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Executive Summary March 16, 2012

The Economy

Despite a chorus of doubters, the U.S. economy is continuing to build on the solid turnaround that began last fall, with good news coming from two key and inextricably linked areas: the job market and the consumer sector.

The private sector added 233,000 jobs in February, the Labor Department announced last week, and the January figure was revised significantly upward (to 285,000 from 257,000), as was the December figure (to 234,000 from 220,000). The headline unemployment rate held steady at 8.3% -- it's now declined or stayed the same in eight straight months. The so-called "U-6" unemployment rate (which takes into account some categories that the headline number does not, like discouraged workers who have given up looking for a job) declined for the fifth straight month, falling to 14.9%. That's still very high, but it marks the first time the figure has fallen below 15% in three years.

Employers are also indicating that they are going to continue to step up hiring. For the coming second quarter, Manpower Inc.'s employment index -- which is based on a survey that asks employers whether they plan to increase, decrease, or hold steady their payrolls -- reached its highest mark since 2008. Nine out of ten firms said they are planning to keep payrolls steady or increase them.

With more Americans employed, retail and food service sales are not surprisingly continuing to rise. They increased 1.1% in February, according to the Commerce Department, the biggest increase in five months. The January figure was also revised upward to 0.6% (from 0.4%). Retail and food service sales have now increased for nine straight months, a good sign for our consumer- and service-driven economy.

Speaking of the service sector, it grew in February for the 26th straight month, and it did so at the fastest rate in a year, according to the Institute for Supply Management. A sub-index indicated that new orders also grew at the fastest pace in a year. Inventories and prices both jumped, however, which is something to keep an eye on.

Another area to keep an eye on: inflation, particularly in commodities. A revised report from the Bureau of Labor Statistics showed that the overall consumer price index rose a very reasonable 0.2% in January vs. the previous month, putting it an also reasonable 2.9% above the year-ago level. But food prices were up 4.4% year-over-year, and fuel oil was up more than 12% year-over-year. And as you probably know all too well, gas prices have only increased since then. A gallon of unleaded regular gas was selling on average for $3.81 in the U.S. as of March 13, up more than 8% in the past month alone. So far, the rise in gas prices hasn't kept the economy from moving forward, but continued increases will at some point act as a drag on growth.

Overseas, Greece finally reached a deal regarding its debt. The markets haven't had a whole lot to say about that, perhaps because many seemed to expect a deal would be reached sooner or later. How the deal plays out will of course be intently watched.

Since our last newsletter, the S&P 500 returned 2.1%, while the Hot List returned 3.8%. So far in 2012, the portfolio has returned 20.1% vs. 11.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 171.5% vs. the S&P's 40.2% gain.

Assets and Inflation

With the economy showing solid improvement and gas and food prices continuing to rise, concerns about inflation have again come to the forefront of many investors' minds. Actually, they've been at or near the top of the list of concerns for many investors ever since the Federal Reserve and U.S. government unleashed their efforts to combat the financial crisis of 2008-09. Since the last week of August 2008, the Fed's balance sheet has more than tripled, with the total factors supplying reserve funds surging from about $939 billion to more than $2.9 trillion. The Fed's purchasing of Treasury bonds as part of its quantitative easing plans has been a big factor in the increase, with the amount of its Treasury holdings nearly doubling.

But an even bigger factor has been the amount of money banks are parking at the Fed -- that figure has soared from $9.75 billion in late August 2008 to nearly $1.6 trillion today. A few factors seem to be behind the huge increase. For one thing, the Fed is paying a quarter of a percent in interest on funds parked with it, which doesn't seem like much but is actually not bad considering how low it is keeping interest rates overall. Some have also posited that a lack of loan demand has led banks to keep their funds with the Fed. And some banks that were burned badly in the commercial real estate market seem unwilling or unable to lend.

Whatever the reasons, the bottom line is that the government has created large sums of money in response to the financial crisis, and hordes of that cash are sitting at the Fed. If and when they start to trickle into the real economy, some significant inflation should come.

