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Executive Summary August 28, 2015

The Economy

Volatility spiked across global markets over the past two weeks, as investors worried about China's slowing growth and looming interest-rate hikes in the US. But underlying economic data at home remained fairly steady.

The job market, for example, continues to look solid. New claims for unemployment have fallen slightly since our last newsletter and are now about 9% below where they were a year ago. Continuing claims, the data for which lag new claims by a week, also moved slightly lower since our last newsletter and are 10% below year-ago levels..

Service sector growth slipped a bit during August, according to the financial firm Markit. A subindex measuring new business at service companies fell to its lowest level since January, while the employment subindex rose at the same pace as July, according to CNBC.

Gross domestic product rose more than previously estimated, according to the Commerce Department. It increased by 3.7%, significantly higher than the 2.3% previous estimate, and also higher than the 3.3% economists were expecting, according to MarketWatch. A big reason for the higher figure: Business investment was significantly stronger than expected, a great sign.

After making a big jump in June, housing starts rose just slightly, by 0.2%, in July, according to the Census Bureau, putting them about 10% above year-ago levels. Permit issuance for new construction fell sharply by 16.3%, but is 7.5% above where it stood a year ago.

A positive from the housing market: New home sales jumped 5.4% in July, according to the Census Bureau. Compared to a year ago, they are 23% higher. Median sale prices were about 2% above where they were a year ago.

Inflation was tame in July. The Consumer Price Index rose just 0.1% , according to the Labor Department. That put it just 0.2% ahead of its year-ago pace, mostly because of the oil and gas price declines. But if you strip out volatile food and energy prices, so-called "core" inflation, which was up 0.1% in July, is 1.8% ahead of its year-ago pace.

Oil and gas prices, meanwhile, have slid recently. As of August 27, a gallon of regular unleaded on average cost $2.53, down from $2.71 a month earlier. That's far below the year-ago level of $3.43.

Overseas, China cut interest rates and banks' reserve requirements to try to boost its slowing growth, Reuters reported. Stocks responded well to the news, though that highlighted how reliant many investors seem to have become on central bank liquidity.

Since our last newsletter, the S&P 500 returned -4.6%, while the Hot List returned -3.4%. So far in 2015, the portfolio has returned -4.5% vs. -3.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 208.8% vs. the S&P's 98.7% gain.

Vexing Indexing?

The sharp declines that have occurred in the stock market over the past couple weeks have brought with them the usual conjecture about whether or not this is the end of the 6 1/2 year bull market and beginning of a new bear market. Of course, for all of the debate on that topic, no one knows for sure. I, for one, suspect that the bull has more life left in it, but that's just a guess.

One highly regarded strategist says, however, that we are already in a "stealth" bear market. Mark Faber recently told CNBC that gains in broad market indexes had been driven by a small number of extremely large stocks that make up a disproportionate amount of most indices. "Indices are close to a high, but if you look at the 12-month new highs and the 12-month new lows, there are far more 12-month new lows than new highs," he said.

The notion of a stealth bear market may be a bit of hyperbole. But the broader issue that Faber raises is an important one. Last year, Apple, Microsoft, Facebook, and Intel accounted for 20% of the S&P 500's gain, David Winters, another highly regarded strategist, recently told WealthTrack. Winters said that the inherent flaw in many index funds is that they are weighted by market capitalization, meaning that they tend to hold a disproportionate amount of the stocks that have performed best. The more that people buy index funds, the more that hot stocks go up, creating a cycle in which large, hot stocks get more and more overvalued.

All of this means that many index funds may not quite be the great diversification tools that they appear to be, even though they may hold hundreds or thousands of stocks. Take the 5 largest stock index funds, which combined have more than $675 billion in assets under management. Three are 500-stock funds that resemble the S&P 500, while the other two have about 3,000 stocks each. All of them have the same top 10 holdings, according to data from MarketWatch and Morningstar. And, on average, those 10 stocks make up 15.5% of the 5 funds' holdings. An investor who puts a chunk of his or her portfolio into one of those index funds because they do not feel confident making big bets on individual stocks thus ends up making some pretty big bets on individual stocks -- often without realizing it.

