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Executive Summary April 1, 2011

The Economy

While concerns about the Libya turmoil and its impact on oil prices are dominating the headlines, the broader U.S. economy continues to rebound, with positive signs coming from the manufacturing and employment arenas over the past fortnight.

This week, jobs-tracker ADP said that the private sector added 201,000 jobs in March, the second straight month the figure has topped the 200,000 mark. Over the past four months, on average, private payrolls have increased by 211,000, nearly three times the average of 74,000 for the previous three months.

New and continuing claims for unemployment also continue to drop. New claims fell slightly in the most recent week (ending March 26), and are about 14% below year-ago levels, according to new Labor Department data. Continuing claims also fell in the most recent week for which data is available (ending March 19), and are more than 21% lower than they were a year ago. The Labor Department is scheduled to release its March unemployment report today, and, as always, it figures to be widely watched and scrutinized by investors.

In terms of economic growth, the latest figures from the Federal Reserve showed that industrial production dropped 0.1% in February. But a closer look at the numbers painted a better picture. First, while the February figure indicated a slight decline in output, the January figure -- initially estimated as a 0.1% drop -- was revised upward to a strong gain of 0.9%. Second, the February decline was caused by a drop in the utility sector's output, which was a result of unseasonably warm temperatures that lowered heating bills, according to the Fed. Manufacturing output actually rose 0.4% in February, while the January manufacturing figure was revised upward from 0.3% to 0.9%, good signs.

A new government report also showed that gross domestic product for the fourth quarter was higher than initially estimated. Previously believed to have growth at a 2.8% pace during the quarter, the economy actually grew at a 3.1% annual rate, the Commerce Department said. That means growth accelerated significantly in the quarter -- GDP growth was 2.6% in the previous quarter.

There are still reasons for concern about the economy, however. One is, of course, those troublesome oil prices. Oil topped $106 a barrel yesterday amid the Libya fears. But as I've noted before, I think a big piece of the increase in oil prices is fear, not fundamentals. Of a bit more concern are food prices. Extreme weather conditions and rising demand have been causing food prices to surge in recent months, and now some of the U.S.'s biggest food firms are saying that their rising costs threaten to seep through to consumers. Hershey's announced it is raising wholesale prices almost 10% on most of its candy items, for example, saying that rising costs for raw materials, utilities, fuel, and transportation have led to the increases. And Wal-Mart's CEO told USAToday that he sees "serious" inflation coming, with "cost increases starting to come through at a pretty rapid rate." While consumer spending has been strong in recent months, continued surges in food prices could cause consumers to cut back, which could slow down the economic recovery.

The housing market, meanwhile, remains on shaky ground. The National Association of Realtors said last week that existing-home sales fell 9.6% in February, while pending home sales rose 2.1%. A government report also showed that new single-family home sales in February were down 16.9% from January. And the S&P/Case-Shiller home prices indices fell again in January, new data showed, with the 20-city index and 10-city index both dropping 0.2%. The 10-city index is now 2.0% below its year-ago level, while the 20-city index is down 3.1%.

As for the markets, since our last newsletter, the S&P returned 4.1%, while the Hot List returned 7.0%. So far in 2011, the portfolio stands at 6.3% vs. 5.4% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 186.9% vs. the S&P's 32.5% gain.

The Terrible Twos?

With all that happened last month in the Middle East and Japan, it was easy to lose sight of the fact that early in March we reached the two-year anniversary of the bull market that began in late Winter 2009. It has been a remarkable run, really. Back in early March of 2009, terms like "depression", "bankruptcy", and "new normal" were popping up at every turn; the entire viability of the American financial system (and that of the globe) was, in fact, in question.

But with a huge boost from the government, and the hard work and ingenuity of its citizens, the U.S. has rebounded from the brink of financial disaster. And from March 9, 2009, through March 9 of this year, the S&P 500 rose 95%, coming back to within about 15% of its pre-financial-crisis highs.