That raises the question of how investors should guard against inflation, a topic I've touched on several times before given the explosion of the Fed's balance sheet in recent years. I thought it would be a good time to re-examine the issue given a couple of things that caught my eye recently. One was a new study recently highlighted by MarketWatch columnist Howard Gold. The study was performed by Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School, who over the years have performed some of the most in-depth research ever on asset prices. Their latest effort looks at 19 different markets since 1900, examining how different assets performed during periods of "marked" inflation. They found that bonds -- not surprisingly -- get crushed in such periods, averaging a real return of -23.2%. Stocks, however, also struggle, they found, losing an average of 12% in real terms.

That sounds troubling, especially given how stocks are generally considered to be good inflation fighters. But if you look at Dimson, Marsh, and Staunton's analysis (which is part of a Credit Suisse report), there's a lot more to the story. For one thing, in their study, "marked" inflation signified inflation of at least 18% annually -- a very steep figure that the U.S. didn't even reach during the sky-high inflation of the late '70s/early '80s.

So how have stocks fared when inflation has been high, but not at that 18% mark? Well, according to the professors, when inflation has been between 8% and 18%, stocks haven't fared great, but they've remained ahead of inflation, with 1.8% average annual real returns. Bonds, on the other hand, have averaged real annual losses of 4.6% in those periods. And, when inflation has run between 4.5% and 8%, stocks have produced annual real returns of 5.2%, while bonds have barely eked out a positive return.

Gold, meanwhile, has been a good hedge in those periods when inflation has been at least 18%, with real returns that were just in positive territory. In the 8% to 18% inflation range, gold has also outperformed stocks, with real returns of 4.4%. In that 4.5% to 8% inflation range, however, gold has produced real returns of just 2.8%.

So when inflation has gotten very high, gold has certainly been a better option than stocks; when inflation has been high but below that 18% mark, the results are mixed. But Dimson, Marsh, and Staunton warn against using inflation data as a timing signal, particularly since investors don't know what the inflation rate is for a particular period until the period is over, and asset prices have already moved. "This is not a market timing tool," they write. "High inflation may look like a sell signal, but our model is derived with hindsight and could not be known in advance; there is clustering of observations, so many of the signals may occur at some past date (e.g. the 1920s); and it is not clear where sales proceeds should be parked. In particular, real interest rates tend to be lower in inflationary times, the expected real return on Treasury bills will be smaller after an inflation hit, and other safe-haven assets like inflation-linked bonds are likely to provide a reduced expected return in real terms."

I'd add a couple other points, one being that in general, trying to time your participation in any asset class is dangerous. It's now been more than three years since the Fed's balance sheet started to balloon -- a sign that inflation should be coming -- and we've yet to see the sort of inflation that many (including myself) thought was on the horizon. Yes, had you bought up gold when the Fed's balance sheet began to balloon in the fall of 2008, you'd have made some excellent profits to-date -- but not because gold protected you against inflation. Inflation has been quite moderate, and at times tepid, since then. Instead, the profits you'd have made were because of fears of inflation -- speculation, in other words. And gold investing is often rife with speculation, thanks to the fact that gold has no true underlying value -- it produces no earnings, as the company behind a stock does, and it comes with no guaranteed coupon rate, like a bond does.

In addition, the data above on stocks and bonds and inflation looks at the stock market as a whole. But during inflationary times, certain types of firms -- commodity producers and those that have enough of a durable competitive advantage that they can pass costs on to consumers -- should perform much better than others. That will show up in their fundamentals, and a fundamental-focused system like ours should pick up fairly quickly on that and be able to profit from buying such stocks.

To me, basing your investment decisions on short-term inflationary changes is a dangerous endeavor. I think the more important issue is assessing how inflation impacts your portfolio over the long term. I've often cited David Dreman's exceptional work on that topic, and now, because Dreman recently revised his Contrarian Investment Strategies, we have new updated data on the subject.

In his revised book, Dreman says that the introduction of permanent inflation to the U.S. economy following World War II was something of a game-changer. "By far the most dangerous new risk over the past sixty years has been inflation, which can attack our savings in many ways," he writes. "Nothing is safe from this virulent virus, although its major victims are the supposedly safest investments we own: savings accounts, T-bills, Treasuries, corporate bonds, and other types of fixed-income securities."

