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Executive Summary September 26, 2014

The Economy

The U.S. has put up some impressive employment numbers since our last newsletter, but that's been counterbalanced by mixed data from other parts of the economy.

We'll start with the positives: New claims for unemployment hit their second-lowest level in 14 years in the week ending Sept. 13. They rose slightly in the following week, but were still at pre-Great Recession levels (and 6.5% below year-ago levels). Continuing claims, the data for which lag new claims by a week, have fallen since our last newsletter, and are 14% below where they were a year ago.

Retail and food service sales have also improved significantly, jumping 0.6% in August according to the Commerce Department. Their year-over-year gain wasn't overly impressive, at 3.2%, but the month-over-month gain was certainly good news.

Industrial production slipped 0.1% in August, however, according to a new Federal Reserve report, with manufacturing output falling 0.4%. Mining output rose 0.5% while utility output, which tends to be seasonally driven, rose 1.0%. July's industrial production gain was revised downward from 0.4% to 0.2%.

The housing market was a mixed bag. New home sales, surged 18.0% in August according to a new government report, and are 32.3% above year-ago levels. Housing starts fell 14.4% during the month, however, according to the Census Bureau, though they were still 7.0% above where they were a year ago. Permit issuance for new construction fell 5.6%, and is 0.3% below year-ago levels.

After showing some signs that it may be picking up earlier in the year, inflation has been tame. In fact, the Consumer Price Index actually fell 0.2% in August, according to the Labor Department. That put it just 1.7% ahead of its year-ago pace. Part of that was the continuing decline in gas prices. A gallon of regular unleaded on average cost $3.34 as of Sept. 24, down nearly 10 cents from a month earlier. The Labor Department said core inflation, which strips out volatile food and energy prices, was unchanged for the month, and is also up 1.7% year-over-year.

Overall since our last newsletter, the S&P 500 returned -1.6%, while the Hot List returned -4.6%. For the year, the portfolio stands at -14.2% vs. 6.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 212.1% vs. the S&P's 96.5% gain.

The Quality-Value Synthesis

Given that we live in an age of endless analytical data, intricately interconnected global markets, and esoteric financial instruments, it's amazing to think how simple the concepts behind good investing are. Consider what Joel Greenblatt, one of the gurus upon whom I base my models, said recently in summing up the philosophies of two of the other gurus who inspired my strategies.

"Ben Graham said, 'Buy it cheap,'" Greenblatt told CNBC, "and his best student, Warren Buffett, added one little twist that made him one of the richest people in the world. He said, 'If I can buy a good company cheap, even better.'"

While they are obviously simplifications, those characterizations get at the heart of Graham's and Buffett's approaches. And that simple "little twist" to which Greenblatt refers -- adding a quality component to a value investing approach -- is at the core of Greenblatt's own "Magic Formula", and at the cores of the strategies used by most of the investing gurus I follow. John Neff, Peter Lynch, David Dreman, the Motley Fool's Gardner brothers, Ken Fisher -- all of them in one way or another used that basic concept of buying good companies at cheap prices to win big over the long haul.

But while the concept is simple, a rather fascinating dynamic is at play within what I'll call the "Quality-Value Synthesis". It involves what happens when you separate the value and quality components.

By itself, value works. Over the past several decades, numerous studies have shown that cheap stocks (determined using such metrics as the price/earnings, price/book, price/sales, and other valuation ratios) outperform the broader market over the long term, confirming Graham's "buy it cheap" philosophy. You might expect the same to be true of quality stocks. It makes intuitive sense that you'd be better off investing in firms with high returns on equity and assets, and strong, consistent margins, rather than those with low ROEs and ROAs and weak margins, right?

Nope. Vitali Kalesnik and Engin Kose of Research Affiliates recently examined the performance of stocks picked using dozens of different "quality" factors (such as return on equity, return on assets, and margin stability) over the past 50 years or so. Their findings?

"Of the 40 measures we examined, 25 have positive performance, including 6 whose results are statistically different from zero," they wrote in a piece for ETF.com. "Of the 9 reported in the literature, 8 had positive returns, and 5 of these were statistically significant. Of the 31 unpublished factors, 18 had positive performance, and only 1 was statistically significant. These results are indistinguishable from random occurrences." In other words, buying high-quality stocks in and of itself hasn't given an investor any advantage over buying low-quality stocks over the past 50 years.