In fact, if you take a look at the holdings of the biggest index funds in terms of assets -- it's one that tracks the S&P 500 -- you get an idea of how much of an impact the "big guys" have on market-weighted indices. The 255 lowest weighted stocks in that index have portfolio weightings ranging from 0.1% to 0.01%. Combined, those 255 stocks make up a little over 14% of the portfolio -- less than the 14.6% of the portfolio that is taken up by just the 8 most heavily weighted stocks. (Fund information comes from ETF.com.)

Perhaps you're thinking that the big guys should be weighted more heavily. Many S&P index fund investors are looking to get representative slice of the US economy, and a company like Apple obviously makes up a much bigger portion of the economy than a company like Diamond Offshore Drilling, which is tied for the lowest weight in the index with a weight of 0.01%. That's true. But even considering that, the index is tilted much more heavily toward the big guys than you would think. While it had about 100 times as much in 2014 earnings and about 85 times as much in trailing 12-month sales as Diamond, Apple is weighted 368 times more heavily than the offshore drilling company in the index. Now, in this particular case, I happen to think that Apple is a better stock than Diamond -- the tech giant has had a spot in the Hot List at various times this year. But that won't always be the case, and the nature of a market-weighted index fund creates a situation where you can be making a big bet on a bad stock.

A Long-Term Benefit

The losses that the Hot List has suffered over the past month have been disappointing, to be sure. But that's what happens when you run a concentrated portfolio. We've seen these types of short-term troubles before, and over the long term we have found that the short-term declines are a worthwhile price to pay for excellent long-term returns.

In addition, I think the prevalence of S&P 500-tracking index funds may well be opening up long-term opportunities for fundamental investment strategies like the Hot List. Historically, smaller stocks have had a long history of outperformance, as I have often noted here, with one big reason being that they are less visible and less followed than bigger stocks. That means you can find some great small stocks flying under the radar. Now, with so many people piling into index funds that heavily weight the biggest firms, the small stock under-the-radar advantage should be even greater. That's because as more and more money goes into these large stocks via index funds, many may become more highly valued than their fundamentals merit -- index fund investors aren't looking at the valuation of every one of the index's holdings before they buy the fund.

Smaller stocks not in the big index funds, conversely, could become even more overlooked than usual, creating big-time bargains in that space. Investors who focus on fundamentals and are willing to invest in smaller stocks should thus be able to reap the benefits over the long term. And smaller, lesser-known stocks that are not in the S&P are the types of companies that the Hot List usually keys on. If you remember, I've written previously about the portfolio's high "active share", which is a measure of how much a portfolio differs from the index it tracks. Research has shown that portfolios with high active share tend to have a better chance of beating the index. The Hot List often has very few holdings that are members of its benchmark, the S&P 500; prior to today's rebalancing, just one of its stocks (Apple) was a member of the index. Rather than going after those large stocks that everyone knows about and which are part of the major indices, the portfolio goes into areas of the market that get less attention, where mispricings of quality stocks are more likely to occur.

All of this isn't to say that you should avoid index funds. I'm not even saying that you should avoid market-weighted index funds. For some investors, a market-weighted index fund may be a great fit for a portion of their portfolio. But the point here is that you need to really know what you are investing in, and how it works. During difficult times, like those we've seen in the past month, it can be tempting to throw up your hands, forgo stock-picking altogether and pile into an index fund. But if you don't know what you're getting into, you could find yourself with some unexpected problems -- and you could miss out on a lot of excellent opportunities.

Editor-in-Chief: John Reese

The Fallen

As we rebalance the Validea Hot List, 7 stocks leave our portfolio. These include: Lumber Liquidators Holdings Inc (LL), Santander Consumer Usa Holdings Inc (SC), Heritage Insurance Holdings Inc (HRTG), Eagle Bancorp, Inc. (EGBN), Amtrust Financial Services Inc (AFSI), Apple Inc. (AAPL) and Jones Lang Lasalle Inc (JLL).

The Keepers

3 stocks remain in the portfolio. They are: Sanderson Farms, Inc. (SAFM), Foot Locker, Inc. (FL) and Chart Industries, Inc. (GTLS).