Essentially, inflation eats away at the value of everything. And because the Federal Reserve has said that it sees one of its mandates as promoting an inflationary environment of 2% or so per year, inflation is essentially hardwired into our system, though it can vary widely from year to year. Over the long haul, that means that everything -- stocks, bonds, bills, gold, real estate -- has 2 or 3 percentage points chopped from its nominal returns. For stocks, it's bad news, but far from terrible. Because equities have averaged returns in the 9% to 10% range over the long haul, after-inflation annualized compound returns still have come in at a very respectable 6.5% in the 1946-2010 period, according to Dreman's research.

But for Treasury bonds and bills, which have averaged much lower nominal returns, the few percentage points that inflation eats away is a death knell. In that same 1946-2010 period, bonds averaged annual compound returns of just 1.6% after inflation; for T-Bills, it was even worse, at just 0.4%. Over time, the difference is staggering: In the average 10-year post-WWII period, stocks have produced compound after-inflation returns of 87.9%. Bonds have returned just 17.2%, and T-bills a mere 4.5%. The longer your holding period, the more dramatic the differences become.

Of course, stocks can fluctuate greatly from year to year, and are thus considered "riskier" than bonds or bills. But Dreman provides some interesting data on how that "risk" plays out if you're a long-term investor. For example, in the post-WWII era, stocks have beaten bonds in 74% of five-year periods, 84% of ten-year periods, 94% of 15-year periods, and 98% of 20-year periods. Compared to bills, stocks have won in 75% of five-year periods, 82% of ten-year periods, 88% of 15-year periods, and 100% of 20-year periods. In other words, if you ride out the short-term volatility of stocks, the odds become overwhelmingly in your favor. The real risk for investors isn't volatility, it's inflation's impact on your portfolio over the long term. (Dreman also includes data on how taxes eat away at even more of your portfolio's nominal returns, which only further bolsters the case for stocks over the long haul.)

Dreman doesn't include gold price data, which is less extensive given that the U.S. only let the free market begin to drive gold prices in the mid-1970s. But according to data from The London Bullion Market Association, gold has increased in price from about $185 per ounce at the start of 1975 to about $1575 at the end of 2011. That makes for an annual compound nominal return of about 6.1%. Inflation averaged about 4% over that period, according to the Labor Department, which means gold has averaged just over 2% in real terms. (Stocks have averaged 8.4% nominal and 4.4% real over the same period.)

Bonds and gold can certainly be good investments. Bonds should be a part of your portfolio, especially as you get closer to retirement. And gold offers benefits that can make it a good choice for a piece of your portfolio, too. But for me, the bottom line is this: Stocks are the best long-term investment vehicle, and timing asset allocation based on short-term inflation expectations is a risk -- a big risk. Even if you think we'll get the sort of runaway inflation in which gold has historically been a much better hedge than stocks, consider this: Investors have bid up the price of gold by 100% or so over the past three-plus years in anticipation of major inflation; if we eventually do get major inflation, isn't it quite possible that the lag time has led a good chunk of gold's inflation-fighting ability to already be baked into its price?

Rather than taking on the risk associated with trying to use inflation to time asset allocation, I think investors are better off focusing on managing the greater risk of inflation's long-term impact on their portfolios. History has shown that risk to be great, and often overlooked. And over the long haul, stocks have proved the best way to counter that risk -- the best antibody for that return-eating "virus", as Dreman so vividly put it. As such, they should be a major component of your portfolio in just about any inflationary and economic climate.

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: Aeropostale, Inc. (ARO), Ternium S.a. (Adr) (TX), Big Lots, Inc. (BIG) and Tech Data Corp (TECD).

The Keepers

6 stocks remain in the portfolio. They are: Caci International Inc (CACI), Forest Laboratories, Inc. (FRX), Northrop Grumman Corporation (NOC), Coinstar, Inc. (CSTR), Bridgepoint Education Inc (BPI) and Altisource Portfolio Solutions S.a. (ASPS).

The Newbies

We are adding 4 stocks to the portfolio. These include: The Tjx Companies, Inc. (TJX), Cash America International, Inc. (CSH), Advance Auto Parts, Inc. (AAP) and Body Central Corp (BODY).

Portfolio Changes

Newcomers to the Validea Hot List

The TJX Companies (TJX): As the parent of Marshalls, T.J. Maxx, and HomeGoods, TJX offers brand-named clothing and merchandise at discount prices -- making it attractive when times are good or bad. The $29-billion-market-cap firm has taken in about $23 billion in sales in the past year.