The magnitude of the rebound, coupled with the events in Japan and the Middle East, have led many pundits to wonder whether the bull is reaching the end of the line. Given the continued improvement in U.S. economic activity, and the recent improvements in the employment situation, I suspect it hasn't. But, of course, I don't know for sure -- no one does, for that matter.

What we do know, however, is what bull markets have done historically -- and while history doesn't always repeat itself, it often rhymes. Looking at past bull markets can thus give us at least some insight into this bull's potential.

With that in mind, I looked back at the past eight bull runs prior to the current one. The data shows that bulls come in a variety of shapes and sizes. On the shorter end of the spectrum, there was the 1966-68 bull, the shortest and smallest in magnitude of the past half-century's bull markets. It lasted 26 months, and saw the S&P 500 gain 48.0%. The 1970-73 bull was the second-shortest, lasting 32 months and involving a gain of 73.5% for the market.

Generally, however, most post-World War II bulls have run further and higher than the current bull. The biggest of the bunch was the 1987-2000 run, which lasted 148 months and saw the S&P gain more than 580%. Other powerful bulls included the six-plus year bull that ran from late 1974 to late 1980, with a 125.6% gain for the S&P, and its successor, the 1982-87 bull, which was a bit shorter in duration but more powerful -- the S&P gained 228.8% during its 60-month run.

Overall, the average of these past eight bulls has lasted more than five years (62 months, to be exact), and involved a 165.7% gain for the S&P. That's significantly longer and higher than the current bull, which has gained about 95% in a bit under 25 months.

Of course, there's no guarantee that this bull will last as long or run as high as the preceding eight bulls have on average. But at the very least, it is an indication that the current bull isn't "due" for an end simply because of its impressive run.

And when I look at other aspects of the current market, I'm encouraged that this bull has room to run. Sentiment is a big reason. Many past bulls have come to a screeching halt when sentiment has reached unsustainable levels, and right now I'm just not seeing that. While the market has staged a fierce rebound over the past two years and the economy has come back from the brink, the general mood of investors seems to be one characterized by skepticism and trepidation. Tell many average Americans that the stock market has regained about 85% of the losses it sustained during the last bear market, or that manufacturing activity has increased for 19 straight months, and many will respond with disbelief. It's to be expected -- the depth and breadth of the financial crisis and market meltdown in 2008 left huge scars, and such traumatic events take a long time to fade from people's minds.

And that's actually good news for stocks. It means that, while the gains of the past two years have been exceptional, there are plenty of investors who remain underinvested in stocks. Inflows to equity mutual funds and exchange-traded funds have picked up significantly since September, and January's and February's were very strong. But overall we haven't seen the sort of sustained push into equities that would be indicative of overly bullish sentiment. As Yale economist Robert Shiller -- the man who foresaw the crashing of both the late 1990s tech bubble and the recent housing bubble -- recently wrote, "the huge surge in stocks since March 2009 doesn't look like a bubble, but more like the end of the depression scare. The rise in equity prices has not come with a contagious new era story, but rather a 'sigh of relief' story."

I agree. That's not to say that all's well and stocks will run upward uninterrupted -- the market is continually barraged by too many unpredictable issues to say with certainty where it will go in the short term, and corrections are a normal part of any bull market. But I do think that, while stocks have run far and fast in the past two years, the broader market remains reasonably priced given the economy's continuing improvement, and there's plenty of fresh powder still waiting on the sidelines. In that sort of environment, I expect my models will be able to pick out some strong, undervalued stocks that should help the Hot List continue to outperform over the long haul.

Editor-in-Chief: John Reese

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Guru Spotlight: John Neff

Most investors wouldn't give a fund described as "relatively prosaic, dull, conservative" a second glance. That, however, is exactly how John Neff described the Windsor Fund that he headed for more than three decades. And, while his style may not have been flashy or eye-catching, the returns he generated for clients were dazzling -- so dazzling that Neff's track record may be the greatest ever for a mutual fund manager.

