The Economy

Economic data released since the last publication of the Hot List Newsletter has disappointed. Employment data came in weaker-than-expected, as did the ISM Manufacturing and Non-Manufacturing Indexes, signaling both the U.S. manufacturing sector and the non-manufacturing sector experienced a slowing of activity in August. The disappointing data appears to increase the probabilities of the Federal Reserve remaining on hold regarding interest rates at its September 20-21 meeting.

Economic activity in the non-manufacturing sector grew in August for the 79th consecutive month, according to the Institute for Supply Management. However, August's non-manufacturing (service sector) index, NMI, registered 51.4%, a decrease of 4.1% from the July reading of 55.5%. This represents continued growth in the non-manufacturing sector at a slower rate, and was considered a disappointment. The August reading was the lowest reading for this index since February 2010. The New Orders Index fell 8.9% from that in July to 51.4%, while the Employment Index fell 0.7% in August to 50.7%. Prices paid by non-manufacturing organizations for purchased materials and services increased in August for the 5th consecutive month, as the Price Index was reported at 51.8%, a decline of 0.1% from the July reading. The August NMI reading of 51.4% corresponds to a 1% increase in annualized gross domestic product.

The Non-Farm Payroll Report, released September 2nd, came in below estimates, as the Labor Department reported an increase of 151,000 jobs in August, versus an expected increase of 180,000. The figures for July and June were revised, with July increasing to +275,000 from +255,000, while the June declined to +271,000 from +292,000. Over the past 3 months, job gains have averaged 232,000 per month. The unemployment rate was unchanged at 4.9% in August and the number unemployed persons remained essentially unchanged at 7.8 million. The number of people considered not in the labor force rose by 58,000. In August, average hourly earnings for all employees on private nonfarm payrolls increased by 3 cents to $25.73. Over the year, average hourly earnings have risen by 2.4 percent. The "U-6" rate, which unlike the headline number, takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job, was unchanged at 9.7%. The August Non-Farm Payroll data for August did not convince the market that the Federal Reserve will raise interest rates at its next meeting, scheduled for September 20-21.

The private sector added 177,000 jobs in August, according to payroll processor ADP. The firm also revised its July jobs number upward from 179,000 to 194,000. The service sector continues to drive the gains, adding 183,000 jobs, while the goods-producing sector extended a contraction, losing 6,000 jobs, identical to the loss reported for July.

Economic activity in the manufacturing sector contracted in August following five consecutive months of expansion, while the overall economy grew for the 87th consecutive month, according to the Institute for Supply Management. The group's August manufacturing index, PMI, registered 49.4%, a decrease of 3.2% from the July reading of 52.6%. The New Orders Index also decreased, falling 7.8% to 49.1%, while the Employment Index dropped 1.1% from the July reading to 48.3%. The August Prices Index registered 53%, a decrease of 2% from the July reading, indicating higher raw materials prices for the sixth consecutive month. If the August PMI of 49.4% is annualized, it corresponds to a 2.0% increase in real annualized gross domestic product.

Personal income rose 0.4% in July, according to the Commerce Department. Real disposable personal income rose 0.4%, while real personal consumption expenditures was up 0.3%. The core PCE Price Index, which excludes food and energy, was up 0.1% after an unrevised 0.1% increase in June. The personal savings rate, personal saving as a percentage of disposable personal income, rose to 5.7% from 5.5%.

Oil prices have been volatile over the past two weeks, falling sharply then recovering to recoup the loss and regain the $47 level, where prices were during the preceding publication of the Hot List Newsletter. Regarding gas prices, a gallon of regular unleaded on average cost $2.19 as of September 8th, up from $2.12 a month earlier. That's about 8.3% below where it was one year ago.



Portfolio Update: Hot List Outperforms, With Some Big Winners

The past two weeks have been good for the Hot List portfolio, as it has outperformed the S&P 500 and produced some notable winners. Overall, six stocks outperformed the S&P 500, one performed on par with the market and three underperformed, with one of the three producing only a marginal loss. Performance evaluations were as of mid-morning on September 8th.

Leading the way with a gain of 11.5%, was LGI Homes, Inc. (LGIH). LGI Homes, Inc. is a homebuilder. The Company is engaged in the design, construction, marketing and sale of new homes in markets in Texas, Arizona, Florida, Georgia, New Mexico, South Carolina, North Carolina, Colorado, Washington and Tennessee. The Company has five segments: The Texas division, the Southwest division, the Southeast division, the Florida division and the Northwest division. LGIH (market cap $830 million) has been a consistently strong performer, recently producing a new 52-week high. The issue scores 100% in the James O'Shaughnessy-based model, as well as in the Validea Momentum Investor model. The Validea Momentum Investor model likes LGIH's impressive annual earnings growth of 81.68%, based on the average of the 3 and 4 year historical eps growth rates. The Validea model also favors LGIH's , earnings consistency and relative strength, which has been increasing over the past four months.

Another winner over the past two weeks was Supreme Industries, Inc. (STS), which gained 4.8% and also moved to a new 52-week high. Supreme Industries, Inc. is a manufacturer of specialized vehicles, including truck bodies, trolleys and specialty vehicles. The Company operates through two segments, which include specialized commercial vehicles and fiberglass products. STS (market cap $298m) scores highly in the Peter Lynch-based model. It's P/E Growth Ratio is a favorable 0.52. In addition, the issue's EPS growth rate of 30.9%, based on the average of the 3, 4 and 5 year historical eps growth rates, also passes the Lynch-model test. STS also ranks highly in the Validea Momentum Investor model, which favors its exceptional relative strength reading of 95.

Another solid performer was John B. Sanfilippo & Son, Inc. (JBSS), which was up 8.9%. JBSS (market cap $605 million) is a processor and distributor of peanuts, pecans, cashews, walnuts, almonds and other nuts. The Company offers nuts under a range of private brands and under the Fisher, Orchard Valley Harvest, Fisher Nut Exactly and Sunshine Country brand names. The Company also markets and distributes a diverse product line of food and snack products, including snack mixes, salad toppings, snacks, snack bites, trail mixes, dried fruit, and chocolate and yogurt coated products under private brands and brand names. The issue scores 100% in my James O'Shaughnessy-inspired model, due to metrics such as earnings per share persistence, a Price/Sales Ratio of 0.64 (based on trialing 12-month sales), and relative strength. JBSS also ranked highly by the Peter Lynch and Kenneth Fisher-based models.

Other issues that outperformed the market over the past two weeks were Amtrust Financial Services Inc. (AFSI), Banc of California (BANC) and Grupo Financiero Galicia S.A. (ADR) (GGAL), which were up 2.9%, 1.6% and 1.5% respectively. Valero Energy Corporation (VLO) performed on par with the market, rising 0.76%.

As for losses, Polaris Industries, Inc. (PII) fell 8.9%, the largest decline in the portfolio over the past two weeks. Polaris Industries Inc. designs, engineers and manufactures off-road vehicles (ORV), including all-terrain vehicles (ATV) and side-by-side vehicles for recreational and utility use, snowmobiles, motorcycles and global adjacent markets vehicles, together with the related parts, garments and accessories. No specific news appears to be associated with the stock's recent decline.