TJX's ability to succeed in a variety of economic climates is clear by looking at its earnings history. It has increased EPS in each year of the past decade, one of the reasons that it impresses my Warren Buffett-based model. My Peter Lynch- and James O'Shaughnessy-based models are also high on TJX. To read more about the stock, scroll down to the "Detailed Stock Analysis" section below.

Cash America International Inc. (CSH): Cash America operates in more than 1,000 locations in the U.S. and Mexico, providing secured non-recourse loans -- pawn loans. It also offers short-term cash advances and check cashing services. The Fort Worth, Tex.-based firm has a market cap of about $1.4 billion.

Cash America gets strong interest from my James O'Shaughnessy- and John Neff-based models. To read more about the stock, see the "Detailed Stock Analysis" section below.

Advance Auto Parts (AAP): Virginia-based Advance Auto ($6.5 billion market cap) is an aftermarket retailer of auto parts. It has more than 3,500 stores across 39 states and some U.S. territories.

Advance Auto is a favorite of my James O'Shaughnessy growth- and Peter Lynch-based models. To read more about it, see the "Detailed Stock Analysis" section below.

Body Central Corp. (BODY): This Florida-based retailer sells young women's apparel. It has about 220 stores located across 24 states in the South, Mid-Atlantic and Midwest of the U.S.

Body Central has a market cap of about $440 million, and gets approval from my Lynch- and O'Shaughnessy-based models. For more information on the stock, scroll down to the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Bridgepoint Education (BPI): Bridgepoint beat analysts' estimates for fourth-quarter profit, announcing net income of $22.9 million, or 41 cents a share, compared with $26.3 million, or 45 cents a share, a year ago, according to Reuters. Revenue rose 15 percent to $221.3 million. Analysts forecast EPS of 38 cents a share on revenue of 216.8 million. Bridgepoint said it is now expecting 2012 earnings of $2.45 to $2.55 a share, on revenue of $1.01 billion to $1.03 billion. That EPS projection fell short of analysts expectations of $2.84, according to Thomson Reuters I/B/E/S, but the revenue projection was above analysts' expectations of $966.8 million.

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

BPI   |   CSH   |   BODY   |   CSTR   |   NOC   |   CACI   |   FRX   |   TJX   |   AAP   |   ASPS   |  

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's wholly owned subsidiaries, Ashford University and the University of the Rockies, are regionally accredited academic institutions that offer associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. These institutions deliver programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2010, it offered approximately 1,345 courses, 71 degree programs and 134 specializations. As of December 31, 2010, it had 77,892 students enrolled in its institutions, 99% of whom were attending classes online.

Cash America International, Inc. provides specialty financial services to individuals through retail services locations and through electronic distribution platforms known as e-commerce activities. These services include secured non-recourse loans, commonly referred to as pawn loans and unsecured consumer loans. The Company's consumer loan portfolio includes short-term single payment loans, longer-term multi-payment installment loans, credit services and participation interests purchased from third parties in the micro line of credit (MLOC) services channel. Through the Credit Services Organization program (the CSO program), it provides a third-party lender's consumer loan product in some markets by acting as a credit services organization on behalf of consumers. As of December 31, 2010, it operated in two segments: retail services and e-commerce. During the year ended December 31, 2010, the Company renamed its Internet Services Division as the E-Commerce Division.

Body Central Corp. is a specialty retailer of young women's apparel and accessories operating retail stores in the South, Mid-Atlantic and Midwest regions of the United States. In addition, the Company operates a direct business through its e-commerce Website, www.bodyc.com, and Body Central catalog. It operates specialty apparel stores under the Body Central and Body Shop banners. It targets women in their late teens and twenties from diverse cultural backgrounds who seek the latest fashions and a flattering fit. Its stores feature a variety of tops, dresses, bottoms, jewellery, accessories and shoes sold primarily under Body Central and Lipstick labels. As of January 1, 2011, it had 209 stores located in fashion retail venues across 23 states in the South, Mid-Atlantic and Midwest. Its average store size is 4,300 square feet. During the fiscal year ended January 2, 2010 (fiscal 2010), the Company opened 27 stores. From fiscal year 2009 through January 1, 2011, it closed 13 stores.

