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Executive Summary June 7, 2013

The Economy

Economic data has been lackluster over the past fortnight, with continuing improvement in the housing sector not enough to keep the stock market's upward climb from stalling.

One area of weakness came in the manufacturing sector, which contracted in May for the first time in six months, according to the Institute for Supply Management. The contraction was not major -- ISM's manufacturing index dipped to 49, just below the 50 mark that separates expansion from contraction -- but it was accompanied by a bigger dip in the New Orders sub-index, which also fell into contraction territory. That could be a sign of more weakness in coming months. The employment sub-index, meanwhile, barely remained in expansion territory.

ISM did offer good news when it came to the much-larger service sector, which expanded in May for the 41st straight month, and did so at a slightly faster pace than it had the previous month. ISM's data showed that new orders in the sector also increased at an accelerating pace, though the improvement in employment conditions almost came to a halt.

Speaking of employment, early readings on May jobs numbers were disappointing. Private payroll processor ADP said businesses added 135,000 jobs during the month, less than many had expected. In addition, the April increase was revised slightly downward to 113,000. Both those figures are below the job gains made in each of the previous six months. Today, the Labor Department is scheduled to release its data for May, and investors will no doubt be watching closely.

As for weekly unemployment claims numbers, new claims remained about flat since our last newsletter, and are nearly 10% below their year-ago level. Continuing claims also remained fairly steady over the most recent two weeks for which data is available. They are 11% below where they stood a year ago, showing nice year-over-year progress.

Consumer data, meanwhile, didn't impress, with the Bureau of Economic Analysis saying that personal income was flat in April. Real personal consumption expenditures rose just 0.1% for the month, while the personal savings rate remained steady at 2.5%, which is on the low side by historical standards.

The BEA's report also gave some not-so-welcome news regarding inflation. After increasing by just 1.2% during the first quarter -- the lowest reading since the financial crisis of 2008 -- the personal consumption expenditures price index rose just 0.7% in April. It's been reported that the PCE price index is one of the key metrics that the Federal Reserve looks at in assessing inflation. Again, it seems that much of the huge amount of liquidity the Fed has been providing just isn't making its way onto Main Street.

While other economic data was mediocre over the past two weeks, the housing sector continued to be a nice bright spot. The latest report from the S&P/Case-Shiller Home Price Indices showed that home prices rose 3.9% in the first quarter vs. last year's fourth quarter, using seasonally adjusted data. For the month of March, prices were up on average 1.1% (seasonally adjusted vs. February) across 20 major cities. Nationally, first-quarter prices were more than 10% above where they were a year ago, a sign of just how solid the housing recovery has been.

Pending home sales, a forward-looking indicator, also increased slightly in April, according to a new report from the National Association of Realtors. They rose 0.3% for the month, putting them nearly 14% ahead of where they were a year ago.

Amid all of this, the S&P 500 has returned -1.7% since our last newsletter, while the Hot List has returned -3.1%. So far in 2013, the portfolio has returned 22.5% vs. 13.8% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 232.3% vs. the S&P's 62.2% gain.

The Rewards -- and Challenges -- of Keeping It Simple

Economies and financial markets are incredibly complex mechanisms. Every part -- and every piece of data -- is impacted (and impacts) scores of other parts, creating a giant web of seemingly endless outcomes. Financial advisors like to remind you of this. One ad I saw recently, for example, asks, "How can power consumption in China impact wool exports from New Zealand, textile production in Spain, and the use of medical technology in the U.S.?" Then, of course, it implies that its advisors have the knowledge and experience to fully understand such complicated economic and financial relationships.

Perhaps they do, though I'm somewhat skeptical. But here's the more important point: Just because economies and markets are incredibly complex, that doesn't mean your investment approach needs to be. I was reminded of that this week while reading an insightful piece that Robert Seawright wrote for the "Above The Market" blog. "We love complexity," Seawright said. "We should of course go with the simpler explanation or approach unless and until something more complex offers greater explanatory power. But we don't. We want to include our pet political ideas, convoluted conspiracy theories or favored market narratives. We are ideological through-and-through, and the more complex the better." Over the past 10 years, however, he says, while hedge funds (which are often known for using strategies described as "complex") have collectively struggled, a simple portfolio with 60% in a broad stock index fund and 40% in bonds has put up annualized returns of more than 7%. Not bad for a decade that included the worst financial crisis in 80 years.

