|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||July 23, 2010|
Fear and stimulus-driven hope are continuing to battle it out in the economy, with investors hanging on just about every earnings report and economic report to get a glimpse of where we're heading.
In terms of economic reports, the news has been mediocre since our last newsletter. Industrial production increased in June, according to the Federal Reserve, though the gain was a mere 0.1%. Still, it did mark the 12th straight monthly increase (except for a flat reading back in February), a good sign.
The manufacturing sector also continues to show signs of growth, though at a slower rate than in previous months. The Philadelphia and New York federal reserves both reported that their manufacturing indices fell in July vs. June (the Philly Fed's from 8 to 5.1, and the New York Fed's from 19.6 to 5.1), but both indices still indicated an expansion in manufacturing activity.
In troubled Europe, meanwhile, good news came from the manufacturing sector. The Eurozone purchasing managers index unexpectedly increased in July, and its level indicated a strong expansion in the sector. Another report showed that Eurozone industrial orders were up nearly 4% in May vs. April, and consumer confidence readings in the region jumped in July. While the practical importance of Europe's economy to the U.S. may well have been overstated in recent months, the psychological importance of a European recovery appears to be significant. It's no coincidence that the U.S. markets began their downward turn right around the same time that Europe's debt woes bubbled over.
Back in the U.S., however, retail sales fell for the second straight month. Not surprisingly, given the dip, confidence was also down. The latest reading for the Thomson Reuters/University of Michigan consumer sentiment index (for June) showed the biggest drop since October 2008, hitting the lowest level since August of last year. It's important to remember that consumer confidence often acts as a contrarian indicator for the stock market, however, something that Mark Hulbert (of MarketWatch and Hulbert Financial Digest) and Kenneth Fisher (one of the gurus upon whom I base one of my top strategies) have both shown in separate studies. That means the tumbling sentiment level may actually be a bullish sign.
Finally, on the employment front, the picture remains troublesome. New claims for unemployment rose about 8.7% in the week ending July 17, the Labor Department reported.
While the economic data has been quite mixed, the corporate profit picture remains quite strong. No doubt helped by the government's massive stimulus programs, companies are continuing to put up strong second-quarter numbers. Among them: bellwethers like Caterpillar, 3M, UPS, and AT&T. And while there's been a lot of talk about how top-line revenue growth has disappointed despite the relatively strong earnings numbers, the data doesn't bear that out. Bespoke Investment Group reported this week that 73% of companies reporting thus far had beaten revenue expectations -- well above the 62% average over the past decade-plus.
Amid all of this, the market has had a very up and down fortnight. The S&P has returned 2.2%, while the Hot List has returned 2.0%. For the year, the portfolio stands at -5.7% vs. -1.9% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 127.4% vs. the S&P's 9.3% gain.
The Seven-Year Report Card
Speaking of performance, the Hot List (and the eight original individual guru-based models that go into it) has hit a significant performance mark, with last week marking the seventh anniversary of these portfolios' inceptions.
It's been a wild, and trying, seven years for the broader market, with the S&P 500 gaining a meager 1.3% per year from July 15, 2003 through July 15 of this year. It's been a different story for our guru-based portfolios, however. In the same period, our eight individual guru-based, 10-stock portfolios averaged a 6.8% annualized return. Our two consensus portfolios were even better. The Top 5 Gurus portfolio (which takes the two best-rated picks from each of the five top-performing individual models) was up an average of 12.1% per year. And the Hot List gained an average of 12.8% per year, nearly 10 times the broader market's gain.
To be sure, some of the individual models fared much better than others. So, given that we've just hit the 7-year mark, I thought it would be a good time to look at these original eight models, which, along with three models added more recently, drive the Hot List's buys and sells. Here they are, in order of their 7-year performance track records:
The Benjamin Graham-based Strategy (7-yr. annualized return: 13.8%): It seems impossible that a strategy that's more than 60 years old could be our top performer over the past seven years. But that's just what the Graham-based model has done. Based on the "Defensive Investor" approach Graham laid out in his 1949 classic The Intelligent Investor, the model is indeed defensive. It explicitly eschews technology stocks (which Graham found too risky), and implicitly avoids financial firms (thanks to its stringent debt requirements). The model requires that a company have at least as much net current assets as it does long-term debt, and that it have a current ratio (current assets/current liabilities) of at least 2.0. Graham was known as the "Father of Value Investing", so it also looks for cheap stocks. Neither the stock's trailing 12-month price/earnings ratio nor its P/E based on three-year average earnings can be over 15, and the product of its P/E and price/book ratios can't be more than 22.