The Newbies

We are adding 7 stocks to the portfolio. These include: G-iii Apparel Group, Ltd. (GIII), Universal Insurance Holdings, Inc. (UVE), Bofi Holding, Inc. (BOFI), Travelers Companies Inc (TRV), Myr Group Inc (MYRG), Forum Energy Technologies Inc (FET) and South State Corp (SSB).

Portfolio Changes

Newcomers to the Validea Hot List

BofI Holding, Inc. (BOFI): BofI -- short for "Bank of Internet" -- is the holding company for BofI Federal Bank, a diversified nationwide bank that provides financing for single and multifamily residential properties, small-to-medium size businesses in target sectors, and selected specialty finance receivables. Though it has just one location -- in San Diego -- its Internet business allows it to have approximately $3.3 billion in assets and approximately 40,000 retail deposit and loan customers across all 50 states.

BofI ($2 billion market cap) gets high scores from my Peter Lynch-, Martin Zweig- and Motley Fool-based models as well as my Momentum Investor approach. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.

Universal Insurance Holdings, Inc. (UVE): Universal is a vertically integrated insurance holding company involved in insurance underwriting, distribution and claims. Its subsidiaries offer homeowners insurance in Florida, North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland.

Universal ($800 million market cap) gets strong interest from my Motley Fool-based model, inspired by an approach outlined by Fool co-creators Tom and David Gardner, as well as my Peter Lynch-based model. Scroll down to the "Detailed Stock Analysis" section to learn more about the stock.

MYR Group (MYRG): This specialty contractor serves the electrical infrastructure market throughout the US and Canada. It provides services on electric transmission and distribution networks and substation facilities to customers that include investor-owned utilities, cooperatives, private developers, government-funded utilities, independent power producers, independent transmission companies, industrial facility owners and other contractors. It also provides commercial and industrial electrical contracting services to general contractors, commercial and industrial facility owners, local governments and developers generally throughout the western and northeastern US.

MYR ($600 million market cap) gets strong interest from my Martin Zweig- and James O'Shaughnessy-based strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Forum Energy Technologies, Inc. (FET) This oilfield products company ($1 billion market cap) offers a mix of engineered capital products and replaced items that are used in the exploration, development, production and transportation of oil and natural gas. Its capital products are targeted at drilling rig equipment for rigs, upgrades and refurbishment projects; subsea construction and development projects; the placement of production equipment on producing wells, and downstream capital projects.

Forum, like many energy stocks, has been hit hard over the past year. But its attractive valuation makes it a favorite of my Kenneth Fisher- and Peter Lynch-based models. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

G-III Apparel Group (GIII): This diversified apparel company has a comprehensive portfolio of over 30 licensed and proprietary brands, including Calvin Klein, Kenneth Cole, Cole Haan, Guess?, Tommy Hilfiger, Levi's, Dockers, Jessica Simpson, Jones New York, Nine West, and G.H. Bass, among others. G-III also has licenses with the four major professional sports leagues, as well as over 100 U.S. colleges and universities. The firm also makes a range of apparel, including outerwear, dresses, sportswear, beachwear, women's suits and women's performance wear, as well as luggage and women's handbags, small leather goods and various accessories.

G-III ($3 billion market cap) is a favorite of my Martin Zweig-based model. To read more about its fundamentals, check out the "Detailed Stock Analysis" section below.

South State Corporation (SSB): South State provides a range of banking services and products through its subsidiary, South State Bank, which offers retail and commercial banking services, mortgage lending services, trust and investment services, and consumer finance loans. It serves customers and conducts its business from about 130 financial centers in South Carolina, North Carolina, and Georgia.

South State ($2 billion market cap) gets strong interest from my Martin Zweig-based model. To read more about it, scroll down to the "Detailed Stock Analysis" section.

The Travelers Companies, Inc. (TRV): Minnesota-based Travelers ($31 billion market cap) provides property casualty insurance for auto, home, and business. The 162-year-old company does business in the US, Canada, the United Kingdom, Ireland, and Brazil.

