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|Executive Summary||August 21, 2009|
The economic news has fluctuated over the past two weeks between hope that we are in the early stages of recovery, and pessimism that another wave of pain is coming. And as it has, the market has made its own stops and starts, with investors now seeming to be looking for more than the minor "green shoots" that have helped push stocks higher over the past few months.
Perhaps the greatest economic problem has been unemployment, and the past fortnight has provided some mixed data in that area. Shortly after our last newsletter, the Labor Department reported that the unemployment rate fell in July for the first time in more than a year. The drop was minor, however, with the rate falling from 9.5% to 9.4% -- and that doesn't include workers have given up looking for work. Indeed, the economy actually lost almost 250,000 jobs for the month.
All in all, however, the number of lost jobs was much better than it has been in recent months, and part of why many economists now see the recession as being over, or about to end. Last week, 27 of the 47 economists surveyed by The Wall Street Journal said they think the recession has ended; another 11 said the trough would hit this month or next month. The respondents, on average, said they expect U.S. gross domestic product to increase by 2.4% this quarter, which would mark the first increase in output since the second quarter of 2008.
Whether or not the recession is over is still up for debate; what's not debatable is that the downturn has forced companies to become more productive. Last quarter, nonfarm business productivity jumped at a 6.4% annualized rate, the Labor Department reported last week, the biggest increase in almost six years. That means businesses could be laying the foundation for some major profit gains once the economy really turns around and demand increases.
And last week the economy gave a solid sign that demand is increasing. Industrial production increased 0.5% in July, the Federal Reserve reported -- which, aside from a hurricane-rebound month last October, was the first increase since December 2007. That's certainly good news, though the Fed also reported that a lot of slack remains in the economy, with capacity utilization 12.4 percentage points below its 1972-2008 average.
Manufacturing activity is also starting to show gains in various regions of the country, with the Philadelphia Federal Reserve Bank reporting this week that factory activity in the mid-Atlantic region grew in August for the first time in 10 months, the Associated Press reported, adding that the report echoed recent findings for the New York region.
The Federal Reserve also sounded some positive signals, announcing that it will finish its $300 billion purchase program of U.S. government debt by the end of October, an indication that the Fed sees the worst of the economic downturn as having passed.
The housing market, which many thought was leveling out, is now showing signs that it may not have bottomed, however. Housing starts -- which were expected to rise almost 3% -- actually dipped 1.0% in July, the Commerce Department reported. New building permits, also expected to rise, dropped almost 2%.
In several areas outside the U.S., signs of life are stronger. Both France and Germany last week reported positive GDP growth for the second quarter, and Japan followed that up by announcing its Q2 GDP grew by an impressive 3.7%.
As for what happens next, the economy seems to be at a sort of crossroads. One road has us continuing to build on the small forward steps (or, in some cases, smaller backward steps) we've seen recently; the other sees the U.S. running into roadblocks that will stall a recovery, with the biggest one being a beaten-up consumer. Last week, the Commerce Department reported that retail sales fell in July, an indication that U.S. consumers aren't yet feeling the pain of the recession lift.
When consumers will feel less constrained is a major debate. The Journal noted this week that household indebtedness has fallen slightly since its peak of 132% in late 2007. But the current level of 124% is still well above historical norms, and some say the consumer's continued need to pay down debt will lead to higher savings rates -- and lower spending rates, which will mean a slow recovery from the recession.
Others disagree, including Joel Naroff, who was named the top economic forecaster in 2008 by Bloomberg Business News. Naroff says he thinks minor recent upticks in consumer spending will grow stronger in the fall -- even if unemployment remains high. "It's not that there is going to be a huge growth in income, or jobs are going to start growing," he told Forbes.com. "It's just that an awful lot of people were so fearful about the future that that they were spending as if they'd already lost their jobs, even if they had jobs."
With the economy not providing conclusive signs that it's headed one way or the other, stocks fluctuated over the past two weeks. The S&P 500 ended up slightly, by 1.0%, while the Hot List fell 3.6%. For the year, the portfolio is still up 29.7% compared to the S&P's 11.5% gain, and since its inception more than six years ago the Hot List is far, far ahead of the index, having gained 112.7% while the S&P has gained .7%.
A Changing Look
While the Hot List has leveled off over the past fortnight, the portfolio has still had an extremely strong bounce-back year so far in 2009. Given that it's nearly tripling the broader market for the year, it's easy to forget that as recently as our March 6 rebalancing, the portfolio was lagging the S&P and down more than 26%. But while stocks were tanking and some were heralding the "end of equities", the Hot List was building up a number of positions in beaten-down, fundamentally strong, bargain-priced stocks.
