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Executive Summary August 2, 2013

The Economy

While economic growth remains tepid, it has been better than expected lately. That -- and continuing strength in the housing market -- have helped keep stocks near all-time highs over the past fortnight.

The tepid growth was evidenced by the Commerce Department's report that gross domestic product grew at a 1.7% pace in the second quarter. Improvements in nonresidential fixed investment and in exports, a smaller decrease in federal government spending, and an upturn in state and local government spending all helped GDP accelerate a bit from its 1.1% first-quarter pace, however, and exceed analysts' estimates of about 1.0%. For what it's worth, the government also revised past GDP data, which showed that growth was 2.8% last year, vs. previous estimates of 2.2%.

The job market, meanwhile, continues to show improvement. Private payroll processor ADP said that 200,000 jobs were added to private, nonfarm payrolls in July, the most this year. New claims for unemployment have declined since our last newsletter, and are now more than 10% below their year-ago level. The Labor Department is slated to announce its overall July job numbers today, and we'll see if its data is similar to ADP's.

Elsewhere, manufacturing activity surged in July, according to the Institute for Supply Management. Its manufacturing index jumped from 50.9 to 55.4, the highest it's been in more than two years. The group's new orders and employment sub-indices also jumped, boding well for the future.

The housing market continues to be a big bright spot for the economy. New home sales hit a five-year high, rising 8.3% in June, according to the Census Bureau. They are now more than 41% above where they were one year ago, and sales prices are up 7.4% year over year.

Existing home sales fell 1.2%in June, according to the National Association of Realtors. But they were still 8.2% above their year-ago pace, and the median sales price was 13.5% above its year-ago level.

The S&P/Case-Shiller Home Price Indices also showed that prices are continuing to rise. New data showed that in May, the 10- and 20-city composite indices both rose about 1% on a seasonally adjusted basis. The 10-city is now 11.8% above its year-ago level, while the 20-city is up 12.2%.

Since our last newsletter, the S&P 500 returned 1.0%, while the Hot List returned 3.5%. So far in 2013, the portfolio has returned 31.9% vs. 19.7% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 257.7% vs. the S&P's 70.6% gain.

Got Value?

The stock market seems to have overcome its mid-May to late-June "taper tantrum" -- the decline that appeared to have been sparked by fears that the Federal Reserve would start tapering its huge asset-purchasing program -- with the S&P continuing to flirt with the previously unsurpassed 1,700 mark. The rebound since late June has been bolstered by some solid numbers from the housing, jobs, and industrial areas of the economy, but many are still thinking that, all in all, the market has come too far, too fast. It's been about a full quarter since we last looked at broader market valuations, and the market's recent run makes it a good time to check back in.

As always, let's start with earnings. Using the S&P 500's July 30 closing price of 1685.96 the index is trading for about 18.4 times trailing 12-month (TTM) as-reported earnings per share, down slightly from 18.5 in early May, when last we checked in. It trades for 16.9 times TTM operating EPS, up from 16.5 in early May.

Using projected earnings for the next year, the operating figure is 14.6, up slightly from 14.4 in May, and the as-reported figure is 15.5, up a decent amount from 14.3. Overall, P/Es are a bit higher than they were a quarter ago, and up significantly over the past nine months or so. But these earnings-related valuations are far from exuberant; they're within what I'd say is the "fair value" range, particularly in a low-interest-rate environment.

The S&P's price/sales ratio, meanwhile, remains where it was three months ago, at 1.4, according to Morningstar.com. Its price/book ratio also remains at 2.1. From 1978 through early 2011, the average S&P price/book ratio was about 2.4, according to data from Ned Davis Research and Comstock Partners, so that figure stacks up quite well. The current price/sales ratio is higher than the historical average cited by Comstock and Ned Davis. But again, it doesn't seem exuberant -- my James O'Shaughnessy-based growth model considers P/S ratios of up to 1.5 to be indicative of good values.

Dividend yields, meanwhile, remain attractive, thought they've dipped slightly to 2.2% (from 2.3%) over the past three months. But for the first time in a couple years, the S&P's dividend yield is significantly lower than the yield on 10-year Treasury bonds, which is about 2.6%. It's a rarity for the 10-year to yield less than the S&P, so perhaps this is simply a sign of a return to greater normalcy. Still, it does mean a bit more competition for stocks.

One figure that continues to rise is the Stock Market/GDP ratio, which compares the market cap of the Wilshire Total Market Index to gross domestic product. It is now 111.8%, up from about 109% in May (and 89.5% last November), according to GuruFocus.com. That puts it in the "Modestly Overvalued" range (90% to 115%), based on the site's analysis of historical data, but it's creeping toward "significantly overvalued" territory (over 115%).