Other stocks that produced losses in the portfolio were Banco Macro SA (ADR) (BMA) and Trex Company, Inc. (TREX), which were down 1.4% and 0.44%, respectively.

Since the last publication of the Hot List Newsletter, the S&P 500 gained about 0.45%, while the Hot List Portfolio outperformed, rising 2.1%. In two weeks, we'll perform our regularly scheduled rebalancing. At that time, we will sell any holdings whose relative scores have fallen significantly and replace them with new stocks that score highly on my models.



Recommended Reading

We all go through periods where our performance is just off. In regards to the stock market, this issue holds true even for money managers who have established long-term, outstanding track records. And, investors can be a fickle bunch, jumping from one strategy to another, based on what is currently "hot." However, a study by Robert W. Baird & Co., which I profile in a recent entry in my Validea Guru Investor Blog, "Fund Managers: The Latest Might Not be the Greatest," provides findings that show "shortsighted" investors who switch to new managers based on recent successes (over a period of 1 to 3 years) might "leave wealth on the table."

The study notes that "at some point in their careers, virtually all top-performing money managers underperform their benchmark and their peers, particularly over time periods of three years or less. Rather than abandoning a top-performing manager during one of these periods, investors should anticipate and, quite often, accept this performance cycle. Why? By chasing performance, investors fall into an ongoing pattern of buying after share prices have risen considerably and selling after they have dropped. This behavior opposes the basic tenet of investing, buy low and sell high, and can cut dramatically into investor wealth."

It appears that patience is the key, as investors who are willing to ride out periods of subpar performance make out better in the long run. According to Baird, "Although there are times when a change in manager is warranted, our research revealed that the longer an investor sticks with a top-performing manager, the better the chances of success."

Even each of the gurus I follow has experienced periods where profits ran dry. However, they stayed with their respective discipline and rode out the bad times. With each successful enough to be recognized as one of the greatest investors in history, enduring the bumps in the road has clearly paid off in the long run.



Guru Spotlight: Joel Greenblatt

In another recent entry in the Validea Guru Investor Blog, I highlight a piece I wrote for Forbes entitled, "Stop The Insanity And Stick To Fundamentals Like Buffett, Graham And Greenblatt." In the article, I note that it is hard to sift through all the noise these days -- a presidential election, political and economic unrest, just to name a few -- and know where to put your money. However, I offered that the wise course of action may be to "turn off the noise and circle back to basics."

Many of the gurus I follow have their own investment mantras that help keep them grounded during turbulent times. One such guru is Joel Greenblatt, whose mantra is: "buying good companies at bargain prices makes sense." It cannot get much simpler than that. And, given the plethora of noise currently being thrust upon us these days by the media, I believe now is an opportune time to profile Greenblatt's stunningly simple investment strategy.

Hedge fund manager Greenblatt's 2005 bestseller The Little Book That Beats The Market, lays out a way to beat the market using two -- and only two -- fundamental variables. The "Magic Formula," as he called it, produced back-tested returns of 30.8 percent per year from 1988 through 2004, more than doubling the S&P 500's 12.4 percent return during that time. Greenblatt also produced exceptional returns as managing partner at Gotham Capital, a New York City-based hedge fund he founded. The firm averaged a remarkable 40 percent annualized return over more than two decades.

The "Magic Formula" is a purely quantitative approach that uses just two variables: return on capital and earnings yield. He looks for stocks with a high earnings yield (earnings before interest and taxes/enterprise value) and a high return on capital (EBIT/tangible capital employed). It's as simple as that.

The return on capital metric accomplishes the first part of Greenblatt's mantra (buying good companies) because it looks at how much profit a firm is generating using its capital. According to The Little Book That Beats The Market, the rationale behind this part of the Magic Formula is that businesses that can earn a high return on capital may also have the opportunity to invest their profits at very high rates of return. And, the ability to earn a high return on capital may also contribute to a high rate of earnings growth. Greenblatt goes on to state that companies that achieve a high return on capital are more likely to have a special competitive advantage that will allow them to continue to earn an above-average return on capital.

The second part of the Greenblatt mantra (at bargain prices) is accomplished by the earnings yield variable. The earnings yield is similar to the inverse of the price/earnings ratio: stocks with high earnings yields are taking in a relatively high amount of earnings compared to the price of their stock.

To choose stocks, Greenblatt simply ranked all stocks by return on capital, with the best being number 1, the second number 2, and so forth. Then, he ranked them in the same way by earnings yield. He then added up the two rankings, and invested in the stocks with the lowest combined numerical ranking.

Greenblatt also uses slightly unconventional ways to calculates earnings yield and return on capital. In figuring out the capital part of the return on capital variable and the earnings part of the earnings yield variable, he doesn't use simple earnings; instead, he uses earnings before interest and taxation. The reason: these parts of the equations should see how well a company's underlying business is doing, and taxes and debt payments can obscure that picture.

In addition, in figuring earnings yield, Greenblatt divides EBIT not by the total price of a company's stock, but instead by enterprise value -- which includes not only the total price of the firm's stock, but also its debt. This gives the investor an idea of what kind of yield they could expect if buying the entire firm -- including both its assets and its debts. Greenblatt's earnings yield calculation is a way to find stocks that are producing a good earnings yield that isn't contingent on a high debt load.

In my Greenblatt model, I calculate return on capital and earnings yield in the same ways that Greenblatt lays out in his book.

In The Little Book That Beats The Market, Greenblatt notes one obvious problem with his simplistic Magic Formula -- "How can our strategy keep working after everyone knows about it?" In response to that issue he acknowledges that there are plenty of times when the Magic Formula doesn't work at all. In fact, "on average, in five months out of each year, the Magic Formula does worse than the overall market. And, often, the Magic Formula doesn't work for a full year or even more."

However, Greenblatt goes on further to state that "if the Magic Formula worked all the time, everyone would probably use it. If everyone used it, it would probably stop working. So many people would be buying the shares of the bargain-priced stocks selected by the Magic Formula that the prices of those shares would be pushed higher almost immediately. In other words, if everyone used the formula, the bargains would disappear and the Magic Formula would be ruined!"

And, most investors won't hold tight during difficult times. If a strategy works in the long run -- taking three or more years to show its stuff -- most people won't stick around. This ties back to the subject of this week's Recommended Reading: "Fund Managers: The Latest Might Not be the Greatest." Greenblatt's strategy does work over the long haul. And, he finds it a good thing that strategy is not a consistent winner over "shorter periods." Longer term, however, the Magic Formula has a spectacular track record.