Coinstar, Inc. (Coinstar) is a provider of automated retail solutions, which offers convenient products and services. the Company's offerings in automated retail include its Redbox business, where consumers can rent or purchase movies and video games from self-service kiosks (Redbox segment), and its Coin business, where consumers can convert their coin to cash or stored value products at self-service coin counting kiosks (Coin segment). Its New Ventures business (New Ventures segment) is focused on identifying, evaluating, building, and developing self-service concepts in the marketplace. On June 9, 2011, the Company completed the sale transaction of the Money Transfer Business to Sigue Corporation (Sigue).

Northrop Grumman Corporation (Northrop Grumman) provides products, services, and integrated solutions in aerospace, electronics, information and services to its global customers. As of December 31, 2011, the Company operated in four segments: Aerospace Systems, Electronic Systems, Information Systems and Technical Services. The Company conducts most of its business with the United States Government, principally the Department of Defense (DoD) and intelligence community. It also conducts business with local, state, and foreign Governments and domestic and international commercial customers. Effective as of March 31, 2011, the company completed the spin-off of Huntington Ingalls Industries, Inc. (HII). HII operates the Company's former shipbuilding business.

CACI International Inc (CACI) along with its wholly owned subsidiaries and joint ventures, is an international information systems, high technology services, and professional services corporation. It delivers professional services and information technology solutions to its clients, primarily the United States government. Other customers include state and local governments, commercial enterprises and agencies of foreign governments. The Company operates two units: domestic operations and international operations. CACI delivers professional services and information technology (IT) solutions to its clients. Its services are primarily targeted to the areas of defense, intelligence, homeland security and IT modernization. In November 2010, the Company acquired TechniGraphics, Inc. and Applied Systems Research Inc. In July 2011, it acquired Pangia Technologies, LLC. In September 2011, CACI acquired Paradigm Holdings, Inc. In October 2011, the Company acquired Advanced Programs Group, LLC.

Forest Laboratories, Inc. (Forest) develops, manufactures and sells branded forms of ethical drug products, most of which requires a physician's prescription. The Company also focuses on the development and introduction of new products, including products developed in collaboration with licensing partners. Its products include those developed by the Company and those acquired from other pharmaceutical companies and integrated into its marketing and distribution systems. The Company's principal products include Lexapro, Namenda, Bystolic, Savella and Teflaro. On April 13, 2011, the Company acquired Clinical Data Inc. (Clinical Data), a specialty pharmaceutical company.

The TJX Companies, Inc. (TJX) is an off-price apparel and home fashions retailer in the United States and worldwide. The Company operates multiple off-price retail chains in the United States, Canada and Europe. As of January 29, 2011, TJX operated five business segments: three in the United States and one in each of Canada and Europe. Each of its segments has its own administrative, buying and merchandising organization and distribution network. Of the United States-based chains, T.J. Maxx and Marshalls , referred to as Marmaxx, are managed together and reported as a single segment and HomeGoods and A.J. Wright each is reported as a separate segment. Outside the United States, its chains in Canada are managed together, and its chains in Europe are managed together. Thus, Canada is reported as a segment and Europe is reported as a segment.

Advance Auto Parts, Inc. is a specialty retailer of automotive aftermarket parts, accessories, batteries and maintenance items primarily operating within the United States. The Company's stores carry a product line for cars, vans, sport utility vehicles and light trucks. It serves both do-it-yourself (DIY) and do-it-for-me Commercial, customers. It operates in two segments: Advance Auto Parts (AAP) and Autopart International, Inc. (AIP). The AAP segment consists of its operations within the Northeastern, Southeastern and Midwestern regions of the United States, Puerto Rico and the Virgin Islands. The AI segment primarily serves the Commercial market from its store locations in the Northeastern and Mid-Atlantic regions of the United States and Florida. At January 1, 2011, the Company operated 3,369 AAP stores within the United States, Puerto Rico and the Virgin Islands. At January 1, 2011, the Company operated 194 stores under the Autopart International trade name.

Altisource Portfolio Solutions S.A.( Altisource), together with its subsidiaries, is a provider of services focused on technology-enabled, knowledge-based functions related to real estate and mortgage portfolio management, asset recovery and customer relationship management. The Company operates in three segments: Mortgage Services, Financial Services and Technology Services. In April 2011, the Company acquired Springhouse, LLC (Springhouse). In July 2011, the Company acquired the assembled workforce of a sub-contractor (Tracmail) in India.

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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