The 10-year cyclically adjusted price/earnings ratio also remains high. The ratio, which uses inflation-adjusted average earnings for the past decade to smooth out short-term fluctuations, is at about 23.9, using Yale Economist Robert Shiller's earnings data. That's up a bit from 23.3 in May, and up sharply from 20.9 back in November. It's also well above the 16.5 historical average (which dates back to 1871). As I've noted before, it may be more appropriate to look at the figure in the context of its post-World War II average, which is 18.3 (after World War II, inflation became a permanent part of the U.S. economy; since inflation eats away so significantly at fixed-income assets, investors should be willing to pay higher multiples for stocks when inflation is a factor). Still, the figure is quite elevated, as it has been throughout almost the entire bull market.

Tobin's Q also indicates that the market is significantly overvalued. Developed by Nobel Laureate James Tobin, the "Q" Ratio is determined by dividing the total price of the stock market by the replacement cost of all of its companies. The Federal Reserve provides data needed to make the calculation in its Flow of Funds Accounts report, though that only is released once per quarter. As of the most recent report, which came at the end of the first quarter, the Q ratio was 1.08, up from 1.02 in early May, according to an analysis done by Doug Short of Advisor Perspectives. That was significantly higher than the historical average of 0.7 using the arithmetic mean and 0.65 using the geometric mean. As has been the case for some time, the current Q indicates the market is significantly overvalued, but it's not nearly as high as it has gotten at some market tops.

All in all, the broader market doesn't look cheap, but it doesn't look overly expensive either; the totality of the data may suggest that prices are on the higher end of the "fair value" range. And that's what you'd expect to see in a mature bull market. You're not going to find market-wide, dirt-cheap valuations four-and-a-half years into a bull. But while valuations are significantly higher than they were, say, nine months ago, they aren't in the "exuberant" range.

With valuations having moved higher over the past year, stock-picking strategies become even more important -- you need to have ways to identify areas of value that remain. And they do remain, as the Hot List's strong performance so far this year shows. On today's rebalancing, we're adding four stocks to the portfolio, and their fundamentals are excellent. Valero Energy, for example, has been growing earnings and revenues at a 20% pace over the long term, has a return on equity that is 17 percentage points higher than its industry average, and yet trades for 7.1 times trailing 12-month EPS, 0.14 times trailing 12-month sales, 1.1 times book value, and at a 0.35 P/E-to-Growth ratio. Bridgepoint Education, meanwhile, may be part of the maligned for-profit education industry, but it trades for just 0.93 TTM sales, 7.4 times TTM EPS, and 1.67 times book value -- and you're getting a lot for your dollar. The firm has grown EPS at a 29% long-term rate, has a 27% return on equity, and has no long-term debt.

The bottom line is that there are still good companies with attractively priced shares out there. Not as many as there were in the early stages of the bull market, of course, but more than enough to fill out a portfolio. If you use proven, fundamental-focused strategies, you can get a leg up on other investors in finding them.
Editor-in-Chief: John Reese

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The Fallen

As we rebalance the Validea Hot List, 4 stocks leave our portfolio. These include: Stamps.com Inc. (STMP), Royal Dutch Shell Plc (Adr) (RDS.A), Western Digital Corp (WDC) and Chevron Corporation (CVX).

The Keepers

6 stocks remain in the portfolio. They are: Williams-sonoma, Inc. (WSM), Usana Health Sciences, Inc. (USNA), Amtrust Financial Services, Inc. (AFSI), Lear Corporation (LEA), Hollyfrontier Corp (HFC) and Hci Group Inc (HCI).

The Newbies

We are adding 4 stocks to the portfolio. These include: Inter Parfums, Inc. (IPAR), Valero Energy Corporation (VLO), Overstock.com, Inc. (OSTK) and Bridgepoint Education Inc (BPI).

Portfolio Changes

Newcomers to the Validea Hot List

Valero Energy Corporation (VLO): This San Antonio-based oil refiner has taken in $137 billion in sales in the past year. It has 16 petroleum refineries, 10 ethanol plants, and a 50-megawatt wind farm among its assets.

Valero ($19 billion market cap) gets strong interest from my Peter Lynch-, Joel Greenblatt-, and James O'Shaughnessy-based models. For more on the stock, see the "Detailed Stock Analysis" section below.

Bridgepoint Education, Inc. (BPI): For-profit education companies have gotten a lot of negative press over the past couple years, but my models think this San Diego-based firm, which owns and operates Ashford University and University of the Rockies, has been hit too hard. My Peter Lynch-based model has strong interest in Bridgepoint, which has a market cap of about $900 million.

Scroll down to the "Detailed Stock Analysis" section to find out more about the stock.