We added the Greenblatt portfolio to our site in January of 2009, but have been tracking its performance internally for several years before that. So far, the model has been a strong performer, with some big ups and downs. Since 2006, this portfolio has returned 107.5%, outperforming the market by 36.4% using its optimal quarterly rebalancing period and 10 stock portfolio size. The portfolio beat the market in 2006 and 2007, and then did what few funds have done: limit losses in what for stocks was a terrible 2008, and handily beat the market in the 2009 rebound. It fell 26.3% in '08 -- not good, but much better than the S&P 500's 38.5% loss -- and surged 63.1% in 2009 (the best individual Guru Strategy performer), vs. 23.5% for the S&P. After beating the market again in 2010, it struggled in 2011 and 2012. In 2013, the Greenblatt-based portfolio bounced back strong, returning more than 50%. In 2014 and 2015, it struggled, losing 2.2% and 11.8%, respectively. This year it remains an underperformer, as the portfolio is down 2.4% versus a 6.7% gain in the S&P 500. These ups and downs are proof of what Greenblatt stresses: that the strategy won't beat the market every month or even every year, which is important to remember. In fact, during that stellar 17-year period he covered in his book, there were even times when it lagged the market for three straight years. But that, he says, is why it works over the long haul: Undisciplined investors bail on the strategy, allowing those who stick with it to pick up the exceptional bargains, while others "leave wealth on the table."

Below is a look at its current holdings. One note: Because of the way financial and utility companies are financed (i.e. with large amounts of debt), Greenblatt excludes them from his screening process, so I do the same. He also doesn't include foreign stocks, so I exclude those from my model as well.

American Renal Associates Holdings Inc. (ARA)
Discovery Communications Inc. (DISCA)
Five Prime Therapeutics Inc. (FPRX)
Gilead Sciences, Inc. (GILD)
HP Inc. (HPQ)
Michael Kors Holdings LTD (KORS)
Natural Health Trends Corp. (NHTC)
Neustar Inc. (NSR)
Silver Spring Networks Inc. (SSNI)
United Therapeutics Corporation (UTHR)



News about Validea Hot List Stocks

John B. Sanfilippo & Son, Inc. (JBSS): On August 24th JBSS announced operating results for both its fiscal 2016 fourth quarter and fiscal year ended June 30, 2016. Net income for the fourth quarter of fiscal 2016 was $7.3 million, or $0.64 per share diluted, compared to net income of $8.5 million, or $0.75 per share diluted, for the fourth quarter of fiscal 2015. Net income for fiscal 2016 was $30.4 million compared to net income of $29.3 million for fiscal 2015. Diluted earnings per share for fiscal 2016 was $2.68 compared to $2.61 for fiscal 2015. Both the current fourth quarter and fiscal year contained an additional week compared to the same periods in fiscal 2015. Fiscal 2016 fourth quarter net sales increased by 4.6% to $231.5 million from net sales of $221.4 million for the fourth quarter of fiscal 2015 due to a 10.4% increase in sales volume, which is defined as pounds sold to customers. The favorable impact upon net sales from the increase in sales volume was offset in part by a significant decline in selling prices for walnuts. Sales volume increased in all distribution channels, and sales volume increased for all major product types except pecans.

Polaris Industries (PII): PII recently announced that the Canadian military will acquire 36 MRZR-D utility vehicles and 12 tactical trailers for evaluation. Polaris says there is an option for up to 18 more MRZR-Ds and up to six more tactical trailers to be delivered under a contract awarded in June.

LGI Homes, Inc. (LGIH): LGIH, on September 7th, announced 383 homes closed in August 2016, up from 320 home closings in August 2015, representing year-over-year growth of 19.7%. The Company ended the first eight months of 2016 with 2,661 home closings, a 23.5% increase over 2,155 home closings during the first eight months of 2015.



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 hotlist@validea.com.

Portfolio Holdings
Ticker Date Added Return
BMA 7/1/2016 4.3%
GGAL 8/26/2016 0.0%
LGIH 7/1/2016 18.5%
AFSI 8/26/2016 3.6%
BANC 8/26/2016 0.2%
VLO 6/3/2016 1.8%
JBSS 8/26/2016 7.2%
PII 8/26/2016 -8.8%
STS 8/26/2016 10.2%
TREX 8/26/2016 -2.3%


Guru 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

BMA   |   GGAL   |   LGIH   |   AFSI   |   BANC   |   VLO   |   JBSS   |   PII   |   STS   |   TREX   |  

BANCO MACRO SA (ADR)

Strategy: P/E/Growth Investor
Based on: Peter Lynch

Banco Macro S.A. (the Bank) is a bank. The Bank offers traditional bank products and services to companies, including those operating in regional economies, as well as to individuals. The Bank offers savings and checking accounts, credit and debit cards, consumer finance loans (including personal loans), mortgage loans, automobile loans, overdrafts, credit-related services, home and car insurance coverage, tax collection, utility payments, automatic teller machines (ATMs) and money transfers. The Bank offers Plan Sueldo payroll services, lending, corporate credit cards, mortgage finance, transaction processing and foreign exchange. The Bank offers transaction services to its corporate customers, such as cash management, customer collections, payments to suppliers, payroll administration, foreign exchange transactions, foreign trade services, corporate credit cards and information services, such as its Datanet and Interpymes services.


DETERMINE THE CLASSIFICATION:

This methodology would consider BMA a "fast-grower".


P/E/GROWTH RATIO: PASS

The investor should examine the P/E (10.80) relative to the growth rate (43.98%), based on the average of the 3, 4 and 5 year historical eps growth rates, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for BMA (0.25) is very favorable.


SALES AND P/E RATIO: PASS

For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth high enough to support a P/E above this threshold. BMA, whose sales are $1,682.0 million, needs to have a P/E below 40 to pass this criterion. BMA's P/E of (10.80) is considered acceptable.


EPS GROWTH RATE: PASS

This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for BMA is 44.0%, based on the average of the 3, 4 and 5 year historical eps growth rates, which is considered 'OK'. However, it may be difficult to sustain such a high growth rate.


TOTAL DEBT/EQUITY RATIO: NEUTRAL

BMA is a financial company so debt to equity rules are not applied to determine the company's financial soundness.


EQUITY/ASSETS RATIO: PASS

This methodology uses the Equity/Assets Ratio as a way to determine a financial intermediary's health, as it is a better measure than the Debt/Equity Ratio. BMA's Equity/Assets ratio (15.00%) is very healthy and above the minimum 5% this methodology looks for, thus passing the criterion.


RETURN ON ASSETS: PASS

This methodology uses Return on Assets as a way to measure a financial intermediary's profitability. BMA's ROA (5.82%) is above the minimum 1% that this methodology looks for, thus passing the criterion.


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for BMA (6.13%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for BMA (-1.46%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


GRUPO FINANCIERO GALICIA S.A. (ADR)

Strategy: Price/Sales Investor
Based on: Kenneth Fisher

Grupo Financiero Galicia S.A. (Grupo Financiero Galicia) is a financial services holding company. The Company's segments include Banking, Regional Credit Cards, CFA, Insurance and Other Grupo Galicia Businesses. Banco de Galicia y Buenos Aires S.A. (Banco Galicia) is a subsidiary of the Company. Its banking business segment represents Banco Galicia consolidated line by line with Banco Galicia Uruguay S.A. (Galicia Uruguay). It operates the regional credit cards segment through Tarjetas Regionales S.A. and its subsidiaries. Its CFA business segment extends unsecured personal loans to low and middle-income segments of the Argentine population. The Company operates the insurance segment through Sudamericana Holding S.A. and its subsidiaries. Its Other Grupo Galicia Businesses segment includes the results of Galicia Warrants S.A., Galicia Administradora de Fondos S.A. Sociedad Gerente de Fondos Comunes de Inversion and Net Investment S.A.


