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Executive Summary May 15, 2009

The Economy

The economy is continuing to muddle through, showing neither signs of a major recovery nor signs that substantial further deterioration is on the way. And, given the depths from which we've just come, that's not a terrible place to be.

Unemployment figures had offered some rays of hope last week, with the news that the economy shed about 22% fewer jobs in April than it did in March, representing the lowest total since last October. Yesterday, however, the government reported that job losses increased in the week ending May 9, largely because of layoffs and furloughs in the auto industry.

Other news was also mixed. Earlier this month, the Institute for Supply Management reported that manufacturing activity jumped in April -- the fourth straight month it has risen. On the negative side, however, retail sales fell 0.4% in April, the government announced. The drop isn't a terrible one, but it shows that consumers are still leery of reopening their wallets -- partly because they're bogged down in debt.

The housing market, meanwhile, appears to be closing in on a bottom -- though we're not there yet. Foreclosure activity remained high in April, according to RealtyTrac, which said that much of the activity involved homes in the early stages of foreclosure as legislative and industry moratoria on foreclosures began to end. Much of the foreclosure activity -- 75% -- occurred in just 10 states, however. High foreclosure rates pushed home prices lower in the first quarter, but, according to the Altos Research's Real-Time Housing Market Report, asking prices rose in 22 of 26 major markets in April.

Finally, the most attention-grabbing issue regarding the economy over the past two weeks may well have been the announcement of the government's bank "stress test" results. The tests showed that 10 of the nation's 19 largest banks will need a total of about $75 billion in additional capital over the coming six months. That's not wonderful news, of course, but the fact that none of the banks appeared to be in serious immediate danger seemed to allay investors' concerns.

The mixed news this past fortnight led to a slowing of the stock surge we've seen since March 9. The S&P 500 and Dow Jones Industrial Average still posted gains for the two-week period, while the Nasdaq fell.

The Hot List, meanwhile, lost 1.0%. It remains well ahead of the S&P for the year, however, having gained 8.6% while the index has fallen 1.1%. Since its July 2003 inception, the portfolio has gained 78.1%, while the S&P has fallen 10.7%.

The Valuation Question

While the Hot List cooled a bit in the past two weeks, the portfolio is coming off of a pretty torrid run. In the past six months it has gained more than 22% while the S&P has gained only about 4%. Back on our March 6 rebalancing, the portfolio was down 26.6% for the year; now, it is up 8.6%. This rebalancing, we're hoping that several new stocks can continue the strong performance. The portfolio is selling six of its 10 holdings and replacing them with new stocks with even more attractive fundamentals. Among the newbies are some well-known firms like Chevron and Cintas, as well as some lesser-known small caps like NetEase.com and Lufkin Industries.

The big question for the broader market, meanwhile, continues to be whether or not the rally is for real. Given the cooling off of the past week or so, the retail sales data, and the fact that we've just gone through one of the steepest bounce-back inclines in history, a number of pundits are saying that the run is over. Whether they're correct or not is anyone's guess; the market is too fickle in the short term for anyone to know for sure.

The question for me thus remains one of valuation. And, just as I addressed some bearish myths last newsletter, I think there's an important valuation myth that merits attention this week.

When the market began moving upward on March 9, many said it was too soon. Value metrics like the 10-year P/E ratio showed that stocks were undervalued, but still significantly pricier than they were in past downturns. While the 10-year P/E fell to around 12 earlier this year, it was down in the single digits in the mid-1970s and early 1980s, bears noted. Given the depth and breadth of the current crisis -- arguably it has been as bad or worse than those of the mid-'70s and early '80s -- it seemed too good to be true that P/Es would bottom around 12 this time around.

The bears forgot to include two critical factors in their analysis, however: interest rates and inflation. Back in the mid-'70s and early '80s, inflation reached into double digits, and interest rates soared. Treasury bonds yielding in excess of 10% looked pretty good to many investors, especially given the fact that their nominal returns -- unlike those of stocks -- were safe. Stocks thus had more competition than usual from bonds, part of why, as value guru Jeremy Grantham recently noted, "high inflation rates typically come with lower than average P/Es and vice versa".