By focusing on beaten down, unloved stocks, Neff was able to find value in places that most investors overlooked. And when the rest of the market caught on to his finds, he and his clients reaped the rewards. Over his 31-year tenure (1964-1995), Windsor averaged a 13.7 percent annual return, beating the market by an average of 3.1 percent per year. Looked at another way, a $10,000 investment in the fund the year Neff took the reins would have been worth more than $564,000 by the time he retired (with dividends reinvested); that same $10,000 invested in the S&P 500 (again with dividends reinvested) would have been worth less than half that after 31 years, about $233,000. That type of track record made the understated, low-key Neff a favorite manager of many other professional fund managers -- an "investor's investor", if you will.

How did Neff do it? By focusing first and foremost on value, and a key part of how he found value involved the Price/Earnings Ratio. While others have called him a "contrarian" or "value investor", Neff writes in John Neff on Investing that, "Personally, I prefer a different label: 'low price-earnings investor.' It describes succinctly and accurately the investment style that guided Windsor while I was in charge."

To Neff, the P/E ratio was key because it involved expectations. If investors were willing to buy stocks with high P/E ratios, they must be expecting a lot from them, because they are willing to pay more for each dollar of future earnings per share; conversely, if a stock has a low P/E ratio, investors aren't expecting much from it. Much like David Dreman, the great contrarian guru who we examined a few newsletters back, Neff found that stocks with lower P/E ratios -- and lower expectations -- tended to outperform, because any hint of improvement exceeded the low expectations investors had for them. Similarly, stocks with high P/Es often flopped, because even strong results couldn't match investors' expectations.

To Neff, however, the P/E wasn't always a lower-is-better ratio. If investors knew that a firm was a dog, they'd rightly avoid its stock, giving it a low P/E ratio but little in the way of future growth prospects. Because of that, he wrote that Windsor targeted stocks with P/E ratios between 40 and 60 percent of the market average.

While it was at the heart of his investment philosophy, the P/E ratio was also by no means the only metric Neff used to judge stocks. He wanted to see earnings growth, but here again it was not a case of more-is-better. A stock with too high a growth rate -- more than 20 percent -- could have trouble sustaining that growth over the long haul. He thus preferred to see growth between 7 and 20 percent per year, the kind of steady, unspectacular growth that could be sustained.

Sustainable growth also meant growth that was driven by sales -- not one-time gains or cost-cutting measures. Neff thus liked to see companies whose earnings growth and sales growth were rising at similar rates. (My Neff-based model interprets this as sales growth needing to be at least 7 percent per year, or at least 70 percent of EPS growth.)

One more key aspect of Neff's strategy involved dividends. He believed that many investors valued stocks strictly on their price appreciation potential, meaning that you can often essentially get their dividend payouts for free. He estimated that about two-thirds of Windsor's 3 percent per year market outperformance during his tenure came from dividends.

To make sure that his analysis captured dividend payments, Neff used the Total Return/PE ratio. This measure divides a stock's total return (that is, its EPS growth rate plus its dividend yield) by its P/E ratio. He looked for stocks whose Total Return/PE ratios doubled either the market average or their industry average.

In recent years, my Neff-inspired model has been very stringent, with very few companies passing all of its tests. Here's a look at the stocks that currently make up my 10-stock Neff-based portfolio:

China Petroleum & Chemical Corp. (SNP)

Alliant Techsystems Inc. (ATK)

Aflac Incorporated (AFL)

Jos. A. Bank Clothiers (JOSB)

Companhia Saneamento Basico (SBS)

Telecom Argentina S.A. (TEO)

Microsoft Corporation (MSFT)

Eli Lilly & Co. (LLY)

Hi-Tech Pharmacal Co. (HITK)

GameStop Corp. (GME)

I began tracking my Neff-based portfolio at the start of 2004. Overall, it has performed substantially better than the broader market, though it's had an up-and-down ride. From its inception through 2007, the portfolio returned about 67%, about double the S&P 500's 32.4% return. The 2008 crash was especially hard on value stocks, however, and the Neff portfolio fell more than 48% for the year, about 10 percentage points behind the S&P. But it bounced back strong in 2009, surging 45.4%. Last year, however, it was barely in the black, gaining just 0.1% vs. the S&P's 12.8% gain. The portfolio has rebounded this year, however, and through Wednesday was up 5.9%, slightly ahead of the S&P. Since its early 2004 inception, it has returned 33.3% vs. the S&P's 19.5% gain.

