|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||April 1, 2011|
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.
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.
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