Today, interest rates are exceptionally low, and deflation -- not inflation -- is the concern of the day. And, as Alan Reynolds, a senior fellow at the Cato Institute recently pointed out for Forbes, that is quite significant in terms of valuations. "It is not hard to envision future earnings disappointments as a result of higher tax rates on companies or shareholders, health care price controls or cap and trade schemes. But these are threats to earnings, not to multiples," Reynolds wrote. "Any big drop in P/E multiplies, by contrast, requires a big increase in bond yields. It is certainly possible to envision massive federal borrowing and aggressive Fed easing culminating in a sizable increase in long-term interest rates. Yet such a future of "reflation" and "crowding out" presupposes faster growth of overall demand, gross domestic final sales. In that case, earnings would be rising so the net effect on stock prices might well be positive."

Reynolds notes that bearish economists typically assume depressed demand and deflation -- "forecasts impossible to reconcile with the double-digit interest rates required" to get to P/E ratios of 10 or lower.

"The height of today's P/E ratio relative to the past tells us nothing except that (1) interest rates are far below average and (2) future earnings are very likely to rise from today's depressed base," Reynolds concludes. "Unless those who have spent the past two months predicting P/E ratios of 8-10 are also predicting a tripling of long-term rates, their forecasts of stock prices are inconsistent and unworthy of the slightest attention."

Along those lines, keep in mind that we are coming off a few quarters of very depressed corporate earnings. Given that low starting point and the massive stimulus injections that have been pumped into the world economy by the U.S., China, and other nations, we may be more likely to see lower P/E ratios because the "E" part of the equation rises than because the "P" goes into a nosedive. And a declining P/E resulting from short-term earnings increasing faster than stock prices seems like a fairly nice predicament for investors.

Of course, all of this isn't to say that the market isn't going to pull back a bit, or even a lot, after this recent surge. If you've read the Hot List for any amount of time, you're well aware that I don't try to predict what the market will do in the short term. The reason that I raise these points about valuation is to highlight the uncertainty of where the market will go in the coming months. For every short-term bearish argument that seems reasonable on the surface -- like the notion that P/Es must go lower -- there seem to be plenty of reasons why it might not be correct.

That short-term uncertainty is always present in the stock market. It's why the great mutual fund manager Peter Lynch -- one of the gurus who inspired my models -- once said that investing in stocks "with a one-year horizon or a two-year horizon, that's silly. That's just like betting on red or black at the casino."

Because no one knows for sure how the market will move from day to day, week to week, or month to month, I believe the best approach is one that comes back to value. And right now -- regardless of how stocks have performed in the past two months and how they will perform in the next few months -- I see a lot of long-term values in the market. And Warren Buffett, Kenneth Fisher, and other gurus I follow have recently expressed similar views. So while the pundits spend time continuing to debate whether or not the rally is for real, I'll keep picking up undervalued stocks of solid companies. In the end, I think the Hot List will reap the rewards.
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The Fallen

As we rebalance the Validea Hot List, 6 stocks leave our portfolio. These include: Ceradyne, Inc. (CRDN), Fossil, Inc. (FOSL), Kennametal Inc. (KMT), World Fuel Services Corporation (INT), Lincoln Electric Holdings, Inc. (LECO) and Oil States International, Inc. (OIS).

The Keepers

4 stocks remain in the portfolio. They are: Ameron International Corporation (AMN), Bj Services Company (BJS), Jos. A. Bank Clothiers, Inc. (JOSB) and Schnitzer Steel Industries, Inc. (SCHN).

The Newbies

We are adding 6 stocks to the portfolio. These include: The Dress Barn, Inc. (DBRN), Cintas Corporation (CTAS), Deckers Outdoor Corporation (DECK), Lufkin Industries, Inc. (LUFK), Netease.com, Inc. (Adr) (NTES) and Chevron Corporation (CVX).