But here's where things really get interesting: Kalesnik and Kose also looked at what happened when they added value factors to the mix. When they did that (focusing on cheap high-quality stocks), "the high-quality portfolio has fewer distressed, slow growing, unprofitable companies with potentially questionable accounting practices," they wrote. "As a result, the high-quality value portfolio has a better risk-adjusted return. Quality is not, in itself, a factor that generates a premium; but value investing conditioned on a properly specified concept of quality is a powerful investment strategy."

Put simply, the Research Affiliates study found that investing in quality stocks matters -- if you are looking at a universe of cheap stocks. It's not the only study to come to that sort of conclusion. In their book Quantitative Value, Wesley Gray and Tobias Carlisle looked at how stocks picked using a variety of quality measures (the equity/total assets, free cash flow/total assets, gross profits/assets ratios, and Greenblatt's own return on capital metric) fared from 1974 to 2011. Their findings: "Other than gross profits on total assets ... no quality measure performs well relative to the Standard & Poor's 500 Total Return Index".

Gray and Carlisle did find that using multiple quality metrics within the most expensive decile of stocks made a bit of a difference, though high quality expensive stocks still well underperformed the S&P 500. In the end, their final model takes the cheapest decile of stocks and applies a suite of quality measures to it to significantly enhance returns. Again, value and quality, working together.

In addition to the obvious (you should use quality and value metrics together in an investing strategy), I think there are two other broader lessons to take away from all of this. One is that you should always use a thorough, well-rounded approach to picking stocks. As Ken Fisher has said, there is no silver bullet in the market. While you may be able to find some single valuation metrics that in and of themselves lead to outperformance over the long haul, combining multiple metrics (both in terms of combining quality and value, and in combining multiple metrics to gauge quality and value) can further enhance returns. Because 12 different strategies go into Hot List (most of which on their own use both quality and value metrics), the portfolio chooses stocks using numerous quality metrics and numerous value metrics. That thorough examination of both quality and value is one big reason I think the Hot List has performed so well over the long haul.

The other lesson is that while good investing strategies make intuitive sense, the reverse is not always true. That is, every strategy that makes intuitive sense is not a good one. Most people, I think, would assume that buying stocks with higher returns on equity or assets or some other quality measure would result in higher returns. But as Carlisle and Gray and Research Affiliates showed, that's often not true. When it comes to how specific variables perform and how they work in combination, you have to rely on facts and data, not hunches and intuition.

With the Hot List, we've tried to create a system focused on facts and data, not hunches and gut feelings. All the strategies were developed based on approaches that the gurus used over lengthy periods of time to beat the market. And now we have more than eleven years of our own data, covering several different types of market environments. And we continue to use our increasing amount of data to hone our approach. Once a year, we look at the long-term historical performance numbers and use that to adjust how much weight each individual Guru Strategy has in terms of selecting the portfolio's stocks. There's no guesswork, no hunch-playing as to which strategy might be "due" for a big year. It's a strictly analytical, quantitative process designed to eliminate emotion from our investing process.

While there are a myriad of strategies that will beat the market over the long haul, I think you'll find that most stick to the numbers and use a diverse group of quality and valuation metrics. Whatever the specifics of your own investment strategy, doing those two things should help put you on the path toward success.

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: Amtrust Financial Services Inc (AFSI), Foot Locker, Inc. (FL), Bed Bath & Beyond Inc. (BBBY) and Monster Beverage Corp (MNST).

The Keepers

6 stocks remain in the portfolio. They are: Agco Corporation (AGCO), Valero Energy Corporation (VLO), Anika Therapeutics, Inc. (ANIK), Sturm, Ruger & Company (RGR), Piper Jaffray Companies (PJC) and Liquidity Services, Inc. (LQDT).

The Newbies

We are adding 4 stocks to the portfolio. These include: Jones Lang Lasalle Inc (JLL), Omnivision Technologies, Inc. (OVTI), Silicon Motion Technology Corp. (Adr) (SIMO) and Ctc Media, Inc. (CTCM).

Portfolio Changes

Newcomers to the Validea Hot List

Silicon Motion Technology Corporation (SIMO): Silicon Motion is a fabless semiconductor company that makes high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products.

Silicon Motion ($900 million market cap) gets strong interest from my Peter Lynch-based model and high marks from several other strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

Jones Lang LaSalle (JLL): JLL is a financial and professional services firm specializing in real estate. It has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries, offering integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients.