The Motley Fool-based Portfolio (7-yr. annualized return: 12.5%): Based on the strategy disclosed by brothers Tom and David Gardner (the creators of the Motley Fool web site), the Fool portfolio came in #2 over these past seven years. It targets small-cap growth stocks, looking for companies with high profit margins, strong sales and earnings growth, high relative strengths, low debt, and low P/E/Growth ratios. It also takes into consideration several other factors, including price and volume levels, and a company's income tax level.
The Kenneth Fisher-based Portfolio (7-yr. annualized return: 11.9%): Based on the strategy that Fisher (a longtime Forbes columnist, money manager, and author) unveiled in his 1984 classic Super Stocks, this approach focuses on a metric Fisher pioneered: the price/sales ratio. While investors for decades relied heavily on the P/E ratio, Fisher found that earnings -- even the earnings of good companies -- can fluctuate greatly from year to year as firms replace equipment or facilities in one year rather than in another, use money for new research that will help the company reap profits later on, or change accounting methods. Sales, however, are much more consistent, and the PSR can thus find strong firms that are going through earnings "glitches" that have driven their stocks down to bargain levels. Fisher also looked at a variety of other metrics, including the debt/equity ratio, profit margins, and earnings growth.
The James O'Shaughnessy-based Portfolio (7-yr. annualized return: 8.0%): This approach actually uses two models -- one growth and one value. The growth model targets companies with high relative strengths and PSRs below 1.5, a combination O'Shaughnessy found would identify stocks that were being embraced by the market, but which hadn't gotten too pricey. It also looks for firms that have upped earnings per share in each year of the past half-decade, without regard to the magnitude of the increases.
The value approach, meanwhile, targets big firms (those with sales at least 1.5 times the market mean) with better-than-average cash flows per share and high dividend yields.
The Peter Lynch-based Portfolio (7-yr. annualized return: 7.8%): Just as Fisher pioneered the use of the PSR, Lynch, one of the most successful mutual fund managers of all time, made the P/E/Growth ratio a popular stock investing tool. By dividing a firm's P/E ratio by its historical growth rate, Lynch found good growth firms selling on the cheap. The rationale: The faster a company is growing, the higher the valuation you should be willing to pay for its earnings. P/E/Gs below 1.0 are acceptable to this model, with those under 0.5 the best case. The Lynch-based approach also looks at factors like the debt/equity ratio, inventory/sales ratio, and, for financial firms, the equity/assets ratio and return on assets rate.
The David Dreman-based Portfolio (7-yr. annualized return: 7.4%): A great student of investor psychology, Dreman found that investors are prone to overreaction. This meant solid companies going through short-term troubles could have their shares beaten down far more than they deserved. Then, when the short-term problems were rectified, the stocks often bounced back very strong. To find these types of unloved stocks, Dreman looked for firms with price/earnings, price/cash flow, price/book, or price/dividend ratios in the bottom 20% of the market.
Sometimes, however, a stock is cheap because it's a dog and everyone knows it. So to separate the unfairly beaten down firms from the dogs, Dreman applied a variety of financial tests to a stock, looking at debt levels, profit margins, returns on equity, and several other factors.
The Martin Zweig-based Portfolio (7-yr. annualized return: 5.6%): Zweig, who put up an exceptional long-term track record with his investment newsletter, was something of a conservative growth investor. He dissected a firm's earnings from a variety of angles, looking not just for high growth rates, but also for growth that was accelerating. He also wanted that growth to be driven by sales, not one-time cost-cutting efforts, and he didn't want earnings to be amped up by high leverage. He also thought there was a limit to how much one should pay for growth -- this approach targets stocks with P/E ratios no greater than three times the market average, and never more than 43 regardless of what the market average is. He also didn't want P/Es to be too low, because that could be the sign of a dog. The model I base on his writings uses a minimum P/E of 5.
The Momentum Investor Portfolio (7-yr annualized return: 1.0%): A customized approach based on the writings of some top momentum strategists, this strategy was by far our worst performer through seven years, lagging the broader market by a bit. It looks for stocks in leading industries with strong recent earnings growth (18% or more in the most recent quarter vs. the year-ago quarter), and strong relative price performance. It also likes high returns on equity and low (or declining) debt/equity ratios, Perhaps not surprisingly, given its weak performance, this model is the only one of my guru-inspired models not to use some sort of value metric (more on this in a bit).
Three Reasons for Outperformance
As I noted above, the performance of these eight original portfolios, and the even-better performance of our two consensus portfolios, has come during a period that has been very rough for the overall market. So, how have the Hot List and the vast majority of these other approaches stayed so far in the black, while being fully invested in some very bad markets? A few reasons stand out to me:
The Numbers: When you deal with quantitative stock-picking strategies, it's easy to start thinking that the good ones work because of some "magic" or "secret" formula. But the reality is much different. My quantitative, guru-inspired models work because they use variables that measure very real business concepts -- concepts that are both critical and timeless. Debt levels, profit margins, consistency of earnings, sales volume -- it's hard to imagine an economy and stock market that wouldn't over the long term value companies that scored well in these areas.