Among them were clothing retailer The Dress Barn, a 70% gainer from late January to mid-April; Schnitzer Steel, a 66% gainer from late January to mid-June; and another clothing retailer, Jos. A. Bank, that from mid-February to the present is up more than 60%.
With the rebound still young and many doubting its legs, the Hot List kept digging into beaten-down areas, adding oil services firms like Oil States International (a 59% gainer from mid-March to mid-May) and World Fuel Services (a 28% gainer in the same span), as well as consumer companies like Deckers Outdoor (which jumped 46% in just one month) and Fossil Inc. (a 34% gainer over a two-month period).
Of course, such figures are satisfying. But as always, the important question is not where the portfolio has been, but where it is going. And with the lazy days of summer drawing to a close and the usually more active fall months coming, I thought it would be a good time to examine exactly where the Hot List is finding value right now -- and the answers involve a few areas that differ from where it's made hay so far this year.
For starters, all of the stocks I just highlighted were essentially small-caps when added to the portfolio (the largest had market caps just over $1 billion). That followed a trend I highlighted back in May: that following bear markets since 1980, small-caps on average have outperformed large-caps by a 39.23% to 27.23% margin in the first six months of a bull market (data from Legg Mason).
In mid-May, however, the portfolio began adding some very large stocks into the mix, and today it has become a mix of small-caps and very-large-caps. Six of its ten holdings have caps of $1.4 billion or less; three -- Chevron, Lloyd's Banking, and Marathon Oil -- have caps of more than $20 billion. Only Sociedad Quimica y Minera -- an interesting Chilean firm that makes plant nutrition products, iodine, and lithium -- falls in mid-range territory, with a cap of about $9 billion.
One thing to note about the addition of the three very large firms is that all are value stocks. So far this year, large-cap value stocks have been by far the weakest of the nine style-box categories, according to Morningstar; over the past three months, they're second-to-last. That makes intuitive sense -- during the market meltdown, small stocks were hit hard as liquidity concerns led to questions about their survival possibilities. But as the economy has stabilized, investors have moved back into those smaller plays, or focused on larger growth stocks, leaving larger value plays behind. My models appear to be picking up on the values created by that phenomenon.
The Hot List is also diversifying in terms of the types of companies it is focusing on. Back in February, 70% of its holdings fell into two sectors, capital goods and services. In March, it moved 40% into energy stocks, and in April 70% of the portfolio was again in two sectors (capital goods and energy). As recently as July, half the Hot List was made up of energy stocks.
Today, however, the portfolio features seven different sectors. The largest portion still comes from energy stocks, but to a lesser degree, with three of the ten holdings coming from that sector. This also seems to make intuitive sense. During the crisis and steep declines of late 2008 and early 2009, certain sectors were particularly maligned. Some, like financials, deserved their beatings, but others, like energy stocks and consumer services firms, included a lot of good companies that were unfairly battered because of fears of economic disaster -- an economic disaster that appears to have been averted. The Hot List thus focused on some of these unfairly beaten-up areas of the market because they offered the best values.
Now that the market has moved upward and some of those pockets of extreme sector fear have begun to dissipate, my models are seeing top values spread across a broader swath of areas, which you'd expect in a more normal market climate.
Two to Watch
Among those values are a couple holdings that are particularly interesting: Jos. A. Bank Clothiers, and Fuqi International. Bank has been in the portfolio for a full six months now, and while it's jumped about 60%, my models remain extremely high on it, with my Peter Lynch- and James O'Shaughnessy-based approaches still giving it strong interest and three other models giving it some interest. The stock has been a major short play by many investors for some time now, but the business just keeps putting up strong numbers. Bank has upped earnings per share in every year of the past decade, including 2008 (in part because of some very aggressive and creative promotions). It's been the same story in '09, with EPS and sales increasing in both of the first two quarters.
Fuqi, meanwhile, has gained about 40% since joining the Hot List in mid-June. The Chinese jewelry maker has upped EPS in seven straight years, but it's the firm's recent performance that is really remarkable. Its EPS have grown (year over year) in each of the past four quarters, and sales went through the roof even during the most difficult economic climate in decades -- more than doubling in last year's fourth quarter and rising 40% and 51%, respectively, in this year's Q1 and Q2. Fuqi still gets approval from my Lynch model and solid marks from two other strategies, though at this point its no longer the buy it once was. That could mean the portfolio will take those nice profits when our next rebalancing occurs in two weeks.