PRICE/SALES RATIO: PASS

The prospective company should have a low Price/Sales ratio. Non-cyclical (non-Smokestack) companies with Price/Sales ratio between .75 and 1.5 are good values. GGAL's P/S ratio of 1.37 based on trailing 12 month sales, falls within the "good values" range for non-cyclical companies and is considered attractive.


PRICE/RESEARCH RATIO: PASS

This methodology considers companies in the Technology and Medical sectors to be attractive if they have low Price/Research ratios. GGAL is neither a Technology nor Medical company. Therefore the Price/Research ratio is not available and, hence, not much emphasis should be placed on this particular variable.


PRELIMINARY GRADE: No Interest in GGAL At this Point

Is GGAL a "Super Stock"? NO


Price/Sales Ratio: FAIL

The Price/Sales ratio is the most important variable according to this methodology. The prospective company should have a low Price/Sales ratio. GGAL's Price/Sales ratio of 1.37 does not pass this criterion.


LONG-TERM EPS GROWTH RATE: PASS

This methodology looks for companies that have an inflation adjusted EPS growth rate greater than 15%. GGAL's inflation adjusted EPS growth rate of 32.23% passes this test.


FREE CASH PER SHARE: PASS

This methodology looks for companies that have a positive free cash per share. Companies should have enough free cash available to sustain three years of losses. This is based on the premise that companies without cash will soon be out of business. GGAL's free cash per share of 7.54 passes this criterion.


THREE YEAR AVERAGE NET PROFIT MARGIN: PASS

This methodology looks for companies that have an average net profit margin of 5% or greater over a three year period. GGAL's three year net profit margin, which averages 18.02%, passes this criterion.


LGI HOMES INC

Strategy: Growth/Value Investor
Based on: James P. O'Shaughnessy

LGI Homes, Inc. is a homebuilder. The Company is engaged in the design, construction, marketing and sale of new homes in markets in Texas, Arizona, Florida, Georgia, New Mexico, South Carolina, North Carolina, Colorado, Washington and Tennessee. The Company has five segments: the Texas division, the Southwest division, the Southeast division, the Florida division and the Northwest division. The Texas division includes homebuilding operations in Houston, Dallas/Fort Worth, San Antonio and Austin locations. The Southwest division includes homebuilding operations in Phoenix, Tucson, Albuquerque, Denver and Colorado Springs locations. The Southeast division includes homebuilding operations in Atlanta, Charlotte and Nashville locations. The Florida division includes homebuilding operations in Tampa, Orlando, Fort Myers and Jacksonville locations. The Northwest division includes homebuilding operations in Seattle location. Its product offerings include entry-level homes and move-up homes.


MARKET CAP: PASS

The first requirement of the Cornerstone Growth Strategy is that the company has a market capitalization of at least $150 million. This will screen out the companies that are too illiquid for most investors, but still include a small growth company. LGIH, with a market cap of $818 million, passes this criterion.


EARNINGS PER SHARE PERSISTENCE: PASS

The Cornerstone Growth methodology looks for companies that show persistent earnings growth without regard to magnitude. To fulfill this requirement, a company's earnings must increase each year for a five year period. LGIH, whose annual EPS before extraordinary items for the last 5 years (from earliest to the most recent fiscal year) were 0.17, 0.50, 1.07, 1.33 and 2.44, passes this test.


PRICE/SALES RATIO: PASS

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy. LGIH's Price/Sales ratio of 1.11, based on trailing 12 month sales, passes this criterion.


RELATIVE STRENGTH: PASS

The final criterion for the Cornerstone Growth Strategy requires that the Relative Strength of the company be among the top 50 of the stocks screened using the previous criterion. This gives you the opportunity to buy the growth stocks you are searching for just as the market is embracing them. LGIH, whose relative strength is 85, is in the top 50 and would pass this last criterion.


AMTRUST FINANCIAL SERVICES INC

Strategy: Patient Investor
Based on: Warren Buffett

Amtrust Financial Services, Inc. (AmTrust) is an insurance holding company. The Company, through its subsidiaries, provides specialty property and casualty insurance focusing on workers' compensation and commercial package coverage for small business, specialty risk and extended warranty coverage, and property and casualty coverage for middle market business. Its segments include Small Commercial Business, Specialty Risk and Extended Warranty, and Specialty Program. The Small Commercial Business segment is engaged in providing workers' compensation, commercial package and other commercial insurance lines produced by wholesale agents, retail agents and brokers in the United States. The Specialty Risk and Extended Warranty segment is engaged in providing coverage for consumer and commercial goods and custom designed coverages. The Specialty Program segment is engaged in writing commercial insurance for defined classes of insureds through general and other wholesale agents.

STAGE 1: "Is this a Buffett type company?"

A bedrock principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers. While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.


LOOK FOR EARNINGS PREDICTABILITY: PASS

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 0.39, 0.68, 0.62, 0.78, 0.97, 1.14, 1.17, 1.78, 2.72, 2.80. Buffett would consider AFSI's earnings predictable, although earnings have declined 1 time(s) in the past seven years, with the most recent decline 8 years ago. The dips have totaled 8.8%. AFSI's long term historical EPS growth rate is 22.8%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 12.0% per year in the future, based on the analysts' consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY: PASS

Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for AFSI, over the last ten years, is 18.3%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 15.2%, 22.8%, 20.9%, 17.9%, 17.8%, 17.0%, 15.1%, 18.5%, 20.8%, 16.9%, and the average ROE over the last 3 years is 18.7%, thus passing this criterion.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON ASSETS: PASS

Buffett also requires, for financial companies, that the average Return On Assets (ROA) be at least 1% and consistent. Return On Assets is defined as the net earnings of the business divided by the total assets of the business. The average ROA for AFSI, over the last ten years, is 3.0%, which is high enough to pass. It is not enough that the average be at least 1%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROA must be at least 1% for Buffett to feel comfortable that the ROA is consistent. The ROA for the last 10 years, from earliest to latest, is 4.2%, 3.8%, 2.6%, 3.0%, 3.1%, 2.6%, 2.3%, 2.4%, 3.1%, 2.9%, thus passing this criterion.


LOOK AT CAPITAL EXPENDITURES: PASS

Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. AFSI's free cash flow per share of $4.20 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.


LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS: PASS

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $11.11 and compares it to the gain in EPS over the same period of $2.41. AFSI's management has proven it can earn shareholders a 21.7% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.


HAS THE COMPANY BEEN BUYING BACK SHARES: BONUS PASS

Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. AFSI's shares outstanding have fallen in the current year from 175,919,998 to 173,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.

The preceding concludes Buffett's qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate AFSI quantitatively.

STAGE 2: "Should I buy at this price?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.


CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]

Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $2.80 and divide it by the current market price of $26.85. An investor, purchasing AFSI, could expect to receive a 10.43% initial rate of return. Furthermore, he or she could expect the rate to increase 12.0% per year, based on the analysts' consensus estimated long term growth rate, as this is how fast earnings are growing.


COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: PASS

Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 2.25%. Compare this with AFSI's initial yield of 10.43%, which will expand at an annual rate of 12.0%, based on the analysts' consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.


CALCULATE THE FUTURE EPS: [No Pass/Fail]

AFSI currently has a book value of $15.08. It is safe to say that if AFSI can preserve its average rate of return on equity of 18.3% and continues to retain 83.82% of its earnings, it will be able to sustain an earnings growth rate of 15.3% and it will have a book value of $62.80 in ten years. If it can still earn 18.3% on equity in ten years, then expected EPS will be $11.49.


CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now take the expected future EPS of $11.49 and multiply them by the lower of the 5 year average P/E ratio (10.2) or current P/E ratio (current P/E in this case), which is 9.6 and you get AFSI's projected future stock price of $110.03.


CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now add in the total expected dividend pool to be paid over the next ten years, which is $8.90. This gives you a total dollar amount of $118.93. These numbers indicate that one could expect to make a 16.0% average annual return on AFSI's stock at the present time. Buffett would consider this a great return.


CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]

If you take the EPS growth of 12.0%, based on the analysts' consensus estimated long term growth rate, you can project EPS in ten years to be $8.70. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio (10.2) or current P/E ratio (current P/E in this case), which is 9.6. This equals the future stock price of $83.31. Add in the total expected dividend pool of $8.90 to get a total dollar amount of $92.21.


CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]

Now you can figure out your expected return based on a current price of $26.85 and the future expected stock price, including the dividend pool, of $92.21. If you were to invest in AFSI at this time, you could expect a 13.13% average annual return on your money. Buffett likes to see a 15% return, but nonetheless would accept this return.


LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: PASS

Based on the two different methods, you could expect an annual compounding rate of return somewhere between 13.1% and 16.0%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 14.6% on AFSI stock for the next ten years, based on the current fundamentals. Buffett likes to see a 15% return, but nonetheless would accept this return, thus passing the criterion.


BANC OF CALIFORNIA INC

Strategy: P/E/Growth Investor
Based on: Peter Lynch

Banc of California, Inc. is a financial holding company. The Company is the parent of Banc of California, National Association (the Bank) and The Palisades Group, LLC (The Palisades Group). The Company's segments include Commercial Banking, which consists of attracting deposits and investing these funds primarily in commercial, consumer and real estate secured loans; Mortgage Banking, which originates conforming single family residential (SFR) loans and sells these loans in the secondary market; Financial Advisory, which is operated by The Palisades Group and provides services of purchase, sale and management of SFR mortgage loans, and Corporate/Other, which includes the holding company. The Company has over 100 banking offices across California and across the West. The Company offers a range of banking services including private, commercial, retail and institutional banking.


DETERMINE THE CLASSIFICATION:

This methodology would consider BANC a "fast-grower".


P/E/GROWTH RATIO: PASS

The investor should examine the P/E (15.45) relative to the growth rate (39.55%), based on the average of the 3 and 5 year historical eps growth rates, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for BANC (0.39) is very favorable.


SALES AND P/E RATIO: NEUTRAL

For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth rate high enough to support a P/E above this threshold. BANC, whose sales are $319.6 million, is not considered large enough to apply the P/E ratio analysis. However, an investor can analyze the P/E ratio relative to the EPS growth rate.


EPS GROWTH RATE: PASS

This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for BANC is 39.5%, based on the average of the 3 and 5 year historical eps growth rates, which is considered 'OK'. However, it may be difficult to sustain such a high growth rate.


TOTAL DEBT/EQUITY RATIO: NEUTRAL

BANC is a financial company so debt to equity rules are not applied to determine the company's financial soundness.


EQUITY/ASSETS RATIO: PASS

This methodology uses the Equity/Assets Ratio as a way to determine a financial intermediary's health, as it is a better measure than the Debt/Equity Ratio. BANC's Equity/Assets ratio (9.00%) is healthy and above the minimum 5% this methodology looks for, thus passing the criterion.


RETURN ON ASSETS: FAIL

This methodology uses Return on Assets as a way to measure a financial intermediary's profitability. BANC's ROA (0.96%) is below the minimum 1% that this methodology looks for, thus failing the criterion.


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for BANC (-18.71%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for BANC (-15.08%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


VALERO ENERGY CORPORATION

Strategy: Value Investor
Based on: Benjamin Graham

Valero Energy Corporation (Valero), through Valero Energy Partners LP (VLP), owns, operates, develops and acquires crude oil and refined petroleum products pipelines, terminals, and other transportation and logistics assets. The Company operates in two segments: refining and ethanol. Its refining segment includes refining and marketing operations in the United States, Canada, the United Kingdom, Aruba and Ireland. Its ethanol segment includes ethanol and marketing operations in the United States. VLP's assets include crude oil and refined petroleum products pipeline and terminal systems in the United States Gulf Coast and the United States Mid-Continent regions. Its refineries can produce conventional gasolines, premium gasolines, gasoline meeting the specifications of the California Air Resources Board (CARB), diesel, low-sulfur diesel, ultra-low-sulfur diesel, CARB diesel, other distillates, jet fuel, asphalt, petrochemicals, lubricants and other refined products.


SECTOR: PASS

VLO is neither a technology nor financial Company, and therefore this methodology is applicable.


SALES: PASS

The investor must select companies of "adequate size". This includes companies with annual sales greater than $340 million. VLO's sales of $76,654.0 million, based on trailing 12 month sales, pass this test.


CURRENT RATIO: FAIL

The current ratio must be greater than or equal to 2. Companies that meet this criterion are typically financially secure and defensive. VLO's current ratio of 1.87 fails the test.


LONG-TERM DEBT IN RELATION TO NET CURRENT ASSETS: PASS

For industrial companies, long-term debt must not exceed net current assets (current assets minus current liabilities). Companies that meet this criterion display one of the attributes of a financially secure organization. The long-term debt for VLO is $6,646.0 million, while the net current assets are $7,528.0 million. VLO passes this test.


LONG-TERM EPS GROWTH: FAIL

Companies must increase their EPS by at least 30% over a ten-year period and EPS must not have been negative for any year within the last 5 years. EPS for VLO were negative within the last 5 years and therefore the company fails this criterion.


P/E RATIO: PASS

The Price/Earnings (P/E) ratio, based on the greater of the current PE or the PE using average earnings over the last 3 fiscal years, must be "moderate", which this methodology states is not greater than 15. Stocks with moderate P/Es are more defensive by nature. VLO's P/E of 9.08 (using the current PE) passes this test.


PRICE/BOOK RATIO: PASS

The Price/Book ratio must also be reasonable. That is, the Price/Book multiplied by P/E cannot be greater than 22. VLO's Price/Book ratio is 1.26, while the P/E is 9.08. VLO passes the Price/Book test.


JOHN B. SANFILIPPO & SON, INC.

