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Executive Summary November 8, 2013

The Economy

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.

Portfolio Update

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.

Editor-in-Chief: John Reese

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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."

Solid Performer

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 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

HCI   |   BPI   |   AFSI   |   LUKOY   |   USNA   |   HFC   |   XIN   |   LEA   |   COH   |   STMP   |  

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.

Bridgepoint Education, Inc. (Bridgepoint) is a provider of postsecondary education services. The Company's academic institutions include Ashford University and University of the Rockies. Its institutions deliver programs primarily online, as well as at their traditional campuses. As of December 31, 2011, the Company had 86,642 total students enrolled in its institutions. Bridgepoint's institutions conduct ongoing faculty and student assessment processes and provide a range of student services. The Company is also focused on developing new technologies, such as through Waypoint Outcomes, Constellation, and the development of its institutions' mobile learning platforms. The Company has developed Constellation to replace third party textbooks with digital course materials. Constellation materials are displayed in a browser-based platform. In January 2012, Bridgepoint introduced Thuze.

Amtrust Financial Services, Inc. is a holding company. The Company is a multinational specialty property and casualty insurer focused on generating consistent underwriting profits. The Company operates in four segments: small commercial business, specialty program and personal lines reinsurance. In January 2013, the Company acquired First Nonprofit Companies, Inc. In February 2013, its subsidiary acquired Car Care Plan (Holdings) Limited from Ally Insurance Holdings, Inc. In April 2013, it acquired Sequoia Insurance Company and its subsidiaries, Sequoia Indemnity Company and Personal Express Insurance Company. In May 2013, the Company acquired Mutual Insurers Holding Company (MIHC) and MIHC's subsidiary, First Nonprofit Insurance Company.

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. In April 2013, the Company acquired a 100% of Samara-Nafta ZAO and completed acquisition of CJSC Kama-Oil. In June 2013, it sold a 99.57% stake in Lukoil Odes'kyi NPZ PAT. The Company's major shareholder is NKO ZAO NRD with a stake of 91.60%.

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.

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.

Xinyuan Real Estate Co., Ltd. (Xinyuan) is a developer of large-scale residential real estate projects aimed at providing middle-income consumers with a comfortable and convenient community lifestyle. Xinyuan has expanded its network to cover a total population of over 64.7 million people in eight selected cities, consisting Beijing, Hefei, Jinan, Kunshan, Suzhou, Zhengzhou, Xuzhou and Chengdu. The Company's United States development arm, XIN Development Group International, Inc. (XIN), is a real estate residential developer that entered the United States market with three projects in 2012. XIN's products portfolio consists of multiple rise buildings, sub-high-rise buildings and high-rise buildings, together with auxiliary services and amenities, such as retail outlets, leisure and health facilities, kindergartens and schools. In October 2013, the Company announced that it has acquired a residential project in Kunshan, Jiangsu Province.

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.

Coach, Inc. (Coach) is a marketer of accessories and gifts for women and men. The Company offers a range of modern, fashionable handbags and accessories. Its product offerings include women's and men's bags, accessories, footwear, wearables, jewelry, travel bags, sunwear, watches and fragrance. The Company operates in two segments: North America, which includes sales to North American consumers through Company-operated stores, including the Internet, and sales to wholesale customers and distributors and International, which includes sales to consumers through Company-operated stores in Japan and mainland China, including the Internet, Hong Kong, Macau, Singapore, Taiwan, Malaysia and Korea and sales to wholesale customers and distributors in 25 countries.

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.

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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.