It's in the Numbers
Finally, I'd like to return to the portfolio's shifting size/sector makeup in recent months. One of the things that I find fascinating about quantitative analysis is that many of the trends that emerge over the course of market history aren't by chance; they are statistical manifestations of very real patterns of investor behavior. The small-cap example I discussed above is a great example. Small-caps tend to struggle in very rough periods because fears about their ability to remain liquid and viable run wild, while their larger peers are considered safer bets; when the crisis ends, investors realize they've overreacted and unfairly punished many good small stocks, and they dive back into them, leading to strong performance for that area of the market.
I didn't design my models specifically to incorporate such broader market patterns, but I always find it interesting that their reading of fundamental stock data will often lead them to respond to or anticipate such trends, as they did when they piled into those beaten-down small-caps. They recognize where the best values are at a given time, and by gravitating toward those areas of the market, they can adapt quickly and often end up ahead of the curve on broader market trends. Of course, that's not always the case, as we saw in 2008. But the portfolio's long-term track record indicates that these quantitative approaches often hone in not only on strong individual stocks, but also broader categories of stocks that are poised for outperformance -- if you are disciplined enough to let them do so.
As we move forward, I expect my models will continue to adapt to the ever-changing market conditions, and take advantage of them more often than not. By focusing on the numbers and on valuations, they'll help keep the portfolio out of the emotional traps into which many undisciplined investors fall, and keep it on the road to continued market outperformance.
Guru Spotlight: John Neff
Most investors wouldn't give a fund described as "relatively prosaic, dull, conservative" a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling -- so dazzling that Neff's track record may be the greatest ever for a mutual fund manager.
By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7 percent annual return, beating the market by an average of 3.1 percent per year. Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers -- an "investor's investor", if you will.
How did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a "contrarian" or "value investor", Neff writes in John Neff on Investing that, "Personally, I prefer a different label: 'low price-earnings investor.' It describes succinctly and accurately the investment style that guided Windsor while I was in charge."
To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren't expecting much from it. Much like David Dreman, the great contrarian guru who we examined a few newsletters back, Neff found that stocks with lower P/E ratios -- and lower expectations -- tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn't match investors' expectations.
To Neff, however, the P/E wasn't always a lower-is-better ratio. If investors knew that a firm was a dog, they'd rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40 and 60 percent of the market average.
While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate -- more than 20 percent -- could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7 and 20 percent per year, the kind of steady, unspectacular growth that could be sustained.
Sustainable growth also meant growth that was driven by sales -- not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7 percent per year, or at least 70 percent of EPS growth.)
One more key aspect of Neff's strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor's 3 percent per year market outperformance during his tenure came from dividends.
To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock's total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.
Now, here's a look at the stocks that currently make up my 10-stock Neff-based portfolio:
Becton, Dickinson and Co. (BDX)
EZCorp, Inc. (EZPW)
Universal Corporation (UVV)
Molina Healthcare, Inc. (MOH)
AmeriGroup Corporation (AGP)
UniFirst Corporation (UNF)
Fresenius Medical Care AG & Co. (FMS)
UGI Corporation (UGI)
Comfort Systems USA, Inc. (FIX)
Barclays PLC (BCS)
Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. These are often the kind of picks that take time to turn around. Because of that, last year was a particularly tough one for the Neff portfolio, as it lost about 48%.
This year, however, patience is paying off for the portfolio, which is already up more than 30%. It's found big winners this year in a number of financial firms like Cash America International, Capstead Mortgage Corporation, Hatteras Financial, Banco Santander, State Street Corp., as well as printing & publishing firm Meredith Corporation -- all of which were the type of stocks many investors were fleeing earlier this year.
I began tracking my Neff-based portfolio at the start of 2004, and despite its rough '08, it's still significantly ahead of the market. The portfolio, which had strong years in 2004, 2005, 2006, and is back on track this year, has gained about 14% since inception (2.4% annualized), not bad when you consider that the S&P has dropped more than 10% (about -2% annualized) in that period. And by continuing to snatch up those unloved, bargain stocks while others remain on the sidelines, I think it will extend its outperformance of the broader market over the long run.
News about Validea Hot List Stocks
Chevron Corp. (CVX): On Aug. 19, the Associated Press reported that Chevron said a subsidiary made two discoveries of natural gas off the coast of western Australia. The discoveries are in the Carnarvon Basin.
Sociedad Quimica y Minera de Chile S.A. (SQM): On Aug. 11, SQM reported second-quarter net income of $83.1 million ($0.32 per ADR), down 34% from $125.7 million ($0.48 per ADR) in the year-ago period. Revenues were $344.8 million, a decrease of about 25% from a year earlier. Sales declined as the economy struggled, but have begun to recover, and the company expects volume for the second half of the year to be higher than it was in the first half of the year.
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.
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