This concept of investing in firms with strong balance sheets and low valuation ratios will sometimes falter in the short term. But over the long haul it will endure, because it is based not on trickery or "magic", but on concepts that are at the heart of how business and markets inherently function.
Value Bias: One thing I've found in researching history's greatest investment strategies is that just about all of these strategies have some sort of value component -- even those that key on strong growth firms, like the Zweig, O'Shaughnessy, and Lynch approaches. For Zweig, it was the P/E ratio, for O'Shaughnessy the price/sales ratio, and Lynch the P/E/Growth ratio. By incorporating a value component into their growth strategies, these investors avoided one pitfall that snares many investors -- the tendency to chase hot stocks that have already had their runs, and have become overpriced and ready for a fall.
As I noted above, the only one of my eight original individual guru-based strategies that didn't beat the market by a wide stretch over its first seven years was the Momentum Investor model -- and it may not be a coincidence that that's the only one that doesn't take valuation into consideration in one way or another.
Discipline: From Ben Graham to Warren Buffett to Peter Lynch, most, if not all, of the gurus I follow talk quite a bit about the importance of staying disciplined no matter what the market throws your way. For the most part, these gurus were not market timers who tried to jump in and out of stocks depending on short-term events or indicators. They knew that investors are rarely successful when trying to time the market, so most of them focused on strong businesses whose shares were selling on the cheap. Then they held those shares until they weren't attractive values anymore, even if it meant having to deal with some major short-term declines.
By using a fully-invested, monthly rebalancing approach, the Hot List is designed with discipline at its core. There's no buying or selling based on macroeconomic trends (which are incredibly hard to forecast) or short-term price movements or headlines. Instead, the portfolio buys stocks of strong businesses when the shares are cheap, and it sells them only at regular intervals (and only if there are better opportunities available at those regular intervals). In doing so, it helps keep at bay the emotions that cause so many investors to buy and sell at inopportune times -- that is, to buy high and sell low.
These three concepts -- sticking to the numbers, looking at valuation, and staying disciplined -- don't represent an effort to reinvent the wheel. They're the same concepts that Graham, Buffett, Lynch, and the other gurus used to beat the market years, and even decades, ago. Too often, however, individual investors allow their emotions to guide their decision-making, and they cast aside these basic, fundamental tenets of good investing. By not falling into that trap, the Hot List and its underlying individual strategies have excelled, and I expect them to continue to do so in the future.
Guru Spotlight: Kenneth Fisher
For decades, the price-to-earnings ratio has been the most widely used valuation measure for stock investors, and a key tool in the arsenals of many of the gurus I follow. While legendary investors like Benjamin Graham, Peter Lynch, and John Neff all used the ratio differently, they and many others agreed that the ratio itself was a key to finding bargain-priced stocks. The investing public and media seems to share their view, with the P/E ratio having long been the only valuation metric that most newspapers include in their daily stock listings.
But in 1984, Kenneth Fisher sent a shockwave through the P/E-conscious investment world. Fisher -- the son of Phillip Fisher, who is known as the "Father of Growth Stock Investing" -- thought there was a major hole in the P/E ratio's usefulness. Part of the problem, he explained in his book Super Stocks, is that earnings -- even earnings of good companies -- can fluctuate greatly from year to year. The decision to replace equipment or facilities in one year rather than in another, the use of money for new research that will help the company reap profits later on, and changes in accounting methods can all turn one quarter's profits into the next quarter's losses, without regard for what Fisher thought was truly important in the long term -- how well or poorly the company's underlying business was performing.
While earnings can fluctuate, Fisher found that sales were far more stable. In fact, he found that the sales of what he termed "Super Companies" -- those that were capable of growing their stock price 3 to 10 times in value in a period of 3 to 5 years -- rarely decline significantly. Because of that, he pioneered the use of a new way to value stocks: the price-to-sales ratio (PSR), which compared the total price of a company's stock to the sales the company generated.
Fisher's findings -- and his results -- helped make the PSR a common part of investment parlance, and helped make him one of the most well-known investors in the world. (He is a perennial member of Forbes' list of "The 400 Richest Americans", his money management firm oversees tens of billions of dollars, and he is one of Forbes' longest running magazine columnists.) The common sense, mostly quantitative approach he laid out in Super Stocks also caught my attention, and led me to create my Fisher-based Guru Strategy.
It's important to note that today, Fisher says his approach to investing has evolved quite a bit since Super Stocks. The key to winning big on Wall Street is knowing something that other people don't, he believes, and when too many people became familiar with PSR investing, he says he needed to find other ways to exploit the market.
