|Executive Summary | Portfolio | Guru Analysis | Watch List|
|Executive Summary||November 8, 2013|
The backlog of reports caused by the partial government shutdown has begun to dislodge, and all in all the data emerging is showing that the economy has been faring pretty well.
Industrial production for example, rose 0.6% in September, according to a new Federal Reserve report. For the full third quarter, production was up at an annual rate of 2.3%. There was a caveat to the September numbers, however, which was that most of the gains were due to a 4.4% increase in utility output, which tends to be fairly volatile and impacted greatly by weather from month to month. Still, manufacturing output increased slightly, rising 0.1%, while mining output increased 0.2%.
New claims for unemployment meanwhile, have fallen a bit over the past two weeks, moving back down toward the level we saw before the government shutdown. They're now 9.6% below where they stood a year ago. Continuing claims are more than 10% below their year-ago level.
New data also showed that overall third-quarter growth was pretty good in the U.S., with gross domestic product rising at a 2.8% pace. There were some aspects of the report that were cause for concern, however. Growth in personal consumption expenditures slowed to 1.5%, down from 1.8% the previous quarter, while business investment dipped significantly to 1.4%, down from 4.7%. Residential investment and auto and food purchases were some of the big drivers behind the overall 2.8% gain.
In the housing market, prices continue to rise. The newest data from the S&P/Case-Shiller Home Price Indices showed that the 10-city and 20-city indices increased 1.3% in August (0.9% when seasonally adjusted) versus July. Both indices were 12.8% above their year-ago levels, the highest year-over-year increases seen since 2006. All 20 cities notched gains for the month, on both month-over-month and year-over-year bases.
There are, however, signs of headwinds for the housing market. Pending home sales fell 5.6% in September, according to the National Association of Realtors. It was the fourth straight monthly decline, as higher mortgage rates and prices curbed buying power, the Realtor group said. It also cited the government shutdown fears as a likely reason for the decline. Pending sales are now just 1.1% above where they were a year ago.
A slowing housing market was one reason that the Federal Reserve decided not to begin tapering its asset purchasing programs at its October meeting. The Fed is going to continue with the current pace of its purchases for now. The European Central Bank did, however, make a significant move since our last newsletter, cutting interest rates to a new record low in order to support the slow recovery occurring in Europe. The ECB also said it would continue to provide major liquidity for European banks well into 2015.
Overall, the events of the past fortnight have had a mixed impact on stocks. Since our last newsletter, the S&P 500 returned -0.3%, while the Hot List returned -3.4%. So far in 2013, the portfolio has returned 30.2% vs. 22.5% for the S&P. Since its inception in July 2003, the Hot List is far outpacing the index, having gained 253.1% vs. the S&P's 74.6% gain.
A couple of the Hot List's holdings hit some rough sledding over the past couple weeks. For-profit education firm Bridgepoint Education was down more than 15% since our last newsletter as of late-morning trading on November 7. A big reason was that Deutsche Bank downgraded the stock from Hold to Sell on November 4, saying that Bridgepoint schools will likely have to lower their tuition prices in response to other for-profit schools doing so. The following day, Bridgepoint reported third-quarter results that missed analysts expectations on both earnings and revenue, further hurting shares. (See below for more details.)
USANA Health Sciences also had a rough fortnight, with its shares down more than 10%. The catalyst for the declines seems to be the earnings report issued shortly before our previous newsletter, in which the firm lowered its forward guidance. The company said that it was doing so because of some changes that may negatively impact results in the short term, but should help in the longer term. Investors don't seem to be taking the news too well, which is not a surprise given how short-term oriented Wall Street is.
