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|Executive Summary||March 6, 2009|
And so continues the economic pain. But is it as great as the stock market would have us believe?
Since our last newsletter two weeks ago, bad news has indeed continued to roll in, with the epicenter of the tremors continuing to be the housing market and the financial sector, two areas inextricably tied because of the mortgage-backed security debacle.
For starters, the housing market: According to the Mortgage Bankers Association reported Thursday that almost 12 percent of all mortgage owners in the U.S. -- more than 5 million homeowners -- were at least one month late in their payments or in foreclosure at the end of last year. That's almost one in eight homeowners in mortgage-related trouble at the end of 2008 -- the highest level in the 37 years the MBA has tracked the figure -- and, as we all know, things don't seem to have gotten easier for homeowners in 2009.
These new numbers are indicative of a shift in the nature of the mortgage problem. Initially, the surge in defaults was due to the resetting of risky adjustable rate subprime mortgages. But the initial round of resets is now mostly done with, according to the MBA. The new culprit in the continued increase in defaults is the economy, as job and income losses are now leading homeowners to default on more basic prime fixed-rate and subprime fixed-rate loans.
As for the financial sector, investors seem to be waiting for some sign -- any sign -- that the government's plans to save the big banks from themselves is working, and we're just not getting it yet. By now you've seen the news about Citigroup shares selling for about $1, and Bank of America isn't far behind, at about $3. Thursday, with Moody's issuing warnings about the state of two of the remaining "strong" banks -- Wells Fargo and JP Morgan Chase -- even the better-positioned financials are being pounded. Morgan's stock dropped about 14 percent Thursday, and Wells' about 16 percent.
To be sure, the financial sector remains a mess. But I'd offer a couple observations on that mess that I think have been lost in the headlines.
The first is that it's a bit remarkable how word of a potential rating change from Moody's -- or any other credit rating agency for that matter -- can continue to have such a huge impact on the markets. After all, the failure of these agencies to appropriately assess the danger of the credit bubble and the mortgage-backed security market are a major part of what got us into this mess in the first place. Loads of debt that Moody's and other credit raters said was top-notch didn't just end up being less than top-notch; it ended up being flat-out rubbish. And yet, the markets still seem to take the rating agencies' words as gospel.
To be clear, this is no endorsement of Wells Fargo or JP Morgan. Both, in fact, fail to get approval from any of my strategies. Perhaps they deserve the warnings rating agencies have issued; perhaps they don't. The key point for investors is this (if I may tweak one of Warren Buffett's famous quotes): You're neither right nor wrong because credit rating agencies agree with you. You're right because your facts are right and your reasoning is right and that's the only thing that makes you right.
The second, perhaps greater point about the continued weakness of the financial sector involves expectations. The term "bailout fatigue" is becoming a part of mainstream parlance these days, and it's not hard to see why. The recent news that AIG is getting another $30 billion line of credit from the government is the latest bit of disgust-generating information that has taxpayers wondering when we'll get to the end of the handouts.
While we'd all like to believe that the AIG handout will be the last the government gives, however, that view is naive, and dangerous. As I noted last week, the build-up of complex derivatives, mortgage-backed securities, and the housing and credit bubbles took years. It will take time for the ship to be righted, and it will take time for the recently approved stimulus package to make some headway.
But just as short-sightedness got us into this economic mess, short-sightedness is now playing a role in keeping us from getting out of it. Investors -- and perhaps today's society in general -- aren't a patient bunch. Because of that, every day that we don't see tangible signs that the bailout is working and the economy is recovering, investors seem to grow more convinced that a recovery may never come. And the markets tumble further.
As they do, they are obscuring some legitimate bright spots that do, in fact, exist. New unemployment claims fell last week to 639,000, according to the Labor Department. That was down from 670,000 the previous week, and less than analysts' prediction of 650,000. And Monster Worldwide's employment index -- which measures online job demand -- rose for the first time since September, increasing in all but three of the major metro markets surveyed. Those figures aren't to say that the employment situation is good -- it's not. But such improvements are important to note (and they're based on more current data than some of the information driving the markets, like AIG's fourth-quarter loss figure).