At the same time that humans are drawn to complexity, Seawright notes, we are in a "fascinating paradox also drawn to extreme simplicity. "We want sure-thing formulae," he says. "We want black-and-white. We don't want the hassle of fine distinctions and careful analysis."

What Seawright really seems to be getting at is that we want to believe we can have control, and I think that's particularly true in the stock market. We want to think that we can master it, whether it's thanks to an incredible amount of esoteric, in-depth knowledge that we've compiled, or the result of some "silver bullet" strategy or variable.

The truth, however, is that with so many moving, interconnected parts in the economy and the market, such control is -- and will always be -- beyond our grasp. You can study for decades, soaking up every ounce of investing knowledge you possibly can, and you are still not going to be right on all of the stocks you pick. Nor will you make money and beat the market every year.

The good news is, you don't need to. In his book, Winning on Wall Street, the late, great Martin Zweig said that you'll never be perfect when it comes to picking stocks. But, he added, "You can, however, be right more than you are wrong. If you are right 60% of the time, ride your profits, and rein in your losses, you'll find that when you're right you're very right, and when you're wrong you're only moderately wrong. In the long run, a 60% success rate translates into huge gains, a 50% rate into solid gains, and even a 40% rate can beat the market."

Zweig found that his approach, which, like that of the Hot List, involved screening thousands of stocks to find those with specific fundamental characteristics, had a built-in error rate of about three-eighths over the long term. "That is, out of eight stocks that I pick, three, or 38 percent, will underperform the market," he wrote. Beating the market 62% of the time still ended up netting him huge profits.

I've had similar results with my Guru Strategies. Of the 14 ten-stock portfolios I track on Validea.com, 13 have beaten the market since their inceptions (most of which were July 15, 2003), and on average they have more than doubled the S&P 500. But the most accurate portfolio -- that is, the one that has made money on the highest percentage of its picks -- has an accuracy rate of 61.0% (the Kenneth Fisher-based portfolio). Some have barely been right on more than half their picks -- the Motley Fool-based portfolio, which has returned 14.6% annualized (nearly tripling the S&P) has an accuracy rating of 51.3%. The Momentum Investor model has actually picked more losers than winners, with an accurate rate of 46.0%, but it is far ahead of the S&P (The Hot List, by the way, stands at 56.4%.)

All of this is evidence that good investing isn't about finding "The Answer", or figuring it all out. It is, rather, about putting the odds in your favor as much as possible. As Seawright says, "The best we can hope for is to create and test an appropriately probabilistic outlook, recognize its limitations, and act accordingly."

That may sound boring, lacking in confidence, and perhaps even a bit defeatist. But the reality is that if you are willing to accept that notion, you can produce returns that are far from boring. For example, had you invested $10,000 in the Hot List portfolio at its inception, you'd have more than tripled your investment today.

The Hot List has done that with what in some ways is a very simple approach. It doesn't try to time the market, it doesn't try to sort through the convoluted macroeconomic landscape to make predictions. It simply uses strategies that have identified winning stocks in the past, and employs them today. And the strategies don't employ mysterious, inscrutable methods -- we're not using pork belly prices in the Malaysian market to miraculously forecast inflation expectations for the United States. We're using strategies that focus on good old-fashioned business concepts like earnings and sales growth, debt levels, and returns on equity and capital, as well as valuation metrics like the price/earnings and price/book ratios.

That being said, the strategies aren't overly simplistic; they are quite thorough. Even the Joel Greenblatt-based strategy, which at first look may appear very simplistic, digs pretty deep into a company's financials and fundamentals. That's because, while it looks at only earnings yield and return on capital, the way it calculates those two figures encompasses several other data points. (For earnings yield, for example, it uses earnings before interest and taxes and divides that by enterprise value, which includes not only the value of the company's shares but the amount of its debt as well.) Seawright advises using approaches that are "as simple as possible, but no simpler", and I think our strategies fit that description.