Travelers gets strong interest from my Peter Lynch-, John Neff-, and James O'Shaughnessy-based strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

News about Validea Hot List Stocks

Foot Locker (FL): Foot Locker said second-quarter fiscal 2015 earnings were 84 cents a share, up 31% from the previous year and ahead of the Zacks Consensus Estimate of 69 cents. Total revenue rose 3.3% to $1.7 billion, beating Zacks Consensus Estimate of $1.66 billion. Comparable-store sales were up 9.6%.

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

BOFI   |   GTLS   |   MYRG   |   UVE   |   TRV   |   SAFM   |   FL   |   GIII   |   FET   |   SSB   |  

BofI HOLDING, INC., is the holding company for BofI Federal Bank. The Bank has deposit and loan customers nationwide including consumer and business checking, savings and time deposit accounts and financing for single family and multifamily residential properties, small-to-medium size businesses in target sectors, and selected specialty finance receivables. The Bank provides consumer and business banking products through the branchless distribution channels and affinity partners. The Bank's deposit products are demand accounts, savings accounts and time deposits marketed to consumers and businesses located in all 50 states. The Bank's primary lending products are residential single family and multifamily mortgage loans. The Bank's business is primarily concentrated in the state of California and is subject to the general economic conditions of that state.

Chart Industries, Inc. (Chart) is a diversified manufacturer of engineered equipment engineered equipment for the industrial gas, energy, and biomedical industries. The Company's equipment and engineered systems are used for low-temperature and cryogenic applications. It operates through three segments: Energy & Chemicals (E&C), Distribution & Storage (D&S) and BioMedical. Its products include vacuum insulated containment vessels, heat exchangers, cold boxes and other cryogenic components. Its E&C and D&S segments manufacture products used in energy-related and industrial applications, such as the separation, liquefaction, distribution and storage of hydrocarbon and industrial gases. Through its BioMedical segment, it supplies cryogenic and other equipment used in the medical, biological research and animal breeding industries. The Company, through Thermax, Inc., provides cryogenic fluid vaporizers utilized in industrial gas, petro-chemical and liquefied natural gas applications.

MYR Group Inc. is a holding company, which provides specialty electrical construction services through its subsidiaries. The Company performs construction services in two business segments: Transmission and Distribution (T&D), and Commercial and Industrial (C&I). T&D segment provides solutions to customers in the electric utility industry and the renewable energy industry. The Company also provides C&I electrical contracting services to property owners and general contractors in the western United States. The Company's wholly owned subsidiaries include The L. E. Myers Co., Harlan Electric Company, Hawkeye Construction, Inc., Great Southwestern Construction, Inc., Sturgeon Electric Company, Inc., MYR Transmission Services, Inc., MYR Group Construction Canada, Ltd., MYR Transmission Services Canada, Ltd. and Northern Transmission Services, Ltd. The Company also provides electrical construction services, and limited gas construction services.

Universal Insurance Holdings, Inc. (UIH), with its wholly owned subsidiaries, is a vertically integrated insurance holding company performing all aspects of insurance underwriting, distribution and claims. The Company's offers homeowners' insurance through the Insurance Entities, Universal Property & Casualty Insurance Company (UPCIC) and American Platinum Property and Casualty Insurance Company (APPCIC). Substantially all aspects of insurance underwriting, distribution and claims processing are performed by the Company's subsidiaries. UPCIC, a wholly owned subsidiary of the Company, is a writer of homeowners insurance in Florida and has commenced its operations in North Carolina, South Carolina, Hawaii, Georgia, Massachusetts, Maryland, Delaware, and Indiana. APPCIC, also a wholly owned subsidiary, writes homeowners multi-peril insurance on Florida homes valued in excess of $1 million, which are limits and coverages currently not targeted through its affiliate UPCIC.

The Travelers Companies, Inc. is a holding company. Through its subsidiaries, the Company is engaged in providing a range of commercial and personal property and casualty insurance products and services to businesses, Government units, associations and individuals. The Company has three operating segments: Business and International Insurance segment, Bond & Specialty Insurance segment and the Personal Insurance segment. Business and International Insurance segment offers a range of property and casualty insurance and insurance related services to its customers, primarily in the United States, as well as in Canada, the United Kingdom, the Republic of Ireland and throughout other parts of the world. Bond & Specialty Insurance segment provides surety, crime, management and professional liability coverages, and related risk management services. Personal Insurance segment includes a range of property and casualty insurance covering individuals' personal risks.