The Institute for Supply Management's services index, while weak, also beat analysts' expectations in January, according to recently released data. So did demand for manufactured products, which fell 1.9 percent in January according to the Commerce Department, significantly less than the 3.5 percent drop that economists forecast.
Nonetheless, the market kept heading downward. For the fortnight, the S&P 500 fell 12.4 percent, while the Hot List dropped 17.0 percent. Since its inception, the portfolio is still well ahead of the index, having gained 20.3 percent compared to the S&P's 31.8 percent loss.
The U.S.: A Value Trap?
Any value investor -- even the best of the bunch -- has fallen into a "value trap", which occurs when a stock that appears undervalued because of a recent price drop never ends up rebounding anytime soon -- if ever.
Based on how many continue to stand on the sidelines, it appears many investors think the U.S. economy itself may be a value trap. The S&P 500 is down more than 50 percent off its 2007 highs and valuation ratios -- even stringent ones like the 10-year price/earnings ratio -- are low, but many are still bailing or avoiding the market. In fact, the American Association of Individual Investors' survey of investor sentiment showed this week that more than 70 percent of investors are bearish, and less than 19 percent are bullish. That's the biggest bear/bull split in almost two decades.
It's easy to understand why. For months now, the market has appeared cheap, and yet it has continued to fall further and further. Now, the market still seems cheap, but why should we believe that it won't get cheaper yet again? In other words, why should investors stay in this market?
I believe there are several reasons, and I'd like to highlight a few of them. While stocks may well decline further in coming weeks, or even months, these reasons are part of why I continue to believe that sticking with stocks is the right move.
First is some interesting research Bloomberg's John Dorfman recently examined. According to Dorfman, Ned Davis Research looked into "waterfall declines" -- sudden drops of 20 percent or more in a few days or weeks -- and found that the declines were generally followed by a three-step process. First there is the decline itself, then a "basing period" of one to three months when the market moves sideways. Then, there is generally a rally in which stocks surge 24 percent on average, over the next 12 months. In all but one of the post-waterfall periods stocks were higher 12 months later (a year after the 1929 crash returns were flat).
Dorfman thinks we are now seeing the second phase of the downturn -- the basing period. And it makes sense. After their big drop in October, the market has done some back and forth movement as investors try to get their bearings. The key point to take away from the data Dorfman presents seems to be this: The fact that the market didn't immediately take off after the lows last fall is a sign that the natural process of recovering from a waterfall decline is playing out -- not a sign that things will never get better.
The second point is that, while the market has been sorting itself out in the past couple months, good signs have, in fact, been popping up. Charles Schwab Chief Investment Strategist Liz Ann Sonders shared a few of them with Yahoo TechTicker Thursday. For one thing, Sonders notes that selling has become less indiscriminate lately. Back in the fall, huge deleveraging and hedge fund and mutual fund redemptions led to forced selling, but now the market is seeing more "fundamentally-based" selling, a good sign -- particularly for fundamental-based approaches like my Guru Strategies. In addition, Sonders says that "The investment-grade segment of the credit market has generally positively diverged from the stock market at the same time credit issuance is surging. We believe, that credit conditions are improving -- notable difference compared to last fall."
In terms of market history, there are also good signs. James O'Shaughnessy, one of the gurus whose writings form the basis for my strategies recently told Reuters that he thinks stocks could rise significantly -- with the S&P reaching 900 -- by the end of the year as savings rates rise and the housing market improves. According to O'Shaughnessy, the recent sell-offs have made it all the more likely that the market will post nice gains over the long run. He specializes in taking a long-term view of market history, and he's found that in the 12 worst 10-year rolling periods since 1926, stocks returned 25 percent the first year after bottoming; 11 percent per year in the three years after bottoming; and 13.5 percent per year in the five years after reaching bottom.
Those figures are key to why staying in the market is the right move. As I've noted many times before, in steep downturns, if you wait to be sure the market is in rebound mode, you're liable to miss a big chunk of the bounceback. Look at the rebounds after the bear markets that ended in 1974 and 1982 and you'll see that the market accelerated off the bottom as fast, or faster, than it fell into it. In fact, in a recent interview with Q1 Publishing, David Dreman, another of the gurus upon whom I base my strategies, said that about 43 percent of the gains come in the first 15 to 20 days after an upturn. "You have to have some exposure to stocks to get in on the biggest part of the upturn," he said.