JLL ($5.6 billion market cap) gets strong interest from my Peter Lynch- and James O'Shaughnessy-based strategies. To read more about it, scroll down to the "Detailed Stock Analysis" section.

CTC Media (CTCM): CTC is an independent media company managing four television channels in Russia, a channel in Kazakhstan, and a TV company in Moldova with combined potential audience over 150 million viewers. International versions of its channels are available in such regions as North America, Europe, Central Asia, Armenia, Georgia, Azerbaijan, the Middle East and Kyrgyzstan.

CTC ($1.4 billion market cap) gets strong interest from my Joel Greenblatt-based model. To read more about its fundamentals, see the "Detailed Stock Analysis" section below.

OmniVision Technologies (OVTI): OmniVision designs and markets high-performance semiconductor image sensors. Its OmniPixel and CameraChip products are highly integrated single-chip CMOS image sensors for mass-market consumer and commercial applications such as mobile phones, notebooks and webcams, digital still and video cameras, security and surveillance systems, entertainment devices, automotive and medical imaging systems.

OVTI gets strong interest from my Peter Lynch-based model. To find out more about the stock, see the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Bed Bath & Beyond (BBBY): Shares of the retailer jumped after it announced strong quarterly results. Net sales rose to $2.94 billion in the second quarter ended Aug. 30, up from $2.82 billion a year earlier, Reuters reported. Net earnings fell to $224.0 million, or $1.17 per share, from $249.3 million, or $1.16 per share, but analysts on average had expected earnings of $1.14 per share on revenue of $2.89 billion, according to Thomson Reuters I/B/E/S. Bed Bath & Beyond also said it expects to earn $5.00 to $5.08 per share for the full year, above the average analysts estimate of $4.80 per share. Shares jumped about 7% in extended trading after the Sept. 23 announcement.

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

ANIK   |   VLO   |   JLL   |   SIMO   |   PJC   |   OVTI   |   CTCM   |   RGR   |   LQDT   |   AGCO   |  

Anika Therapeutics, Inc. (Anika) develops, manufactures and commercializes therapeutic products for tissue protection, healing and repair. These products are based on hyaluronic acid (HA), a naturally occurring, biocompatible polymer found throughout the body. As of December 31, 2011, Anika's wholly owned subsidiary, Anika Therapeutics S.r.l., had over 20 products commercialized, primarily in Europe. These products are also all made from hyaluronic acid, based on two technologies: HYAFF, which is a solid form of HA, and ACP gel, an autocross-linked polymer of HA.

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.

Jones Lang LaSalle Incorporated (Jones Lang LaSalle), is a financial and professional services firm specializing in real estate. Jones Lang LaSalle has over 200 corporate offices worldwide and operations in more than 1,000 locations in 70 countries. The Company offers integrated real estate and investment management services on a local, regional and global basis to owner, occupier and investor clients. It delivers an array of Real Estate Services (RES) across its three geographic business segments: the Americas, Europe, Middle East and Africa (EMEA), and Asia Pacific. LaSalle Investment Management, a wholly owned member of the Jones Lang LaSalle group that consists of its fourth business segment, is a diversified real estate investment management company. In July 2014, Jones Lang LaSalle Inc acquired CLEO Construction Management (CLEO), a construction project management services firm that specializes in medical facilities.

Silicon Motion Technology Corporation (SMTC) is a holding company. The Company's operations are conducted through Silicon Motion, Inc. (SMI Taiwan), a wholly owned subsidiary located in Taiwan and FCI, Inc. (FCI), a wholly owned subsidiary of SMTC, located in Korea. The Company is a fabless semiconductor company that designs, develops and markets, high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. SMTC designs, develops and markets high performance, low-power semiconductor products for the multimedia consumer electronics market. Its products include mobile storage, mobile communications, multimedia systems-on-a-chip (SoCs) and other products. Its product offerings address three main markets: mobile storage, multimedia SoCs and mobile communications markets. On October 25, 2011, its subsidiary FCI acquired BTL System, Inc.

Piper Jaffray Companies is an investment bank and asset management firm, serving the needs of corporations, private equity groups, public entities, non-profit entities and institutional investors in the United States and internationally. The Company operates in two segments: Capital Markets and Asset Management. The Capital Markets segment provides investment banking and institutional sales, trading and research services for various equity and fixed income products. The Asset Management segment includes traditional asset management activities and related services. The Company markets the investment banking and institutional securities business under Piper Jaffray name. Its asset management business is marketed under Advisory Research, Inc. In July 2013, Piper Jaffray Companies announced that it has completed its purchase of Seattle-Northwest Securities Corporation. In July 2013, the Company announced that it has completed its purchase of Edgeview Partners L.P.