Inter Parfums, Inc. (IPAR): This New York City-based firm makes fragrances and skin care products that are sold under such names as Karl Lagerfeld, Gap, Banana Republic, and Brooks Brothers. The $1-billion-market-cap firm gets strong interest from my Motley Fool-inspired small-cap model, which is based on the writings of Fool co-creators Tom and David Gardner. For more on the stock, see the "Detailed Stock Analysis" section below.

Overstock.com, Inc. (OSTK): Salt-Lake-City-based Overstock is an online discount retailer that sells a broad range of products, ranging from furniture and rugs to electronics to clothing and jewelry to automobiles. It sells products in the U.S. and internationally.

Overstock ($800 million market cap) has taken in over $1.2 billion in sales in the past year. It gets strong interest from my Momentum Investor model and high marks from several others. Scroll down to the "Detailed Stock Analysis" section to find out more about the stock.

News about Validea Hot List Stocks

Lear Corporation (LEA): Lear reported second-quarter net income of $137.3 million, down from $145.4 million a year earlier, but excluding one-time items the per-share profit was $1.62, more than the $1.36 average analyst estimate, Bloomberg reported. Lear raised its full-year sales forecast to $15.8 billion, up from a high end of $15.5 billion. Shares rose to their highest level since Lear exited bankruptcy in 2009, Bloomberg said.

Western Digital (WDC): Though results beat expectations, Western Digital shares fell after quarterly earnings and sales data came in well below year-ago levels. Revenue for the quarter ended June 28 fell 23% to $3.7 billion, while earnings per share minus items fell 41% to $1.96, Investor's Business Daily reported. The results beat analyst consensus estimates of $3.62 billion in sales and EPS of $1.81. Shares fell about 6% the day after the announcement. The Hot List is selling Western this rebalancing, as other firms' fundamentals have surpassed its fundamentals.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at my strategies and investment approach. If you have any questions, please feel free to contact us at hotlist@validea.com.

Current Portfolio

Detailed Stock Analysis

Disclaimer: The analysis is from Validea's selection and interpretation of content from the guru's book or published writings, and is not from nor endorsed by the guru. See Full Disclaimer

USNA   |   BPI   |   VLO   |   IPAR   |   HCI   |   OSTK   |   LEA   |   AFSI   |   HFC   |   WSM   |  

USANA Health Sciences, Inc. develops and manufactures science-based nutritional and personal care products. The Company has operations in 15 markets worldwide, where it distributes and sells its products by way of direct selling. The Company reports operations in two geographic regions: North America and Asia Pacific, which is further divided into three sub-regions; Southeast Asia/Pacific, Greater China, and North Asia. North America includes the United States, Canada, Mexico, and direct sales from the United States to the United Kingdom and the Netherlands. Southeast Asia/Pacific includes Australia, New Zealand, Singapore, Malaysia, and the Philippines; Greater China includes Hong Kong, Taiwan and China; and North Asia includes Japan and South Korea. The Company's customer base consists of two types of customers: Associates and Preferred Customers. As of December 31, 2011, the Company had 222,000 active Associates and 64,000 active Preferred Customers worldwide.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's academic institutions include Ashford University and University of the Rockies. Its institutions deliver programs primarily online, as well as at their traditional campuses. As of December 31, 2011, the Company had 86,642 total students enrolled in its institutions. Bridgepoint's institutions conduct ongoing faculty and student assessment processes and provide a range of student services. The Company is also focused on developing new technologies, such as through Waypoint Outcomes, Constellation, and the development of its institutions' mobile learning platforms. The Company has developed Constellation to replace third party textbooks with digital course materials. Constellation materials are displayed in a browser-based platform. In January 2012, Bridgepoint introduced Thuze.

Valero Energy Corporation (Valero) is an independent petroleum refining and marketing company. Valero's refineries can produce conventional gasoline's, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as a slate of premium products, including conventional blendstock for oxygenate blending and reformulated gasoline blendstock for oxygenate blending, gasoline meeting the specifications of the California Air Resources Board, a diesel fuel, and low-sulfur and ultra-low-sulfur diesel fuel. It also owns 10 ethanol plants in the central plains region of the United States with a combined ethanol nameplate production capacity of about 1.1 billion gallons per year. It operates in three business segments: refining, ethanol, and retail. In May 2013, CST Brands Inc announced that the Company which includes Corner Store and Depanneur du Coin, spun off from Valero Energy Corporation.

Inter Parfums, Inc. operates in the fragrance business, and manufactures, markets and distributes an array of fragrances and fragrance related products. The Company operates in two segments: European based operations and United States based operations. Its prestige fragrance products are produced and marketed by its European operations through its 74% owned subsidiary in Paris, Interparfums SA. The Company's specialty retail and mass market fragrance and fragrance related products are marketed through its United States operations These fragrance products are sold under trademarks owned by the Company or pursuant to license or other agreements with the owners of brands which include the Gap, Banana Republic, Anna Sui, Brooks Brothers, bebe, Betsey Johnson, Nine West, Lane Bryant and Jordache.