Portfolio Changes

Newcomers to the Validea Hot List

Chevron Corporation (CVX): Like other energy firms, this San Ramon, Calif.-based oil and natural gas giant has been hit hard since commodity prices tumbled last summer. But its stock has bounced back strong since the March 9 low, and three of my Guru Strategies -- those I base on the writings of Peter Lynch, Kenneth Fisher, and James O'Shaughnessy -- think it has a lot more room to grow. Chevron, which does business in more than a hundred countries and has a market cap of more than $136.5 billion, also goes beyond the oil and gas arena. The firm has invested more than $2 billion in alternative and renewable energy technologies (including solar, geothermal, and hydrogen power) and energy efficiency services since 2002, and expects that figure to grow to more than $4.5 billion by 2009.

To find out why Chevron gets high ratings from my strategies, scroll down to the "Detailed Stock Analysis" section below.

Cintas Corporation (CTAS): Serving about 800,000 businesses, this Cincinnati-based firm is a leading supplier of corporate uniforms, and also provides a variety of ancillary business products and services. While some of its offerings are sensitive to economic shifts, others (restroom supplies, first aid products, flame-resistant clothing) come with steadier demand. The $3.7-billion-market-cap firm gets approval from both my Benjamin Graham- and James O'Shaughnessy-based strategies. To see why, check the "Detailed Stock Analysis" section below.

Deckers Outdoor Corporation (DECK): This footwear firm owns such popular brands as Ugg and Teva. The 36-year-old company is based in Goleta, Calif., and also operates in China, Macau and the U.K. It sells its products to domestic retailers and international distributors, and through its websites, catalogs and retail outlet stores. Deckers has a market cap of $655 million and has taken in more than $725 million in sales in the past 12 months.

Deckers gets approval from both my Peter Lynch- and Benjamin Graham-based models. Find out why in the "Detailed Stock Analysis" section below.

Lufkin Industries (LUFK): Based in Lufkin, Texas, Lufkin designs, engineers, manufactures, sells, installs and services oil field equipment and power transmission products for energy firms around the world.

Lufkin is a small cap, with a market cap of $577 million, but it has taken in more than $750 million in sales in the past year. It gets approval from my Benjamin Graham-, Peter Lynch-, and Kenneth Fisher-based models. To see why, check out the "Detailed Stock Analysis" section below.

The Dress Barn (DBRN): This New York state-based clothing retailer posted a 70% gain while in the Hot List from Jan. 23 through April 17. It's dipped close to 10% since the portfolio sold it, and my Peter Lynch-, Benjamin Graham-, and Kenneth Fisher-based models think that makes this $815 million small-cap a buy once again.

Dress Barn operates more than 800 stores in 46 states under the "dressbarn" name, as well as close to 700 more stores under the "maurices" name. It specializes in apparel for women age 35 to 55, and, while it's a small-cap, it has taken in almost $1.5 billion in sales over the past 12 months. To find out why my models like the stock, see the "Detailed Stock Analysis" section below.

NetEase.com, Inc. (NTES): Based in Beijing, NetEase is one of China's leading Internet and online gaming service providers. It has a market cap of almost $4 billion. The firm has increased earnings in seven straight years, and grew sales in every quarter of 2008.

NetEase's stock has been on fire this year. After declining for the first half of January, it started on a run that has taken it 80% higher, with much of the gains coming after it announced excellent first-quarter earnings in late February. My Momentum Investor strategy thinks it can keep it up. To see why, scroll down to the "Detailed Stock Analysis" section below.

News about Validea Hot List Stocks

Chevron Corp. (CVX): On May 1, Chevron announced first-quarter net income of $1.84 billion, or 92 cents per share, down from $5.17 billion, or $2.48 per share, in the year-ago quarter due largely to the lower price of oil, the Associated Press reported. Total revenue fell 45 percent to $36.1 billion. Worldwide production rose about 2 percent from a year ago, however, in part because of the 2008 startup of deepwater projects in Nigeria and the U.S. Gulf of Mexico, AP stated. Chevron expects to up production by 4 percent this year as it develops new projects, according to AP.