One bright spot for the Hot List was Coach Inc., whose shares were up more than 5%. The gains seemed to be a bounce-back that occurred after shares were hit hard because of a disappointing earnings and guidance announcement. That announcement and the accompanying declines occurred shortly before the Hot List bought the stock, so it looks like the portfolio fared quite well on the timing of this buy. As I often note, investors tend to overreact in the short term to negative news, which leads shares of stocks hit by short-term bad news poised for rebounds after the initial declines. Going forward, that would seem to be good news for stocks like Bridgepoint and USANA. Next week, we'll rebalance the portfolio, at which time we'll see if they and the Hot List's other holdings will remain, or if they'll be surpassed by other opportunities.
Guru Spotlight: Warren Buffett
With his humble Midwest beginnings, plainspoken wisdom and wit, and incredible wealth, Warren Buffett has become the most-watched investor in the world. But as interesting a character as Buffett is, the more important piece of the Buffett puzzle for investors is this: How did he do it?
My Buffett-based Guru Strategy attempts to answer that question. Based on the approach Buffett reportedly used to build his fortune, it tries to use the same conservative, stringent criteria to choose stocks that the "Oracle of Omaha" has used in evaluating businesses.
Before we get into exactly how this strategy works, a couple notes about Buffett and my Buffett-based strategy: First, while most of my Guru Strategies are based on published writings of the gurus themselves, Buffett has not publicly disclosed his exact strategy (though he has hinted at pieces of it). My Buffett-inspired model is based on the book Buffettology, written by Mary Buffett, Warren's ex-daughter-in-law, and David Clark, a Buffett family friend, both of whom worked closely with Buffett.
Second, while most of my Buffett-based method centers on a company's fundamentals, there are a few non-statistical criteria to keep in mind. For example, Buffett likes to invest in companies that have very recognizable brand names, to the point that it is difficult for competitors to take away their market share, no matter how much capital they have. One example of a current Berkshire holding that meets this criterion is Coca-Cola, whose name is engrained in the culture of America, as well as other parts of the world.
In addition, Buffett also likes firms whose products are simple for an investor to understand -- food, diapers, razors, to name a few examples. In the end, however, for Buffett, it comes down to the numbers -- those on a company's balance sheet and those that represent the price of its stock.
In terms of the numbers on the balance sheet, one theme of the Buffett approach is solid results over a long period of time. He likes companies that have a lengthy history of steady earnings growth, and, in most cases, the model I base on his philosophy requires companies to have posted increasing earnings per share each year for the past ten years. There are a few exceptions to this, one of which is that a company's EPS can be negative or be a sharp loss in the most recent year, because that could signal a good buying opportunity (if the rest of the company's long-term earnings history is solid).
Another part of Buffett's conservative approach: targeting companies with manageable debt. My model calls for companies to have the ability to pay off their debt within five years, based on their current earnings. It really likes stocks that could pay off their debts in less than two years.
Smart Management, and an Advantage
Two qualities Buffett is known to look for in his buys are strong management and a "durable competitive advantage". Both of those are qualitative things, but Buffett has used certain quantitative measures to get an idea of whether a firm has those qualities. Two of those measures are return on equity and return on total capital. The model I base on Buffett's approach likes firms to have posted an average ROE of at least 15% over the past 10 years and the past three years, and an ROTC of at least 12% over those time frames.
Another way Buffett examines a firm's management is by looking at how the it spends the company's retained earnings -- that is, the earnings a company keeps rather than paying out in dividends. My Buffett-based model takes the amount a company's earnings per share have increased in the past decade and divides it by the total amount of retained earnings over that time. The result shows how much profit the company has generated using the money it has reinvested in itself -- in other words, how well management is using retained earnings to increase shareholders' wealth.
The Buffett method requires a firm to have generated a return of 12% or more on its retained earnings over the past decade.
The Price Is Right?
The criteria we've covered so far all are used to identify "Buffett-type" stocks. But there's a second critical part to Buffett's analysis: price -- can he get the stock of a quality company at a good price?
One way my Buffett-based model answers this question is by comparing a company's initial expected yield to the long-term treasury yield. (If it's not going to earn you more than a nice, safe T-Bill, why take the risk involved in a stock?)
