2.8 billion -- about one-half of 1 percent -- that went into domestic stocks.
Equity purchasing by individuals has been higher of late, but by no means feverish. Hulbert, again citing TrimTabs data, says that in April (through April 23), $22.1 billion of new money had been invested in bond funds, with $8.3 billion in international stocks, $2.7 billion in hybrid and commodity funds, and $3.3 billion in domestic stocks. That means about 9% of new money went into domestic equities.
Fund flow data can vary depending on where you look, but other groups seem to be finding somewhat similar results. Investment Company Institute data shows that since April 2009, huge sums of money have flowed into bond mutual funds, while domestic equity flows have actually been negative. Like TrimTabs, ICI's data shows that more money has flowed into equities recently (about $5.3 billion in the first three weeks of April), but that bond funds (which took in almost $19 billion in the same period) continue to absorb the majority of new money.
And Morningstar says that U.S. stock ETF flows were negative ($-14.5 billion) in 2009 and again in the first quarter of 2010 (-$2.9 billion), while bond ETF flows (including taxable and municipal bonds) were positive in 2009 ($38.7 billion) and the first quarter of this year ($8.8 billion). (That trend did change in March, however, as domestic stock ETFs took in $10.9 billion and taxable and municipal bond funds took in about $4.7 billion.)
All of this shouldn't come as a big surprise. The fact that the rally has been led by institutional investors, which poured more than $56 billion into equities in the fourth quarter of 2009 alone (according to TrimTabs' analysis of Federal Reserve data) makes sense. The financial crisis of 2008 and early 2009 and the accompanying bear market were among the worst the U.S. had experienced in decades. Such events take an emotional toll, particularly on individual investors. Institutions may have asset allocation targets that require them to have a certain portion of their portfolios in stocks, and they also may have the experience and expertise that provide them with more conviction to buy during a big bear market. Many individual investors don't have either of those factors pushing them back toward equities. If you've been invested in stocks during the rally, you should thus be commended for exercising discipline and long-term thinking, and not bowing to the fears that have led so many individuals to miss out on some huge gains.
When will individual investors really start to return to stocks? No one knows for sure. The fear generated by the crisis of late '08/early '09 may linger in the minds of many for some time. But the fact that so many remain on the sidelines (or underinvested), in combination with decent valuations for the broader market, is an indication that we're far from the "irrational exuberance" that has killed other bull runs.
Of course, that doesn't mean the market can't or won't hit some short-term problems -- there are plenty of issues still confronting the economy both at home and abroad. But the backdrop of muted sentiment, along with decent valuations for the broader market, should continue to help provide ample opportunity to find and profit from strong, undervalued individual stocks.
Guru Spotlight: David Dreman
While all the gurus I follow have built their fame and fortunes using different investment approaches, there is at least one striking similarity that most -- if not all -- of them share: They are contrarians. When the rest of Wall Street is zigging, they are zagging; when Wall Street zags, they zig. By having the strength of conviction to march to their own drummers and not follow the crowd, they have been able to key in on the types of strong, undervalued stocks that have made them -- and their clients or shareholders -- very happy.
But while most of the gurus upon which my strategies are based are contrarians, one stands out among all the others: David Dreman. Throughout his long career, Dreman has sifted through the market's dregs in order to find hidden gems, and he has been very, very good at it. His Kemper-Dreman High Return Fund was one of the best-performing mutual funds ever, ranking number one out of 255 funds in its peer groups from 1988 to 1998, according to Lipper Analytical Services. And when Dreman published Contrarian Investment Strategies: The Next Generation (the book on which I base my Dreman strategy) in 1998, the fund had been ranked number one in more time periods than any of the 3,175 funds in Lipper's database.
Throughout his career, Dreman has keyed in on down-and-out diamonds in the rough, finding winners in such beaten-up stocks as Altria (after the tobacco stock plummeted amid lawsuit concerns) and Tyco (which had been hit hard by an embarrassing CEO fiasco).
How -- and why -- did Dreman manage to pick winners from groups of stocks that few other investors would touch? Well, Dreman, perhaps more than any other guru I follow, is a student of investor psychology. And at the core of his research is the belief that investors tend to overvalue the "best" stocks -- those "hot" stocks everyone seems to be buying -- and undervalue the "worst" stocks -- those that people are avoiding like the plague, like Altria and Tyco. In addition, he also believed that the market was driven largely by how investors reacted to "surprises", frequent events that include earnings reports that exceed or fall short of expectations, government actions, or news about new products. And, he believed that analysts were more often than not wrong about their earnings forecasts, which leads to a lot of these surprises.