There's no doubt that the economy remains severely wounded. But it and the stock market are no value traps. There is plenty of value in them -- just look at the hundreds of billions of dollars in cash on companies' balance sheets, the market's low 10-year P/E ratio, and, of course, the physical and intellectual capital American firms possess. Of course, as with any good value stock, it may take more time than you'd like for that value to show, as fear keeps investors from realizing the opportunity before them. But make no mistake, as the fears subside, the value in the U.S. economy and stock market will indeed show, and investors who quit on these assets will end up wishing they hadn't.
If you've been a Hot List reader for any significant amount of time, you know that my Guru Strategies have a distinct value bias. The majority of these models -- ranging from my Benjamin Graham approach to my Warren Buffett model to my Joseph Piotroski strategy -- are focused on finding good, often beaten-down stocks selling at bargain prices; that is, they target value stocks.
But that doesn't mean that all of my gurus were cemented on the value side of the growth/value pendulum. In fact, the guru we'll examine today, Martin Zweig, used a methodology that was dominated by earnings-based criteria. He looked at a stock's earnings from a myriad of angles, wanting to ensure that he was getting stocks that had been producing strong growth over the long haul and even better growth recently -- and that their growth was coming from the right sources.
Zweig's thoroughness paid off. His Zweig Forecast was one of the most highly regarded investment newsletters in the country, ranking number one for risk-adjusted returns during the 15 years that Hulbert Financial Digest monitored it. It produced an impressive 15.9 percent annualized return during that time. Zweig has also managed several mutual funds, and was co-founder of Zweig Dimenna Partners, a multibillion-dollar New York-based firm that has been ranked in the top 15 of Barron's list of the most successful hedge funds.
Before we delve into Zweig's strategy, a few words about the man himself. While some of the gurus we've looked at in recent Guru Spotights -- Buffett and John Neff in particular come to mind -- lived modest lifestyles, Zweig put his fortune to use in some pretty fun, flashy ways. He has owned what Forbes reported was the most expensive apartment in New York City, a penthouse atop Manhattan's Pierre Hotel that was at one time valued at more than $70 million. He's also an avid collector of a variety of different kinds of memorabilia. The Wall Street Journal has reported that he's owned such one-of--a-kind items as Buddy Holly's guitar, the gun from Dirty Harry, the motorcycle from Easy Rider, and Michael Jordan's jersey from his rookie season with the Chicago Bulls. He even owns the sperm costume from Woody Allen's film Everything You Always Wanted to Know About Sex. His collecting interests also span the historic (several old stock certificates, including one signed by Commodore Vanderbilt) as well as the nostalgic (like the two old-fashioned gas pumps that are almost identical to those he'd seen at the nearby Mobil station while growing up in Cleveland), Financial World has reported.
Zweig may spend his cash on some flashy, fun items, but the strategy he used to compile that cash was a disciplined, methodical approach. His earnings examination of a firm spanned several categories:
Trend of Earnings: Earnings should be higher in the current quarter than they were a year ago in the same quarter.
Earnings Persistence: Earnings per share should have increased in each year of the past five-year period; EPS should also have grown in each of the past four quarters (vs. the respective year-ago quarters).
Long-Term Growth: EPS should be growing by at least 15 percent over the long term; a growth rate over 30 percent is exceptional.
Earnings Acceleration: EPS growth for the current quarter (vs. the same quarter last year) should be greater than the average growth for the previous three quarters (vs. the respective three quarters from a year ago). EPS growth in the current quarter also should be greater than the long-term growth rate. These criteria made sure that Zweig wasn't getting in late on a stock that had great long-term growth numbers, but which was coming to the end of its growth run.