Lufkin Industries (LUFK): On May 7, Lufkin declared a second quarter cash dividend of $0.25 per share on its common stock. The dividend, equal to that paid in each of the past five quarters, will be paid on June 10, to shareholders of record on June 1.

The Next Issue

In two weeks, we will publish another issue of the Hot List, at which time we will take a closer look at the Guru Strategy I base on the approach of the great Warren Buffett. 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

JOSB   |   SCHN   |   AMN   |   DECK   |   BJS   |   LUFK   |   DBRN   |   NTES   |   CTAS   |   CVX   |  

Jos. A. Bank Clothiers, Inc. (Jos. A. Bank) is a designer, retailer and direct marketer (through stores, catalog and Internet) of men's tailored and casual clothing and accessories. It sells all of its products exclusively under the Jos. A. Bank label through its 460 retail stores (as of January 31, 2009, which includes seven outlet stores and 12 franchise stores) located throughout 42 states and the District of Columbia in the United States, as well as through the Company's nationwide catalog and Internet (www.josbank.com) operations. Its products are targeted at the male career professional and emphasize the Jos. A. Bank brand of tailored and casual clothing and accessories. The Company's products, which range from the original Jos. A. Bank Executive collection to the more luxurious Jos. A. Bank Signature collection to the exclusive Jos. A. Bank Signature Gold collection. Jos. A. Bank operates through two segments: Stores and Direct Marketing.

Schnitzer Steel Industries, Inc. is a recycler of ferrous and non-ferrous metals. The Company is a recycler of used and salvaged vehicles, and a manufacturer of finished steel products. The Company provides an end of life cycle solution for a variety of products through its vertically integrated businesses, including sale of used auto parts, procuring autobodies and other metal products and manufacturing them into finished steel products. It operates in three business segments: the Metals Recycling Business (MRB), the Auto Parts Business (APB) and the Steel Manufacturing Business (SMB). In September 2007, the Company acquired a mobile metals recycling business that provides additional sources of scrap metal to the Everett, Massachusetts facility. In February 2008, it acquired the remaining 50% equity interest in Pick-N-Pull Auto Dismantlers, LLC Nevada. In August 2008, the Company acquired a self-service used auto parts business with three locations in the Southern United States.

Ameron International Corporation (Ameron) is a multinational manufacturer of engineered products and materials for the chemical, industrial, energy, transportation and infrastructure markets. It has three segments: Fiberglass-Composite Pipe Group, Water Transmission Group and Infrastructure Products Group. The Fiberglass-Composite Pipe Group manufactures and markets filament-wound and molded fiberglass pipe, tubing, fittings and well screens.The Water Transmission Group manufactures and supplies concrete and steel pressure pipe, concrete non-pressure pipe, protective linings for pipe and fabricated steel products, such as large-diameter wind towers. The Infrastructure Products Group consists of two operating segments, which are aggregated: the Hawaii Division and the Pole Products Division. In October 2007, Ameron acquired the business of Polyplaster, Ltda., a Brazilian fiberglass-pipe operation.

Deckers Outdoor Corporation is engaged in designing, producing and managing footwear and the category creator in the sport sandal, luxury sheepskin, and footwear segments. The Company sell the products, including accessories, such as handbags, headwear, packs and outerwear, through domestic retailers and international distributors and directly to the consumers, both domestically and internationally, through Websites, call centers, retail concept stores and retail outlet stores. The Company markets its products under four brands: UGG, Teva, Simple and TSUBO. Teva is the Company's brand of the sport sandal market of product line, such as casual open-toe and closed-toe footwear, adventure travel shoes, outdoor cross training shoes, trail running shoes, amphibious footwear, light hikers, and other rugged outdoor footwear styles and accessories. UGG is the brand and the category creator for luxury sheepskin footwear. The Simple brand comprises sustainable footwear and accessories.