Sanderson Farms, Inc. is a poultry processing company which is engaged in the production, processing, marketing and distribution of fresh and frozen chicken and other prepared chicken items. In addition, the Company is engaged in the processing, marketing and distribution of prepared chicken through its wholly owned subsidiary, Sanderson Farms, Inc. (Foods Division). It produces a range of processed chicken products and prepared chicken items. It sells ice pack, chill pack, bulk pack and frozen chicken, in whole, cut-up and boneless form, under the Sanderson Farms brand name to retailers, distributors, and casual dining operators in the south-eastern, south-western, north-eastern and western United States and to customers who resell frozen chicken into export markets. During the fiscal year ended October 31, 2013 (fiscal 2013), it processed 452 million chickens, or over 3.0 billion dressed pounds.

Foot Locker, Inc. is a retailer of shoes and apparel. The Company operates in two segments: Athletic Stores and Direct-to-Customers. The Athletic Stores segment is an athletic footwear and apparel retailer whose formats include Foot Locker, Lady Foot Locker, Kids Foot Locker, Champs Sports, Footaction and SIX:02, as well as the retail stores of Runners Point Group, including Runners Point and Sidestep. The Direct-to-Customers segment includes Footlocker.com, Inc. and other affiliates, including Eastbay, Inc., and the direct-to-customer subsidiary of Runners Point Group, which sell to customers through their Internet and mobile sites and catalogs. As of January 31, 2015, the Company operated 3,423 primarily mall-based stores in the United States, Canada, Europe, Australia and New Zealand. As of January 31, 2015, the Company operated a total of 78 franchised stores, of which 31 are in the Middle East, 27 in Germany and Switzerland, and 20 in the Republic of Korea.

G-III Apparel Group, Ltd. designs, manufactures, and markets a range of apparel products. The Company's apparel products include outerwear, dresses, sportswear, swimwear, women's suits and women's performance wear, as well as footwear, luggage and women's handbags, small leather goods and cold weather accessories. The Company operates through three segments, Licensed Products, Non-Licensed Products, and Retail Operations. The Licensed products segment includes sales of products under brands licensed by the Company from third parties. The Non-licensed products segment includes sales of products under its own brands and under private label brands. The retail operations segment consists primarily of its Wilsons Leather and G.H. Bass stores, as well as Calvin Klein Performance stores.

Forum Energy Technologies, Inc. is an oilfield products company. The Company designs, manufactures and distributes products and engages in aftermarket services, parts supply and related services. Its product offering includes a mix of engineered capital products and replaced items that are used in the exploration, development, production and transportation of oil and natural gas. Its capital products are targeted at drilling rig equipment for rigs, upgrades and refurbishment projects; subsea construction and development projects; the placement of production equipment on producing wells, and downstream capital projects. Its engineered systems are components used on drilling rigs or in the course of subsea operations, while its consumable products are used to maintain operations at well sites in the well construction process, within the supporting infrastructure and at processing centers and refineries. Its segments are Drilling & Subsea and Production & Infrastructure.

South State Corporation (South State), formerly First Financial Holdings, Inc. is a bank holding company. The Company provides a range of banking services and products to its customers through its wholly owned bank subsidiary, South State Bank (the Bank), formerly SCBT, a South Carolina-chartered commercial bank. The Bank provides a range of retail and commercial banking services, mortgage lending services, trust and investment services, and consumer finance loans. As at December 31, 2014, the Company had approximately $7.8 billion in assets, $5.7 billion in loans, $6.5 billion in deposits, $984.9 million in shareholders' equity and a market capitalization of approximately $1.6 billion. The Company serves customers and conducts its business from 127 financial centers in 19 South Carolina counties, four North Carolina counties, ten northeast Georgia counties and two coastal Georgia counties.

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.


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.

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