So why have I continued to use my Super Stocks-based model? Two reasons: First, Fisher's publisher reissued the book in 2007, with the same PSR focus. Second, the strategy flat out works. Since its July 2003 inception, my 10-stock Fisher-based portfolio has gained 117.1% (11.7% annualized), while the S&P 500 has gained just 6.9% (1.0% annualized). That makes it one of my most successful long-term strategies.
Price-to-Sales and "The Glitch"
Fisher is a student of investor psychology, and his observations about investor behavior are what led to his PSR discovery. Often, he found, companies will have a period of strong early growth and become the darlings of Wall Street, raising expectations to unrealistic levels. Then, they then have a setback. Their earnings drop, or continue to grow but simply don't keep pace with Wall Street's lofty expectations. Their stocks can then plummet as investors overreact and sell, thinking they've been led astray.
But while investors overreact, Fisher believed that these "glitches" are often simply a part of a firm's maturation. Good companies with good management identify the problems, solve them, and move forward, and as they do the stock's price begins to rise again. If you can buy a stock when it hits a glitch and its price is down, you can make a bundle by sticking with it until it rights the ship and other investors jump on board.
The key in all of this was finding a way to evaluate a firm when its earnings were down, or when it was losing money (remember, you can't use a P/E ratio to evaluate a company that is losing money, because it has no earnings). The answer: by looking at sales, and the PSR.
According to the model I base on Fisher's writings, stocks with PSRs below 1.5 are good values. And the real winners are those with PSR values under 0.75 -- that's the sign of a Super Stock. To find the PSR, Fisher says to take the total value of a company's stock, i.e. its market cap (the per-share price multiplied by the number of shares outstanding). We then divide that number by the firm's trailing 12-month sales.
One note: Because companies in what Fisher called "smokestack" industries -- that is, industrial or manufacturing type firms that make the everyday products we use -- grow slowly and don't earn exceptionally high margins, they don't generate a lot of excitement or command high prices on Wall Street. Their PSRs thus tend to be lower than those of companies that produce more exciting products, Fisher said. He adjusted his PSR target for these firms, and the model I base on his writings looks for smokestack firms with PSRs between 0.4 and 0.8; it is particularly high on those with PSR values under 0.4.
Beyond the PSR
While the PSR was key to Fisher's strategy, he warned not to rely exclusively on it. Terrible companies can have low PSRs simply because the investment world knows they are headed for financial ruin.
Other quantitative measures Fisher used include profit margins (he wanted three-year average net margins to be at least 5 percent; the debt/equity ratio (this should be no greater than 40 percent, and is not applied to financial firms); and earnings growth (the inflation-adjusted long-term EPS growth rate should be at least 15 percent per year).
Fisher also made an interesting observation about companies in the technology and medical industries. He saw research as a commodity, and to measure how much Wall Street valued the research that a company did, he compared the value of the company's stock (its market cap) to the money it spends on research. Price/research ratios less than 5 percent were the best case, and those between 5 and 10 percent were still indicative of bargains. Those between 10 and 15 percent were borderline, while those over 15 percent should be avoided.
One of the Best
The variety of variables in my Fisher-based model are a big part of why I think it continues to work, long after the PSR has become a well-known stock analysis tool. While it uses the PSR as its focal point, it also makes sure firms have strong profit margins, earnings growth, and cash flows, and low debt/equity ratios. That well-rounded approach helped it get through one of the worst periods for the broader market in history and stay far, far ahead of the market over the long haul -- all while the PSR has been a well-known investing tool. I expect this solid approach will continue to pay dividends over the long haul.
Now, here's a look at the stocks that currently make up my 10-stock Fisher-based portfolio.
Raytheon Company (RTN)
Sterlite Industries India Limited (SLT)
Clearwater Paper Corp. (CLW)
Kapstone Paper and Packaging Corp. (KS)
General Dynamics Corporation (GD)
Ross Stores, Inc. (ROST)
Aeropostale, Inc. (ARO)
Apollo Group (APOL)
Jos. A. Bank Clothiers (JOSB)
Lincoln Educational Services (LINC)
News about Validea Hot List Stocks
Western Digitial Corporation(WDC): Western reported a 35% gain in fourth-quarter profit thanks to strong revenue gains, but warned that first-quarter profit and revenue will be lower than previously expected. Revenue for the first quarter is now come in between $2.35 billion and $2.45 billion, with earnings of 80 cents to 90 cents per share. Analysts previously expected $2.6 billion in revenue and profit of $1.47 per share, according to Thomson Reuters, the Associated Press reported.
Raytheon Company (RTN) : The U.S. Navy has awarded Raytheon a five-year, $250 million contract for support of the V-22 aircraft. Raytheon said the contract involves V-22 avionics systems software, situational awareness software and prototype hardware, and avionics acquisition support.
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 email@example.com.
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