OmniVision Technologies, Inc. (OmniVision) designs, develops and markets integrated and semiconductor image-sensor devices. The Company's main products, image-sensing devices, which the Company refers to as CameraChip image sensors, capture an image electronically and is used in a number of consumer and commercial mass-market applications. The Company's CameraChip image sensors are manufactured using the complementary metal oxide semiconductor (CMOS), fabrication process and are single-chip solutions that integrate several distinct functions, including image capture, image processing, color processing, signal conversion and output of a fully processed image or video stream. The Company has also integrated its CameraChip image sensors with wafer-level optics, which the Company refers to as CameraCubeChip imaging devices. The Company's CameraCubeChip imaging device is a small footprint, total camera solution.

CTC Media, Inc. operates three Russian television networks CTC, Domashny and Peretz. CTC network offers entertainment programming targeted at 6-54 year-old viewers. Domashny network targeted at 25-59 year-old female viewers. Peretz focusing primarily on edgy and comedy programming. Starting January 2013 CTC targets 10 to 45 year-old viewers and Peretzl focuses on 25 to 49 year-old viewers. As of December 31, 2012, approximately 100 million people were within the coverage of CTC's signal, approximately 63 million people are within the coverage of Domashny's signal, and approximately 61 million people are within the coverage of Peretz's signal. . It also operates Channel 31, a television network in Kazakhstan, and a television channel in Moldova, each offering entertainment programming. In addition, it has in-house production operations focused on series, sitcoms and shows. During 2012, its signals are converted to MPEG-4.

Sturm Ruger & Co Inc, formerly Sturm, Ruger & Company, Inc., is engaged in the design, manufacture, and sale of firearms to domestic customers. The Company operates in two segments: firearms and investment castings. The firearms segment manufactures and sells rifles, pistols, revolvers, and shotguns principally to a select number of licensed independent wholesale distributors primarily located in the United States. The investment castings segment manufactures and sells steel investment castings. The Company offers products in four industry product categories, which include rifles, shotguns, pistols, and revolvers. The Company's firearms are sold through independent wholesale distributors, principally to the commercial sporting market. The Company's customers include Jerry's/Ellett Brothers, Davidson's, Sports South and Lipsey's.

Liquidity Services, Inc. is an auction marketplace for surplus and salvage assets. The Company enables buyers and sellers to transact in an automated online auction environment offering over 500 product categories. The Company's marketplaces provide professional buyers access to a global, organized supply of surplus and salvage assets presented with digital images and other relevant product information. It organizes its products into categories across industry verticals, such as consumer electronics, general merchandise, apparel, scientific equipment, aerospace parts and equipment, technology hardware and specialty equipment. It's online auction marketplaces are www.liquidation.com, www.govliquidation.com, www.govdeals.com and www.liquibiz.com. It also operates a wholesale industry portal www.goWholesale.com. In July 2012, the Company acquired GoIndustry-DoveBid plc. In November 2012, the Company acquired National Electronics Service Association.

AGCO Corporation (AGCO) is a manufacturer and distributor of agricultural equipment and related replacement parts globally. The Company sells a range of agricultural equipment, including tractors, combines, self-propelled sprayers, hay tools, forage equipment and implements. It also manufactures and distributes grain storage and handling equipment systems, as well as protein production systems. Its products are recognized in the agricultural equipment industry and are marketed under a range of brands, including Challenger, Fendt, Massey Ferguson and Valtra. The Company distributes its products through a combination of approximately 3,100 independent dealers and distributors in more than 140 countries. In September 2013, Grain Systems, Inc. (GSI), a global brand of the Company announced that it has purchased Johnson System Inc. (JSI), manufacturer of catwalks, towers and support structures based in Marshall, Michigan.

Watch List

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


The names of individuals (i.e., the 'gurus') appearing in this report are for identification purposes of his methodology only, as derived by Validea.com from published sources, and are not intended to suggest or imply any affiliation with or endorsement or even agreement with this report personally by such gurus, or any knowledge or approval by such persons of the content of this report. All trademarks, service marks and tradenames appearing in this report are the property of their respective owners, and are likewise used for identification purposes only.

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.