To be clear though, using strategies like these may make for a relatively simple investment process, but that doesn't mean it's easy. But the hard part comes not in the form of complexity. Instead, it has to do with emotional fortitude. Emotions of all sorts will confront you at every turn when you are investing, telling you to buy stocks because some pundit on TV said so, or telling you to sell when you see a scary headline about Europe's debt problems, or telling you to snatch up the hot stock that everyone else seems to be buying. Those emotions will make you think that you need to act now, or else you'll lose your retirement savings, or you won't have enough money to pay for your children's college education, or you'll end up far behind your friends and neighbors in the end.

Seawright touches on the "simple-but-hard" concept -- and so does Warren Buffett. Asked by Fortune a few years back for his best investing advice, Buffett offered this: "Investing is simple but it's not easy. The reason it's not easy is because emotions get in people's ways. They get all excited about stocks when they've gone up recently and then the get depressed when they've gone down." Investors can make money, he said, "if they can take the emotion out of it, and just simply stick with good businesses. ... You have to sit back and have a [long-term] philosophy."

As usual, Buffett's comments are incredibly wise. That's why we manage the Hot List in such a methodical, unemotional, disciplined manner. We never buy and sell on hunches or headlines. We focus on the fundamentals. And we think long-term. That makes for what may seem like a relatively simple strategy, compared to those who spend their time glued to financial news and/or poring over the latest day-to-day, minute-to-minute market news. But it sure isn't easy, particularly when the negative headlines are piling up and the market is heading downward. But in the end, although it's hard, it's worth it. That's what the gurus we follow and our own experience with our portfolios has taught us.

Editor-in-Chief: John Reese

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** Validea Capital Management is a separate investment advisory firm managed by Validea.com founder John Reese. Thre information above in not intended as personal investment advice and should not be interpreted as such.

The Fallen

As we rebalance the Validea Hot List, 3 stocks leave our portfolio. These include: The Tjx Companies, Inc. (TJX), Netease, Inc (Adr) (NTES) and Lukoil (Adr) (LUKOY).

The Keepers

7 stocks remain in the portfolio. They are: Valero Energy Corporation (VLO), Williams-sonoma, Inc. (WSM), Usana Health Sciences, Inc. (USNA), Chevron Corporation (CVX), Royal Dutch Shell Plc (Adr) (RDS.A), Lear Corporation (LEA) and Hollyfrontier Corp (HFC).

The Newbies

We are adding 3 stocks to the portfolio. These include: Stamps.com Inc. (STMP), Patterson Companies, Inc. (PDCO) and Hci Group Inc (HCI).

Portfolio Changes

Newcomers to the Validea Hot List

Patterson Companies, Inc. (PDCO): Minnesota-based Patterson is a medical supply firm that provides a range of products for dentists, dental laboratories, and other healthcare providers throughout North America. It's also a major distributor of veterinary supplies in the U.S., and it distributes rehabilitation supplies used in the physical and occupational therapy markets. Patterson ( $4.2 billion market cap) gets strong interest from my Benjamin Graham-based model, and high marks from several other strategies, including my Warren Buffett approach. For more on its fundamentals, see the "Detailed Stock Analysis" section below.

Stamps.com Inc. (STMP): This California-based company ($575 million market cap) allows customers to pay for and print postage for a variety of letters and packages online. The 16-year-old firm gets solid marks from several of my models, including my Peter Lynch- and Motley Fool-based strategies. For more on the stock, see the "Detailed Stock Analysis" section below.

HCI Group, Inc. (HCI): Tampa-based HCI ($345 million market cap) is the parent of Homeowners Choice Property & Casualty Insurance Company, which provides homeowners insurance in Florida. It has posted some impressive recent growth in both earnings and revenues, part of the reason my Motley Fool-based strategy is high on the stock. My Peter Lynch-based model also has strong interest in HCI. To read more about its fundamentals, scroll down to the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Chevron Corporation (CVX): Argentina's Supreme Court unfroze Chevron's assets in that country, reversing a months-long embargo, The Motley Fool reported on June 6. Chevron is trying to work with Argentine state-run energy company YPF to develop the Vaca Muerta shale field, which is the world's second-largest shale-oil basin, the site reported. The market didn't respond as well as one might think to the news, as shares fell 0.8% for the day.