Strategy: Growth/Value Investor
Based on: James P. O'Shaughnessy

John B. Sanfilippo & Son, Inc. is a processor and distributor of peanuts, pecans, cashews, walnuts, almonds and other nuts. The Company offers nuts under a range of private brands and under the Fisher, Orchard Valley Harvest, Fisher Nut Exactly and Sunshine Country brand names. The Company also markets and distributes a diverse product line of food and snack products, including snack mixes, salad toppings, snacks, snack bites, trail mixes, dried fruit, and chocolate and yogurt coated products under private brands and brand names. The Company's principal products are raw and processed nuts. The Company's nut product line includes black walnuts, English walnuts, macadamia nuts, pistachios, pine nuts, Brazil nuts and filberts. The Company's products are sold through various distribution channels to buyers of nuts, including food retailers, commercial ingredient users, contract packaging customers and international customers.


MARKET CAP: PASS

The first requirement of the Cornerstone Growth Strategy is that the company has a market capitalization of at least $150 million. This will screen out the companies that are too illiquid for most investors, but still include a small growth company. JBSS, with a market cap of $594 million, passes this criterion.


EARNINGS PER SHARE PERSISTENCE: PASS

The Cornerstone Growth methodology looks for companies that show persistent earnings growth without regard to magnitude. To fulfill this requirement, a company's earnings must increase each year for a five year period. JBSS, whose annual EPS before extraordinary items for the last 5 years (from earliest to the most recent fiscal year) were 1.58, 1.98, 2.36, 2.60 and 2.68, passes this test.


PRICE/SALES RATIO: PASS

The Price/Sales ratio should be below 1.5. This value criterion, coupled with the growth criterion, identify growth stocks that are still cheap to buy. JBSS's Price/Sales ratio of 0.62, based on trailing 12 month sales, passes this criterion.


RELATIVE STRENGTH: PASS

The final criterion for the Cornerstone Growth Strategy requires that the Relative Strength of the company be among the top 50 of the stocks screened using the previous criterion. This gives you the opportunity to buy the growth stocks you are searching for just as the market is embracing them. JBSS, whose relative strength is 67, is in the top 50 and would pass this last criterion.


POLARIS INDUSTRIES INC.

Strategy: Patient Investor
Based on: Warren Buffett

Polaris Industries Inc. (Polaris) designs, engineers and manufactures off-road vehicles (ORV), including all-terrain vehicles (ATV) and side-by-side vehicles for recreational and utility use, snowmobiles, motorcycles and global adjacent markets vehicles, together with the related parts, garments and accessories. The Company's segments are ORV/Snowmobiles, Motorcycles and Global Adjacent Markets. These products are sold through dealers and distributors located in the United States, Canada, Western Europe, Australia and Mexico. Its ORVs include Sportsman ATVs, Polaris ACE, RANGER, RZR and Polaris GENERAL side-by-side vehicles. It produces snowmobiles, ranging from youth models to utility and economy models to performance and competition models. Its Motorcycles segment consists of Victory, Indian motorcycles and the moto-roadster, Slingshot. It offers products in the light-duty hauling, people mover and urban/suburban commuting sub-sectors of the Work and Transportation industry.

STAGE 1: "Is this a Buffett type company?"

A bedrock principle for Buffett is that his type of company has a "durable competitive advantage" as compared to being a "price competitive" or "commodity" type of business. Companies with a "durable competitive advantage" are more likely to be found in these sub-industries: Brand Name Fast Food Restaurants, Brand Name Beverages, Brand Name Foods, Brand Name Toiletries and Household Products, Brand Name Clothing, Brand Name Prescription Drugs, Advertising, Advertising Agencies, TV, Newspapers, Magazines, Direct Mail, Repetitive Services for Businesses, Low Cost Producers of Insurance, furniture, or Low Cost Retailers. While you should be easily able to explain where the company's pricing power comes from (i.e. a strong regional brand image, a business tollgate, its main products are #1 or # 2 in its field and has been on the market for years and hasn't changed at all, a consumer or business ends up buying the same product many times in a year, etc. or having the lowest production cost among its competition), there are certain figures that one can look at that can qualify the company as having a durable competitive advantage.


LOOK FOR EARNINGS PREDICTABILITY: PASS

Buffett likes companies to have solid, stable earnings that are continually expanding. This allows him to accurately predict future earnings. Annual earnings per share from earliest to most recent were 1.36, 1.55, 1.75, 1.53, 2.14, 3.20, 4.40, 5.40, 6.65, 6.75. Buffett would consider PII's earnings predictable, although earnings have declined 1 time(s) in the past seven years, with the most recent decline 7 years ago. The dips have totaled 12.6%. PII's long term historical EPS growth rate is 15.7%, based on the 10 year average EPS growth rate, and it is expected to grow earnings 13.0% per year in the future, based on the analysts' consensus estimated long term growth rate. For the purposes of our analysis, we will use the more conservative of the two EPS growth numbers.


LOOK AT THE ABILITY TO PAY OFF DEBT PASS

Buffett likes companies that are conservatively financed. Nonetheless, he has invested in companies with large financing divisions and in firms with rather high levels of debt. PII has a debt of 463.3 million and earnings of 375.1 million, which could be used to pay off the debt in less than two years, which is considered exceptional.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON EQUITY: PASS

Buffett likes companies with above average return on equity of at least 15% or better, as this is an indicator that the company has a durable competitive advantage. US corporations have, on average, returned about 12% on equity over the last 30 years. The average ROE for PII, over the last ten years, is 44.1%, which is high enough to pass. It is not enough that the average be at least 15%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROE must be at least 10% for Buffett to feel comfortable that the ROE is consistent. In addition, the average ROE over the last 3 years must also exceed 15%. The ROE for the last 10 years, from earliest to latest, is 57.7%, 61.3%, 82.9%, 48.8%, 39.5%, 43.8%, 43.7%, 66.2%, 51.2%, 44.9%, and the average ROE over the last 3 years is 54.1%, thus passing this criterion.


LOOK FOR CONSISTENTLY HIGHER THAN AVERAGE RETURN ON TOTAL CAPITAL: PASS

Because some companies can be financed with debt that is many times their equity, they can show a consistently high ROE, yet still be in unattractive price competitive businesses. To screen this out, for non-financial companies Buffett also requires that the average Return On Total Capital (ROTC) be at least 12% and consistent. In addition, the average ROTC over the last 3 years must also exceed 12%. Return On Total Capital is defined as the net earnings of the business divided by the total capital in the business, both equity and debt. The average ROTC for PII, over the last ten years, is 33.0% and the average ROTC over the past 3 years is 38.2%, which is high enough to pass. It is not enough that the average be at least 12%. For each of the last 10 years, with the possible exception of the last fiscal year, the ROTC must be at least 9% for Buffett to feel comfortable that the ROTC is consistent. The ROTC for the last 10 years, from earliest to latest, is 23.1%, 28.4%, 33.7%, 24.7%, 31.1%, 36.3%, 38.0%, 43.2%, 40.7%, 30.7%, thus passing this criterion.


LOOK AT CAPITAL EXPENDITURES: PASS

Buffett likes companies that do not have major capital expenditures. That is, he looks for companies that do not need to spend a ton of money on major upgrades of plant and equipment or on research and development to stay competitive. PII's free cash flow per share of $0.76 is positive, indicating that the company is generating more cash that it is consuming. This is a favorable sign, and so the company passes this criterion.