To predict where a stock will be in the future, Buffett uses not just one, but two different methods to estimate what the company's earnings and stock's rate of return will be 10 years from now. One method involves using the firm's historical return on equity figures, while another uses earnings per share data. (You can find details on these methods by viewing an individual stock's scores on the Buffett model on Validea.com, or in my latest book, The Guru Investor.)
This notion of predicting what a company's earnings will be in 10 years may seem to run counter to Buffett's nonspeculative ways. But while using these methods to predict a company's earnings for the next 10 years in her book, Mary Buffett notes: "In most situations this would be an act of insanity. However, as Warren has found, if the company is one of sufficient earning power and earns high rates of return on shareholders' equity, created by some kind of consumer monopoly, chances are good that accurate long-term projections of earnings can be made."
My Buffett-based 10-stock portfolio wasn't one of my original portfolios, instead coming online in late 2003. Since then, it's returned 115.1 %, vs. 66.6% for the S&P 500 (figures through Nov. 4). That's 8.0% annualized, vs. just 5.3% for the S&P.
The portfolio has been a very strong performer over the last two years. While the broader market was flat in 2011, the Buffett-based portfolio jumped 10.2%. In 2012, it gained more than 15%, again topping the index. This year, it has gained 28.8% vs. the S&P's 24.0%.
In the end, Buffett-type stocks are not the kind of sexy, flavor-of-the-month picks that catch most investors' eyes; instead, they are proven businesses selling at good prices. That approach, combined with a long-term perspective, tremendous discipline, and an ability to keep emotions at bay (allowing him to buy when others are fearful), is how Buffett has become the world's greatest investor. Whatever the size of your portfolio, those qualities are worth emulating.
Now, here's a look at my Buffett portfolio's current holdings. It's an interesting group, and some of the holdings might not seem like "Buffett-type" plays on the surface. But they have the fundamental characteristics that make them the type of stocks Buffett has focused on while building his empire.
The TJX Companies, Inc. (TJX)
PT Telekomunikasi Indonesia (TLK)
Monster Beverage Corp. (MNST)
Coach, Inc. (COH)
Ross Stores, Inc. (ROST)
CNOOC Limited (CEO)
Hibbett Sports, Inc. (HIBB)
First Cash Financial Services (FCFS)
Advance Auto Parts (AAP)
NetEase Inc. (NTES)
News about Validea Hot List Stocks
USANA Health Sciences (USNA): USANA announced that it is building a state-of-the-art $40 million facility in Beijing that will house manufacturing and production operations. The facility will be nearly 319,000 square feet, making it the largest in all of USANA's 19 international markets. USANA has negotiated land usage rights for the new building with the Beijing Economic and Technological Development Area, which houses a number of high-tech industries. The company anticipates that construction will begin in 2014, and that the facility will be operational during the latter part of 2015.
Bridgepoint Education (BPI): Bridgepoint reported third-quarter revenue of $185.6 million, down from $252.1 million for the same period a year ago. Net income was $10.1 million, compared with $29.8 million, while fully diluted earnings per share was $0.18, down from $0.53. Both the revenue and EPS results missed analysts expectations. Shares fell about 3% the day of the announcement.
Bridgepoint also announced that it has entered into a license agreement with a subsidiary of Forbes Media LLC, under which Ashford University's College of Business will be named the Forbes School of Business. Bridgepoint has licensed certain trademarks and print and online content from Forbes, as well as other intellectual property, for use in Ashford's bachelor's and master's business programs, the company said. The agreement has an initial 12-year term, with an option to renew for subsequent 12-year terms at Bridgepoint's election, subject to certain conditions. Bridgepoint paid $15 million as part of the agreement, and will pay royalties based on a percentage of annual revenues attributable to Ashford University's business-related programs, subject to a $2.5 million annual minimum.
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 firstname.lastname@example.org.
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