BJ Services Company is a provider of pressure pumping and oilfield services for the petroleum industry. Pressure pumping services consist of cementing and stimulation services used in the completion of new oil and natural gas wells and in remedial work on existing wells, both onshore and offshore. Oilfield services include casing and tubular services; precommissioning, maintenance and turnaround services in the pipeline and process business, including pipeline inspection; chemical services; completion tools, and completion fluids. The Company conducts its operations through four segments: U.S./Mexico Pressure Pumping Services; Canada Pressure Pumping Services; International Pressure Pumping Services, and Oilfield Services Group. On May 21, 2008, the Company acquired Innicor Subsurface Technologies Inc.

Lufkin Industries, Inc., is a supplier of oil field and power transmission products. The Company is divided into two operating segments: Oil Field and Power Transmission. Through its Oil Field segment, the Company manufactures and services artificial reciprocating rod lift equipment and related products, which are used to extract crude oil and other fluids from wells. Through its Power Transmission segment, the Company manufactures and services high-speed and low-speed increasing and reducing gearboxes for industrial applications. In January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfil contractual obligations and close all trailer facilities. In March 2009, the Company acquired International Lift Systems, LLC (ILS), a manufacturer of artificial lift systems serving oil and gas companies.

The Dress Barn, Inc. operates women's apparel specialty stores, principally under the names dressbarn, dressbarn woman and maurices. As of July 26, 2008, the Company operated 1,503 stores in 48 states and the District of Columbia, including 656 dressbarn Combo stores (a combination of its dressbarn and dressbarn woman brands), 677 maurices stores, 134 dressbarn stores and 36 dressbarn woman stores. Its dressbarn stores are typically operated as Combo stores, offering both dressbarn and larger-sized dressbarn woman merchandise. The Dress Barn, Inc. also operates stand-alone dressbarn and dressbarn woman stores in certain markets. Its dressbarn brands cater to 35 to 55 year-old women, sizes 4 to 24. The dressbarn stores offer in-season and casual fashion located primarily in convenient strip shopping centers in major trading and markets and surrounding suburban areas. As of July 26, 2008, the Company operated 1,503 stores in 48 states.

NetEase.com, Inc. operates an interactive online community in China, and is a provider of Chinese language content and services through its online games, Internet portal and wireless value-added services businesses. The Company generates revenues from fees it charge users of its online games and from selling advertisements on the NetEase Websites, and to a much lesser extent, of wireless value-added and other fee-based services. The Company's basic service offerings on the NetEase Websites are available without charge to its users.

Cintas Corporation (Cintas) provides specialized products and services to businesses of all types throughout the United States and Canada. The products and services provided by Cintas include uniforms and apparel, mats, mops and towels, restroom and hygiene service, first aid, safety, fire protection, branded promotional products, document shredding and storage, cleanroom resources and flame resistant clothing. The Company operates in four operating segments: Rental Uniforms and Ancillary Products, Uniform Direct Sales, First Aid, Safety and Fire Protection Services and Document Management Services.

Chevron Corporation (Chevron) manages its investments in subsidiaries and affiliates, and provides administrative, financial, management and technology support to the United States and International subsidiaries that engage in fully integrated petroleum operations, chemicals operations, mining operations of coal and other minerals, power generation and energy services. Exploration and production (upstream) operations consist of exploring for, developing and producing crude oil and natural gas, and also marketing natural gas. Refining, marketing and transportation (downstream) operations relate to refining crude oil into finished petroleum products; marketing crude oil and the many products derived from petroleum, and transporting crude oil, natural gas and petroleum products by pipeline, marine vessel, motor equipment and rail car. In April 2009, Reliance Industries Limited bought back Chevron Corporation's 5% stake in Reliance Petroleum Limited.

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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