LOOK AT MANAGEMENT'S USE OF RETAINED EARNINGS: PASS

Buffett likes to see if management has spent retained earnings in a way that benefits shareholders. To figure this out, Buffett takes the total amount of retained earnings over the previous ten years of $23.25 and compares it to the gain in EPS over the same period of $5.39. PII's management has proven it can earn shareholders a 23.2% return on the earnings they kept. This return is more than acceptable to Buffett. Essentially, management is doing a great job putting the retained earnings to work.


HAS THE COMPANY BEEN BUYING BACK SHARES: BONUS PASS

Buffett likes to see falling shares outstanding, which indicates that the company has been repurchasing shares. This indicates that management has been using excess capital to increase shareholder value. PII's shares outstanding have fallen over the past five years from 68,430,000 to 65,000,000, thus passing this criterion. This is a bonus criterion and will not adversely affect the ability of a stock to pass the strategy as a whole if it is failed.

The preceding concludes Buffett's qualitative analysis. If and when he gets positive responses to all the above criteria, he would then proceed with a price analysis. The price analysis will determine whether or not the stock should be bought. The following is how he would evaluate PII quantitatively.

STAGE 2: "Should I buy at this price?" Although a firm may be a Buffett type company, he won't invest in it unless he can get a favorable price that allows him a great long term return.


CALCULATE THE INITIAL RATE OF RETURN: [No Pass/Fail]

Buffett compares his type of stocks to bonds, and likes to see what a company's initial rate of return is. To calculate the initial rate of return, take the trailing 12-month EPS of $5.77 and divide it by the current market price of $82.79. An investor, purchasing PII, could expect to receive a 6.97% initial rate of return. Furthermore, he or she could expect the rate to increase 13.0% per year, based on the analysts' consensus estimated long term growth rate, as this is how fast earnings are growing.


COMPARE THE INITIAL RATE OF RETURN WITH THE LONG-TERM TREASURY YIELD: PASS

Buffett favors companies in which the initial rate of return is around the long-term treasury yield. Nonetheless, he has invested in companies with low initial rates of return, as long as the yield is expected to expand rapidly. Currently, the long-term treasury yield is about 2.25%. Compare this with PII's initial yield of 6.97%, which will expand at an annual rate of 13.0%, based on the analysts' consensus estimated long term growth rate. The company is the better choice, as the initial rate of return is close to or above the long term bond yield and is expanding.


CALCULATE THE FUTURE EPS: [No Pass/Fail]

PII currently has a book value of $14.42. It is safe to say that if PII can preserve its average rate of return on equity of 44.1% and continues to retain 66.25% of its earnings, it will be able to sustain an earnings growth rate of 29.2% and it will have a book value of $187.58 in ten years. If it can still earn 44.1% on equity in ten years, then expected EPS will be $82.80.


CALCULATE THE FUTURE STOCK PRICE BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now take the expected future EPS of $82.80 and multiply them by the lower of the 5 year average P/E ratio (19.8) or current P/E ratio (current P/E in this case), which is 14.4 and you get PII's projected future stock price of $1,189.05.


CALCULATE THE EXPECTED RATE OF RETURN BASED ON THE AVERAGE ROE METHOD: [No Pass/Fail]

Now add in the total expected dividend pool to be paid over the next ten years, which is $40.53. This gives you a total dollar amount of $1,229.58. These numbers indicate that one could expect to make a 31.0% average annual return on PII's stock at the present time. Buffett would consider this an absolutely fantastic expected return.


CALCULATE THE EXPECTED FUTURE STOCK PRICE BASED ON AVERAGE EPS GROWTH: [No Pass/Fail]

If you take the EPS growth of 13.0%, based on the analysts' consensus estimated long term growth rate, you can project EPS in ten years to be $19.59. Now multiply EPS in 10 years by the lower of the 5 year average P/E ratio (19.8) or current P/E ratio (current P/E in this case), which is 14.4. This equals the future stock price of $281.26. Add in the total expected dividend pool of $40.53 to get a total dollar amount of $321.80.


CALCULATE THE EXPECTED RETURN USING THE AVERAGE EPS GROWTH METHOD: [No Pass/Fail]

Now you can figure out your expected return based on a current price of $82.79 and the future expected stock price, including the dividend pool, of $321.80. If you were to invest in PII at this time, you could expect a 14.54% average annual return on your money. Buffett likes to see a 15% return, but nonetheless would accept this return.


LOOK AT THE RANGE OF EXPECTED RATE OF RETURN: PASS

Based on the two different methods, you could expect an annual compounding rate of return somewhere between 14.5% and 31.0%. To pinpoint the average return a little better, we have taken an average of the two different methods. Investors could expect an average return of 22.8% on PII stock for the next ten years, based on the current fundamentals. Buffett would consider this an exceptional return, thus passing the criterion.


SUPREME INDUSTRIES, INC.

Strategy: Growth Investor
Based on: Martin Zweig

Supreme Industries, Inc. (Supreme) is a manufacturer of specialized vehicles, including truck bodies, trolleys and specialty vehicles. The Company operates through two segments, which include specialized commercial vehicles and fiberglass products. The Company manufactures specialized commercial vehicles that are attached to a truck chassis. The Company's truck bodies are offered in aluminum, FiberPanel PW, FiberPanel HC, or SignaturePlate. The Company's products include Signature van bodies, Iner-City cutaway van bodies, Spartan service bodies, Spartan cargo vans, Kold King insulated van bodies, stake bodies, armored sport utility vehicles (SUVs), armored trucks and specialty vehicles, and trolleys. Its products are attached to light-duty truck chassis and medium-duty truck chassis. Supreme integrates a range of options into its truck bodies, including liftgates, cargo-handling equipment, customized doors, special bumpers, ladder racks and refrigeration equipment.


P/E RATIO: PASS

The P/E of a company must be greater than 5 to eliminate weak companies, but not more than 3 times the current Market P/E because the situation is much too risky, and never greater than 43. STS's P/E is 16.75, based on trailing 12 month earnings, while the current market PE is 15.00. Therefore, it passes the first test.


REVENUE GROWTH IN RELATION TO EPS GROWTH: FAIL

Revenue Growth must not be substantially less than earnings growth. For earnings to continue to grow over time they must be supported by a comparable or better sales growth rate and not just by cost cutting or other non-sales measures. STS's revenue growth is 1.69%, while it's earnings growth rate is 30.86%, based on the average of the 3 and 4 year historical eps growth rates. Therefore, STS fails this criterion.


SALES GROWTH RATE: PASS

Another important issue regarding sales growth is that the rate of quarterly sales growth is rising. To evaluate this, the change from this quarter last year to the present quarter (12.4%) must be examined, and then compared to the previous quarter last year compared to the previous quarter (9.7%) of the current year. Sales growth for the prior must be greater than the latter. For STS this criterion has been met.


The earnings numbers of a company should be examined from various different angles. Three of these angles are stability in the trend of earnings, earnings persistence, and earnings acceleration. To evaluate stability, the stock has to pass the following four criteria.


CURRENT QUARTER EARNINGS: PASS

The first of these criteria is that the current EPS be positive. STS's EPS ($0.48) pass this test.