HCI Group Inc, formerly Homeowners Choice, Inc., is a holding company. The Company, through its subsidiaries, is engaged in the property and casualty insurance business. Through Homeowners Choice Property & Casualty Insurance Company, Inc. (HCPC) and subsidiaries, primarily Homeowners Choice Managers, Inc. (HCM), Southern Administration, Inc., Claddaugh Casualty Insurance Company, Ltd., and its subsidiary, HCPCI Holdings LLC, it provides property and casualty homeowners' insurance, condominium-owners' insurance and tenants' insurance to individuals owning property in Florida. Its subsidiaries also include TV Investment Holdings LLC, which owns and operates a marina facility located in Florida; Unthink Technologies Private Limited. During the year ended December 31, 2011, it organized TV Investment Holdings LLC, HCI Holdings LLC and HCI Technical Resources, Inc.

Overstock.com, Inc. (Overstock) is an online retailer offering discount brand name, non-brand name and closeout merchandise, including bed-and-bath goods, home decor, kitchenware, furniture, watches and jewelry, apparel, electronics and computers, sporting goods, and designer accessories, among other products. The Company is also a channel through, which customers can purchase cars, insurance and travel products and services. Overstock sells advertising. The Company also sells books, magazines, compact discs (CDs), digital versatile discs (DVDs) and video games (BMMG). Overstock sells these products through its Internet Websites located at www.overstock.com, www.o.co and www.o.biz. Overstock operates in two segments: direct business and fulfillment partner business. As of December 31, 2011, the Company offered approximately 251,000 non-BMMG products and approximately 637,000 BMMG products.

Lear Corporation is a tier 1 supplier to the global automotive industry. The Company supplies its products to automotive manufacturers with automotive seat systems and related components, as well as electrical distribution systems and related components. The Company has two segments: seating and electrical power management systems (EPMS). The seating segment includes seat systems and related components, such as seat frames, recliner mechanisms, seat tracks, seat trim covers, headrests and seat foam. The EPMS segment includes electrical distribution systems for traditional powertrain vehicles, as well as for hybrid and electric vehicles. As of December 31, 2011, it had 20 joint ventures located throughout Asia, as well as five in North America, two in Europe and Africa and one with operations in all three regions.

Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four segments: small commercial business, specialty program and personal lines reinsurance. In January 2013, the Company acquired First Nonprofit Companies, Inc. In February 2013, its subsidiary acquired Car Care Plan (Holdings) Limited from Ally Insurance Holdings, Inc. In April 2013, it acquired Sequoia Insurance Company and its subsidiaries, Sequoia Indemnity Company and Personal Express Insurance Company. In May 2013, the Company acquired Mutual Insurers Holding Company (MIHC) and MIHC's subsidiary, First Nonprofit Insurance Company.

HollyFrontier Corporation (HollyFrontier), formerly Holly Corporation, is a petroleum refiner, which produces light products, such as gasoline, diesel fuel, jet fuel, specialty lubricant products, and specialty and modified asphalt. HollyFrontier operates in two segments: Refining and Holly Energy Partners, L.P. (HEP). The Refining segment includes the operations of its El Dorado, Tulsa, Navajo, Cheyenne and Woods Cross Refineries and NK Asphalt. The HEP segment involves all of the operations of HEP. As of December 31, 2011, it operated five refineries having a combined crude oil processing capacity of 443,000 barrels per day that serve markets throughout the Mid-Continent, Southwest and Rocky Mountain regions of the United States. The Company merged with Frontier Oil Corporation (Frontier), on July 1, 2011. On November 9, 2011, HEP acquired from the Company certain tankage, loading rack and crude receiving assets located at its El Dorado and Cheyenne Refineries.

Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The direct-to-customer segment of the Company's business sells its products through its six e-commerce Websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and rejuvenation.com) and seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed and Bath, PBteen, West Elm and Rejuvenation). Its e-commerce platform is available to customers in more than 75 countries, while its catalogs reach customers throughout the United States. The retail segment of its business sells products through its five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation). As of January 29, 2012, it operated 576 stores in 44 states, Washington, D.C., Canada and Puerto Rico. On November 1, 2011, the Company acquired Rejuvenation Inc.

Watch List

The Watch List contains the highest scoring stocks according to our guru consensus system that are not currently in the Hot List portfolio. We provide this list both for informational purposes and for investors who are not comfortable with a portfolio of ten stocks.


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