Just like Neff himself, the Neff-based model often treads into the most unloved parts of the market. As you can see above, many of its current holdings come from industries or sectors -- healthcare, financials, telecom -- that have either been lagging or have substantial fears lingering over them. But by ignoring the crowd and focusing on these firms' strong financials and fundamentals, I think the Neff model will end up benefiting significantly from many of these picks.

News about Validea Hot List Stocks

GameStop Corp. (GME): On March 24, GameStop announced fiscal fourth-quarter earnings of $237 million, or $1.56 a share, up about 10% from $215.9 million, or $1.29 a share, in the year-ago period. Sales were $3.69 billion, up from $3.52 billion. Analysts polled by FactSet Research on average expected earnings of $1.56 a share on sales of $3.71 billion, MarketWatch reported, adding that GameStop also announced a first-quarter forecast that topped analysts' estimates.

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 hotlist@validea.com.

Current Portfolio

Detailed Stock Analysis

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Bridgepoint Education, Inc. (Bridgepoint) is a accredited provider of postsecondary education services. The Company offers associate's, bachelor's, master's and doctoral programs in the disciplines of business, education, psychology, social sciences and health sciences. It delivers its programs online, as well as at its traditional campuses located in Clinton, Iowa, and Colorado Springs, Colorado. As of December 31, 2009, it offered approximately 1,150 courses, 60 degree programs and 125 specializations and concentrations. As of December 31, 2009, it had 53,688 students enrolled in its institutions, 99% of whom were attending classes online.

Aeropostale, Inc. is a mall-based specialty retailer of casual apparel and accessories. The Company designs, markets and sells its own brand of merchandise principally targeting 14 to 17 year-old young women and young men. The Company also sells Aropostale merchandise through its e-commerce Website, www.aeropostale.com. During the fiscal year ended January 30, 2010 (fiscal 2009), the Company launched P.S. from Aeropostale, which offers casual clothing and accessories focused on elementary school children between the ages of 7 and 12. During fiscal 2009, the Company completed the closure of its 14 store Jimmy'Z concept. Jimmy'Z Surf Co., Inc., a wholly owned subsidiary of Aeropostale, Inc., was a contemporary lifestyle brand targeting young women and men aged 18 to 25.

GameStop Corp. (GameStop) is a retailer of video game products and personal computer (PC) entertainment software. The Company sells new and used video game hardware, video game software and accessories, as well as PC entertainment software, and related accessories and other merchandise. As of January 30, 2010, the Company operated 6,450 stores in the United States, Australia, Canada and Europe, primarily under the names GameStop and EB Games. GameStop also operates the electronic commerce Website www.gamestop.com and publish Game Informer, a multi-platform video game magazine in the United States based on circulation, with approximately 4 million subscribers. During the fiscal year ended January 30, 2010 (fiscal 2009), GameStop operated its business in four segments: United States, Canada, Australia and Europe.

OpenTable, Inc. (OpenTable) provides solution that forms an online network connecting reservation-taking restaurants and people who dine at those restaurants. Its solutions include its Electronic Reservation Book (ERB), for restaurant customers and www.opentable.com, a restaurant reservation Website for diners. The OpenTable network includes approximately 12,000 OpenTable restaurant customers spanning all 50 states, as well as select markets outside of the United States. During the year ended December 31, 2009, the Company seated an average of approximately four million diners per month. Restaurants pays OpenTable an one-time installation fee for onsite installation and training, a monthly subscription fee for the use of its software and hardware and a fee for each restaurant guest seated through online reservations.