QUARTERLY EARNINGS ONE YEAR AGO: PASS

The EPS for the quarter one year ago must be positive. STS's EPS for this quarter last year ($0.26) pass this test.


POSITIVE EARNINGS GROWTH RATE FOR CURRENT QUARTER: PASS

The growth rate of the current quarter's earnings compared to the same quarter a year ago must also be positive. STS's growth rate of 84.62% passes this test.


EARNINGS GROWTH RATE FOR THE PAST SEVERAL QUARTERS: FAIL

Compare the earnings growth rate of the previous three quarters with long-term EPS growth rate. Earnings growth in the previous 3 quarters should be at least half of the long-term EPS growth rate. Half of the long-term EPS growth rate for STS is 15.43%. This should be less than the growth rates for the 3 previous quarters which are 6.67%, 144.44% and 100.00%. STS does not pass this test, which means that it does not have good, reasonably steady earnings.


This strategy looks at the rate which earnings grow and evaluates this rate of growth from different angles. The 4 tests immediately following are detailed below.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN PRIOR 3 QUARTERS: PASS

If the growth rate of the prior three quarter's earnings, 71.43%, (versus the same three quarters a year earlier) is less than the growth rate of the current quarter earnings, 84.62%, (versus the same quarter one year ago) then the stock passes.


EPS GROWTH FOR CURRENT QUARTER MUST BE GREATER THAN THE HISTORICAL GROWTH RATE: PASS

The EPS growth rate for the current quarter, 84.62% must be greater than or equal to the historical growth which is 30.86%. STS would therefore pass this test.


EARNINGS PERSISTENCE: FAIL

Companies must show persistent yearly earnings growth. To fulfill this requirement a company's earnings must increase each year for a five year period. STS, whose annual EPS growth before extraordinary items for the previous 5 years (from the earliest to the most recent fiscal year) were 0.11, 0.77, 0.68, 0.51, and 0.76, fails this test.


LONG-TERM EPS GROWTH: PASS

One final earnings test required is that the long-term earnings growth rate must be at least 15% per year. STS's long-term growth rate of 30.86%, based on the average of the 3 and 4 year historical eps growth rates, passes this test.


TOTAL DEBT/EQUITY RATIO: PASS

A final criterion is that a company must not have a high level of debt. A high level of total debt, due to high interest expenses, can have a very negative effect on earnings if business moderately turns down. If a company does have a high level, an investor may want to avoid this stock altogether. STS's Debt/Equity (8.01%) is not considered high relative to its industry (163.72%) and passes this test.


INSIDER TRANSACTIONS: PASS

A factor that adds to a stock's attractiveness is if insider buy transactions number 3 or more, while insider sell transactions are zero. Zweig calls this an insider buy signal. For STS, this criterion has not been met (insider sell transactions are 118, while insiders buying number 51). Despite the fact that insider sells out number insider buys for this company, Zweig considers even one insider buy transaction enough to prevent an insider sell signal, therefore there is not an insider sell signal and the stock passes this criterion.


TREX COMPANY, INC.

Strategy: P/E/Growth Investor
Based on: Peter Lynch

Trex Company, Inc. is a manufacturer of wood-alternative decking and railing products. The Company markets its products under the brand name Trex. The Company offers a set of outdoor living products in the decking, railing, porch, fencing, trim, steel deck framing and outdoor lighting categories. Its decking products include Trex Transcend, Trex Enhance and Trex Select. The Company's railing products include Trex Transcend Railing, Trex Select Railing and Trex Reveal aluminum railing. It offers Trex Transcend Porch Flooring and Railing System, a porch product, and a fencing product called Trex Seclusions. The Company offers TrexTrim product, which is a cellular polyvinyl chloride residential exterior trim product. It offers a triple-coated steel deck framing system called Trex Elevations. The Company offers outdoor lighting systems, including Trex DeckLighting and Trex Landscape Lighting. It also offers Trex Hideaway, which a hidden fastening system for grooved boards.


DETERMINE THE CLASSIFICATION:

This methodology would consider TREX a "fast-grower".


P/E/GROWTH RATIO: PASS

The investor should examine the P/E (30.89) relative to the growth rate (81.60%), based on the average of the 3 and 4 year historical eps growth rates using the current fiscal year eps estimate, for a company. This is a quick way of determining the fairness of the price. In this particular case, the P/E/G ratio for TREX (0.38) is very favorable.


SALES AND P/E RATIO: NEUTRAL

For companies with sales greater than $1 billion, this methodology likes to see that the P/E ratio remain below 40. Large companies can have a difficult time maintaining a growth rate high enough to support a P/E above this threshold. TREX, whose sales are $461.4 million, is not considered large enough to apply the P/E ratio analysis. However, an investor can analyze the P/E ratio relative to the EPS growth rate.


INVENTORY TO SALES: PASS

When inventories increase faster than sales, it is a red flag. However an increase of up to 5% is considered bearable if all other ratios appear attractive. Inventory to sales for TREX was 6.06% last year, while for this year it is 5.24%. Since inventory to sales has decreased from last year by -0.82%, TREX passes this test.


EPS GROWTH RATE: FAIL

This methodology favors companies that have several years of fast earnings growth, as these companies have a proven formula for growth that in many cases can continue many more years. This methodology likes to see earnings growth in the range of 20% to 50%, as earnings growth over 50% may be unsustainable. The EPS growth rate for TREX is 81.6%, based on the average of the 3 and 4 year historical eps growth rates using the current fiscal year eps estimate, which is considered too fast.


TOTAL DEBT/EQUITY RATIO: PASS

This methodology would consider the Debt/Equity ratio for TREX (38.30%) to be normal (equity is approximately twice debt).


FREE CASH FLOW: NEUTRAL

The Free Cash Flow/Price ratio, though not a requirement, is considered a bonus if it is above 35%. A positive Cash Flow (the higher the better) separates a wonderfully reliable investment from a shaky one. This methodology prefers not to invest in companies that rely heavily on capital spending. This ratio for TREX (2.05%) is too low to add to the attractiveness of the stock. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.


NET CASH POSITION: NEUTRAL

Another bonus for a company is having a Net Cash/Price ratio above 30%. Lynch defines net cash as cash and marketable securities minus long term debt. According to this methodology, a high value for this ratio dramatically cuts down on the risk of the security. The Net Cash/Price ratio for TREX (0.34%) is too low to add to the attractiveness of this company. Keep in mind, however, that it does not adversely affect the company as it is a bonus criteria.



Watch List

The top scoring stocks not currently in the Hot List portfolio.

Ticker Company Name Current
Score
TSCO TRACTOR SUPPLY COMPANY 56%
SWHC SMITH & WESSON HOLDING CORP 47%
AMWD AMERICAN WOODMARK CORPORATION 46%
HOPE HOPE BANCORP INC 43%
WDR WADDELL & REED FINANCIAL, INC. 41%
HOMB HOME BANCSHARES INC 39%
WGO WINNEBAGO INDUSTRIES, INC. 38%
THO THOR INDUSTRIES, INC. 38%
UFPI UNIVERSAL FOREST PRODUCTS, INC. 37%
WAL WESTERN ALLIANCE BANCORPORATION 37%



Disclaimer

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.