While Zweig's EPS focus certainly puts him on the "growth" side of the growth/value spectrum, his approach was by no means a growth-at-all-costs strategy. Like all of the gurus I follow, he included a key value-based component in his method. He made sure that a stock's price/earnings ratio was no greater than three times the market average, and no greater than 43, regardless of what the market average was. (He also didn't like stocks with P/Es less than 5, because they could be indicative of an outright dog that investors were wisely avoiding.)
In addition, Zweig wanted to know that a firm's earnings growth was sustainable over the long haul. And that meant that the growth was coming primarily from sales -- not sost-cutting or other non-sales measures. My Zweig model requires a firm's revenue growth to be at least 85 percent of EPS growth. If a stock fails that test but its revenues are growing by at least 30 percent a year, it passes, however, since that is still a very strong revenue growth rate.
Like earnings growth, Zweig believed sales growth should be increasing. My model thus requires that a stock's sales growth for the most recent quarter (vs. the year-ago quarter) to be greater than the previous quarter's sales growth rate (vs. the year-ago quarter).
Finally, Zweig also wanted to makes sure a firm's growth wasn't driven by unsustainable amounts of leverage (a key observation given all that's happened recently). Realizing that different industries require different debt loads, he looked for stocks whose debt/equity ratios were lower than their industry average.
There's one more thing you should know about Zweig. He relied a good amount on technical factors to adjust how much of his portfolio he put into stocks. Some of the indicators he used to move in and out of the market included the Federal Reserve's discount rate; installment debt levels; and the prime rate. His mottos included "Don't fight the Fed" (meaning investors should be more bullish when interest rates were low or falling) and "Don't fight the tape" (which related to his practice of getting more bullish or bearish based on market trends).
Those rules are tough for an individual investor to put into practice; Zweig used what he called a "Super Model" that meshed all of his indicators into a system that determined how bullish or bearish he was. But over the years, I've found that using only the quantitative, fundamental-based criteria Zweig outlined in his book can produce very strong results. My Zweig-inspired model has been one of my best performers since its July 2003 inception, returning 14.2 percent while the S&P 500 has fallen nearly 29 percent.
The model tends to choose stocks from a variety of areas. Currently, my 10-stock Zweig-based portfolio's holdings range from retailers to energy firms to healthcare companies to metal miners:
Brink's Home Security Holdings (CFL)
Southwestern Energy Company (SWN)
Netflix, Inc. (NFLX)
New Oriental Education & Technology Group (EDU)
CVS Caremark Corporation (CVS)
Cerner Corporation (CERN)
Tower Group, Inc. (TWGP)
Catalyst Health Solutions, Inc. (CHSI)
Green Mountain Coffee Roasters Inc. (GMCR)
As you might expect with a growth strategy, the Zweig portfolio tends not to hold on to stocks for a long time. Usually it will hold a stock for a few months, though it is not averse to longer periods if the stock continues to be a prospect for more growth.
What I really like about the Zweig strategy is that, while it certainly would qualify as a growth approach, it doesn't look at growth in a vacuum. As you've seen, it examines earnings growth from a variety of angles, making sure that it is strong, improving, and sustainable. In doing so, it allows you to find some fast-growing growth stocks that are not paper tigers, but instead solid prospects for continued long-term success.
News about Validea Hot List Stocks
American Eagle Outfitters Inc. (AEO): On March 5, American Eagle reported a 7 percent decline in same-store sales for February, but the figure was close to half of the 13.4 percent drop Wall Street expected, the Associated Press reported.
Esterline Corp. (ESL): On Feb. 26, Esterline reported first-quarter net income of $27 million, or $0.90 a share, down from $31 million, or $1.04 a share in the year-ago period. Sales fell to $309.7 million from $357.3 million for the period, which ended Jan. 30, according to Puget Sound Business Journal. Analysts forecast earnings of $0.80 per share and revenue of $375.1 million, the Journal said, adding that the results were impacted by slowing air traffic and airlines de-stocking inventories and deferring retrofits of airplanes. Esterline reiterated its guidance for EPS of $3.70 to $3.90 per share in the fiscal year.
The Next Issue
In two weeks, we will publish another issue of the Hot List, at which time we will rebalance the portfolio. If you have any questions, please feel free to contact us at firstname.lastname@example.org.
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