Acme Packet, Inc., incorporated on August 3, 2000, provides session border controllers (SBCs) that enable service providers, enterprises, government agencies and contact centers to deliver interactive communications, such as voice, video and other real-time multimedia sessions, across Internet protocol (IP) network borders. The Company's Net-Net product supports a range of communications applications at multiple network border points and also supports service architectures, such as IP Multimedia Subsystem (IMS). The Company's Net-Net family of products consists of the Net-Net OS software platform, the 2600, 3800, 4250, 4500 and 9200 platforms; 4500 Advanced Telecommunications Computing Architecture blade (ATCA blade); and Element Management System (EMS), Session Analysis System (SAS), and Route Manager Central (RMC), management applications. On April 30, 2009, the Company acquired Covergence Inc.

Sanofi-Aventis is a pharmaceutical group engaged in the research, development, manufacture and marketing of healthcare products. The Company's business includes two main activities: pharmaceuticals and human vaccines through sanofi pasteur. It is also present in animal health products through Merial Limited (Merial). In its pharmaceutical activity, it specializes in six therapeutic areas: diabetes, oncology, thrombosis and cardiovascular, central nervous system (CNS), and internal medicine. The global portfolio of sanofi-aventis also consists of a range of other pharmaceutical products in Consumer Health Care (CHC) and other prescription drugs, including generics. It offers vaccines in five areas: pediatric combination vaccines, influenza vaccines, adult and adolescent booster vaccines, meningitis vaccines and travel and endemic vaccines. In October 2010, Siegfried Holding AG sold its PulmoJet Inhalation Project to the Company. In February 2011, the Company acquired BMP Sunstone Corp.

Pre-Paid Legal Services, Inc. designs, underwrites and markets legal expense plans. The Company's life events legal plans (referred to as Memberships) provide for a range of legal services.The identity theft related benefits include a credit report and related instructional guide, a credit score and related instructional guide, credit report monitoring with daily online and monthly offline notification of any changes in credit information and identity theft restoration services. As of December 31, 2009, the Company had 1,547,585 Memberships in force with members in all 50 states, the District of Columbia and the Canadian provinces of Ontario, British Columbia, Alberta and Manitoba. Approximately 90% of such Memberships were in 29 states and provinces.

Skechers U.S.A., Inc. (Skechers) design and market Skechers-branded contemporary footwear for men, women and children under several lines. addition to Skechers-branded lines, the Company also offers several designer, fashion and street-focused footwear lines for men, women and children. These lines are branded and marketed separately from Skechers and appeal to specific audiences. Its brands are sold through department stores, specialty stores, athletic retailers, and boutiques as well as catalog and Internet retailers. Along with wholesale distribution, its footwear is available at its e-commerce Website and its own retail stores. Skechers operates 90 concept stores, 92 factory outlet stores and 37 warehouse outlet stores in the United States, and 22 concept stores and five factory outlets internationally. The Company operates in four reportable segments: domestic wholesale sales, international wholesale sales, retail sales, and e-commerce sales.

Western Digital Corporation (WD) designs, develops, manufactures and sells hard drives. It sells its products worldwide to original equipment manufacturers (OEMs) and original design manufacturers (ODMs) for use in computer systems, subsystems or consumer electronics (CE) devices, and to distributors, resellers and retailers. Its hard drives are used in desktop computers, notebook computers, and enterprise applications such as servers, workstations, network attached storage, storage area networks and video surveillance equipment. Its hard drives are used in CE applications, such as digital video recorders (DVRs), and satellite and cable set-top boxes (STBs). It also sells its hard drives as stand-alone storage products by integrating them into finished enclosures, embedding application software and offering the products as WD-branded external storage appliances for personal data backup and portable or expanded storage of digital music, video and other digital data.

Tractor Supply Company is an operator of retail farm and ranch stores in the United States. The Company operates retail stores under the names Tractor Supply Company and Del's Farm Supply and operate a Website under the name TractorSupply.com. Its stores are located in towns outlying metropolitan markets and in rural communities, and offer a selection of merchandise, which include equine, pet and small animal products, including items necessary for their health, care, growth and containment; hardware and seasonal products, including lawn and garden power equipment; truck, towing and tool products; work/recreational clothing and footwear for the entire family; maintenance products for agricultural and rural use, and home decor, candy, snack food and toys.

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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