When you put those factors together, you get the crux of Dreman's contrarian philosophy. Surprises happen often, and because the "best" stocks are often overvalued, good surprises can't increase their values that much more. Bad surprises, however, can have a very negative impact on them. The "worst" stocks, meanwhile, are so undervalued that they don't have much further down to go when bad surprises occur. But when good surprises occur, they have a lot of room to grow. By taking a "contrarian" approach -- i.e. targeting out-of-favor stocks and avoiding in-favor stocks -- Dreman found you could make a killing.
Specifically, Dreman compared a stock's price to four fundamentals: earnings, cash flow, book value, and dividend yield. If a stock's price/earnings, price/cash flow, price/book value, or price/dividend ratio was in the bottom 20% of the market, it was a sign that investors weren't paying it much attention. And to Dreman, that was a sign that these stocks could end up becoming winners. (In my Dreman-based model, a firm is required to be in the bottom 20% of the market in at least two of those four categories to earn "contrarian" status.)
But Dreman also realized that just because a stock was overlooked, it wasn't necessarily a good buy. After all, investors sometimes are right to avoid certain poorly performing companies. What Dreman wanted to find were good companies that were being ignored, often because of apathy or overblown fears about the stock or its industry. To find those good firms, he used a variety of fundamental tests. Among them were return on equity (he wanted a stock's ROE to be in the top third of the 1,500 largest stocks in the market); the current ratio (which he wanted to be greater than the stock's industry average, or greater than 2); pre-tax profit margins (which should be at least 8 percent), and the debt/equity ratio (which should be below the industry average, or below 20 percent). By using those and other fundamental tests in conjunction with his contrarian indicator tests (the low P/E, P/CF, P/B, and P/D criteria we reviewed before), he was able to have great success finding strong but unloved firms that had the potential to take off once investors caught on to their true strength.
Because Dreman took advantage of the overreactions of others, he found that one of the best times to invest was during a crisis. "A market crisis presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest," he wrote in Contrarian Investment Strategies. "People no longer examine what a stock is worth; instead, they are fixated by prices cascading ever lower. Further, the event triggering the crisis is always considered to be something entirely new." Dreman's advice: "Buy during a panic, don't sell."
This type of contrarian approach isn't for the faint-of-heart. You never know exactly when fear will subside and investors will wake up to a bargain they've been overlooking. And that means the stocks this model targets may very well keep falling in the short term after you buy them, which, for my Dreman-based portfolio, is what happened during the recent financial crisis and bear market. The portfolio, which had trounced the S&P from its inception through 2006, fell on tough times as fears about the economy grew, lagging the S&P by about 15 percentage points in both 2007 and 2008.
But, as fears abated and the crisis passed, investors began to recognize the strong stocks they'd been shunning. And the Dreman portfolio has reaped the benefits, returning more than 37% in 2009 (vs. 23.5% for the S&P) and another 10% or so thus far this year (vs. about 6% for the S&P), putting it well ahead of the broader market for the long haul. The Dreman portfolio has now returned about 70% (more than 8% annualized) since its July 2003 inception, compared to about 18% (or 2.5% annualized) for the S&P 500.
As you might imagine, the portfolio will tread into areas of the market others ignore because of its contrarian bent. Its current holdings, for example, include several picks from some of the most maligned sectors -- four from the financial sector (which is still the subject of much investor skepticism); three from healthcare (which many have shied away from because of fears about the new healthcare bill's impact); and even one from the airline industry, which has had its fair share of problems in recent years, including the impact of the Iceland volcano's eruption.
Here's the full list of the portfolio's holdings:
Bristol Myers Squibb Co. (BMY)
Southern Copper Corporation (SCCO)
Telefonica S.A. (TEF)
Eli Lilly & Co. (LLY)
Mercury General Corporation (MCY)
Annaly Capital Management (NLY)
American Financial Group (AFG)
WellPoint, Inc. (WLP)
Ares Capital Corporation (ARCC)
Gol Linhas Aereas Inteligentes SA (GOL)
News about Validea Hot List Stocks
ITT Educational Services: On April 22, ITT reported first-quarter net income of $87.5 million ($2.46 per share), up 44% from the year-ago period. Revenues jumped 33% to $384 million as enrollment increased by 22%. Both earnings and revenue results topped analysts' expectations of $2.28 in EPS on revenue of $373 million, the Associated Press reported. Shares fell, however, due to fears of a regulatory crackdown on for-profit education firms, AP added.
The Brink's Company (BCO): Brink's has acquired a majority stake in a Russian cash processing business. Terms of the deal were not disclosed, but Brink's said the move complements the acquisition of a cash-in-transit business it made in the first quarter of 2009. Brink's now has about 500 employees in Russia.
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 email@example.com.
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