Lukoil (LUKOY): First-quarter profit at the Russian oil giant fell 32% to $2.58 billion, thanks to Urals crude price declines and income tax increases, Bloomberg reported. Analysts expected $2.75 billion. Sales were down 4.2% to $33.8 billion. Shares of Lukoil were down 8.7% since our last newsletter (through June 6). The Hot List is selling the stock on today's rebalancing, as other stocks now have higher scores than it does.

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

LUKOY   |   USNA   |   HCI   |   VLO   |   LEA   |   RDS.A   |   HFC   |   PDCO   |   CVX   |   WSM   |   STMP   |  

NK Lukoil OAO (Neftyanaya Kompaniya LUKOIL OAO or NK LUKOIL OJSC) is a Russia-based integrated oil and gas company. The Company is engaged in the business of oil exploration, production, refining, marketing and distribution. It is an owner of refineries, gas processing, petrochemical plants and gas stations network located in Russia, Eastern and Western Europe, as well as Africa. The Company's petroleum products are sold in the Russian Federation, the Commonwealth of Independent States (CIS) countries, Eastern and Western Europe, Asia and the United States. NK Lukoil OAO operates through numerous subsidiaries and affiliated companies. As of December 31, 2011, the Company's major shareholder was ING Bank (Eurasia) ZAO with a stake of 75.93%. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO. In April 2013, the Company completed acquisition of CJSC Kama-Oil.

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.

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.

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.

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.

Royal Dutch Shell plc (Shell) is an independent oil and gas company. The Company owns, directly or indirectly, investments in the numerous companies constituting Shell. Shell is engaged worldwide in the principal aspects of the oil and gas industry and also has interests in chemicals and other energy-related businesses. The Company operates in three segments: Upstream, Downstream and Corporate. Upstream combines the operating segments Upstream International and Upstream Americas, which are engaged in searching for and recovering crude oil and natural gas; the liquefaction and transportation of gas; the extraction of bitumen from oil sands that is converted into synthetic crude oil, and wind energy. Downstream is engaged in manufacturing; distribution and marketing activities for oil products and chemicals. Corporate represents the key support functions, comprising holdings and treasury, headquarters, central functions and Shells self-insurance activities.

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.

Patterson Companies, Inc. (Patterson) is a distributor serving three markets: the United States companion animal (dogs, cats and other common household pets) and equine veterinary supply, and the worldwide rehabilitation and assistive products supply market. The Company operates in three segments: dental supply, veterinary supply and rehabilitation supply. As Patterson's business, Patterson Dental is a distributor of dental products in North America. Webster Veterinary (Webster) is a distributor of veterinary supplies primarily to companion-pet (dogs, cats and other common household pets) and equine veterinary clinics across the United States. Patterson Medical is a distributor of rehabilitation medical supplies and equipment. During the fiscal year ended April 28 2012 (fiscal 2012), it acquired American Veterinarian Supply Corp., Surgical Synergies Pty Ltd. and Orthoplast. In September 2012, its Patterson Dental acquired Iowa Dental Supply, LLC.

Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates and provides administrative, financial, management and technology support to the United States and international subsidiaries that engage in petroleum operations, chemicals operations, mining operations, power generation and energy services. Upstream operations consist primarily of exploring for, developing and producing crude oil and natural gas; processing, liquefaction, transportation and regasification associated with liquefied natural gas; transporting crude oil by international oil export pipelines; transporting, storage and marketing of natural gas; and a gas-to-liquids project. Downstream operations consist primarily of refining crude oil into petroleum products; marketing of crude oil and refined products; transporting crude oil by pipeline, motor equipment and rail car, and manufacturing and marketing of commodity petrochemicals, plastics for industrial uses and fuel and lubricant additives.

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.

Stamps.com Inc. is a provider of Internet-based postage solutions. The Company's customers use its service to mail and ship a variety of mail pieces, including postcards, envelopes, flats and packages, using a range of United States Postal Service (the USPS) mail classes, including First Class Mail, Priority Mail, Express Mail, Media Mail, Parcel Post, and others. Its customers include individuals, small businesses, home offices, medium-size businesses and enterprises.

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.